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Note: To satisfy a requirement in a state governmental scheme for self-insurance to protect workers from losses due to workplace accidents (known in the U.S. as Workman's Compensation), Spring Ford Industries, Inc. (Applicant) obtained a standby LC in the amount of US$1,000,000 issued by PNC Bank (Issuing Bank) in favor of the Pennsylvania Bureau of Worker's Compensation (Beneficiary). The terms of the standby LC were mandated by the state agency. According to the opinion, they provided "that [n]o deviation from this language is permitted." The instructions also provided the language for a "Funding Trust Agreement which will also serve as the trust for the Deposit of Letter of Credit Proceeds.' " To ensure its reimbursement, Issuing Bank entered into an agreement with Applicant entitled a "Trust Agreement". It "provided that 'the trust fund is established to provide a source of funds and to maintain adequate reserves for the payment of workers' compensation claims.' Section 2(e) of the Trust Agreement provided that [Beneficiary] could direct 'proceeds from security posted by [Applicant] to secure its Claims Liability, such as...letters of credit, be deposited into a segregated account that is part of the Trust Fund.' "

Prior to Applicant becoming insolvent under the U.S. Bankruptcy Code and after being informed that the LC would not be renewed, Beneficiary drew on the letter of credit for US$1,0000,000. Applicant subsequently filed for federal bankruptcy protection and Issuing Bank filed an unsecured claim for US$1,000,000 for which it received distributions of 52%.

Having paid all claims and expenses, Beneficiary had an excess of US$440,000, which it deposited into a segregated part of the stated trust fund. Claiming these funds, Issuing Bank brought an adversary action in the bankruptcy case against the Applicant. On cross motions for summary judgment, the U.S. Bankruptcy Court for the Eastern District of Pennsylvania, Sigmund, C.J., granted summary judgment in favor of Applicant. On appeal, The U.S. District Court for the Eastern District of Pennsylvania affirmed.

The District Court noted Issuer's argument that the "excess funds that remained in the Trust...should be characterized as 'proceeds' from the Letter of Credit and not be considered part of the bankruptcy estate." The court noted than an LC and its proceeds "are not part of the bankruptcy estate because the issuing bank distributes its own assets under the letter of credit and not the assets of the debtor/customer who caused the letter of credit to be issued." It also noted that, "Once the beneficiary fulfills the requirements of the letter of credit and draws on it, the issuer of the letter of credit cannot direct how the beneficiary uses the proceeds." Therefore, the court concluded that since the proceeds were deposited into the trust at the direction of the Beneficiary, "it is the Trust Agreement that dictates the precise way the funds are supposed to be used."

Concerning the Trust Agreement, the court concluded that Issuer had no rights except as provided in the state statutes establishing the scheme. Since Issuer had not demonstrated such a right, the court concluded that it had none.

The court noted, however, that the Trust Agreement provided Applicant with a reversionary interest in the Trust. Since the Beneficiary had no further claim to the Trust, this interest was given effect.

Issuer argued that the purpose of the statute was not to provide the Applicant with a "windfall" in the form of excess proceeds. Applicant argued that Issuer could have protected itself and at the trial the Bankruptcy Court had detailed several ways, namely "(1) inserting language in the Letter of Credit that limited the [Beneficiary]'s draw to anticipated workers compensation claims and costs or requiring refund of any excess; (2) inserting language in the Trust Agreement calling for its own right of reversion to unused Letter Proceeds; or (3) contracting with [Applicant] for a security interest in other assets." The District Court agreed, noting Issuer's objection that the form was mandated but stated that "[Issuing Bank] could have protected itself by inserting language into the Trust Agreement requiring reversion of the Trust Proceeds to it, or when [Applicant] sought to do business with [Issuing Bank] for the Letter of Credit, [Issuing Bank] could have demanded from [Applicant] a security interest in [Applicant]'s other assets which would have assured [Issuing Bank] that it would be a secured creditor rather than one of a number of unsecured creditors as it now finds itself." Alternatively, the court suggested that it "could have priced its fee to [Applicant] to better reflect its financial risks or, if [Issuing Bank]'s assessment suggested risks too great to accept, [Issuing Bank] could have declined this transaction altogether."

[JEB/bain]

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