Letters of Credit in Tenant Bankruptcy: Landlord Rights, the § 502(b)(6) Cap, and the Recent Tupperware Decision

Overview

When a commercial tenant files for bankruptcy, the landlord’s ability to recover its damages often hinges on whether it required a letter of credit as security under the lease.  Letters of credit are the preferred lease security, valued because they are generally agreed to not be part of the bankruptcy estate, allowing them to be drawn without bankruptcy court authorization. But a growing body of case law, most recently illustrated in the Tupperware bankruptcy case in Delaware, reveals that the letter of credit is not an unconditional backstop. Depending on how a lease is drafted and whether a landlord files a proof of claim in the bankruptcy case, the cap on lease rejection damages under 11 U.S.C. § 502(b)(6) may significantly limit what a landlord can keep.

Letter of Credit Basics

A standby letter of credit issued in connection with a commercial lease is a promise by a financial institution (the issuer) to pay a specified sum to the landlord (the beneficiary) upon presentation of specified documents, which typically include a certification that the tenant has defaulted. Unlike a security deposit, the funds are the issuer’s money, not the tenant’s money, and thus are not part of the bankruptcy estate.

This letter of credit structure rests on the independence principle. The issuer’s obligation to the beneficiary is wholly independent of the underlying lease between landlord and tenant. A court cannot enjoin the draw simply because the tenant is in bankruptcy. As the Tupperware court noted, letters of credit are “considered the gold standard for payment assurance in commercial transactions and function as the virtual equivalent of cash”.

A letter of credit transaction involves three separate contracts: (i) the lease which requires the tenant to post security; (ii) the reimbursement agreement between the tenant (applicant) and the issuer, backed by collateral; and (iii) the letter of credit itself between the issuer and the landlord-beneficiary.

Because the issuer pays from its own funds, it is well established that the automatic stay under 11 U.S.C. § 362 does not bar a post-petition draw on letter of credit.

The § 502(b)(6) Rejection Damage Cap

When a debtor-tenant rejects a lease in bankruptcy under § 365 of the Bankruptcy Code, landlords are typically left with an unsecured rejection damages claim. To prevent landlords from dominating a bankruptcy case with enormous long-term lease claims that could overwhelm other general unsecured creditors — Congress capped landlord recoveries. Under § 502(b)(6), a landlord’s allowed claim for lease rejection damages is limited to the greater of one (1)  year’s rent reserved under the lease, or 15% of the remaining lease term, not to exceed three (3) years.

A traditional cash security deposit has always been subject to this cap.  The landlord must apply a security deposit against its capped claim, and any excess must be returned to the estate. However, the unsettled question is whether the same logic applies to letter of credit proceeds?

Three (3) circuits have addressed the interplay between letters of credit and § 502(b)(6), reaching divergent results.

Third Circuit: In re PPI Enterprises (U.S.), Inc. (2003)

In PPI, the landlord of a Manhattan office building held a $650,000 letter of credit as security for its tenant’s performance. After the tenant abandoned the premises and ceased making rent payments, the landlord drew down the entire letter of credit and later filed a lease rejection claim in the tenant’s Chapter 11 case. The Third Circuit affirmed that the letter of credit’s proceeds must be treated like a security deposit because the lease expressly stated the letter of credit was provided “in lieu of” a cash security deposit. As a result, the amount drawn under the letter of credit was applied to reduce the landlord’s capped claim.  The landlord could not both pocket the letter of credit proceeds and assert its full capped claim against the estate.

The key to PPI‘s holding is lease language.  In examining the same, the court concluded the letter of credit was the equivalent to a security deposit, subjecting it to the capped claim amount.

Fifth Circuit: In re Stonebridge Technologies, Inc. (2005)

The Fifth Circuit reached a different result than the Court in PPI. In Stonebridge, the landlord drew on the full letter of credit after the tenant’s bankruptcy, retaining an amount in excess of what § 502(b)(6) would have permitted — but critically, the landlord did not file a proof of claim. The Fifth Circuit held that § 502(b)(6) “applies only to claims against the bankruptcy estate.” Without a filed claim, applying the cap would convert a claims-allowance statute into a “self-effectuating avoiding power”. Accordingly, the landlord was entitled to retain the entire letter of credit proceeds.

The divergence between these circuits has produced an important strategic dynamic.  A landlord that holds a letter of credit well above the § 502(b)(6) cap may be better off simply drawing on the letter of credit and forgoing the filing of any proof of claim, at least in jurisdictions following Stonebridge.

The Tupperware Case (Adv. Pro. No. 25-50062, Bankr. D. Del., April 1, 2026)

The Tupperware adversary proceeding tests the Third Circuit’s PPI framework under facts designed to exploit the Stonebridge loophole, with a new twist that may close it.

Tupperware Brands Corporation filed for Chapter 11 on September 17, 2024. At the time of its filing, Tupperware was party to an eleven-year commercial lease for its corporate headquarters in Florida, with Spirit Realty, L.P. as landlord. The lease required Tupperware to maintain a $10,000,000 letter of credit as security for its full performance under the lease. The lease also contained a $10,000,000 liquidated damages provision, triggered upon a “Material Default” (defined to include three consecutive months of non-payment), payable first with the letter of credit proceeds.

Tupperware’s assets were sold via credit bid to Party Products, LLC. Under the asset purchase agreement, Party Products assumed Tupperware’s obligation to reimburse the issuer if Spirit drew on the letter of credit.

