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U.S. Bankruptcy law and letters of credit fit uneasily together since each set of laws generally ignores the other. This article addresses how legal issues impacting letter of credit rights and obligations are handled under the Bankruptcy Code when the applicant or beneficiary becomes subject to a bankruptcy.1
Several areas of bankruptcy law can impact parties involved in LC transactions discussed in the questions (Q), answers (A) and tips (T) below. These include the ipso facto, automatic stay, preference, lease cap and executive compensation cap provisions of the Bankruptcy Code.2
While this article discusses bankruptcy and LC considerations from a U.S. standpoint, many of these areas could emerge in other jurisdictions and LC parties would want to think through the scenarios based on their applicable law.
Ipso Facto Issue Affecting the Beneficiary's Right to Draw
Q: If the applicant’s bankruptcy triggers an LC draw right, does the ipso facto clause under Bankruptcy Code §365(e)(i) prevent the beneficiary from drawing?
A: Most courts say a beneficiary may draw on an LC posted by its bankrupt debtor even though the only default authorizing the draw is the applicant’s bankruptcy. Depending on the court and the facts, some courts say the ipso facto clause matters.3
T: To avoid argument that bankruptcy alone triggers the LC draw right and therefore violates the ipso facto clause, beneficiaries should look for other reasons that trigger the right to draw, such as a missed payment, contract breach or misrepresentation, and/or require a clean LC where possible.
Automatic Stay Issues Affecting the Right of the Beneficiary to Draw on an LC
Q: Does the Bankruptcy Code's automatic stay under Bankruptcy Code §362 impact the beneficiary's right to draw?
A: Not usually. The draw is not subject to the automatic stay because courts find that the LC draw is made against the issuing bank and not the bankrupt applicant or its property, and is therefore not subject to the automatic stay. The stay prevents taking enforcement action against the debtor or its property to enforce collection of a debt, but not the issuing bank.
T: Avoiding the automatic stay is one of the primary benefits for having a letter of credit secure or support payment of a debt. It provides instant liquidity.
Q: Does drawing on an LC ever require the beneficiary to obtain bankruptcy court relief from the automatic stay?
A: In some cases it could if the beneficiary, as a precondition to drawing, must take actions against the bankrupt applicant-debtor that are stayed by the bankruptcy filing. Such actions could include notifying the applicant of a default, declaring a default, or terminating a lease. Some courts say however, that notices of a default or of an intention to draw on an LC are informational only and not actions to collect a debt requiring relief from the automatic stay.
T: Draft the LC and the underlying agreement it supports to allow for draws on the LC without taking action that may be stayed. For example, the beneficiary should consider inserting an automatic acceleration and default without notice provision in the underlying agreement if the debtor is bankrupt or subject to acts of insolvency which allow drawing on the supporting LC.
Q: If (i) the applicant files for bankruptcy, (ii) the LC does not have an auto-extend provision and will expire during bankruptcy unless extended, (iii) the obligations supported by the LC are not yet due, and (iv) the applicant in the underlying agreement agreed to have its bank extend the LC or the applicant agreed to consent to a draw to allow it, can that agreement be enforced in the debtor- applicant's bankruptcy?
A: A bankruptcy court could determine that the automatic stay prevents the beneficiary from enforcing the covenant against the bankrupt applicant-debtor and/or that the debtor or its trustee can reject the pre-bankruptcy agreement requiring the applicant to extend the LC's expiration date.
T: To prevent this result, the beneficiary should (i) require an automatic extension provision in the LC with a right to draw if the beneficiary receives the issuer's notice of non-extension before the LC expires or (ii) require the LC's outside expiration date to extend beyond the last payment to be made by the debtor plus 120 days to cover preference claims (see discussion below).
Preferences Affecting Beneficiary's Right to Retain Draw Proceeds
Q: Is the beneficiary's receipt of the draw proceeds to pay an antecedent debt that the LC supports a preference that the beneficiary must return to the bankrupt applicant's estate?
