Lease Termination Damages and Letters of Credit: The Fifth Circuit Pops the Cap
Daniel I. Morenoff
Hughes & Luce, LLP; Dallas
The U.S. Court of Appeals for the Fifth Circuit recently addressed the intersection of letters of credit with Bankruptcy Code §502(b)(6)’s statutory cap on the allowance of damages for bankruptcy claims arising from the termination of leases of nonresidential real property. EOP-Colonnade of Dallas Ltd. P’ship. v. Faulkner (In re Stonebridge Tech., Inc.), 430 F.3d 260 (5th Cir. 2005). The Fifth Circuit allowed a lessor to retain amounts drawn against its letter of credit in excess of the statutory cap – a result contradicting a common reading of the decisions of two other courts of appeals.
Before the Fifth Circuit Court of Appeals decision in Stonebridge, a consensus had begun to form that the decisions on this topic from the Third Circuit Court of Appeals (Solow v. PPI Enter. (U.S.), Inc. (In re PPI Enter. (U.S.), Inc.), 324 F.3d 197 (3d Cir. 2003)) and the Ninth Circuit’s Bankruptcy Appellate Panel (Redback Networks, Inc. v. Mayan Networks Corp. (In re Mayan Networks Corp.), 306 B.R. 295 (9th BAP 2004)) stood for the proposition that lessors who see their leases rejected in bankruptcy could recover no more than the statutory cap from any source including the debtor’s estate and any letter of credit.1 Indeed, all disclaimers aside, the lower court rulings in Stonebridge were widely interpreted to stand for exactly this holding.
The Fifth Circuit’s Stonebridge opinion clearly refutes this reading of §502(b)(6) and establishes safe havens for lessors seeking to structure their affairs to allow them to recover more, cumulatively, than §502(b)(6)’s statutory cap would allow the lessor to recover from the lessee alone. While there are internal flaws in the logic through which the Fifth Circuit Court of Appeals established these safe harbors, at least one underlying rationale is clearly correct. As a result, Stonebridge is rightly decided, and nonresidential real property lessors should be able to rely on it in structuring transactions to utilize letters of credit to recover more than the value of §502(b)(6)’s statutory cap.
Facts of Stonebridge
In Stonebridge, the debtor held a lease of nonresidential real property that required the posting of both cash and a letter of credit as security deposits. The debtor posted both pre-petition. The debtor also gave the issuer of the letter of credit both a note obliging the debtor to reimburse any draw against the letter of credit and a certificate of deposit securing most of the issuer’s potential claim.
In his bankruptcy, the debtor rejected the lease. On the basis of the debtor’s post-petition defaults,2 the lessor drew down the letter of credit (in an amount exceeding §502(b)(6)’s cap of the lessor’s allowable claim against the estate).3 While the lessor never filed a claim in the debtor’s bankruptcy for rejection damages, the issuer of the letter of credit sought stay relief to allow it to apply its certificate of deposit to its reimbursement claim against the debtor’s estate. Eventually, the trustee for the debtor settled the issuer’s claim by allowing the application of the certificate of deposit in exchange for an assignment to the estate of the issuer’s wrongful-draw claims against the lessor.
The trustee then sued the lessor for wrongful draw, alleging among other things that the draw was wrongful because the lessor had no right to recover more than §502(b)(6)’s cap in damages for the termination of the lease. The bankruptcy court and district court agreed with the trustee.
Recognizing that the PPI and Mayan Networks courts had held that letter-of-credit draws should be credited against a lessor’s allowable capped claim against the estate, the Fifth Circuit nonetheless overturned the lower courts. The Fifth Circuit differentiated PPI and Mayan Networks primarily on the basis that the lessor had not filed a proof of claim. The Fifth Circuit held that “the damages cap of §502(b)(6) does not apply to limit the beneficiary’s entitlement to the proceeds of the letter of credit unless and until the lessor makes a claim against the estate.”
Ineffectiveness of First Safe Harbor
Numerous practitioners have noticed that while this part of Stonebridge seems to create a safe harbor for lessors seeking to recover damages beyond §502(b)(6) through a letter of credit, that safe harbor is not without pitfalls.
A lessor could decline to file a proof of claim, seemingly bringing it within this language from Stonebridge and allowing a draw against a letter of credit. However, pursuant to Code §501(c), “[i]f a creditor does not timely file a proof of such creditor’s claim, the debtor or the trustee may file a proof of such claim.” To the extent that the Stonebridge court says that the cap applies whenever a claim is made, this leaves the safety of the safe harbor at the discretion of the debtor or trustee.
