Draw on Letter of Credit Has Same Effect As Cash Forfeiture

These issues were recently examined by the 9th Circuit Bankruptcy Appellate Panel in Redback Networks, Inc. v. Mayan Networks Corporation (In re Mayan Networks Corporation), 42 BCD 196 (9th Cir. BAP 2004). In Mayan, the court found that although an LC and its proceeds are not property of the estate, because the debtor pledged cash to the bank issuing the LC, the draw on the LC had an impact on property of the estate and, therefore, the LC was to be treated as a security deposit for the purposes of calculating the amount of a landlord's capped lease rejection damage claim under section 502(b)(6) of the Bankruptcy Code. In essence, the decision focuses on the substance of the parties' rights as opposed to mere form (an LC).

The LC as 'Collateral'

By way of background, the debtor, Mayan Networks Corporation (Debtor), delivered to its landlord Redback Networks, Inc. (Landlord) two forms of security: $351,033 in cash and an LC in the amount of $648,966. The Debtor's reimbursement obligation to the issuing bank for the LC was fully secured by a $650,000 cash deposit. In the Chapter 11 case, Landlord filed a damage claim arising from the Debtor's rejection of the lease.

An issue arose as to whether the funds the Landlord received from its draw on the LC should be applied to reduce the “allowed” and capped claim against the Debtor. The Bankruptcy Court held that money received from the draw on the LC should be applied to reduce the Landlord's capped claim. The BAP Court affirmed.

The BAP Court relied upon the legislative history of section 502(b)(6) of the Bankruptcy Code and the 2nd Circuit's decision in Oldden v. Tonto Realty Corp., 143 F.3d 916 (2d Cir. 1944) in determining that an LC should be treated like a security deposit and applied after the section 502(b)(6) cap in calculating the Landlord's lease rejection damage claim. Landlord argued that since the LC was not “property of the estate,” and the bank's obligation to pay the Landlord on the LC was independent of the debtor's obligation to reimburse the bank, Landlord should be able to apply the proceeds from the LC to its entire damage claim irrespective of the section 502(b)(6) cap.

The BAP court stated that although LCs are independent from their underlying contracts under the “independence principle,” and neither the LC nor its proceeds are property of the estate, such argument is a red herring. Instead, an appropriate analysis must look to the impact that the draw on the LC has on property of the estate. Because the Debtor pledged $650,000 in cash collateral to the issuing bank to secure repayment upon a draw, “property of the estate” was, in effect, being used to pay the Landlord. The draw on the LC had the same effect as the forfeiture of the bank's cash deposit.

The court rationalized that because the issuing bank was fully secured on its reimbursement claim and not a true third-party obligor who bore substantial risk, there was an adverse impact on the estate from the application of the LC proceeds. Ultimately, the LC had the same effect as a cash security deposit since the money left in the estate is reduced by the amount drawn on the LC. The court also noted that even where a debtor does not pledge cash to the bank issuing an LC, such a cash forfeiture would still result if the debtor was liable for replenishment of the LC or the bank could pursue a recovery from the debtor once the LC was drawn down.

There was a concurring opinion in Mayan, in which the concurring Judge believes the majority decision relied too much upon legislative history and the Oldden case and did not focus enough on the revised Article 5 of the Uniform Commercial Code, which may permit LC issuers subrogation rights under section 509 of the Bankruptcy Code. Ultimately, the concurring Judge concludes that landlords are permitted to obtain credit enhancements, which will net them more than the 502(b)(6) cap as long as the excess does not come from property of the estate.

Treatment of LCs in Bankruptcy

Mayan underscores that the real issue is whether a debtor has a residual interest and is entitled to the return of some or all of the funds under the terms of the underlying agreements with the beneficiary and/or issuing bank, regardless of the source of the funds. Blind reliance upon the form of an LC or its proceeds will not be dispositive of the estate's interest in such funds. With respect to LC proceeds, the underlying relationship between the debtor and the beneficiary of the LC determines the debtor's rights to seek the return of any excess “collateral.” The fact that the “collateral” is provided in the form of an LC does not alter a creditor's obligation to return the excess after determining the allowed claim. In Mayan, the claim was capped per the statute and the form of the LC did not circumvent that cap.