A: Normally the beneficiary is not charged with a preference for draws on an LC under §547 of the Bankruptcy Code if (i) the LC was issued at the same time as the debt it supports arose (a so- called contemporaneous exchange of value exception to a preference), (ii) the LC was issued before the preference period began, or (iii) the reimbursement obligation to the LC issuer is unsecured at the time of the draw.
T: These three situations cover most situations that arise when an LC is issued to support a debt or other obligation.
Q: Can the applicant-debtor's estate recover draws that constitute indirect preferences?
A: One exception to the answer to the previous question about preferences can occur if (i) the LC is issued during the preference period, (ii) to secure an antecedent debt, and (iii) the application's reimbursement obligation is secured by collateral obtained in the preference period at the time the LC is issued. This is known as an indirect preference. In effect, some courts say that collateral was indirectly pledged to or for the benefit of the beneficiary via the issuing bank during the preference period and therefore the draw proceeds are subject to recovery by the bankruptcy estate as an indirect preference.
T: We are not recommending that creditors turn down an LC if it is offered to support an antecedent debt. If an LC and its collateral is issued to support an antecedent debt, the beneficiary should consider avoiding taking actions against the applicant that may precipitate its filing for bankruptcy during the preference period. Once the 90-day preference period passes after the LC has been issued, the danger of an indirect preference to non-insiders as stated above is avoided.
Q: If during the preference period the applicant-debtor collateralizes an already outstanding LC supporting its antecedent debt, will the beneficiary have to return LC draw proceeds as a preference?
A: No, the preference claim is between the bankrupt applicant and its issuing bank. This is not normally regarded as an indirect preference to the beneficiary because the applicant's bankruptcy estate is not diminished; it can seek to recover the value of the newly pledged collateral from the issuing bank as a preference.
T: We are not recommending that issuing banks turn down collateral if needed after the LC is issued. The issuer's preferred position, however, is to take and have remain in place full collateral for reimbursement from when the LC is issued until it is fully drawn or expires. For example, the issuer can avoid a preference claim if it has a pre-existing line of credit with a letter of credit subfacility that is fully secured and perfected before the preference period up through the time the LC is issued and expires.
Q: Does the beneficiary of an LC issued to support an antecedent debt avoid a preference if the applicant directly pays the beneficiary the debt within the preference period?
A: It depends.
T: In highly structured financing transactions, such as LC-backed municipal bond issues, direct pay LCs are used so that periodic payments are made from the LC itself and not from the borrower. Direct pay LCs avoid not only stay issues, but also claims of indirect preferences as outlined above.
Preferences and Other Bankruptcy Rules Affecting the Issuer's Right to Obtain and Retain Reimbursement from a Bankrupt Applicant
Q: In what circumstances does the LC bank become exposed to preference claims for collateralizing and/or taking a reimbursement payment for a draw on an LC?
A: An issuer can avoid a preference claim related to reimbursement of a payment on the LC if the reimbursement obligation is fully collateralized and perfected at or before the LC was issued or before the preference period commenced. For newly added and needed collateral, whether it will be treated as preferential depends on when the collateral for reimbursement was obtained.
The issuing bank may be deemed to have received a preference if, after it has issued an LC and within the preference period of the applicant, it (i) takes and perfects a security interest in new collateral (including cash collateral) to secure reimbursement for a previously unsecured or under- secured LC and uses that collateral to reimburse itself for a draw on the LC, or (ii) takes an unsecured reimbursement payment from the debtor-applicant as reimbursement for a draw on the issuing bank's LC.
T: If there is concern about the applicant's financial stability or a danger of a bankruptcy while the issuer's LC is outstanding, the issuer should obtain and perfect full collateralization of the applicant's LC reimbursement obligations at the outset — before or at the time each LC is issued.
Q: How can the issuing bank have the bankrupt applicant reimburse it for draws honored on its LC?