Unless there is another basis for the Fifth Circuit’s ruling that the lessor is entitled to draw down its letter of credit regardless of §502(b)(6)’s cap, lessors can take no comfort in the Stonebridge ruling. As a practical matter, they would be unable to plan their actions to assure that they could draw down a letter of credit to pay damages following rejection. If this is the only basis for Stonebridge, henceforth lessors should not negotiate for letters of credit in amounts greater than the statutory cap, as their right to draw down would be entirely contingent on the (arguably negligent) inaction of a debtor or trustee.
Despite appearances, if this is all there is to Stonebridge, the case stands for the same principle that PPI and Mayan Networks have been understood to stand for – that, as a practical matter, letters of credit cannot be used to increase the possible recovery of a lessor.
Additional Problem with Filing of Claim Distinction: Third-Party Discharge
The Fifth Circuit’s reliance on the filing of a proof of claim to distinguish PPI and Mayan Networks also faces an additional problem. If the above-quoted language actually means that a debtor may cut off the rights of a lessor who is the beneficiary under a letter of credit to draw down that letter of credit simply by entering bankruptcy and filing a proof of claim on the lessor’s behalf, then the Code discharges all contractual liabilities of solvent issuers (non-debtor third parties) beyond the limits of the §502(b)(6) cap.
Section 524(e) of the Code expressly states that discharge of a debtor cannot discharge non-debtor third parties (with one, inapplicable exception). Courts applying §524(e) in the chapter 11 context have refused to allow even confirmation of a plan to discharge the liabilities of non-debtor third parties. See Gillman v. Cont’l. Airlines (In re Cont’l. Airlines), 203 F.3d 203, 211 (3d Cir. 2000); Resorts Int’l., Inc. v. Lowenschuss (In re Lowenschuss), 67 F.3d 1394, 1401 (9th Cir. 1995).
Against the backdrop that even a debtor discharge and the presence of the whole panoply of procedural protections of the plan confirmation process cannot discharge third-party liabilities, it is unthinkable that a debtor can nonetheless discharge the liabilities of a letter-of-credit issuer under the organic state law of the UCC the most difficult of commercial transactions with which to interfere, simply by entering bankruptcy and filing a proof of claim on behalf of the lessor.
Secondary Safe Harbor in Stonebridge
Fortunately, the Fifth Circuit did not rely solely on this basis in reaching its ruling. In a less-remarked portion of the Stonebridge decision, the Fifth Circuit noted that “§502(b)(6)…‘allows only one thing – disallowance of the filed claim to the extent that it exceeds the statutory cap.’” Citing Bartell, Laura B., “The Lease Cap and Letters of Credit: A Reply to Professor Dolan,” 120 Banking L.J. 828, 835-36 (2003). Refusing to “convert §502(b)(6) into a self-effectuating avoiding power that would allow the trustee to bring an adversary proceeding against a lessor who exercises his rights under a letter of credit,” the Stonebridge court holds that §502(b)(6) is a shield capping what is recoverable from the estate, not a sword allowing trustees to attack draws on letters of credit.4
Stonebridge recognizes that §502(b)(6) operates only to limit the allowable claim against the estate and not, more broadly, to limit the damages of the lessor or the remedies of the lessor against other parties. Entirely aside from whether or not a claim is filed for damages and where the estate acquires a right to recover amounts drawn in excess of the §502(b)(6) cap, on this basis, Stonebridge indicates that a lessor may recover from the issuer of its letter of credit the full amount of damages it is due under a rejected nonresidential real property lease.
As a result, lessors should be able to rely on this case in concluding that they may continue to structure their transactions to secure lessee obligations through letters of credit without fear that a bankruptcy court will rule that they can still recover no more in damages than the §502(b)(6) cap.
Consistency of Stonebridge with PPI and Mayan Networks
Interestingly, when Stonebridge is so understood, a close reading of PPI and Mayan Networks shows that neither case conflicts with the important portion of Stonebridge from the perspective of lessors.