The Mayan decision has broad reach on the treatment of LCs in bankruptcy beyond landlords. It can be applied to many situations where an LC is posted as collateral (eg, workers' compensation bonds, other contractual security, etc.). Thus, in any transaction where a debtor posts an LC as “collateral” for a creditor's claim, based upon Mayan, the court could 1) estimate and cap the amount of the “allowed claim” under section 502(c) of the Bankruptcy Code; 2) apply any amounts drawn down by the creditor to the allowed claim; and 3) order that any amounts in excess of the allowed claim be returned to the estate for the benefit of all creditors. This could occur even if the time period underlying the creditor's claim were still years off. Thus, a debtor could ask the court to fix the amount of a contingent or future claim and require that the LC be applied to satisfy that claim. A creditor would not necessarily be entitled to argue that its true claim would not be determined until some future point, and thereby retain the LC to pay down the claim as and when it matured. If a debtor can estimate a claim and establish that the creditor is oversecured through the LC, a basis exists to compel surrender of the excess LC proceeds to the debtor's estate.

It is well-settled that “property of the estate” is broadly defined under section 541 of the Bankruptcy Code as including all legal and equitable interests of a debtor. Therefore, the breadth of property of the estate includes a debtor's indirect, residual or reversionary interest in the return of funds. It is also equally acknowledged that, in general, a letter of credit (LC) is an independent obligation of the issuing bank and, under the “independence principle,” is not necessarily property of the estate. From time to time, these two concepts — broad estate interest in property versus the treatment of a LC — clash in bankruptcy. In these instances, some courts will look at “substance” and not “form” to determine whether the debtor's residual interest in an LC is property of its estate.

LCs are routinely posted by debtors as a form of collateral. Rarely — if ever — is an LC posted unrelated to the debtor's obligation to the “beneficiary” (it's not a “gift”). As with any form of collateral, a creditor does not have an absolute right to keep the collateral apart from the underlying debt. As such, the debtor continues to have a residual interest in any such collateral in excess of the allowed secured claim, which residual interest should be made available to satisfy claims of other creditors

The “independence principle” for LCs should not necessarily affect this end result. Therefore, whether or not collateral is in the form of an LC, courts should look to the parties' underlying rights to determine the ultimate ownership interest in the LC's proceeds. Where a creditor is holding LC proceeds that clearly exceed its allowed secured claim, it should not be permitted to retain those funds simply because the funds constitute the “proceeds” of an LC. In performing this analysis, a court may also examine the impact the draw on an LC would have on a debtor's estate.

These issues were recently examined by the 9th Circuit Bankruptcy Appellate Panel in Redback Networks, Inc. v. Mayan Networks Corporation (In re Mayan Networks Corporation), 42 BCD 196 (9th Cir. BAP 2004). In Mayan, the court found that although an LC and its proceeds are not property of the estate, because the debtor pledged cash to the bank issuing the LC, the draw on the LC had an impact on property of the estate and, therefore, the LC was to be treated as a security deposit for the purposes of calculating the amount of a landlord's capped lease rejection damage claim under section 502(b)(6) of the Bankruptcy Code. In essence, the decision focuses on the substance of the parties' rights as opposed to mere form (an LC).

The LC as 'Collateral'

By way of background, the debtor, Mayan Networks Corporation (Debtor), delivered to its landlord Redback Networks, Inc. (Landlord) two forms of security: $351,033 in cash and an LC in the amount of $648,966. The Debtor's reimbursement obligation to the issuing bank for the LC was fully secured by a $650,000 cash deposit. In the Chapter 11 case, Landlord filed a damage claim arising from the Debtor's rejection of the lease.

