Stonebridge Technologies: When Not Filing a Bankruptcy Claim Pays Off

On November 8, 2005, the United States Court of Appeals for the Fifth Circuit published In re Stonebridge Technologies, 430 F.3d 260 (5th Cir. 2005). One of the holdings in Stonebridge is likely to have a lasting impact in the Fifth Circuit – the Court of Appeals ruled that draws on letters of credit serving as a security deposit under a real estate lease are not subject to the cap imposed by 11 U.S.C.A. § 502(b)(6) when a landlord does not file a proof of claim. Section 502(b)(6) provides for the disallowance of a damage claim made by a landlord against a debtor tenant as a result of a termination of a lease if the claim exceeds the amount of rent reserved under the lease for the greater of one year, or 15 percent of the remaining term of the lease (not to exceed three years), plus unpaid rent as provided in that section. This damages cap is intended to prevent a lessor who files a claim against the estate from reaping a disproportionate share of the bankruptcy estate to the detriment of the remaining pool of unsecured creditors. Stonebridge clarifies that the Section 502(b)(6) cap does not apply to limit the draw under a letter of credit provided as a security deposit under a lease if the landlord who required a tenant to provide the letter of credit, and is secured thereby, does not file a claim in the tenant’s bankruptcy case seeking damages for the tenant’s termination of the lease.

Procedural Background

In Stonebridge, EOP-Colonnade of Dallas Limited Partnership (Landlord), as lessor, entered into a lease agreement with Stonebridge Technologies, Inc. (Debtor), as lessee, pursuant to which Debtor leased space in an office building. The lease required Debtor to provide a security deposit to Landlord, which security deposit was comprised of $105,298.85 in cash, and an irrevocable, stand-by letter of credit in the amount of $1,430,065.74 issued in favor of Landlord. Debtor executed a note payable to the issuing bank under the letter of credit, secured by a certificate of deposit for $1,250,000, to reimburse the issuing bank in the event that Landlord had occasion to draw on the letter of credit. The lease was signed on September 21, 2000; on September 6, 2001, Debtor filed its Chapter 11 case. On October 23, 2001, Debtor and Landlord announced in open court that the lease would be rejected. Prior to that court appearance, Landlord initiated a draw request to the issuing bank for the full amount of the letter of credit. The request was honored on October 30, 2001, by the issuing bank, which issued a check to Landlord in the amount of $1,430,965.74.

Subsequently, the issuing bank filed a motion for relief from the automatic stay to apply the certificate of deposit that Debtor had pledged to reimburse the issuing bank in the event that Landlord drew upon the letter of credit. The bankruptcy trustee (Trustee) reached a compromise with the issuing bank, allowing the certificate of deposit to be applied in exchange for the assignment of certain claims held by the issuing bank against Landlord. Subsequently, the Trustee brought an adversary action in the bankruptcy court against Landlord, claiming, among other things, that Landlord had breached the lease by prematurely drawing on the letter of credit and retaining an amount in excess of the cap mandated by Section 502(b)(6).

The bankruptcy court reasoned that the letter of credit was part of the security deposit, and, as such, was subject to the Section 502(b)(6) cap. The bankruptcy court went on to find that Landlord’s draw of the full amount of the letter of credit before the entry of the order approving the rejection of the lease was a breach of the lease and constituted a negligent misrepresentation to the issuing bank that the full amount of the letter of credit was “due and owing.” Accordingly, the bankruptcy court awarded the bankruptcy estate, as assignee of the issuing bank, among other things, damages in excess of $180,000 for Landlord’s negligent misrepresentation. Landlord unsuccessfully appealed the bankruptcy court’s decision to the district court.

The Trustee’s Argument Before the Fifth Circuit

The Trustee argued to the Fifth Circuit that the letter of credit was part of the security deposit under the lease and, accordingly, was within the purview of the Section 502(b)(6) cap. In essence, the Trustee maintained that landlords may not offset actual damages against their security deposit and then claim for the balance under Section 502(b)(6). To the extent that a landlord has a security deposit in excess of the amount of its claim under Section 502(b)(6), the Trustee asserted before the appellate court that the excess must be returned to the bankruptcy estate.

In arguing that the Section 502(b)(6) cap applied, the Trustee relied on Solow v. PPI Enterprises, Inc. (In re PPI Enterprises, Inc.), 324 F.3d 197 (3d Cir. 2003). In that case, the debtor had been leasing office space under a 10-year lease. The debtor’s performance under its lease was guaranteed by an indirect corporate parent of debtor. As part of its security deposit, the debtor provided a letter of credit in the amount of $650,000. In September of 1991, two years into the lease term, the debtor abandoned its office and ceased paying rent. After delivering written notice of debtor’s default and giving notice of an intent to terminate the lease, the landlord drew down on the letter of credit. (At that point, the remaining rent for the duration of the lease amounted to $5.86 million.) Within weeks, the landlord filed suit against the debtor and the guarantor under the lease and won a partial summary judgment that the debtor wrongly terminated its lease. The judgment did not address the issue of damages. Four years later, the landlord requested that the court schedule a trial for damages. The day before that trial was to begin, the debtor filed its Chapter 11 case. Subsequently, the landlord filed a proof of claim for damages under the lease with the bankruptcy court.

