Redback Networks, Inc. v. Mayan Networks Corp. (In Re Mayan Networks Corp.)

306 B.R. 295, 52 Collier Bankr. Cas. 2d 815, 53 U.C.C. Rep. Serv. 2d (West) 105, 2004 Bankr. LEXIS 184, 42 Bankr. Ct. Dec. (CRR) 196, 2004 WL 369886

• Court: United States Bankruptcy Appellate Panel for the Ninth Circuit
• Decided: February 5, 2004
• Docket: BAP No. NC-02-1483-JRyK, Bankruptcy No. 01-55393-ASW
• Status: Published

Opinions

OPINION

JONES, Bankruptcy Judge.

Appellant appeals from the bankruptcy court’s order determining that a draw upon a letter of credit given as security for a lease should reduce the amount of Appellant’s allowed claim under 11 U.S.C. § 502(b)(6).²

We AFFIRM.

I. Facts

In January 2000, Mayan Networks Corporation (the “Debtor”) and Redback Networks, Inc. (the “Landlord”) entered into a sublease of a large commercial building. The Debtor delivered to the Landlord two forms of security for the sublease: (1) cash of $351,033 and (2) a $648,966 letter of credit issued by Silicon Valley Bank. The sublease specifically provided that the letter of credit was delivered “as security for the faithful performance by [Debtor] of all of [Debtor’s] obligations under this Sublease.” Sublease, January 2000, at 2. The Sublease also provided that, “[t]he Sublease Letter of Credit, or so much thereof as remains after the curing of any default ..., shall be returned to [Debtor] at the expiration of the term of this Sublease and surrender of the Premises by [Debtor].” Id. at 3. The Debtor pledged over $650,000 cash to the bank to secure the letter of credit.

On November 5, 2001, the Debtor filed its Chapter 11 petition and shortly thereafter moved to reject the sublease. The Landlord filed a general unsecured claim for damages arising from the rejection of the sublease and an administrative claim for post-petition rent. The Debtor and the Official Committee of Unsecured Creditors (the “Committee”) objected to the Landlord’s claim. Prior to the hearing on the objection to claim, the Landlord agreed to apply its cash security deposit to reduce its allowed claim as capped by § 502(b)(6).

The Landlord, the Debtor, and the Committee stipulated that the Landlord’s remaining unsecured claims consisted of an undisputed claim and a disputed claim. The undisputed claim was for $1,701,535, which represented $339,203 for pre-petition rent, plus one year’s rent of $1,362,331 as reduced by the application of the cash security deposit. The disputed claim was for the $648,966 drawn on the letter of credit.

The bankruptcy court determined that the money received from the draw on the letter of credit should be applied toward the allowed claim, thereby reducing the Landlord’s unsecured claim against the bankruptcy estate. This appeal followed.

II. Issue

Section 502(b)(6) limits the amount of damages that a landlord can claim for early termination of a lease. The issue on this appeal is 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.

III. Standard of Review

The only issues presented by this appeal are issues of law. The Bankruptcy Appellate Panel “reviews issues of law under the de novo standard .... ” Shook v. CBIC (In re Shook), 278 B.R. 815, 821 (9th Cir. BAP 2002).

IV. Discussion

A. THE LANGUAGE OF THE STATUTE

Section 502(b) states that,

if such objection to a claim is made, the court, after notice and a hearing, shall determine the amount of such claim ... and shall allow such claim in such amount, except to the extent that—

(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds-(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease ....

11 U.S.C. § 502(b)(6).

The plain meaning of a statute is conclusive, “except in the rare cases [in which] the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafters. In such cases, the intention of the drafters, rather than the strict language, controls.” United States v. Ron Pair Enters., Inc., 489 U.S. 235, 242, 109 S.Ct. 1026, 103 L.Ed.2d 290 (1989) (citation and internal quotation marks omitted). Here, it is clear that a court shall allow a claim by a landlord so long as the amount of the claim does not exceed one year’s rent. However, no mention is made in the text as to whether security deposits are part of “such claim,” the amount of which is limited by § 502(b)(6). See In re Handy Andy Home Improvement Ctrs. Inc., 222 B.R. 571, 574 (Bankr.N.D.Ill.1998). The ambiguity that creates the issue for this appeal is whether the claim that shall be allowed is the total amount of damages that a landlord may recover or the amount that the landlord may claim against the bankruptcy estate in addition to any security that has been recovered. With such an ambiguity on the face of the statute, the court must resort to legislative history. Id.