An issue arose as to whether the funds the Landlord received from its draw on the LC should be applied to reduce the “allowed” and capped claim against the Debtor. The Bankruptcy Court held that money received from the draw on the LC should be applied to reduce the Landlord's capped claim. The BAP Court affirmed.

The BAP Court relied upon the legislative history of section 502(b)(6) of the Bankruptcy Code and the 2nd Circuit's decision in Oldden v. Tonto Realty Corp. , 143 F.3d 916 (2d Cir. 1944) in determining that an LC should be treated like a security deposit and applied after the section 502(b)(6) cap in calculating the Landlord's lease rejection damage claim. Landlord argued that since the LC was not “property of the estate,” and the bank's obligation to pay the Landlord on the LC was independent of the debtor's obligation to reimburse the bank, Landlord should be able to apply the proceeds from the LC to its entire damage claim irrespective of the section 502(b)(6) cap.

The BAP court stated that although LCs are independent from their underlying contracts under the “independence principle,” and neither the LC nor its proceeds are property of the estate, such argument is a red herring. Instead, an appropriate analysis must look to the impact that the draw on the LC has on property of the estate. Because the Debtor pledged $650,000 in cash collateral to the issuing bank to secure repayment upon a draw, “property of the estate” was, in effect, being used to pay the Landlord. The draw on the LC had the same effect as the forfeiture of the bank's cash deposit.

The court rationalized that because the issuing bank was fully secured on its reimbursement claim and not a true third-party obligor who bore substantial risk, there was an adverse impact on the estate from the application of the LC proceeds. Ultimately, the LC had the same effect as a cash security deposit since the money left in the estate is reduced by the amount drawn on the LC. The court also noted that even where a debtor does not pledge cash to the bank issuing an LC, such a cash forfeiture would still result if the debtor was liable for replenishment of the LC or the bank could pursue a recovery from the debtor once the LC was drawn down.

There was a concurring opinion in Mayan, in which the concurring Judge believes the majority decision relied too much upon legislative history and the Oldden case and did not focus enough on the revised Article 5 of the Uniform Commercial Code, which may permit LC issuers subrogation rights under section 509 of the Bankruptcy Code. Ultimately, the concurring Judge concludes that landlords are permitted to obtain credit enhancements, which will net them more than the 502(b)(6) cap as long as the excess does not come from property of the estate.

Treatment of LCs in Bankruptcy

Mayan underscores that the real issue is whether a debtor has a residual interest and is entitled to the return of some or all of the funds under the terms of the underlying agreements with the beneficiary and/or issuing bank, regardless of the source of the funds. Blind reliance upon the form of an LC or its proceeds will not be dispositive of the estate's interest in such funds. With respect to LC proceeds, the underlying relationship between the debtor and the beneficiary of the LC determines the debtor's rights to seek the return of any excess “collateral.” The fact that the “collateral” is provided in the form of an LC does not alter a creditor's obligation to return the excess after determining the allowed claim. In Mayan, the claim was capped per the statute and the form of the LC did not circumvent that cap.

The Mayan decision has broad reach on the treatment of LCs in bankruptcy beyond landlords. It can be applied to many situations where an LC is posted as collateral (eg, workers' compensation bonds, other contractual security, etc.). Thus, in any transaction where a debtor posts an LC as “collateral” for a creditor's claim, based upon Mayan, the court could 1) estimate and cap the amount of the “allowed claim” under section 502(c) of the Bankruptcy Code; 2) apply any amounts drawn down by the creditor to the allowed claim; and 3) order that any amounts in excess of the allowed claim be returned to the estate for the benefit of all creditors. This could occur even if the time period underlying the creditor's claim were still years off. Thus, a debtor could ask the court to fix the amount of a contingent or future claim and require that the LC be applied to satisfy that claim. A creditor would not necessarily be entitled to argue that its true claim would not be determined until some future point, and thereby retain the LC to pay down the claim as and when it matured. If a debtor can estimate a claim and establish that the creditor is oversecured through the LC, a basis exists to compel surrender of the excess LC proceeds to the debtor's estate.