Beware a False Sense of Security Why Banks Should Think Twice Before Insuring Performance of Real Estate Leases

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Dec/Jan 2004

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Each year, banks insure
performance of large numbers of commercial real estate leases through
letters of credit. Such letters of credit run in favor of landlords, are
backed by reimbursement agreements executed by tenants and are
collateralized by tenants' cash collateral. Annual fees equal to 2
percent or more of the face amount of such letters are charged by issuing
banks.

Should a tenant default on a lease supported by a
letter of credit, demand is made by the landlord on the issuing bank. The
bank first pays the landlord and then reimburses itself from the
tenant's cash collateral. Despite the apparently problem-free nature
of this arrangement, however, there are substantial risks attendant on a
bank's issuing a letter of credit insuring a tenant's
performance under a commercial real estate lease. These risks are endemic
to real estate leasing and its disfavored treatment under §502(b)(6)
of the Bankruptcy Code.<a href="#1" name="1a">1</a>

The bankruptcy courts have treated
§502(b)(6)'s limitations on landlords' rights in varying
ways where letters of credit are involved.<a href="#2" name="2a">2</a> Significantly, the concurring
opinion in Redback Networks Inc. v. Mayan
Networks Corp. (In re Mayan Networks Corp.), 306
B.R. 295 (9th Cir BAP 2004), took dead aim at the cash collateral banks
receive in support of letters of credit issued at debtor-tenants'
request.

In Mayan, a debtor-tenant posted a letter of credit to insure
performance of a pre-bankruptcy lease. Following bankruptcy, the landlord
drew on the letter of credit. A dispute then arose over the proper amount
of the landlord's unsecured claim, with the debtor-tenant maintaining
that the landlord's unsecured claim—already limited to one
year's rent under §502(b)(6)—was further subject to
reduction to the extent the landlord had previously drawn under the letter
of credit.

Consistent with both PPI and Stonebridge, the Mayan majority held the letter of credit equivalent to a cash security
deposit and, relying on the oft-cited decision of Oldden v. Tonto Realty Corp., 143
F.2d 916 (2nd Cir. 1944) (holding that proceeds from traditional cash
security deposit reduced the unsecured claim allowed under §63(a)(9)
of the former Bankruptcy Act), held that the unsecured claim allowed under
§502(b)(6) must be reduced by the amount of the landlord's
letter of credit draw. The majority opinion in Mayan is noteworthy only for its suggestion that, had the letter
of credit in question not been secured by the debtor-tenant's
property, no offset against the landlord's unsecured claim would have
been appropriate under §502(b)(6) (See
Mayan, at 300-301).

Mayan's concurring opinion is by Bankruptcy Judge Christopher Klein and is
premised on what he describes as the holistic relationships among, inter alia, §§502(b)(6), 502(e), 524(e), 542 and 553(a). (See Mayan at 304, citing United Savings Ass'n. v. Timbers of Inwood Forest
Assocs. Ltd., 484 U.S. 365 (1988); 310.

Judge Klein's analysis starts with the
proposition that §502(b)(6) cannot be read as an absolute bar to
landlords obtaining sums in excess of §502(b)(6) limits because
§524(e) clearly contemplates full landlord recourse against non-debtor
guarantors, even where this results in the landlord recovering sums well in
excess of what is contemplated by §502(b)(6). Mayan at 306-307.

Rather, in the court's view, §502(b)(6)
does not restrict landlords' remedies at all. What it does instead is
cap debtor-tenants' liabilities. The distinction is best illustrated
where, pre-petition, a debtor-tenant has hypothecated §541(a) property
of the estate to a bank to collateralize a letter of credit issued to
insure lease performance for a period in excess of that allowed under
§502(b)(6). While Stonebridge ordered the landlord to make a refund to the
debtor-tenant in such case, that is not the result favored by Judge Klein.
Thus:

[T]he common assumption that letters of credit and
other forms of guaranty or credit enhancements are devices by which the
§§502(b)(6)-(7) caps can be circumvented is incorrect. Although
landlords unquestionably get more out of their credit enhancements, the
estate is never liable for more than the amount of the statutory cap.

