Bankruptcy Court Treats Letter of Credit Like Security Deposit

Prepared by Steven P. Heller, Esq.
PNM Doc. No. 598157.13
March 24, 2004

On February 5, 2004, the Ninth Circuit Bankruptcy Appellate Panel held that a landlord's draw under a letter of credit (backed by the tenant's cash) may be subject to some of the same limitations in bankruptcy that apply to cash security deposits. Redback Networks, Inc. v. Mayan Network Corporation (In re Mayan Networks Corporation).

If a tenant rejects a lease in bankruptcy, the amount that the landlord may collect from the tenant is limited: this liability "cap" is equal to past due rent, plus rent due under the lease for the greater of (i) one year or (ii) 15%, not to exceed three years, of the remaining lease term. The tenant's cash security deposit applies toward, and is subject to, the cap. By contrast, the amount the landlord may collect from a guarantor is not subject to the cap. Landlords increasingly have used letters of credit rather than cash security deposits in the hope that letters of credit would be the best of all worlds: like guaranties, not subject to the cap, and like security deposits, not subject to guarantor defenses and readily collectible. The decisions in this area have been confusing and inconsistent, and this case is no exception.

A tenant delivered a letter of credit, as security, to its landlord. To obtain the letter of credit, the tenant pledged cash to the issuer. After the tenant filed under chapter 11 and rejected the lease, the landlord drew down the letter of credit. The amount of the draw was less than the cap. The fact that the tenant provided cash to secure the letter of credit led the Court to conclude that the "true nature of this [letter of credit] arrangement" was to have the "the debtor provide a [cash] security deposit". The Court therefore treated the draw on the letter of credit as a cash security deposit by applying the drawn amount against the cap, thereby reducing the landlord's other claims against the tenant. The Court suggested that the result would have been different if the letter of credit had not been secured by assets of the tenant.

The concurring opinion states that the cap would not limit the landlord's right to recover its damages under a letter of credit, although this issue was not before the Court because the amount of the draw was less than the cap. The concurring opinion also states that the letter of credit issuer would not have a reimbursement claim against the tenant in excess of the cap, even if the issuer were fully secured.

If the Mayan holding becomes the governing law in this area, then draws under a letter of credit (backed by the tenant's cash) will be applied against the cap and thereby reduce the landlord's remaining claims against the tenant. This is bad news for landlords, but the remaining claims, if unsecured, may be relatively worthless anyway. The bigger issue to landlords is whether, when the letter of credit is greater than the cap, the amount of the draw will be subject to the cap (like cash security deposits) or not (like guaranties). This issue was not present in Mayan because the letter of credit was less than the cap. However, the Court's reasoning--by comparing the letter of credit to a cash security deposit instead of a guaranty--suggests that the Court might have also held that a draw under a letter of credit is subject to the cap when the letter of credit is backed by the tenant's cash. Although the concurring opinion suggests otherwise, it also raises the troubling specter of a letter of credit issuer not being able to collect more than the cap from the tenant, even if the tenant provides cash collateral.

This case creates more problems than solutions. Landlords may now face an additional problem of trying to monitor and control the collateral securing their letters of credit. Letter of credit issuers may now be concerned with the enforceability of their reimbursement rights and may be reluctant to issue letters of credit at all. Without further guidance from the courts, letters of credit should be issued and used only with the advice of counsel and the utmost of caution.

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