The legislative history states that the provision “limits the damages allowable to a landlord of the debtor,” and that the purpose of the statute is “to compensate the landlord for his loss while not permitting a claim so large (based on a long-term lease) as to prevent other general unsecured creditors from recovering a dividend of the estate.” S.Rep. No. 95-989, reprinted in 1978 U.S.C.C.A.N. 5787, 5849; H.R.Rep. No. 95-595, reprinted in 1978 U.S.C.C.A.N. 5963, 6309. The history also states that a landlord’s “allowed claim is for his total damages, as limited by this paragraph,” and that “the claim will be divided into a secured portion and an unsecured portion in those cases in which the deposit that the landlord holds is less than his damages.” Id.

The legislative history specifically endorses the Second Circuit case of Oldden v. Tonto Realty Corp., 143 F.2d 916 (2d Cir.1944), which requires that a security deposit counts toward the total claim of a landlord. In Oldden, the court held that $3,000 deposited as security for a lease should be deducted from the claim after the statutory limit had been applied. Id. In agreeing with the holding of Oldden, the legislative history of § 502(b)(6) states that the landlord “will not be permitted to offset his actual damages against his security deposit and then claim for the balance under this paragraph. Rather, his security deposit will be applied in satisfaction of the claim that is allowed under this paragraph.” H.R.Rep. No. 95-595; S.Rep. No. 95-989, U.S.Code Cong. & Admin.News 1978, 5787, 5963, 5849-50, 6310.

It is clear that security deposits are to be applied after the § 502(b)(6) cap, thereby reducing the unsecured claim that a landlord may have against the estate. The question is left as to whether the letter of credit will be treated like a security deposit for the purposes of calculating the amount of a landlord’s claim under § 502(b)(6).

B. LETTERS OF CREDIT AND THE INDEPENDENCE PRINCIPLE

One of the central arguments made by the Landlord is that a draw on a letter of credit does not reduce the allowed claim because neither the letter of credit nor its proceeds are property of the estate. The obligation of a bank to honor a letter of credit is independent of the underlying contract. The Landlord argues that since the letter of credit is not property of the estate and the bank’s obligation to pay on the letter of credit is independent of the debtor’s obligation to reimburse the bank, the landlord should be able to apply the proceeds from the letter of credit to the damage claim before application of the cap in § 502(b)(6).

The standby letter of credit is a commercial instrument that obligates the issuer to pay the beneficiary upon presentation of certain documents, proving that the customer has defaulted on its obligation. Andy Marine, Inc. v. Zidell, Inc., 812 F.2d 534, 536 (9th Cir.1987). The issuer’s obligation under the letter of credit is independent of the' underlying contract. Cal. Comm.Code § 5103(d); Hamada v. Far East Nat’l Bank (In re Hamada), 291 F.3d 645, 650 (9th Cir.2002). Thus, the issuer’s obligation “does not depend on the fact of default, but upon the presentation of documents as evidence of default.” Andy Marine, 812 F.2d at 536. As a result of the independence of letters of credit from their underlying contracts, neither the letter of credit nor its proceeds are property of the debtor’s bankruptcy estate. See Musika v. Arbutus Shopping Ctr. Ltd. P’ship (In re Farm Fresh Supermarkets of Md., Inc.), 257 B.R. 770, 772 (Bankr.D.Md. 2001).

However, as the court below pointed out, the fact that letters of credit themselves are not property of the estate is a red herring. There is nothing in the statute or in case law that suggests that the limitation in § 502(b)(6) applies only to amounts that are paid directly from property of the estate. Rather, the appropriate analysis looks to the impact that the draw upon the letter of credit has on property of the estate. Here, the $650,000 cash pledged to the Bank was property of the estate, and it was used in effect to pay the landlord.

In Solow v. PPI Enters., Inc. (In re PPI Enterprises, Inc.), 324 F.3d 197 (3d Cir.2003), the debtor defaulted on a lease with eight years remaining on the lease, and the landlord subsequently made a $650,000 draw upon a letter of credit which had been given as security for the lease. Id. at 200. Almost five years later, on the eve of a trial to determine damages for the debt- or’s breach, the debtor filed its Chapter 11 petition. Id. at 201. The landlord argued that the letter of credit was independent of his claim against the debtor, and thus should not be applied to reduce his § 502(b)(6) claim. Id. at 209. The Third Circuit disagreed, noting that the letter of credit was intended as a security deposit and the debtor would be liable to the landlord for replenishment of the security if the landlord were forced to draw upon the letter of credit. Id. at 209-10. The court also noted that once the letter of credit was drawn down, the bank could pursue recovery of its loss against the debtor. Id. at 209. If the full amount of the claim were allowed under such circumstances, the court reasoned, the letter of credit would result in an “end run” around the § 502(b)(6) cap. Id. Therefore the court followed the rationale of Oldden. Id.

