Landlords Use Letters of Credit to Bypass the Claim Cap of 502(b)(6)

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Jun 1998

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andlord clients often ask how they can avoid the cap on their lease rejection damage
claims imposed by §502(b)(6) of the Bankruptcy Code. Section 502(b)(6)
provides that the claim of a landlord against a debtor-tenant for future damages
resulting from a rejected lease is capped at "the rent reserved by such lease, without
acceleration, for the greater of one year, or 15 percent, not to exceed three
years, of the remaining term of such lease" following the earlier of the bankruptcy
filing date and the date the tenant surrendered the premises. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§502(b)(6) (2001)</a> (the "claim cap").<a href="#1" name="1a">1</a> The landlord's claim for damages
is treated as a general pre-petition unsecured claim. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §502(g)</a>.

A security deposit does not avoid the claim cap. It is well-settled law that a
security deposit held by a landlord with respect to a lease rejected by the tenant must
be applied against the claim as capped pursuant to §502(b)(6).<a href="#2" name="2a">2</a> Any excess
security deposit must be returned to the debtor-tenant. This principle was first
announced in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Tonto Realty Corp., 143 F.2d 916 (2d Cir.
1944)</a> (decided under the predecessor to §502(b)(6)). The legislative history
of §502(b)(6) makes it clear that the claim is first capped and then reduced
to the extent of the security deposit. The House and Senate Reports state that the
landlord is not "permitted to offset his actual damages against his security deposit and
then claim for the balance under [§502(b)(6)]. Rather, his security deposit will
be applied in satisfaction of the claim that is allowed under [§502(b)(6)]."
H.R. Rep. No. 595 (1977); S. Rep. No. 989 (1978), reprinted
in U.S.C.C.A.N. 5963, 5787. Recent case law affirms the Oldden
principle. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re All for a Dollar Inc., 191 B.R. 262
(Bankr. D. Mass. 1996)</a>; In re Blatstein, 1997 U.S. Dist. LEXIS
13376 (E.D. Pa. Aug. 26, 1997).

However, landlords have increasingly turned to requiring their tenants to provide
letters of credit to secure their leasehold obligations. The question has thus arisen:
Can a landlord effectively avoid the claim cap of §502(b)(6) through a letter
of credit?

<h3>The Independence Principle</h3>

Unlike a security deposit, a letter of credit and its proceeds do not constitute
property of the debtor's estate. Under the well-established "independence principle,"
a letter of credit and its proceeds are property of the issuing bank paid on account
of its independent obligation to the beneficiary of the letter of credit. See, e.g.,
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Celotex Corp., 978 F.2d 146, 148 (4th Cir. 1992),
cert. denied, 507 U.S. 1030 (1993)</a> (holding that a letter of credit is
not property of the debtor's estate); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Blue Quail Energy Inc. (In re
Compton Corp.), 831 F.2d 586, 589-90 (5th Cir. 1987)</a> (holding
that the automatic stay does not prohibit a lender from drawing upon a letter of credit
following the borrower's bankruptcy because the lender is receiving property of the issuer,
not property of the debtor's estate, and that "the independence principle [is] the
cornerstone of letter of credit law"); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sabratek Corp., 257 B.R. 732,
735 (Bankr. D. Del. 2000)</a> (holding that the proceeds of a letter of
credit could not be recovered in the bankruptcy case because neither the letter of credit
nor its proceeds were property of the estate); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Green, 210 B.R. 556,
559 (Bankr. N.D. Ill. 1997)</a> ("A letter of credit is an independent
obligation, and neither the letter of credit nor its proceeds are debtor's property even
if the letter of credit is secured by the debtor's property."); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Labs. v.
Sec. Pac. Nat'l. Trust Co. (In re Zenith Labs. Inc.), 104 B.R. 667,
671 (Bankr. D. N.J. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Cont'l. Ill. Nat'l. Bank

& Trust Co. of Chi. (In re Ill.-Cal. Express Inc.), 50 B.R.
232, 235 (Bankr. D. Colo. 1985)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc. v. Fairchild Aircraft
Corp. (In re Planes Inc.), 29 B.R. 370, 371 (Bankr. N.D. Ga.
1983)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. First Nat'l. Bank of Md. (In re Page), 18 B.R.
713, 716 (D. D.C. 1982)</a>; see, also, Stillman, James R., et al.,
"When the Tenant Goes Out of Business: The Letter of Credit Arranger's Reimbursement
and Security Agreement," SF40 ALI-ABA 573, 581 (2001) (stating that
"[t]he letter of credit is meant to be a perfect non-debtor source of repayment, truly
independent from the bankruptcy estate"); 5 Collier's on Bankruptcy ¶549.04[1]
(15th ed. rev. 1999) ("Property of the estate also does not include the
proceeds of a letter of credit paid to a creditor of the debtor who is a beneficiary
of the letter").