A: If the applicant's reimbursement obligation is collateralized and perfected contemporaneously with or before the LC's issuance or was granted and perfected prior to the preference period, the issuing bank's liens should not be considered preferential. The lender's perfected security interests should remain valid in the applicant-debtor's bankruptcy, both before and after LC draws.
T: If the LC is outstanding or drawn after bankruptcy, the lender will need to obtain relief from the automatic stay in the debtor's bankruptcy proceedings to enforce and realize on its collateral security for reimbursement or seek adequate protection of it. This brings into play all the considerations for obtaining relief from the stay, including exercising setoff rights against the applicant's funds at the issuing bank.
If the issuer's reimbursement rights are unsecured, the issuer should file and pursue a claim for the unreimbursed draw amount and related damages in the applicant’s bankruptcy case.
Q: Can an LC issuer lose its LC reimbursement security in a Bankruptcy Code §363 sale of the debtor applicant's assets in bankruptcy?
A: Yes. Asset purchase agreements and orders under Bankruptcy Code §363 frequently provide that assets are transferred to the purchaser free and clear of the lender's security interests and that the security interests attach to the sale proceeds of the assets subject to the bank's security interests.
T: Bank issuers should consider carefully what protections should be included in §363 agreements and orders before they are approved by the Bankruptcy Court. Provisions in the sale order and agreement should assure the issuer that its LCs are terminated with the sale, some other issuer of the buyer replaces them, or the issuer's LCs remain fully collateralized post-sale.
Other Circumstances Where a Beneficiary May Have to Return LC Proceeds to a Bankrupt Applicant
Q: Are LCs' securing leases or employment contracts subject to limits on the amount that can be drawn when the lessee or employer files for bankruptcy and defaults on its lease or employment contract?
A: Where a claim is filed in the bankruptcy proceedings of the tenant, some courts have held that LC proceeds securing a lease should be subtracted from the bankruptcy cap. Some courts have allowed LC proceeds exceeding the cap to be drawn and retained by the landlord beneficiary when there was a lease default if the landlord did not make a claim in the tenant's bankruptcy.
When the LC supports an employer's payment of "golden parachute" compensation to an executive, courts have held that when drawn by the executive of a now-bankrupt company applicant, the executive may retain the LC proceeds that exceed the cap.
T: To avoid bankruptcy caps on future rents or compensation, landlords and executives should consider bargaining for LCs to support their claims that can be drawn post-bankruptcy of their tenant or employer. If they are able to do so successfully, they would not need to seek relief in a bankruptcy court to obtain payment for what is due them regardless of the cap that would limit their claims in bankruptcy.
Q: Are there other circumstances when the beneficiary must return LC draw proceeds to the bankrupt applicant-debtor's estate?
A: Proceeds may have to be returned to a bankrupt beneficiary's estate if, under non-bankruptcy law, the draw was excessive, illegal, fraudulent, or violated the underlying agreement between the applicant-debtor and the beneficiary. Depending on the circumstances of the case, courts are divided on whether the excess LC proceeds should be returned to the issuer or the applicant.
T: The issuer should consider inserting in its reimbursement agreement with the applicant a requirement that the beneficiary return excess proceeds from an LC draw to the issuer rather than the applicant. If possible, the issuer should have the beneficiary acknowledge this requirement directly or indirectly via the underlying agreement between the applicant and beneficiary.
LC Rights Affected by the Beneficiary's Bankruptcy
Q: Can a Debtor in Possession or Bankruptcy Trustee draw on the bankrupt beneficiary's nontransferable LC?
A: The beneficiary's rights under an LC are transferable by operation of law. Under UCC §5-113 a trustee in bankruptcy or court appointed receiver qualify as a transferee by operation of law and therefore is authorized to draw on the beneficiary's LC to the same extent that the beneficiary could draw.
