A federal court in California recently has thrown its weight behind a majority rule that holds that letter of credit proceeds should be applied to damages resulting from the rejection of a lease of non-residential real property. In re Connectix Corp., No. 05-556848, 2007 WL 2137802 (Bankr. N.D. Cal. May 10, 2007). The court also addressed the formula the parties should employ to arrive at a damages figure.

Pre-petition, Connectix Corporation (the debtor) had entered into a global restructuring arrangement that required the debtor to return certain property to the landlord. Thereafter, the debtor commenced a bankruptcy case and sought to reject the lease. Upon rejection, the landlord filed a claim in the debtor’s bankruptcy case, to which the trustee ultimately objected. The trustee argued that the calculation of the claim was inconsistent with the Bankruptcy Code, and that the landlord was required to reduce its claim by the proceeds of a letter of credit.

When a lease of non-residential real property is rejected, the landlord is entitled to assert a claim in the lessee’s bankruptcy case. To prevent landlords from asserting huge claims for non-payment of accelerated rent (which would often encompass several years), the Bankruptcy Code limits the claim that can be asserted. The statute limits the landlord’s claim to all currently due rent plus accelerated rent for the remainder of the lease subject to a computation limitation. See 11 U.S.C. § 502(b)(6).

Here, the landlord argued that its claim should be allowed pursuant to 11 U.S.C. § 502(b)(6) in an amount equal to the prepetition accrued rent (which was undisputed) plus the aggregate amount of accelerated rent through the remainder of the lease term, times 15 percent. In other words, the landlord’s calculation was a sum of all rent that would have accrued through the expiration of the original lease term multiplied by 15 percent.

The trustee, on the other hand, took the position that the “additional accelerated rent” provision of the claim should be limited only to the rent that would have come due during the period of time that was equal to 15 percent of the remaining term. The trustee’s argument limited the claim for accelerated rent to only the rent that would have accrued in the period of time that was equal to 15 percent of the remaining lease term.

The court reviewed the case law concerning the application of each of these mathematical equations for purposes of determining the lessor’s damages, and adopted the latter (i.e., the limitation on the length of the period of time for which a claim can be based). The court, however, did note that this analysis represents the “minority” view of the cases addressing the issue.

The court next analyzed whether a landlord that holds a security deposit in the form of a letter of credit may apply the proceeds of the drawn letter of credit to the damages that it incurred before otherwise limiting the claim under the Bankruptcy Code. In following the majority view on this issue, the court determined that the letter of credit proceeds must be applied as a reduction to the otherwise allowable claim in the case.

Therefore, the landlord is required to first compute the amount of the allowed claim in accordance with the Bankruptcy Code (and reduce the damages as required by 11 U.S.C. § 502(b)(6)), and then further reduce such claim by the amount of any proceeds of the letter of credit or other security deposit that was held by the landlord. This case advises landlords to complete a series of calculations before ultimately settling on the amount of a claim that should be sought in a bankruptcy case. These calculations are particularly important for leases with “escalating rent” scenarios since the different calculation could be (and most likely will be) substantial. A landlord also must determine whether the security deposits it holds are in excess of the amount of the claim allowable under the Bankruptcy Code to determine whether a claim should even be asserted.