Article

Factual Summary: To assure repayment of installment payments in the event of default in connection with the construction of an ethanol plant, Contractor/Applicant obtained a standby LC in favor of Manufacturer/Beneficiary in an amount that was eventually increased to US$8,111,994.69. When Contractor/Applicant sought Beneficiary/ Manufacturer's approval of change orders that would add 44.5 days to the timetable due to "serious problems", Beneficiary/Manufacturer served Contractor/Applicant with a default notice and Contractor/Applicant filed liens, initiated allegation and sought protection under the US Bankruptcy Code Chapter 11 (Reorganization). When Beneficiary/ Manufacturer drew down the entire amount of the LC, Contractor/Applicant filed an adversary proceeding seeking injunctive relief, or in the alternative, special relief regarding disposition of the proceeds. The bankruptcy court denied Contractor/ Applicant's motions. On appeal, affirmed in part and denied in part.


Legal Analysis:

1. Injunction: The appellate court noted that to succeed in its appeal of the denial of injunctive relief, Contractor/Applicant would have to show a substantial possibility of success on the merits. The court cited with approval the conclusion of the bankruptcy court that "generally federal courts enjoin the drawing down of standby letters of credit only in narrow circumstances where fraud in the transaction has been shown". It noted that while Contractor/ Applicant had "alleged fraud obliquely", there was no proof of fraud. The court stated its conclusion that Manufacturer/Beneficiary "[was] attempting to draw down on the LOC based on a good faith (although perhaps ultimately mistaken) belief that it [was] entitled to do so under" the terms of the agreement.

2. Bankruptcy; Segregation of Proceeds: Contractor/Applicant argued that if the proceeds were disbursed and it prevailed in the arbitration, it would be unable to recover from Manufacturer/ Beneficiary due to its insolvency. The court, concluding that Manufacturer/Beneficiary would become insolvent were US$4.3 million not made available, ruled that there was no need for the balance and, accordingly, ordered segregation of this amount.

3. Segregation of Proceeds; Requirements: The appellate court ruled that in order to grant segregation, it must be proved that (1) the Applicant/ Contractor would suffer irreparable injury absent segregation; (2) the other party would not suffer substantial injury if segregation was allowed; (3) the Applicant/Contractor should demonstrate a substantial possibility (although less than a likelihood) of success on appeal; and (4) public interest weighed in favor of granting a brief segregation. The court then reasoned that as Beneficiary/Manufacturer's insolvency was Applicant/Contractor's irreparable harm, and there was no evidence that the Beneficiary/ Manufacturer has an immediate need for the $3.8 million, partial segregation of proceedings would be granted.

Comment:

1. The court's determination that there is no LC fraud sufficient to justify injunctive relief is correct. However, the relief granted, segregation of part of the proceeds, resembles the relief that would have been granted had an injunction been awarded and the analysis appears strikingly similar (with the exception of the request of LC fraud). The case must be classified as an instance of the unique impact of bankruptcy. The question must be asked whether the obligation of the issuer, the LC, or its proceeds were property of the estate.

2. While recognizing that LC fraud is "generally" required for granting injunctive relief in US federal bankruptcy courts, and correct in its conclusion that there was no LC fraud, the appellate opinion does not refer to Revised UCC Section 5- 109 (Fraud and Forgery).

[JEB\yn]

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