Article

Factual Summary: To provide security for its obligations as a self insurer under the Pennsylvania Worker's Compensation Act, Employer, a textile manufacturer, arranged for Bank to issue an LC for US$1,000,000 payable to the State Agency as beneficiary. Applicant entered an agreement titled "Acknowledgement of the Terms and Conditions on Posting Letters of Credit" with Issuer which indicated when State Agency/Beneficiary could draw on the LC, including receipt of a notice of non-renewal. It also provided for the creation of a trust to hold the proceeds of the LC in the event of such a draw. The LC itself provided no conditions or qualifications to Beneficiary/State Agency drawing on the presentation other than a complying presentation.

The day after the LC was issued, Applicant formed a Trust of which Issuer was the trustee "to provide a source of funds and to maintain adequate reserves" to pay worker's compensation claims, and in which Applicant was obligated to maintain certain funds. The Trust Agreement, to which State Agency was not a party, provided that:

[State Agency] may direct that proceeds from security posted by the Employer to secure its Claims Liability, such as surety bonds or letters of credit, be deposited into a segregated account which is a part of the Trust Fund. During a Default, [State Agency] may direct the use of such security proceeds to pay Claims Liability, Claims Administration Expenses and Trust Operating Expenses as outlined in this Agreement. If the Default is cured or if [State Agency] determines that the proceeds from the security are no longer needed, [State Agency] may direct that any remaining such security proceeds held in the segregated account be distributed as directed by [State Agency].

Subsequently, State Agency drew on the full amount of the LC, allegedly due to the refusal of the Issuer to extend the expiration date of the credit, was paid, and deposited the LC proceeds into the Trust. Applicant shortly thereafter filed for protection under the US Bankruptcy Code, Chapter 11 (debtor reorganization). After State Agency paid all worker's compensation claims and expenses from the LC proceeds, US$440,000 remained.

Issuer filed an unsecured claim for reimbursement of US$1,000,000 which the court allowed against the bankruptcy estate of Applicant, of which US$528,890.08 was paid. Issuer then sought to recoup the balance from the excess LC proceeds and asked for a determination from the court that these funds were not the property of the estate and should be returned to Issuer. Applicant contended that the excess proceeds were the property of the estate.

The bankruptcy court granted summary judgment against Issuer in favor of Applicant's estate.

Legal Analysis:

1. Independence Principle: Issuer argued that under the independence principle neither LCs nor their proceeds constitute property of a bankruptcy estate. Applicant, on the other hand, argued that the Trust Agreement gave it a reversionary interest in any excess LC proceeds. The court agreed that the independence principle would preclude a bankrupt applicant from asserting an interest in an LC solely based on the LC instrument because the applicant is not a party to the agreement between the issuer and beneficiary, as "the letter of credit is a contract between..." them. The court noted, however, that Applicant was "not proceeding against the Excess pursuant to the Letter of Credit", but was proceeding under the Trust Agreement.

2. Reimbursement, Underlying Trust Agreement: The section of the Trust Agreement between Applicant and Issuer dealing with the rights of the parties stated:

It is understood and agreed that no person or corporation, except the parties hereto, shall have any rights under this Agreement or in the Trust Principal except as provided in this Agreement. The Trust Fund shall not be subject to the direct action or seizure by any creditor or claimant of the Employer under any writ or proceeding at law or equity except as contemplated by and under the Acts. The Employer shall not have right, title, interest, claim or demand whatsoever in or to the Trust Principal other than the right to a proper application and accounting of it by the Trustee and the right of reversion as provided under sections 2(e), 13 and 14(c), all as set forth in this Agreement.

The court noted that under this provision Issuer has no rights to the Trust, while Applicant has rights of reversion specified in several sections of the Trust Agreement. Section 2(e) deals with the security posted by Applicant, in this case the LC, and states "[i]f the Default is cured or if [State Agency] determines that the proceeds from the security are no longer needed, [State Agency] may direct that any remaining such security proceeds held in the segregated account be distributed as directed by [State Agency]." Since the Trust Agreement gives all reversionary rights to Applicant the excess LC proceeds are part of the Applicant's Bankruptcy estate.

3. LC Proceeds: The court emphasized the separate agreements that governed the LC proceeds in this case. It stated:

The Letter of Credit before me ... simply deals with the mechanics for draw down. Nothing in that contract [the LC] speaks to either how the Letter Proceeds are to be used or whether any amounts are to be returned. Therefore, once [Issuer] performed under the Letter of Credit and paid the funds to [State Agency], that contract was fully executed and all obligations were satisfied. [State Agency] was free to do whatever it wanted with the Letter Proceeds, subject to any other contracts or statutory restrictions which might bind it. Here it chose to place the Letter [of Credit] Proceeds into the Trust Fund, which in turn is governed by the Trust Agreement. As noted, that agreement gives all rights of reversion to [Applicant].

Comments:

1. Sometimes courts vested with the protection of the interests of creditors of insolvent applicants ignore letter of credit law in their zeal to marshal assets for the estate. On the other hand, LC fans sometimes tend to overstate the scope of the independence rule. Here, the court's nod to the interests of the estate does not clash with LC law principles. Having paid the LC, the issuer cannot claim some right to the excess proceeds that is greater than its rights as a creditor of the applicant.

[JEB/lhd]

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