Leases and Letters of Credit:  One Step Forward, Two Steps Back?

I. Bruce Speiser of Pircher, Nichols & Meeks
California Center – May 2004
May 1, 2004

If a tenant rejects a lease in bankruptcy, the landlord’s recovery is capped; the recovery is limited to pre-petition 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. 11 U.S.C. § 502(b)(6). The tenant’s cash security deposit applies toward, and is subject to, this liability “cap”. Landlords increasingly have avoided the use of cash security deposits and opted for guaranties and letters of credit to try to circumvent this cap.

The utility of these devices has been muddied, however, by a recent decision by the Ninth Circuit Bankruptcy Appellate Panel in Redback Networks, Inc. v. Mayan Network Corporation (In re Mayan Networks Corporation), --- B.R. ---, 2004 WL 369886, 4 Cal. Daily Op. Serv. 1601, 2004 Daily Journal D.A.R. 2363 (9th Cir. BAP, February 5, 2004) (“Mayan”). In this case, the court 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.


In this case, in January 2000 the tenant delivered cash and a letter of credit to its landlord as security for a sublease. Specifically, the tenant provided 1,033 cash and a 8,966 letter of credit to its landlord. The tenant also pledged over 0,000 cash to the bank to secure the letter of credit.

The tenant filed its Chapter 11 petition on November 5, 2001 and, shortly afterwards, moved to reject the sublease. The landlord drew down on the letter of credit and also filed a general unsecured claim for damages arising from the rejection of the sublease, along with an administrative claim for post-petition rent. The Official Committee of Unsecured Creditors and the tenant/debtor objected to the landlord’s damage claim. Prior to the hearing on the objection to the claim, the landlord agreed to apply the cash security deposit (1,033) to reduce its allowed claim as capped by Bankruptcy Code § 502(b)(6). Thereafter, the landlord, tenant/debtor and Unsecured Creditors’ Committee agreed that the landlord’s remaining unsecured claims consisted of (i) an undisputed claim for ,701,535 (representing 9,203 for pre-petition rent, plus one year’s rent of ,362,331 as reduced by application of the cash security deposit), and (ii) a disputed claim for the 8,966 drawn on the letter of credit (in this regard, it bears noting that even if this entire sum was applied to the landlord’s claim, the cap would not have been reached).

The issue before the bankruptcy court was whether the draw on the letter of credit should apply towards the cap. Contrary to the position of the landlord, which argued that the draw on the letter of credit should not be subject to the bankruptcy cap, the bankruptcy court held that the landlord’s draw reduced the landlord’s allowed (and capped) claim against the bankruptcy estate. The landlord appealed.


The appellate panel unanimously affirmed the decision of the bankruptcy court. Characterizing the issue before it as “whether a landlord’s draw upon a letter of credit offered as security for a lease will be applied in partial satisfaction of the allowed claim,” the majority opinion determined that because the tenant provided cash to secure the letter of credit, the "true nature of this [letter of credit] arrangement" was to have the "the debtor provide a [cash] security deposit". The majority opinion 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 amount owed to the landlord directly by the tenant’s bankruptcy estate. The majority opinion suggested that the result may have been different if the letter of credit had not been secured by the tenant’s assets.

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 appellate panel because, as noted above, 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.


Under Mayan, 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/debtor. 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 whether the landlord may recover the full amount of the letter of credit from the issuing bank (as is the case with third party guaranties). This issue was not present in Mayan because the letter of credit was less than the cap. However, the reasoning of the appellate panel – by comparing the letter of credit to a cash security deposit instead of a guaranty – suggests that the appellate panel also might have 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 suggested that a letter of credit issuer may not be able to collect more than the cap from the tenant, even if the tenant provides cash collateral.

This decision creates more problems than solutions, and offers little guidance to the real estate community. 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 with the utmost of caution.