Article

by Brooke Wunnicke, Esq.

The purpose of this article is to serve as a warning. If you are a party to a letter of credit transaction, and any of the other parties files for bankruptcy (or is involuntarily declared bankrupt) under the US Bankruptcy Code, proceed with caution. Although bankruptcy laws are now found in every part of the world, e.g., Europe, Asia, the Middle East etc., they are not uniform. This article is limited to discussing only US federal bankruptcy law and the applicant or beneficiary as the bankrupt party (in a voluntary bankruptcy proceeding) to a letter of credit transaction.

US federal bankruptcy laws are codified in the US Bankruptcy Code (the Code). When a company files for bankruptcy, it may do so either under Chapter 7 or Chapter 11 of the Code. If it files under Chapter 7, the company is seeking liquidation. If it files under Chapter 11, the company is financially distressed and wants to restructure its debt in a way acceptable to both the company's owners and its creditors. A Chapter 11 proceeding involves a court-appointed trustee, preparation of reorganization plan(s), creditors' meetings, etc. It can be prolonged and very costly. Chapter 11 filings, however, are frequently chosen by companies wanting to continue in business, but for which prompt financial relief is necessary.

The fate of a letter of credit when any party to that credit files for bankruptcy is determined by unavoidably complex laws - with sometimes perplexing results. For example, In re Powerine Oil Co., 59 F.3d 969 (1995), which involved a bankruptcy debtor who was an applicant for the letter of credit in issue, had a puzzling result. The court's opinion questioned in its opening paragraph "Can an unsecured creditor be better off when the debtor defaults rather than paying off the debt? Yes: Law can be stranger than fiction in the Preference Zone."

Terminology

A few brief definitions of terms often occurring in US bankruptcy laws that may be useful to the reader are set forth below in alphabetical order.

Automatic stay

Section 362(a) of the Code provides that on the filing of a bankruptcy petition, a mandatory halt automatically and immediately occurs with respect to any act to gain possession or to exercise control over any property of the debtor's estate. The few statutory exceptions would not be applicable in the letter of credit context of this article. For example, if the issuer has a lawsuit pending against the applicant, and the applicant files for bankruptcy, that immediately halts the lawsuit.

Debtor

The person or entity filing bankruptcy (or involuntarily declared bankrupt) is called the "bankruptcy debtor" or "debtor."

Executory contract

The term "executory contract" may be unfamiliar to the reader, as it is to most Americans, because the term is used primarily by American bankruptcy lawyers. An "executory contract" under US bankruptcy law is a contract between a bankruptcy debtor and another party under which both parties have substantial and material performance obligations still due. Section 323 of the Bankruptcy Code declares that the trustee is the representative of the debtor's estate and may sue or be sued. Section 365 (11 U.S.C.§ 365(c)) provides: "The trustee may not assume or assign any executory contract ... of the debtor, whether or not such contract prohibits or restricts assignment of rights or delegation of duties, if ... (2) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor."

The United States Congressional Record states, concerning § 365(c): "Thus, under this provision, contracts such as loan commitments and letters of credit are nonassignable, and may not be assumed by the trustee [emphasis added]." The prevailing rule under US bankruptcy law is that a letter of credit remains wholly executory until the beneficiary has complied with its terms. The rationale for this rule is that the bankruptcy trustee may not assume a letter of credit, because the credit provides a financial accommodation to, or for the benefit of, the debtor.

Preferential transfer

Section 547 of the Bankruptcy Code (11 U.S.C. §547) is based on the concept that the bankruptcy debtor may not give improper preference to a creditor. Inherent in a preference is transfer of the debtor's property, and Section 547 authorizes the trustee in bankruptcy to avoid - i.e., set aside - preferential transfer. The statute lists five elements that must coexist to constitute a preferential transfer:

1. the transfer is to or for the benefit of a creditor;

2. the transfer is made for or on account of a debt that was in existence when the transfer was made;

3. the debtor was insolvent when the transfer was made;

4. the transfer was made on or within 90 days before the date that the debtor filed a petition in bankruptcy or between 90 days and one year before the petition filing date if the creditor when the transfer was made was an "insider"; and,

5. the transfer made it possible for the creditor to receive more than it would otherwise have received if the transfer had not been made.

Section 547 broadly defines the word "transfer" as it is used in the term "preferential transfer". Floyd Trustee v. American Block Roland Niles International, Inc. (In re Cooper Manufacturing Corp., 344 B.R. 406 (Bankr. S.D.Tex. 2006) is an interesting example of the preference statute's 90-day provision applied in the letter of credit context. The debtor had been named beneficiary of a letter of credit. Before the preference period began, the beneficiary had transferred proceeds of the credit by valid assignments to four creditors. During the 90-day preference period, the four creditors received their shares of the credit. The trustee in bankruptcy sued these four assignees, claiming that their receipt of the credit's proceeds within 90 days of the bankruptcy filing were voidable preferences. The trustee lost because the court held that "for the purpose of calculating the preference period under 11 U.S.C. § 547(b) a transfer occurs on the date the contractual right to the proceeds is assigned, not on the date the payment is actually made."

Property of the debtor's estate

This is defined under Section 541 of the Bankruptcy Code, 11 U.S.C. § 541, and the definition is broad, including all legal or equitable interests in property as of the commencement of the bankruptcy case. The generally accepted rule is that a letter of credit and its proceeds are not part of the bankrupt debtor's estate. The judicial reasoning for this is that when the issuer receives a proper presentation for a draw under the letter of credit, the issuer is obligated to pay from its own assets, not from property in the applicant-debtor's bankruptcy estate.

Some cases have held, however, that this general rule does not apply in particular circumstances. In re Graham Square, Inc., 126 F.3d 823, 828 (6th Cir. 1997) states the basis for holding the general rule inapplicable:

"It is one thing to attempt to prevent the distribution of the proceeds of a letter of credit, an attempt the doctrine of independence is designed to prevent, but it is quite another to bring an action on the underlying contract that created the letter of credit."

Other provisions

Apart from the more prominent provisions mentioned above, there are others that should be briefly noted:

For the commercial lessor who is the beneficiary of a letter of credit to secure payments under a long-term commercial lease, the Bankruptcy Code has a special provision imposing a "cap" on the lessor's damages and a separate body of bankruptcy law respecting letters of credit securing leases.

In the US, the insolvency of a bank is not subject to the Bankruptcy Code but to its own statute, the federal Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA).

The recently enacted Chapter 15 (2005) of the Bankruptcy Code, entitled "Ancillary and Other Cross- Border Cases", incorporates the Model Law on Cross-Border Insolvency. The key concept of Chapter 15 is "comity of nations", which refers to a body of rules - not part of international law - that is based on courtesy, mutual convenience, and respect for the laws of another country. The 26 provisions of Chapter 15 merit a separate article.

Conclusion

This article has only touched briefly on some of the more frequently encountered aspects of US bankruptcy law relative to letters of credit. One thing is clear: if you are a party to a letter of credit transaction in which another party files bankruptcy proceedings (or is involuntarily declared bankrupt), beware! Proceed immediately to find out and to protect your rights.

Brooke Wunnicke is a lawyer with Hall & Evans LLC, Denver, Colorado USA. She is co-author of Standby and Commercial Letters of Credit (3rd ed., Wolters Kluwer Law & Business) with a 2008 Supplement. Her e-mail is wunnickeb@hallevans.com