Both cases saw the rejection of nonresidential real property leases followed by the lessor-beneficiary drawing down against letter-of-credit damages less than the §502(b)(6) cap. In each, the lessor-beneficiary then filed a proof of claim and litigation ensued over whether the amount drawn from the letter of credit should be credited against the §502(b)(6) cap or whether it should be credited against the total damages suffered, leaving an allowed claim in the full amount of the §502(b)(6) cap.
In both cases, the appellate court was faced with the question of how much could be recovered from the estate. In both cases, the appellate court considered the bank’s reimbursement claims against the estate to be, as a matter of economic reality, the same claim for damages from the rejection of the nonresidential real property lease, even if asserted by a different party. In both cases, mindful that §502(b)(6) caps the total liability of the estate, the appellate court ruled that the lessor’s letter-of-credit draw must be set off against the §502(b)(6) cap to assure that, after the allowance of the bank’s reimbursement claim, the total liability of the debtor did not exceed the statutory cap.5
Nothing in these cases held or even suggested that §502(b)(6) operated to limit the lessor-beneficiary’s rights against the issuer of its letter of credit. While parties including the trustee in Stonebridge have tried to use language from these cases to limit the reach of the independence principle in this way, neither case actually stood for the proposition that §502(b)(6) could be used offensively to do anything more than limit the total liability of a bankruptcy estate resulting from the rejection of a lease of nonresidential real property.
Consistency of Secondary Safe Harbor in Stonebridge with Parallel Area of Law: Treatment of Guarantors
Furthermore, this understanding of Stonebridge is entirely consistent with a parallel area of the law. Imagine that instead of demanding a letter of credit to secure the lease, the lessor had demanded a third-party guaranty. It is well established that the liability of that third-party guarantor extends to the full amount of contractual damages without limitation by the §502(b)(6) cap. See Cromwell Field Assoc. LLP v. May Dept. Stores Co., 5 Fed.Appx. 186, 189 (4th Cir. 2001) (“11 U.S.C. §502(b)(6) does not cut off and extinguish the lessor’s claim for amounts in excess of the amount chargeable to the debtor’s estate…[T]hus, the lessor can still look to the person or entity that guaranteed the debtor’s lease obligations; Kopolow v. P.M. Holding Corp. (In re Modern Textile, Inc.), 900 F.2d 1184, 1191 (8th Cir. 1990) (“although the Bankruptcy Code limits the amount which a lessor can claim against the debtor’s bankrupt estate following the trustee’s rejection of an unexpired lease…that limitation does not operate to cut off and extinguish the lessor’s claim for amounts in excess of the amount chargeable to the debtor’s estate [so] the lessor can still look to the person or entity that guaranteed the debtor’s lease obligations” for the balance).
As expressly noted by the concurring opinion in Mayan Networks, “a letter of credit is merely a powerful guaranty.” Mayan Networks, 306 B.R. at 301. There would have been no justification in either the Code or in equity for the Stonebridge court to agree with the lower courts that uniquely among guarantors, letter-of-credit issuers are excused from their full contractual obligations under their guaranty, the letter of credit, by §502(b)(6).
Conclusion
Stonebridge states that §502(b)(6) caps recoveries from the estate, but has nothing to say about the liability of third-party, non-debtor letter-of-credit issuers. While this holding differs from the prevailing understanding of PPI and Mayan Networks, it is consistent with those cases.
Lessors have an interest in obtaining guaranties and letters of credit to protect themselves against rejection of nonresidential real property leases in bankruptcy. Nothing in law or equity, including §502(b)(6), prevents lessors from structuring their contractual relationships to allow them recourse to such protections following debtors’ rejections of their leases in bankruptcy.
In crafting lease arrangements then, a lessor may structure the transactions to allow the recovery of more than the §502(b)(6) cap. In order to make such strategies as safe as possible, the cautious lessor should:
- get a letter of credit or guaranty from a creditworthy third party;
- if possible, have the letter of credit purchased by a bankruptcy remote source (not the debtor);
- draft its lease and draw documents so that a non-stayed filing in the bankruptcy serves as a trigger to allow the draw of a letter of credit (e.g., provide that when a default exists, acceleration automatically occurs without notice, so that a demand for payment [in the form of a filed proof of claim] allows the draw of the full amount of a letter of credit); and
- have the debtor or bankruptcy remote purchaser obtain the letter-of-credit under a letter of credit agreement that specifies that the issuer’s indemnification rights are subject to the §502(b)(6) cap and subordinate to the lessor’s right to recover the full amount of that capped claim from the debtor.