T: The issuer is not required to prove the sufficiency of the transfer of the beneficiary's rights under the LC by operation of law; it can rely on evidence of the transfer provided by the trustee to it such as a verified copy of the court order appointing it as bankruptcy trustee or receiver.4
Q: How can a lender's or other secured creditor's security interest in a beneficiary's letter of credit rights5 be perfected and prevail against the beneficiary's bankruptcy trustee?
A: Either:
T: An issuer is not required to consent to an assignment of proceeds unless the LC affirmatively states that it is assignable, or the LC is a presentation LC and the beneficiary and assignee consent to commercially reasonable requirements of the issuer as conditions of the assignment. In either case, the issuer may require use of its assignment form and require reasonable conditions for consenting to the assignment.6
Q: Can a creditor-assignee of a beneficiary be deemed to have received a preference by obtaining assignment of the beneficiary's letter of credit rights to secure a debt of a beneficiary that becomes subject to a bankruptcy?
A: If the assignment of LC proceeds is perfected before the preference period or at the same time as the debt's creation, the assignment should not be considered preferential. If the assignment is made and acknowledged within the preference period to secure an antecedent debt, it could be considered preferential.
Q: Can the beneficiary's creditor avoid bankruptcy issues by becoming a transferee beneficiary of its debtor's LC?
A: The transferee beneficiary could be subject to a preference challenge if the transfer is made for the purpose of securing the original LC beneficiary's antecedent debt owed to the transferee beneficiary and it is made during the transferor beneficiary's preference period. It could also be subject to automatic stay issues if the transferee beneficiary must take actions against the original beneficiary that are stayed in order to draw on the transferred LC.
T: Similar considerations and precautions that apply to avoid automatic stay and preference issues that affect the original beneficiary's rights to draw and retain LC proceeds and, for assignment of LC rights, to the secured party's rights, should be considered and addressed when a creditor becomes a transferee beneficiary to secure a debt.
In sum, letters of credit fit uneasily with the Bankruptcy Code. Knowing how the rules of the Bankruptcy Code interplay with letter of credit law and practice can help parties plan around them or take actions to deal with them. Some of the risks outlined above for LC applicants, beneficiaries, and issuers can be mitigated in documentation while others can only be recognized and assessed.
Although tips are given after answers, approaches and responses that should be considered and taken will vary from situation to situation. LC participants should seek the advice of knowledgeable and experienced counsel when dealing with bankruptcy issues that affect their LC rights and obligations.
* The statements in this article reflect the author's individual opinions and not those of their respective organizations or of DCW, do not constitute legal advice and are for informational purposes only. Case citations are omitted, but are available from the authors' materials submitted to the American Bar Association at its September 2023 Business Law Section meeting in Chicago.
** Carter Klein, Of Counsel at Jenner & Block LLP and Janis Penton, USC Gould School of Law.
1This article does not address what the law is and what happens when the LC issuing bank becomes insolvent and is taken over by the FDIC. That subject was covered in Mark Warren’s article, “Letters of Credit in U.S. Bank Failures: Possible Outcomes,” in the October 2023 DCW issue at p. 37.
2This article assumes a basic understanding of these U.S. bankruptcy provisions. The relevant sections of the Bankruptcy Code are cited when each provision is discussed and can be found in Chapters 3, 5, 7 and 11 of the United States Code (11 U.S.C. §§101 et seq.).
3See, e.g., the February 2023 DCW issue at p. 26 discussing TC Skyward Aviation, Inc. v. Deutsche Bank A.G., NY Branch, 557 F. Supp. 3d 477 (S.D.N.Y. 2021).
4See Official Comments to UCC §5-113.
5The term “letter of credit rights” is defined under UCC Article 9 which deals with security interests in personal property. The definition includes “a right to payment or performance under a letter of credit” whether or not demanded, but “does not include the right of a beneficiary to demand payment or performance under a letter of credit.”
6UCC §5-114(d) and Official Comment 3 to it; see also ISP98 Rule 6.08.