Reviewing Letters Of Credit As Security For Leases In Bankruptcy: Do You Receive What You Expect?

Under section 502(b)(6) of the United States Bankruptcy Code, a landlord's claim for damages under a lease rejected during the bankruptcy proceeding is capped at the greater of rent reserved under the lease for (a) one year; or (b) 15% or the remaining lease term, not to exceed three years. Under that calculation, a lease with a remaining term of 81 months or more would be entitled to claim greater than one year's rent.

In lieu of a cash security deposit, landlords frequently require the posting of a letter of credit. In most cases, the issuing bank will enter into a reimbursement agreement with the debtor procuring the letter of credit, pursuant to which the debtor promises to reimburse the issuing bank for the amount of any draws thereunder. Often, collateral is provided by the debtor to secure the reimbursement obligation.

It is well established that a cash security deposit will be applied to the capped claim. However, the law is uncertain regarding the proceeds of a letter of credit. If there is a draw under a letter of credit posted as security for a lease, are the proceeds applied to the "capped" claim, thereby reducing the amount that the landlord can recover from the bankruptcy estate, or instead can the proceeds be applied to the claim in excess of the cap, so the landlord can take the letter of credit proceeds and still assert the full capped claim in the bankruptcy case?

Three Circuit Courts of Appeal have addressed this issue. In Solow v. PPI Enterprises (U.S.), Inc. (In re PPI Enterprises (U.S.), Inc.), 324 F.3d 197 (3d Cir. 2003), a landlord asserted that the proceeds of an unsecured letter of credit should be applied to the claim in excess of the cap. Because the lease provided by its terms that the letter of credit could be provided in lieu of a cash security deposit, the court affirmed the bankruptcy court's determination that the letter of credit proceeds were in the nature of a security deposit and should be applied to the capped portion of the claim.

The Ninth Circuit Bankruptcy Appellate Panel in Redback Networks, Inc. v. Mayan Networks Corp. (In re Mayan Networks Corp.), 306 B.R. 295 (B.A.P. 9th Cir. 2004) held that a draw under a letter of credit which the debtor collateralized had the same effect upon the bankruptcy estate as the application of a cash security deposit on the debtor's estate and required the proceeds to be applied to the capped claim amount. In AMB Property, L.P. v. Official Creditors ex rel. AB...