Legal Notes

Secured Lender, The, Nov/Dec 2004 by Helfat, Jonathan N, Kohn, Richard M

Redback Networks, Inc. v. Mayan Networks Corp., et al. (In re Mayan Networks Corp.), 306 B.R. 295 (B.A.P. 9th Cir. 2004) (A landlord's draw upon a letter of credit securing a lease is applied toward the allowed claim, thereby reducing the landlord's unsecured claim against the bankruptcy estate.)

In January 2000, Mayan Networks Corporation ("Mayan") and Redback Networks, Inc. ("Landlord") entered into a five-year sublease of a commercial building, with annual base rentof$l,935,429.60for2001. Mayan delivered two forms of security for the sublease to Landlord: $351,033.80 in cash and an unconditional letter of credit for $648,966.20 issued by Silicon Valley Bank ("Bank") for the benefit of Landlord. The sublease specified that the letter of credit was delivered "as security" for Mayan's faithful performance under the sublease, and that the letter of credit (less any portion thereof used to cure defaults) was to be returned to Mayan upon expiration of the sublease's term. Mayan pledged $650,000 in cash to Bank to secure the letter of credit.

In November 2001, Mayan filed a Chapter 11 case and moved to reject the sublease. Landlord filed a general unsecured claim for damages arising from the sublease rejection and an administrative claim for post-petition rent. In March 2002, Landlord drew the full $648,966.20 on the letter of credit. Although Mayan and the Official Committee of Unsecured Creditors ("Committee") thereafter objected to the amount of Landlord's claims, Committee, Mayan and Landlord ultimately stipulated that $2,701,535.14 was the correct measure of the cap on Landlord's damages (the "Permitted Claim") established under section 502(b)(6) of the Bankruptcy Code and that the $351,033.80 cash portion of the security deposit should be credited against (and in reduction of) the Permitted Claim.

The parties were in dispute, however, as to whether the proceeds of the letter of credit would be applied in partial satisfaction of the Permitted Claim or paid in addition to the Permitted Claim. The bankruptcy court held that such proceeds must be credited against the Permitted Claim, thereby reducing the Permitted Claim by $648,966.20. Landlord appealed the decision. The Bankruptcy Appellate Panel of the Ninth Circuit affirmed.

Section 502(b)(6) of the Code, which limits the amount of damages that a landlord can claim for early termination of a real estate lease, specifies that a court shall allow a landlord's claim except to the extent that "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 panel noted that the purpose of not allowing a landlord's claim to exceed one year's rent is to compensate the landlord for its loss while not permitting a claim so large as to prevent other general unsecured creditors from recovering from the bankruptcy estate. The statute's legislative history specifically endorses Oldden v. Tonto Realty Corp., 143 F.2d 916 (2d Cir. 1944), which requires that security deposits be applied in satisfaction of (and not on top of) the section 502(b)(6) damage cap.

Landlord argued that, since the letter of credit is not property of the bankruptcy estate, and Bank's obligation to pay on the letter of credit is independent of the underlying sublease and the obligation of Mayan to reimburse Bank, Landlord should be able to collect the proceeds of the letter of credit in addition to the Section 502(b)(6) damage cap. The panel, however, found Landlord's reasoning unpersuasive, observing that nothing in the statute or case law suggests that the damage cap applies only to amounts paid directly from the bankruptcy estate. Instead, the panel felt that the appropriate inquiry is the impact on the property of the bankruptcy estate. The $650,000 cash pledged by Mayan to Bank was property of the estate and, when the letter of credit was drawn this cash was taken from the estate and, in effect used to pay Landlord. The panel distinguished the obligation of Bank to pay on the letter of credit (secured by $650,000 of cash collateral) from cases that have held that the liability of a third-party guarantor (who bears true, substantial risk) is not limited by section 502(b)(6).

In affirming the decision of the bankruptcy court, the panel found that the letter of credit in this case was not distinguishable from the security deposit in Oldden. Although Oldden expressly deals with only security deposits, the panel felt that the rationale of Oldden applies to anything that is equivalent to a security deposit. The panel reasoned that a security deposit is not limited to cash only, and on the facts of this case the letter of credit was in the nature of a security deposit. The language of the sublease described the letter of credit as security; in addition, the full amount of the letter was secured by a cash deposit. Since the draw on the letter credit had the same effect on the bankruptcy estate as forfeiture of a cash security deposit, the proceeds of the letter of credit must be applied in partial satisfaction of Landlord's section 502(b)(6) claim, thereby reducing the Permitted Claim by $648,966.20.