A recent ruling by the U.S. Court of Appeals for the Fifth Circuit has breathed new life into the use of letters of credit as security devices for commercial real property leases held in bankruptcy. EOP—Colonnade of Dallas LP v. Faulkner (In re Stonebridge Technologies, Inc.), 430 F.3d 260 (5th Cir. 2005) provides landlords with an expanded remedy following several recent rulings limiting access to letters of credit funding.
Bicoastal decisions issued by the U.S. Courts of Appeal for the Third and Ninth Circuits have limited the amount a landlord may collect under a letter of credit issued in its favor as security for a bankrupt party’s lease obligations to the amount the landlord was permitted to collect as an allowed bankruptcy claim under Bankruptcy Code §502(b)(6).
Section 502(b)(6) limits a landlord’s bankruptcy claim to (a) unpaid prepetition rent plus (b) the greater of one year’s rent under the lease or 15 percent (but not to exceed three years) of the rent for the remaining term of the lease. The time periods are calculated from the earlier of the petition date or the date the bankrupt party surrender the premises, and the claim is reduced by mitigation the landlord should have received from re-letting or actually does receive from administrative rent paid by the debtor during the bankruptcy case.
Letter of Credit Limits
In Solow v. PPI Enterprises, Inc. (In re PPI Enterprises, Inc.), 324 F.3d 197 (3d Cir. 2003) and AMB Property, LP v. Official Creditors Committee for the Estate of AB Liquidating Corp., 416 F.3d 961 (9th Cir. 2005) the appeals courts held that the amount a landlord collects from the issuer of the letter of credit was applied to the landlord’s claim as limited under § 502(b)(6). In effect, the courts agreed that the letters of credit amounted to security deposits.
Inferentially under these holdings, any excess of the amount of the letter of credit over the § 502(b)(6) limited claim could not be drawn by the landlord.
However, EOP—Colonnade provides landlords with a possible out. In this case, the landlord, EOP, had a long-term lease with Stonebridge and held a security deposit consisting in part of a $1.4 million letter of credit. The lease was rejected, and EOP drew down on the letter of credit which was insufficient to fully satisfy the unpaid rent remaining due under the long-term lease, but exceeded the § 502(b)(6) capped claim.
Although the debtor had agreed to the draw down, the liquidating trustee creatively made an agreement with the bank issuing the letter of credit to acquire for the bankruptcy estate any claim the bank had against EOP for drawing more under the letter of credit than allowed under §502(b)(6). The trustee relied on PPI Enterprises and a similar Ninth Circuit case, Redback Networks, Inv. v. Mayan Networks Corp. (In re Mayan Networks Corp.), 306 B.R. 295 (9th Cir. 2004), to argue that EOP’s letter of credit draw was too large. The trustee took the position that the letter of credit should be treated just like a cash security deposit, and the amount that could be used to satisfy the landlord’s claim was limited by the § 502(b)(6) cap.
Both the bankruptcy court and the district court held that the draw was too large, but the Fifth Circuit reversed. The appeals court reasoned that the § 502(b)(6) limitation applied only to a claim made by the landlord against the bankruptcy estate. If the landlord makes no claim—and EOP did not make one against the Stonebridge Technologies bankruptcy case—the letter of credit situation is outside the purview of the bankruptcy and the § 502(b)(6) limitation. The corollary is that the full amount of the letter of credit (up to its stated limit) is available to satisfy the landlord’s breach of lease claim.
If EOP—Colonnade generally is accepted, landlords with bankrupt tenants have the potential to obtain larger recovery by forgoing filing a proof of claim against the bankruptcy estate. The judgment as to whether to file a claim will require careful consideration of the facts, and the likely outcome of the bankruptcy reorganization or liquidation. The common wisdom of prior years—that the ultimate recovery to a landlord would be the sum of the draw under the letter of credit plus whatever dividend was paid by the bankruptcy estate—no longer applies.
This article is presented for informational purposes only and is not intended to constitute legal advice.