While it is true that one of the three contracts
entailed in a letter of credit transaction is the reimbursement contract
between the applicant (person obtaining letter of credit) and the issuer
providing for reimbursement of the issuer for draws by the beneficiary on
the letter of credit, that reimbursement contract right is treated in
bankruptcy like any other co-obligation and leaves the issuer of the
letter of credit subrogated to the rights of the beneficiary against the
estate. Once the allowable claim (up to the §502(b)(6) cap) is paid in
full, then all other claims, including the issuer's claim against the
estate on the reimbursement contract, are disallowed. To the extent the
issuer holds collateral that is property of the estate and that is not
eligible for offset under §553(a) because the claim is
"disallowed" under §502 (which does not distinguish
between secured and unsecured claims), the collateral has to be turned over
to the estate under §542.
</blockquote>

Mayan at 310.

As of this writing, Mayan—which was decided on Feb. 5, 2004—has not been
cited by any subsequent case on any basis and has been the subject of only
a single commentator's note.<a href="#3" name="3a">3</a>

<h4>Conclusion</h4>

Among debtor-tenant-applicants, creditor-landlords
and banks issuing letters of credit to guarantee the performance of leases
by debtor-tenant-applicants, bankruptcy is a zero-sum game. It used to be
that, to the extent they could be bargained for pre-petition, letters of
credit put the ultimate loss on debtor-tenant-applicants despite
§502(b)(6); no longer. Today, the ultimate fall guys are issuing
banks, which foolishly think their security is always foolproof in
bankruptcy. If Mayan is followed, then any security received by issuing banks for
letters of credit in excess of the §502(b)(6) cap is illusory, and the
issuing banks are at the mercy of their debtor-tenant-applicants. Banks
should modify their letter-of-credit practices accordingly, either by
charging more for the risk of guaranteeing performance of real estate
leases or, possibly, by avoiding issuing letters of credit for such
purposes altogether.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> 11 U.S.C.
§502(b)(6). All further statutory references are to the Bankruptcy
Code (11 U.S.C. §§101 et seq.). <a href="#1a">Return to article</a>

<a name="2">2</a> See Solow v. PPI Enters. (U.S.) (In re PPI Enters. (U.S.), 324 F.3d 197 (3rd Cir. 2003) (applying limitations of
§502(b)(6) to letter of credit issued by bank in landlord's
favor at tenant's request); see, also,
Faulkner v. EOP-Colonnade of Dallas LP (In re Stonebridge Techs. Inc.), 291 B.R. 63 (Bankr. N.D. Tex. 2003) (same holding, but
requiring refund by landlord to debtor-tenant of excess over limitations of
§502(b)(6) received by landlord from bank); but see Musika v. Arbutus Shopping Ctr. Ltd. P'ship. (In re
Farm Fresh Supermarkets of Md. Inc.), 257
B.R. 770 (Bankr. D. Md. 2001) (letter of credit proceeds not §541(a)
property of bankruptcy estate and are not recoverable by bankruptcy
trustee). <a href="#2a">Return to article</a>

<a name="3">3</a> See Shelby and McFadden, "Reader Alert: In re Mayan Networks
Corp.—Letter of Credit Draw Effect on an
Allowed Claim Under 11 U.S.C. §502(b)(6)," California Real Property Journal
(Summer 2004) Vol. 22, No. 3 (noting, inter
alia, Judge Klein's concurring decision
and its conclusion that "the bank issuing the L-C will be forced to
disgorge the excess collateral (i.e., amounts [of security] held in excess of the [Section] 502(b)(6) cap) held against the L-C")). <a href="#3a">Return to article</a>

Journal Authors

William McGrane

Journal Date

Wednesday, December 1, 2004 - 12:00

Bankruptcy Rule

2004