In addition, even though §105 of the Bankruptcy Code<a href="#3" name="3a">3</a> arguably gives
bankruptcy courts the power to enjoin draws pursuant to letters of credit, bankruptcy
courts have generally refused to do so because they do not wish to disturb the
"independence principle." See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc. v. Concept Design Elecs.
& Mfg. Inc. (In re Duplitronics Inc.), 183 B.R. 1010, 1017-18
(Bankr. N.D. Ill. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Brule Constr. Co. v. Sheesley's
Plumbing & Heating Co., 84 B.R. 638, 645 (D. S.D. 1988)</a>.
However, some courts have enjoined payments under letters of credit under "unusual
circumstances." See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Investment Co. v. Great American Bank,

131 B.R. 146 (D. Ariz. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Delaware River Stevedores
Inc., 129 B.R. 38 (Bankr. E.D. Pa. 1991)</a>.

The net result is that while a landlord would have to disgorge the amount of a
security deposit in excess of the claim cap, the landlord arguably should not have
to disgorge what the landlord receives under a letter of credit. If neither the
letter of credit nor its proceeds are property of the estate, then §502(b)(6)
may not be applicable. Section 502(b)(6) acts to limit the amount of an allowed
claim by a landlord against the debtor's estate and not against a third party's
estate.

<h3>The Cases Are in Disagreement</h3>

Notwithstanding the independence principle, the cases are in disagreement. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re PPI Enterprises (U.S.) Inc., 228 B.R. 339 (Bankr. D. Del.
1998)</a>, the landlord, Solow, had a letter of credit for $650,000. Solow
subsequently drew down the letter of credit for the entire $650,000 after the
tenant-debtor terminated the lease. The court held that the letter of credit was a
"security deposit." Therefore, under §502(b)(6), the proceeds of the letter of
credit were to be applied in satisfaction of the claim cap. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 350</a>.

However, in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Arbutus Shopping Center Limited Partnership (In re Farm
Fresh Supermarkets of Maryland Inc.), 257 B.R. 770 (Bankr. D. Md.
2001)</a>, the court ruled differently. The landlord, Arbutus, leased property to
Farm Fresh, the tenant. A standby letter of credit was posted for the benefit of
Arbutus in the amount of $38,000. Upon Farm Fresh's subsequent bankruptcy and
default under the lease, Arbutus drew down the entire $38,000. The trustee
sought to recover the $38,000 as a violation of the claim cap under
§502(b)(6). The court held that "neither the letter of credit nor its proceeds
were property of the debtor's estate, and therefore the trustee may not maintain the
instant lawsuit to recover them." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 772</a>. The landlord was able to retain
the proceeds of the letter of credit despite the fact that the proceeds exceeded the
claim cap of §502(b)(6).

Recently, in an unpublished case, the U.S. Bankruptcy Court for the District
of Delaware granted summary judgment for a landlord. In Darwin Networks Inc. v.
NPE Assets Management L.P. (In re Darwin Networks Inc.) (Case Nos.
01-0095 and 01-0096, Adversary Proceeding No. A01-4601), the
debtor, Darwin Networks Inc., delivered a letter of credit in the amount of
$275,000 to the lessor, NPE Assets Management L.P. NPE drew the entire
$275,000 after Darwin filed for bankruptcy. Thereafter, Darwin filed a motion
to reject the lease. Under the claim cap of §502(b)(6), the maximum allowable
claim for rent was $146,684.04. Darwin filed a motion requesting turnover
of the amount of the $275,000 letter of credit draw exceeding the
$146,684.04. However, the judge granted summary judgment for NPE, resting
its holding on the "independence principle." Section 502(b)(6) was deemed
inapplicable to letters of credit, and NPE did not have to disgorge any of the
proceeds of the letter of credit.

These cases are analogous to cases holding that non-debtor guarantors cannot assert
the claim cap to avoid liability for damages arising out of the debtor-tenant's lease
rejection. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Modern Textile Inc., 900 F.2d 1184,
1191 (8th Cir. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Assocs. L.P. v. Clark, 83 B.R.
357, 358 (D. Md. 1988)</a>.

<h3>Conclusion</h3>

Landlords have nothing to lose and much to gain by seeking letters of credit from
their tenants rather than a cash security deposit to protect themselves in the event
their tenants file for bankruptcy and reject a lease. Although there is plenty of
case law and legislative history holding that the amount of a security deposit in
excess of the claim cap must be disgorged, the same rule does not necessarily apply
to letters of credit. Although the courts are split on the issue of whether a
landlord should be able to draw on a letter of credit to its fullest extent regardless
of the claim cap under §502(b)(6), some courts have ruled in the landlord's
favor on this issue, allowing them to move to the front of the line.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> All statutory references are to the <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Code, 11 U.S.C. §101</a> et seq., except as otherwise noted. <a href="#1a">Return to article</a>

<a name="2">2</a> This is separate from any state law provision that may limit the application of a security deposit when a lease is surrendered to
the lessor. For example, see <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Civil Code §1950.7(c)</a>, which limits the security deposit to those damages incurred retroactive
to the surrender of the premises and does not allow for offset against any "prospective" damages. <a href="#2a">Return to article</a>

<a name="3">3</a> Section 105 of the Bankruptcy Code states that the bankruptcy court "may issue any order, process or judgment that is necessary
or appropriate to carry out the provisions of this <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 11 U.S.C. §105(a)</a>. <a href="#3a">Return to article</a>

Journal Authors

Geoffrey L. Berman

Peter M. Gilhuly

Shira R. Isenberg

Journal Date

Monday, June 1, 1998 - 12:00