The influential Third Circuit Court of Appeals in Solow v. PPI Enterprises (U.S.) Inc., et al. (In re PPI Enterprises (U.S.) Inc., Docket No. 01-4140, March 28, 2003 (Scirica, J.) recently decided a case with potential for significant impact on commercial landlords. The chief holding states that landlords holding rejection claims reduced by operation of Bankruptcy Code Section 502(b)(6) are not impaired for purposes of entitlement to vote on a plan of reorganization. The court also called into question the increasingly common practice of using letters of credit in lieu of cash security deposits as a means of enhancing landlord claims. Additionally, the court rejected the contention that a case filed for the chief (if not the sole) purpose of reducing a landlord rejection claim is necessarily in bad faith.
The Bankruptcy Code (11 U.S.C. 101 et seq.), under Section 365 grants a trustee the right to reject a commercial real property lease. Section 502(b)(6) limits the amount that a landlord can recover on account of such a rejection to "[t]he 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," and "[a]ny unpaid rent due under such lease, without acceleration …” The cap imposed by Section 502(b)(6) is viewed as an absolute “limit based on fairness.” 4 Collier on Bankruptcy, Sec. 502.03 at 7a (Alan N. Resnick and Henry J. Sommer, eds., 15th ed. 2002). Thus even in a solvent estate, a landlord claim is subject to the 502(b)(6) cap. In re Federated Department Stores, 131 B.R. 807, 818 (S.D. Ohio 1991).
In a chapter 11 case, Section 1124 of the Bankruptcy Code presumptively permits holders of claims, including landlords holding rejection claims, to vote to accept or reject confirmation of a plan of reorganization. However, only those creditors whose claims are “impaired” by a plan have the right to vote. Under Section 1124(a), a claim is “impaired” if the plan alters the “legal, equitable and contractual rights to which such claim ... entitles the holder of such claim…” The debtor has the burden of demonstrating the lack of impairment.
The landlord, a Manhattan office tower owner (who by the way fared handsomely in recoveries on his other claims), argued that the broad definition of claim under the Bankruptcy Code required a finding of impairment whether caused by the plan or by a statute the cap under Section 502(b)(6) resulted in “impairment” of his rights under state law, thereby entitling him to vote against confirmation of the plan. Citing the Bankruptcy Court’s distinction between “statutory impairment” which may limit the amount to which a creditor might otherwise be due under non-bankruptcy law and “plan impairment,” under which a plan alters the legal rights associated with a claim (In re PPI Enterprises (U.S.) Inc., 222 B.R. 339, 353 (Bankr. D. Delaware 1998 (Walsh, J.)), the court observed that Section 1124 does not reference non-bankruptcy law, and concluded that the appropriate barometer for measurement is “whether the plan itself is the source of limitation of a creditor’s legal, equitable or contractual rights.” Otherwise every claim capped pursuant to Section 502(b)(6) would be entitled to vote, thus rendering that section “a nullity.” The court thereby concluded that a landlord’s claim capped pursuant to Section 502(b)(6) is not impaired and affirmed the bankruptcy court’s finding that the landlord was deemed to have accepted the plan.
In addition, the Court upheld the finding that the landlord’s 502(b)(6) claim was properly reduced by the amounts drawn on a letter of credit in lieu of a security deposit. Generally, a landlord must apply a security deposit received from the debtor after reduction of its claim under Section 502(b)(6). See In re Handy Andy Home Improvement Centers, Inc., 222 B.R. 571, 574 (Bankr. N.D. Ill. 1998); In re All For A Dollar, 191 B.R. 262, 264 (Bankr. D. Mass. 1996); In re Blatstein, 1997 U.S. Dist. LEXIS 13376 (E.D. Pa. August 26 1997). Many landlords have resorted to the use of letters of credit to avoid this requirement. The argument is that, because under the “independence principle” a letter of credit represents a third party obligation, namely an the obligation of issuer to the beneficiary, (see Willis v. Cellotex Corp. 978 F. 2d 146, 148 (4th Cir. 1992) cert denied, 507 U.S. 1030 (1993)), the estate should not be entitled to the benefit of the landlord’s contractual rights under a letter of credit. This proposition has been sustained in other courts. See Musika v. Arbutis Shopping Center L.P. (In re Farm Fresh Supermarkets of Maryland Inc.), 257 B.R. 770, 772 (Bankr. D. Md. 2001). The Third Circuit nevertheless ruled, without expressly deciding the issue, that, because the lease specifically required the provision of a letter of credit in lieu of a cash security deposit, and expressly required the debtor to replenish security in the event of a draw, the parties intended the letter of credit to function as a security deposit. Accordingly, the proceeds of the letter of credit would be treated as such and applied to the landlord’s claim after application of 502(b)(6).
Finally, the court upheld the finding that the case, the primary purpose of which was to cap the landlord’s claim under Section 502(b)(6), was not filed in “bad faith.” Cases not filed in good faith may be dismissed for “cause” under Section 1112(b), and under Section 1129(a)(3) plans must be proposed in good faith and “not by any means forbidden by law.” The inquiry is typically a factual one and subject to review only for abuse of discretion. Given the bankruptcy court’s finding that the primary purpose of the case was indeed to avail itself of Section 502(b)(6), a purpose expressly contemplated by the Bankruptcy Code, the Third Circuit found no abuse of discretion in its rejection of the landlord’s motion for dismissal and bad faith objection to the plan.
The Third Circuit holding, which establishes precedent (at least as to the voting issue) in the key district of Delaware, and will be persuasive authority elsewhere, grants debtors additional flexibility and authority to formulate and confirm plans which might otherwise be thwarted by landlord objections. The case also signals that the practice of using letters of credit in lieu of cash security deposits to avoid further reduction of rejection claims may lose efficacy. Additionally, the court recognized the legitimacy of the use of Bankruptcy for purposes of reducing landlord damage claims, even where no business reorganization or purpose other than liquidation is intended.