The relevant timeline unfolded as follows:

1. October 2, 2024: Spirit sent a default notice for non-payment of September rent;
2. October 22, 2024: Spirit drew one (1) month’s rent from the letter of credit;
3. January 23, 2025: After three (3) consecutive months of non-payment, Spirit declared a Material Default and submitted a draw request to issuer for the remaining balance of $9,589,108.27;
4. Party Products sought a temporary restraining order to block the draw, arguing that Spirit’s recovery must be capped under § 502(b)(6);
5. The court denied the restraining order, finding the alleged harm was purely economic;
6. Spirit received the full amount of the letter of credit, then never filed a proof of claim in the bankruptcy case; and
7. As the party ultimately obligated to reimburse the issuer, Party Products filed a proof of claim on Spirit’s behalf under Bankruptcy Code § 501(b).

The lease was ultimately rejected as of March 31, 2025. Party Products then filed an adversary proceeding seeking: (i) a declaration that Spirit was prohibited from drawing any amount in excess of post-petition pre-rejection rent, plus the 502(b)(6) cap amount; (ii) a finding that the lease’s liquidated damages provision was an unenforceable penalty; and (iii) an unjust enrichment recovery for amounts retained in excess of the cap.

The Court denied Spirit’s motion to dismiss on all three (3) counts. First, following PPI, the court found that the letter of credit – described in the lease as “security for the full and faithful performance” of the tenant’s obligations – was intended to function as a security deposit. Under those circumstances, PPI mandates that proceeds are subject to the § 502(b)(6) cap.

Spirit’s Stonebridge defense — that the cap cannot apply because no landlord-filed claim exists — was not dismissed out of hand. But the court held that Party Products’ filing of a claim on Spirit’s behalf under § 501(b), as a co-debtor subrogee, was sufficient to overcome the “no proof of claim” loophole at the pleading stage. Party Products relied on UCC § 5-117, which provides that an applicant who reimburses an issuer is subrogated to the issuer’s rights against the beneficiary. The Court held that whether subrogation ultimately supports the § 501(b) filing was a merits question that survived dismissal.

Next, in addressing the liquidated damages clause in the lease, the court held that Party Products had sufficiently alleged that the clause was an unenforceable penalty under Florida law. The provision applied only during the first five (5) years of the eleven-year lease — with no analogous provision for the final six (6) years — raising a colorable argument that the sum is disproportionate to any reasonably expected damages and operated as a windfall for Spirit. The Court noted that fact-intensive inquiry was needed to resolve this issue, hence it was inappropriate for resolution on a motion to dismiss.

Finally, the Court held that the unjust enrichment claim, seeking return of proceeds above the § 502(b)(6) cap, could proceed as its viability depended on the resolution of the other counts of the complaint.

Key Implications for Landlords

The Tupperware decision crystallizes several issues that landlords and their counsel must carefully evaluate.

For landlords, be sure to review the lease terms, if there is a letter of credit.  If the lease language does not comport with the analysis noted here, it may be worthwhile amending or modifying the lease, if possible.  For example, if a lease describes a letter of credit as “security” for the tenant’s performance, courts applying PPI will treat the letter of credit like a cash security deposit for § 502(b)(6) purposes. Landlords who wish to preserve the full letter of credit amount as a remedy beyond the statutory cap must be cautious: lease language tying the letter of credit to the tenant’s underlying obligations may bring it within the cap.

Second, it is important to think about whether a claim should be filed. Under normal circumstances, landlords hardly ever think about whether to file a proof of claim, as it is such an easy process.  However, if a landlord has a letter of credit, it may want to pause and really analyze whether filing benefits them or not.  The Stonebridge approach of drawing on the letter of credit and NOT filing a claim, remains viable in the Fifth Circuit and potentially in others. However, Tupperware demonstrates that a sophisticated assignee with reimbursement exposure can use § 501(b) to file a claim on the landlord’s behalf and activate § 502(b)(6), potentially eliminating the benefit of the strategy.

Finally, reviewing the lease language regarding any liquidated damage provision is essential.  Landlords frequently pair large letters of credit with liquidated damages clauses to ensure recoverability of long-term losses. In Tupperware, the $10 million liquidated damages provision which was only applicable during the first five (5) years of an eleven-year lease, was found to be a plausible unenforceable penalty at the pleading stage.

Practical Takeaways

The Tupperware ruling, while decided at the motion-to-dismiss stage, sends a clear signal that courts in the Third Circuit will scrutinize letter of credit draws that exceed the § 502(b)(6) cap — particularly where the letter of credit is structured as lease security and a party with reimbursement exposure can step in to file a claim. The ultimate merits of Party Products v. Spirit Realty are subject to an interlocutory appeal and potentially trial. The final resolution — particularly on whether Party Products’ § 501(b) filing is sufficient to trigger § 502(b)(6) and whether the liquidated damages clause is enforceable — will be closely watched whether through trial and/or the appellate process, as a significant development at the intersection of letter of credit law and bankruptcy claims practice.

How Stark & Stark Helps Landlords Navigate Retail Bankruptcies

Stark & Stark’s Shopping Center and Retail Development Group regularly represents landlords nationwide in complex retail Chapter 11 cases, including in the District of New Jersey, Southern District of New York, District of Delaware, and other key jurisdictions. Our team advises on critical issues such as lease security, letters of credit, and bankruptcy claims strategy to help landlords protect their interests.

Most recently, our Group has represented landlords and trade creditors in the Value City Furniture, TGI Friday’s, Express, Rite Aid, Big Lots, JOANN’s, Party City, Bed Bath & Beyond, David’s Bridal, American Freight, and LL Flooring cases. We focus on helping owners preserve cash flow, minimize vacancy risk, and position assets for long-term stability. For more information on how Stark & Stark can assist you, please contact shareholders Joseph Lemkin at (609) 791-7022 (jlemkin@stark-stark.com) or Thomas Onder at (609) 219-7458 (tonder@stark-stark.com).