Joshua E. Luber, Letters of Credit and 11 U.s.c. Sec. 502(b)(6): the Full Analysiswhy the Fifth Circuit's Decision in in Re Stonebridge Is Only Part of the Answer

• Publication year: 2011

LETTERS OF CREDIT AND 11 U.S.C. Sec. 502(b)(6): THE FULL ANALYSIS

WHY THE FIFTH CIRCUIT'S DECISION IN IN RE STONEBRIDGE IS ONLY PART OF THE ANSWER

INTRODUCTION

When a tenant holding a long-term leasehold on commercial real property files under the U.S. Bankruptcy Code ("Bankruptcy Code"), it creates significant financial and legal issues for the landlord, the estate of the debtor, and the other creditors of the estate. Assuming the bankruptcy filing results in a breach of a lease,¹the landlord is left holding a claim against the estate in an amount potentially equal to the unpaid rent for the balance of the lease term. If the lease term is long, such as fifty or one hundred years, the landlord's claim would significantly diminish the chances of any recovery from the estate by other unsecured creditors.

To protect against this perceived inequitable result, Congress fashioned a draconian remedy within the Bankruptcy Act of 1898, which simply disallowed landlords' claims for prospective rent.²It was not until 1934 that Congress realized barring landlords from holding any claim at all might be equally unjust.³The result was new legislation,⁴which became the precursor to the current version of Sec. 502(b)(6) of the Bankruptcy Code, which now provides landlords a limited right to share in the estate.⁵However, the language and interpretation of this particular provision has been the subject of much debate and some questionable judicial analysis.

The debate centers around how much security a landlord may acquire (and ultimately keep) to insure its projected stream of rental income after a tenant defaults and thereafter seeks shelter behind the walls of bankruptcy. A landlord of commercial real property will often require its tenant to post a security deposit. Traditionally, the tenant provides the landlord with a cash security deposit, which may or may not be refundable to the tenant upon successful completion of the lease term. Cash, however, is not the landlord's only option. In recent years, an increasing percentage of security deposits have been created using a standby letter of credit.⁶

A standby letter of credit,⁷like a security deposit, provides assurance for the performance of an obligation.⁸A letter of credit provides for payment by a third party to one party to a contract when the other contracting party fails to perform its obligation.⁹There are typically three parties to a letter of credit: the issuer (usually a bank), the applicant (the tenant, for present purposes), and the beneficiary (the landlord).¹⁰The tenant pays the bank a fee and provides a reimbursement agreement for the bank to issue the letter of credit for the landlord's benefit.¹¹If the tenant defaults on his obligations under the lease, the landlord may draw upon the letter of credit, i.e., request payment, and the bank is obligated to pay the landlord.¹²

A landlord has two primary options to secure his interest in a lease, which may be used together or separately-a cash security deposit and a letter of credit.¹³However, in light of the Bankruptcy Code, as interpreted by those courts that have addressed the issue, there exists significant doubt as to whether the landlord can ever fully secure the financial obligations undertaken by a tenant under a long term lease. The Bankruptcy Code¹⁴provides a statutory limit on the amount of damages a landlord can recover against a debtor's estate for unpaid rent resulting from the termination of a lease of real property (the "Cap").¹⁵The Cap limits the landlord's damages to the greater of one year's rent or 15% of the total rent due for the remaining term of the lease, not to exceed a maximum term of three years.¹⁶Depending on the amount of security being held by a landlord, two possible scenarios emerge from application of the Cap: (1) the landlord holds a security deposit, as either cash or a letter of credit, in an amount less than the Cap; or (2) the landlord holds security in an amount greater than the Cap.

In the first scenario, the landlord's claim is bifurcated into a secured and unsecured portion.¹⁷The security deposit represents the secured claim, and the amount of the unsecured claim is the difference between the capped amount and the security deposit.¹⁸This is the more common of the two scenarios, and the landlord's right to keep the entire security deposit therein has been unchallenged.¹⁹The second scenario, in which the landlord holds a security deposit in an amount greater than the Cap, is far less common but creates an interesting dilemma. The issue is whether the landlord should be allowed to keep his full security deposit, which he bargained for and acquired prior to bankruptcy, or whether the Cap should be interpreted to require the return of the security in excess of the Cap.²⁰When the landlord holds a cash security deposit in excess of the Cap, as opposed to a letter of credit, there are strong arguments for the landlord to retain the surplus.²¹The likely result, however, is the landlord will have to disgorge the difference.²²Conversely, when a landlord holds a letter of credit as security, the differences between the letters of credit and cash security deposits effectively negate the disgorgement argument.

