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...