The bankruptcy court ultimately decided that the landlord’s damages claim was subject to the cap imposed by Section 502(b)(6), and was reduced by application of the letter of credit. The district court affirmed the bankruptcy court’s decision and the landlord filed an appeal to the United States Court of Appeals for the Third Circuit. On appeal to the Third Circuit, the landlord argued that a security deposit was fundamentally different from a letter of credit, that the landlord maintained contractual rights to the proceeds from the letter of credit, and that landlord’s rights under the letter of credit against the issuing bank should not be affected by the Section 502(b)(6) cap. The Third Circuit reasoned that although some courts have adopted the “independence principle,” which works to separate proceeds from a letter of credit from the debtor’s estate, it was clear from the facts of the case that the parties intended that the letter of credit act as a security deposit. The Third Circuit accepted the debtor’s argument that if the issuing bank paid out on the letter of credit, the issuing bank would seek recovery from the debtor, which would ultimately mean that the debtor would pay the $650,000 twice – once in the form of the original letter of credit, and then again if the issuing bank was able to recover from the debtor. As a result, the landlord would receive a windfall over other creditors, and the debtor would be liable twice for the same amount of money. The Third Circuit upheld the decision of the lower courts and imposed the cap, effectively limiting the landlord’s damages; the holding was predicated on the Third Circuit’s finding that the parties substantially viewed the letter of credit as a security deposit.

The Fifth Circuit’s Decision

The Fifth Circuit acknowledged that it was “well-established” that letters of credit and the proceeds of letters of credit are not property of the bankruptcy estate due to the independent obligation owed by the bank issuing the letter of credit to the beneficiary of the letter of credit. In re Stonebridge Technologies, Inc., 430 F.3d at 269. Unlike the Third Circuit in PPI Enterprises, however, the Fifth Circuit did not base its decision on whether the parties intended the letter of credit to serve as a security deposit. Instead, the Fifth Circuit focused on the plain language of Section 502(b), noting that the section only applied to claims against the bankruptcy estate and observing that claims are not automatically assumed as a result of the rejection of a lease, but instead, must be formally filed against the bankruptcy estate. Id. at 269-70. In Stonebridge, Landlord never filed a claim against the bankruptcy estate, resulting in the inapplicability of Section 502. “Stated simply, the claim of a lessor against the assets of the estate is an essential precondition to apply the damages cap at all. Thus, the damages cap of Section 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.” Id.. If Landlord had filed a claim against the estate, Section 502(b)(6) would have capped the rejection damages at $1,353,032.02, about $77,000 less than the letter of credit provided. Id. at 270 n.9.

Notwithstanding the plain language of Section 502 and the precondition that a claim be filed in order for that section to be applicable, the Trustee argued that because the letter of credit was intended by the parties to serve as a security deposit, the proceeds of the letter of credit were within the purview of Section 502(b)(6). The Fifth Circuit was troubled by this argument, noting that the argument implicitly converted Section 502(b)(6) into a self-effectuating avoidance power, similar to a Section 547 preference action, that would allow a trustee to file an adversary proceeding against a lessor who does nothing more than exercise its rights under a letter of credit. Id. at 270. Not only did the Fifth Circuit find this approach inconsistent with the plain language of Section 502(b), but it also found that the Trustee’s argument was unsupported by and inconsistent with the language in the Bankruptcy Code. Id.

The Fifth Circuit found that the fundamental difference between Stonebridge and In re PPI Enterprises is that in Stonebridge, the lessor did not file a claim in bankruptcy court, while in PPI Enterprises, the lessor did file a claim. This was the single distinguishing point: “[i]n [In re PPI Enterprises], however, the landlord filed a claim against the bankruptcy estate seeking lease-rejection damages in excess of the amount of the security deposit. Thus, the Trustee’s reliance on [In re PPI Enterprises] is misplaced, because the record conclusively demonstrates that [Landlord] never filed a proof of claim against the Stonebridge estate. In sum, Section 502(b)(6) does not alter the entitlement of [Landlord] to the full proceeds of the Letter of Credit in the case where [Landlord] has not also filed a claim against the estate for recovery of unpaid lease monies.” Id. at 271.

Conclusion

The implications of In re Stonebridge could be far felt. The decision certainly reinforces the notion that letters of credit are an attractive alternative to the traditional cash security deposit. Additionally, of course, In re Stonebridge emphasizes the importance of landlords whose claims are secured by letters of credit carefully considering whether they should file a claim against a bankruptcy estate, as doing so might result in application of the Section 502(b)(6) cap. Although the Fifth Circuit has distinguished the decisions of the Third Circuit and other courts that have applied the Section 502(b)(6) cap to security deposits that were letters of credit, it will be interesting to see if other courts follow the Fifth Circuit’s lead and look to whether the landlord has filed a proof of claim before determining whether the cap applies. If the distinction made by the Fifth Circuit is interpreted as being non-substantive, i.e., a matter of form over substance, the decisions of the Fifth and Third Circuits on this issue that initially appear to be harmonious may not be. The resulting split between the Fifth Circuit and the Third Circuit is likely to be at issue in the future.

For more information, e-mail Trisha Rich at trisha.rich@hklaw.com or call toll free, 1.888.688.8500.