Article

Note: Joella Grayson (Borrower) applied for a loan through TJD Financial Services, Inc. (Loan Broker), which arranged the loan with United Texas Investors, L.P. (Lender). Pursuant to the terms of the loan, Borrower received USD 3,750 and agreed to pay Lender USD 6,499, securing the loan with Borrower's motor vehicle. Loan Broker's fees were paid by Lender from a portion of the loan proceeds. As part of the loan arrangement, Borrower/Applicant entered into a Credit Services Agreement with Lender, which described the letter of credit that Loan Broker/Issuer would issue in favor of Lender/Beneficiary:

"The lender may not give you a loan unless we [Loan Broker/Issuer] issue a conditional LOC. If the lender requires a LOC, then you [Borrower/Applicant] understand that such a LOC may be issued to the lender on your behalf. In the event that the lender requests a LOC, then you agree that you have applied with us as an applicant for a LOC to ensure your payment of the loan. As an applicant, you request us as issuer to issue our LOC in favor of a third party Lender as beneficiary pursuant to Chapter 5 of the Texas Uniform Commercial Code in an amount not to exceed principal, interest, later charges, dishonored payment device charges or other amounts as applicable on the loan that we arrange for you. Payment under the LOC is conditioned on presentment by the beneficiary to us of the beneficiary's sight draft and a drawing certificate stating that the loan secured by our LOC is unpaid and in default. Partial drawings are permitted provided the aggregate of drawings does not exceed the maximum amount under the LOC. The LOC will expire 90 days from the maturity date of the loan, or such other date specified in the LOC. If you timely exercise your right to cancel this Agreement, our LOC shall be automatically revoked and shall have no further effect. You instruct us to pay the beneficiary's draft up to the maximum amount of the LOC upon presentment to us of documentation complying with the conditions set forth above. You understand that we are not responsible for determining the accuracy of any statement made by the third-party lender/beneficiary and that our duty is strictly to pay upon proper presentment of the required documents. All matters pertaining to the LOC may be documented in properly authenticated electronic form including, without limitation, issuance of the letter of credit, presentations, drawings, drafts, certificates, and other communications between us and the beneficiary related to the LOC. You agree to pay us any amounts paid by us pursuant to the LOC, and you authorize us to initiate electronic checks or debits to your bank account for amounts owed to us" (emphasis added by court).

When Borrower/Applicant failed to repay the loan and declared bankruptcy, Lender/Beneficiary filed a claim against Borrower/Applicant's bankruptcy estate. The U.S. Bankruptcy Court for the Southern District of Texas, Isgur, J., disallowed the claim.

Borrower/Applicant argued that Lender/Beneficiary's actions violated various statutes including the Truth in Lending Act, the Texas Credit Services Organization Act (CSO Act), and the Texas Deceptive Trade Practices Act. Such violations, the Fifth Circuit held, may be asserted defensively to disallow Lender/Beneficiary's claims pursuant to the Bankruptcy Code. Among her various assertions, Borrower/Applicant alleged that Lender/Beneficiary and Loan Broker/Issuer had violated the CSO Act by fraudulently and falsely representing that, in exchange for the Loan Broker/Issuer fee, Loan Broker/Issuer would issue a letter of credit in favor of Lender/Beneficiary when both Loan Broker/Issuer and Lender/Beneficiary knew that Loan Broker/Issuer "never issues [Lender/Beneficiary] an actual letter of credit" in such situations.

The Judge noted that the Texas Business and Commerce Code (TBCC) provides:

"Rights and obligations of an issuer to a beneficiary or a nominated person under a letter of credit are independent of the existence, performance, or nonperformance of a contract or arrangement out of which the letter of credit arises or which underlies it, including contracts or arrangements between the issuer and the applicant and between the applicant and the beneficiary."

The Judge further cited Comment 6 to the same section:

"When a document labelled a letter of credit requires the issuer to pay not upon the presentation of documents, but upon the determination of an extrinsic fact such as applicant's failure to perform a construction contract, and where that condition appears on its face to be fundamental and would, if ignored, leave no obligation to the issuer under the document labelled letter of credit, the issuer's undertaking is not a letter of credit."

According to the opinion, however, under the terms of the purported letter of credit issued by Loan Broker/Issuer, "[Lender/Beneficiary] does not have the right to payment upon presentment of the documents. When a borrower defaults, [Lender/Beneficiary] must wait for payment until after the collateral is repossessed and foreclosed upon. ... Only afterwards may [Lender/Beneficiary] seek any deficiency from [Loan Broker/Issuer]" (citations omitted).

Comparing the TBCC's definition of a letter of credit to what Loan Broker/Issuer actually issued, the Judge concluded that "[t]his instrument is not a letter of credit under Texas law because [Lender/Beneficiary] is not entitled to payment upon presentment" and that any representation that Loan Broker/Issuer had issued a letter of credit was "glaringly false and misleading". The Judge, however, ruled that "[Borrower/Applicant] cannot prove she was injured by [Lender/Beneficiary]'s CSO Act violations because she simply was not aware of the representations contained in the relevant documents." As such, the Judge ruled that "[Borrower/Applicant] is not entitled to have the claim disallowed because of [Lender/Beneficiary]'s violations of the CSO Act."

Though [Borrower/Applicant] was unable successfully to assert Lender/Beneficiary's CSO Act violations to disallow the claim, she did successfully assert a defense for constructive fraudulent transfer, disallowing Lender/Beneficiary's claim. The Judge ruled that "[Borrower/Applicant] did not receive reasonably equivalent value in exchange for incurring the obligation to repay $6,499.00." Thus, Lender/Beneficiary's payment of the Loan Broker/Issuer fee to Loan Broker/Issuer constituted a constructive fraudulent transfer because "[Lender/Beneficiary] knew it was paying a debt that [Borrower/Applicant] did not in fact owe."

Comment: An interesting aspect of this case relates to the interest rate that Borrower would have received had an actual letter of credit been issued. By the terms of the agreement between Borrower and Loan Broker, Loan Broker agreed to "use [its] best efforts to: . . . issue a letter of credit (the 'LOC') to secure [Borrower's] repayment to the Lender". When Lender was asked in testimony whether an actual letter of credit would have driven down the interest rate on the loan to Borrower, it responded "Absolutely," leaving the Judge to conclude that "[h]ad [Loan Broker] actually performed under the contract as promised [by actually providing a letter of credit], [Borrower] could have received a more favorable interest rate."

[JEB/jdc]

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