In the recent case of In re Condor Systems, Inc., 296 B.R. 5 (9th Cir. BAP 2003), we held that a draw upon a letter of credit did not reduce the allowed claim of an employee under § 502(b)(7). In Condor, the employee was terminated 21 months prepetition. The employment agreement provided the employee a $350,000/year base salary and a severance package of $1,400,000, payable in eight quarterly installments. The $1,400,000 was funded by an irrevocable letter of credit issued by Bank of America. The employee had drawn $1,050,000 prepetition, and he ultimately drew the remaining $350,000 on the letter of credit. The bankruptcy court reduced the employee’s § 502(b)(7) claim by the $1,400,000 he had drawn on the letter of credit. On appeal, we reversed the bankruptcy court because the § 502(b)(7) cap should not be reduced by payments from co-obligors if there is no impact on the estate.

In Condor, the debtor did not provide security to the bank, and there was no adverse impact on the estate by the draw-downs on the letter of credit. Thus, the relationship between the parties in Condor was more analogous to a third-party guarantee than to a security deposit. Several cases have held that the liability of a guarantor that is not in bankruptcy is not limited by section § 502(b)(6). See, e.g., Kopolow v. P.M. Holding Corp. (In re Modern Textile, Inc.), 900 F.2d 1184 (8th Cir.1990); Bel-Ken Assocs. Ltd. P’ship v. Clark, 83 B.R. 357 (D.Md.1988); Things Remembered, Inc. v. BGTV, Inc., 151 B.R. 827 (Bankr.N.D.Ohio 1993). As the court in Bel-Ken noted, “common sense dictates that the guarantor remain fully liable even when the principle debtor seeks relief under the Bankruptcy Code. After all, what good is a guaranteed lease if the guarantor escapes liability when the debtor does?” Bel-Ken, 83 B.R. at 359.

In light of Condor, we do not follow the rationale of PPI Enterprises where the debtor did not pledge property of the estate to secure the letter of credit. However, the present case is distinguishable from Condor and the guarantee cases, because we do not have a true third party obligor who bears substantial risk. The Bank was fully protected if it had to pay on the letter of credit. Inserting the Bank between the Landlord and the Debtor did not change the true nature of this arrangement, which was to have Debtor provide a security deposit on the lease. The $650,000 cash security to the Bank was property of the estate and the structure of this arrangement was really an attempt to circumvent Oldden. Accordingly, the logic of Oldden should apply.

C. EQUIVALENCE OF THE LETTER OF CREDIT TO A SECURITY DEPOSIT

As the court explained in Oldden, “in the light of [the] history and purpose of the statutory provision and its clearly expressed intent, we should construe it so as to give it full force and effect, and not allow it to be nullified by crafty draftsmanship in particular leases.” Oldden, 143 F.2d at 920. As the court below pointed out, although Oldden expressly deals only with security deposits, the rationale of Oldden applies to anything that is equivalent to a security deposit. In fact, a “security deposit” is not limited to cash only. If the collateral would come back to the Debtor, but for the existence of the pledge of security, then it is a security deposit for the purposes of this analysis.

On the facts of this case, the letter of credit is in the nature of a security deposit. The lease itself described the letter of credit as “security” for the tenant’s obligations under the lease. Although the words “security deposit” are not used, the principles of Oldden still apply. From the standpoint of the Debtor’s other creditors, the letter of credit has the same effect as a cash security deposit. That is, the amount of money left in the estate to pay unsecured claims is reduced by $650,000. Meanwhile, the landlord has received the full amount of its secured claim, from both the cash security deposit and from the letter of credit.

In this case, the Debtor pledged $1 million as security for its lease. Of that amount, $350,000 was given to the landlord, and $650,000 was deposited in a bank, with a letter of credit then being issued by the bank. The only effective difference between the letter of credit and the cash security deposit was the location of the funds. To allow the landlord to obtain an advantage simply by keeping the money pledged as security in the tenant’s bank would defeat the purpose of § 502(b)(6).

V. Conclusion

Letters of credit have yet to find a comfortable place in bankruptcy law. However, it is not necessary to distinguish the letter of credit in this case from the security deposit in Oldden. Here, the language of the lease described the letter of credit as security for the lease and the letter of credit was fully secured by a cash deposit. The draw upon the letter of credit had the same effect on the estate as the forfeiture of a cash security deposit, and the purposes of § 502(b)(6) will be best served if the same rule is applied. Therefore, the draw upon the letter of credit will be applied in satisfaction of the landlord’s claim against the debtor and the amount of such a claim will be reduced by the amount of the draw.

AFFIRMED.

2 . Unless otherwise indicated, all chapter, section, and rule references are to the Bankruptcy Code, 11 U.S.C. §§ 101-1330 and to the Federal Rules of Bankruptcy Procedure, Rules 1001-9036.