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Publication

February 14, 2006Client Alert

Landlord's Draw on Letter of Credit May be Limited in Bankruptcy

Letters of credit are often preferred methods of ensuring payment on commercial leases because they do not tie up the tenant's cash in the same manner as a cash security deposit, and because they are an independent obligation of the letter of credit issuer, unaffected by a tenant's bankruptcy. Or are they?

Recent cases are further developing the issue of whether a landlord's claim against a letter of credit is limited by the cap on a landlord's damages in the Bankruptcy Code, and whether letter of credit proceeds must be credited against the capped damage claims allowed by the Bankruptcy Code.

Under § 502(b)(6) of the Bankruptcy Code, a landlord's damages against the bankruptcy estate are limited to two components: (1) unpaid rent due without acceleration on the earlier of (i) the bankruptcy filing date and (ii) the date the leased property was repossessed or surrendered, plus (2) rent reserved by the lease without acceleration for the greater of (a) one year, or (b) 15%, not to exceed 3 years, of the remaining term of the lease after the earlier of (i) the bankruptcy filing date and (ii) the date the leased property was repossessed or surrendered.

Two issues have arisen when a landlord has rights to draw on a letter of credit for unpaid rent: first, do those letter of credit draws reduce the landlord's capped claim in bankruptcy, and second, does the claim cap in bankruptcy reduce what the landlord can draw under the letter of credit?

Assume that the landlord files a claim in the bankruptcy estate for the capped amount permitted to the landlord by the Bankruptcy Code. A number of cases have held that the draw under the letter of credit (like a security deposit) will reduce the amount of the capped claim allowed the landlord in the bankruptcy. See, e.g., In re Mayan Networks Corp., 306 B.R. 295, 299 (9th Cir. BAP 2004). Why? The cap is designed to compensate the landlord for its loss while not permitting a claim so large as to prevent other general unsecured creditors from recovering a dividend from the bankruptcy estate. If the letter of credit issuer can, after remitting under the letter of credit, simply turn to the debtor to assert a claim against it, then the bankruptcy estate is liable for more than the capped landlord's claim.

What if the landlord has a right to draw under a letter of credit an amount that exceeds the capped bankruptcy claim amount? A recent case indicates that if the landlord files no proof of claim in the tenant's bankruptcy, then the § 502(b)(6) cap does not apply, and the letter of credit draw may exceed the capped claim amount. In re Stonebridge Technologies, Inc., 430 F.3d 260, 270 (5th Cir. 2005).

The Stonebridge case suggests that the landlord's situation should be analyzed and a careful decision made about whether to file a claim in a bankruptcy where a letter of credit is available.

For more information on this or other bankruptcy questions, please contact Ann Ustad Smith at 608.283.2251, or ausmith@michaelbest.com, or Paul A. Lucey at 414.270.2719, or palucey@michaelbest.com.

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