After Stonebridge, a lessor should expect a debtor or trustee to file a proof of claim on the lessor’s behalf. Assuming this will occur, the lessor’s decision to file or not file a proof of claim should have no impact on that lessor’s right to draw down its letter of credit. One way or another, a claim will be filed triggering any effect Stonebridge requires such a filing to have. Accordingly, lessors holding letters of credit should not refrain from filing proofs of claim.
Aside: Interesting Jurisdictional Point
Finally, one additional detail of the Stonebridge decision is worth noting – the jurisdictional basis for the case to be heard in federal court. In Stonebridge, the trustee brought a claim assigned to it by a third party after the petition date. It was a tort claim held by one third-party creditor against another third-party creditor. The claim was not a part of the bankruptcy estate at the petition date. Indeed, it could not have been, because the claim arose post-petition.
The Fifth Circuit sua sponte discusses the jurisdictional basis for it to hear and reach the merits of the claim and rules that the claim is within the “related to” jurisdiction of the district court pursuant to 28 U.S.C. §1334. The Fifth Circuit bases this conclusion on the fact that the issuer’s claim against the estate would theoretically be reduced by the successful prosecution of the wrongful-draw action against the lessor-beneficiary.
This conclusion is suspect for at least two reasons. First, the trustee in Stonebridge acquired the claim against the lessor-beneficiary as part of a settlement of the issuer’s claim. After approval of the issuer’s settlement, further litigation with the lessor-beneficiary would have had no impact on the amount of the issuer’s settled claim against the estate. Second, even aside from the settlement with the issuer, the issuer’s claim is subrogated to the claim of the lessor-beneficiary. These claims are capped by §502(b)(6), so it is simply untrue that the estate would have been impacted by the result of the litigation of the wrongful-draw action. The same amount should have been paid out by the estate regardless, with only the incidence of the payment susceptible to change through the assigned litigation.6
Nonetheless, Stonebridge holds that the claim against the lessor-beneficiary “could have any conceivable effect on the estate being administered,” so the claim is “related to” the bankruptcy. This case establishes a new threshold for how attenuated a “conceivable effect” may be, and exactly how far a trustee can push bankruptcy jurisdiction.
Practitioners should bear this decision in mind as a tool available to expand the scope of bankruptcy’s “related to” jurisdiction in the future.
1For the reasons discussed below, this emerging consensus did not accurately reflect the far narrower actual holdings of these decisions.
2The Fifth Circuit Court of Appeals holds that the lessor’s motion to compel payment of an unpaid administrative claim was a demand for cure satisfying the lease’s notice requirements and giving rise to an event of default when uncured. As a result, according to the Fifth Circuit, this bankruptcy pleading and the debtor’s post-petition failure to pay as demanded, even before a ruling on the motion, gave rise to an event of default that allowed the lessor’s draw against the letter of credit.
3 On Oct. 23, 2001, the parties had announced to the court their agreement to the lease’s rejection, effective before Oct. 23, 2001. On Oct. 25, 2001, three days after their presentment, the issuer honored the lessor’s draw documents for the letter of credit. On Nov. 8, 2001, the court entered an order approving the rejection of the lease nunc pro tunc, effective as of Oct. 1, 2001.
4This self-effectuating language of Stonebridge has its own problems. In Stonebridge, the trustee took from the letter-of-credit’s issuer an assignment of its independent cause of action against the lessor-beneficiary. The Code needn’t include any avoidance power whatsoever for this assigned cause of action to be brought by the assignee-trustee. Accordingly, whether §502(b)(6) gives rise to a “self-effectuating avoiding power” was irrelevant to the case.
5There is an interesting argument between the concurring opinion in Mayan Networks and the majority opinion in that case as to whether the lessor or the issuer should be allowed to recover the amount of the letter of credit draw as part of its claim against the estate before imposition of the cap. This argument has no relevance to this article, which focuses on the ability of a lessor to draw against the letter of credit amounts above the §502(b)(6) cap.
6The bankruptcy court’s approval of the settlement, however, precluded this result. The settlement resulted in the debtor paying more than the §502(b)(6) cap in damages to the issuer of the letter of credit. If, as argued above, §502(b)(6) operates as a cap on the cumulative damages the estate must pay as a result of the rejection of a lease, including the indemnification claim of the issuer, then the bankruptcy court should not have approved the settlement.