In November of 2005, the Fifth Circuit's decision in EOP-Colonnade of Dallas, Ltd. Partnership v. Faulkner (In re Stonebridge Technologies, Inc.)²³overruled all notable precedent when it held a landlord could retain the full proceeds of a letter of credit, regardless of the Cap.²⁴The court reasoned the Cap did not apply because the landlord never filed a claim for future rent damages.²⁵This analysis is critical and has been posited by commentators in the past.²⁶The court, however, ignored many of the issues tackled by the lower courts²⁷and many of the arguments presented by other commentators.²⁸

The Fifth Circuit's opinion also leaves the state of the law based in form rather than substance.²⁹This Comment will examine the historical background associated with the landlord's dilemma of security, and then provide the full legal analysis and arguments in support of the proposition that a landlord who holds a letter of credit in excess of the Cap should be entitled to keep the entire amount, whether he files a claim or not.

Part I will cover two topics. Part I.A-B traces the history of the Cap- why it was created, for what purpose, under what circumstances, how it was promulgated, and how it works in practice. Part I.C-D provides an understanding of letters of credit, compares letters of credit to cash security deposits and guaranties, and discusses how letters of credit work in practice.

Part II examines the relevant case law. A brief synopsis of the few pre- Stonebridge cases that have addressed the interplay between letters of credit and the bankruptcy limitation on a landlord's claim is outlined in Part II.A-D. Part II.E discusses the Fifth Circuit's Stonebridge decision in greater detail. Finally, Part II.F attempts to reconcile all the cases.

This Comment argues secured landlords should be treated like every other secured creditor. In proving this seemingly obvious proposition, Part III.A explores the arguments in favor of a landlord keeping his security deposit in excess of the Cap, regardless of whether the security deposit is posted as cash or a letter of credit. Part III.A.1 first analyzes Oldden v. Tonto Realty Corp.,³⁰ the case that incorporated the Cap into the common law,³¹and shows the decision is at odds with bankruptcy law and policy. Part III.A.2, a comparison between landlords and mortgagees, will demonstrate that landlords deserve equal treatment with their brethren lenders. Finally, further analysis of Oldden and a comparison to mortgagees in Part III.A.3 shows that when the security deposit is greater than the Cap, the landlord should not be treated like an over- secured creditor who is required to return the surplus to the estate.

With a firm understanding of the arguments regarding a security deposit generally, an explanation of why letters of credit deserve special treatment in Part III.B further supports the proposition that a landlord should be entitled to retain the full letter of credit proceeds in excess of the Cap. The arguments against retaining a cash security deposit in excess of the Cap will be addressed by examining the differences between a cash security deposit and a letter of credit. These differences will highlight two key points. First, there is no bankruptcy mechanism for a tenant to recover money properly drawn on a letter of credit, as explained in Part III.B.1. Second, and most importantly, Part III.B.2 will explain why the current judicial reasoning with regard to letters of credit is inadequate for resolving the problem Congress intended to remedy.

Finally, Part IV clarifies the options available for rent security under letters of credit today and announces a new approach. This approach is preferable because it is more equitable to all parties involved, more consistent with bankruptcy law and policy, and addresses the problem Congress intended to resolve.

I. BACKGROUND

A. The Historical Evolution of the Bankruptcy Cap

In analyzing the Cap as it exists and is applied today, it is helpful to understand the evolution of a landlord's remedy in bankruptcy. Prior to 1934, landlords were unable effectively to make a claim for damages for the loss of future rent arising from the termination of a lease.³²In the Bankruptcy Act of

1867, Congress provided a "creditor may prove for a proportionate part [of rent due] up to the time of the bankruptcy,"³³but did not provide for losses from future rent. The Bankruptcy Act of 1898³⁴did not even have an express provision on rent, instead relying upon a "remnant of medieval theory,"³⁵the provable claim.³⁶If a claim was not provable, it could not share in the distribution of the bankruptcy estate and would not be discharged in bankruptcy.³⁷Under this standard, courts universally held a landlord's claim for...