Notes & Comment
Vol. 2004, No. 3
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Commercial Real Estate: Bankruptcy and Letters of Credit
The legal landscape abounds with fallout from the dot.com meltdown. Perhaps no "brick and mortar" business has felt the pain from that go-go era so much as, well, the suppliers of "brick and mortar" -- the commercial real estate industry.
A common feature in commercial office leasing then, as now, is the landlord's demand for a security deposit, either in the form of cash or a letter of credit, and sometimes both. The amount and form of security deposit often depends on what the market will bear. What would happen to the security deposit if a dot.com tenant, for instance, subsequently filed for bankruptcy? For many, this was not an isolated or academic question.
A Bankruptcy Appellate Panel (BAP) of the U.S. Court of Appeals for the Ninth Circuit has now held that amounts drawn by a landlord against a cash security deposit and a letter of credit following a tenant's bankruptcy reduce the amount of the landlord's unsecured claim for "lost" rent under 11 U.S.C. §502(b)(6). In re Mayan Networks Corporation, No. NC-02-1483-JryK (February 5, 2004) (Opinion available at http://www.ce9.uscourts.gov, "BAP Opinions" tab, look for "Opinions" tab, search by "In re" name or date).
Security Deposits and the Bankrupt Tenant
According to Section 502(b)(6) of the Bankruptcy Code, an unsecured landlord has limited rights once a commercial office tenant files for bankruptcy. Basically, the landlord's unsecured claim against the bankrupt tenant's estate, notwithstanding what the lease might say, is capped at unpaid pre-petition rent plus post-petition rent that is the greater of one year of then-current rent, or fifteen percent of the remaining rent under the lease, not to exceed three years. This cap reflects a policy decision that all unsecured creditors should have reasonably equivalent access to what's left of the bankrupt estate and that commercial landlords should be limited to their fair share.
At the height of the Internet frenzy, Mayan Networks Corporation (Tenant) signed a five-year sublease with Redback Networks, Inc. (Landlord) in January 2000 for a 95,000 square foot commercial office building. Landlord required both a cash security deposit ($351,033) and a letter of credit (LC) in the amount of $648,966 as "security for [Tenant's] faithful performance" under the sublease. Tenant pledged $650,000 in cash deposits as security to the bank issuing the LC. The LC was to be returned to Tenant at the end of the sublease term, less amounts drawn to cure Tenant’s defaults along the way.
Tenant filed its Chapter 11 petition in November 2001 and rejected the sublease, owing some $339,203 in unpaid pre-petition rent. Landlord filed an unsecured bankruptcy claim that was contested by others. The parties stipulated that Landlord must reduce the amount of its maximum bankruptcy claim for lost rent by applying the cash security deposit.
The issue in Mayan Networks Corporation was whether the amount of LC ($648,966) also reduced the amount of Landlord's maximum claim for lost rent under the statutory cap. Landlord had calculated what the statutory cap allowed (all unpaid pre-petition rent, plus one year of then-current rent) and reduced that amount only by the amount of cash security deposit. It argued that cash received under the LC should be separate from, in addition to, not applied against the maximum amount of its "lost" rent claim under bankruptcy law. The lower court disagreed, and the Ninth Circuit BAP affirmed.
Security Deposits Under the Section 502(b)(6) Cap
Both cash security deposits and LCs secured by cash deposited at the bank apply to the amount capped by Section 502(b)(6). In Mayan Networks Corporation, Landlord did not contest that the cash security deposit applied to and reduced its maximum bankruptcy claim for lost rent. It argued, however, that the LC was an independent obligation of the bank, that funds secured by the LC were bank funds, not property of the Tenant, and should not reduce the amount of Landlord’s unsecured claim for lost rent.
Citing Solow v. PPI Enterprises, Inc. (In re PPI Enterprises, Inc., 324 F. 3d 197 (3rd Circ. 2003)), the Ninth Circuit BAP held that an LC established to secure the tenant's performance under a commercial office lease, which is secured by cash deposits made with the bank issuing the LC, and which is to be returned to the tenant at the end of lease term, is the property of the bankrupt estate and is applied against and reduces the amount of a landlord's maximum unsecured claim under Section 502(b)(6). Characterizing both forms of security deposit, "[t]he only effective difference between the letter of credit and the cash security deposit," according to the BAP in Mayan Networks Corporation, "was the location of the funds."
In contrast, had the bank not required security for the LC, had Tenant's funds not been on deposit as collateral for its obligation to pay the LC, the BAP might well have reached a different result. Under those circumstances, no Tenant property (cash collateral) would have been used directly or indirectly to offset the banks' payment under the LC.
Summary and Conclusion
In most situations, a landlord's ability to recover rent from a bankrupt tenant is limited by Section 502(b)(6) of the Bankruptcy Code. Landlords often try to protect themselves from default or bankruptcy by requiring cash deposits and letters of credit, and sometimes both. While these devices provide a ready source of cash in the event of default or bankruptcy, cash security deposits reduce the maximum amount of the landlord's unsecured claim for rent against a bankrupt tenant. And Mayan Networks Corporation now tells us that amounts paid under letters of credit, secured by cash funds deposited by the tenant with the bank issuing the LC, also reduce the amount of the landlord's maximum bankruptcy claim for lost rent.
© Matthew Joseph 2004. Law Offices of Matthew Joseph, San Mateo, California, practices in the areas of intellectual property licensing, commercial real estate leasing, and corporate and business transactions. No legal advice is intended by the information provided herein and recipients should independently consult counsel before taking any action related to this subject matter.