Article

Topics: Bankruptcy

Prior History: Rafool v. Evans (In re Cent. Ill. Energy, L.L.C.), 482 B.R. 772 (Bankr. C.D. Ill. 2012) noted in 2013 ANNUAL REVIEW OF INTERNATIONAL BANKING LAW & PRACTICE at 481; Rafool v. Evans (In re Cent. Ill. Energy, L.L.C.), No. 07-82817, 2010 Bankr. LEXIS 1814 (Bankr. C.D. Ill., June 16, 2010) noted in 2011 ANNUAL REVIEW OF INTERNATIONAL BANKING LAW & PRACTICE at 543.

Note: Central Illinois Energy, LLC (Beneficiary) was formed in 2004 for the purpose of constructing, owning, and operating an ethanol production facility. Lurgi PSI, Inc. (Applicant) was retained by Beneficiary to design and construct the facility, and as a retainage of monthly progress payments, it applied for four standby letters of credit to be issued to Beneficiary. Two letters of credit were issued by Calyon Credit Agricole CIB, one was issued by DZ Bank AG, and one was issued by Commerzbank.

The two LCs issued by Calyon Credit Agicole CIB (Issuer) were at issue in the case. Both were subject to New York state law according to their terms. Both were to expire on 15 December 2008. Neither LC was drawn on.

Attorney Michael Evans represented Beneficiary during its negotiations with Applicant. During Fall 2007, Beneficiary began to experience financial difficulties and consulted with a separate attorney regarding the potential for filing for bankruptcy protection. In December 2007, Beneficiary filed a chapter 7 (liquidation) bankruptcy petition. The bankruptcy Trustee sued Attorney Evans and his firm (collectively, "Defendants") for legal malpractice, alleging that they had unreasonably failed to advise Beneficiary to draw upon the letters of credit prior to the bankruptcy filing. Trustee sought the full amount of the letters of credit.

Defendants moved for summary judgment, arguing that they could not have proximately caused the Beneficiary's damages because Beneficiary could have drawn upon the LCs after the bankruptcy filing. Beneficiary responded that Section 365(c)(2) of the Bankruptcy Code (11 U.S.C. § 365(c)(2) (2012)) prevented Beneficiary from drawing upon the LCs after the bankruptcy filing. Section 365(c)(2) states that a bankruptcy "trustee may not assume or assign any executory contract . . . if . . . 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, or to issue a security of the debtor."

The Bankruptcy Court found that Section 365(c) (2) was not applicable to the LCs, because they were not "contracts of the Debtor", executory contracts, or "contract[s] to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor." Because the LCs did not fall within Section 365(c)(2), the Bankruptcy Court opined that they could have been assumed by the bankruptcy Trustee. Thus the court concluded that Defendants did not proximately cause any damages because Beneficiary's counsel was aware of the LCs well-before their expiration dates and could have advised Beneficiary to draw on them before their expiration. Beneficiary appealed. The United States District Court for the Central District of Illinois, applying Illinois law as to the obligation of the attorneys and New York law regarding whether the LCs fall within Section 365(c)(2), McDade, J. affirmed.

The District Court Judge first considered whether the LCs were "contracts of the Debtor" and affirmed the Bankruptcy Court's holding that they were not. The Judge considered other cases in which courts had loosely referred to the three obligations involved in a letter of credit transaction-including the issuer's obligation to the beneficiary-as three contracts. It rejected the majority of those opinions, however, since those opinions did not conduct any substantive analysis of whether the three obligations are truly contractual, noting that the opinions used the word "contract" simply to describe that there were three independent obligations involved in a letter of credit transaction. The Judge found that the obligation owed to a beneficiary by an issuer is not a contract, because the obligation does not fulfill the requirements of a contract under New York law-namely the requirement of consideration. At best, the District Court found, the issuer owes a contractual obligation to the applicant to issue the letter of credit, but that would not qualify as a "contract of the Debtor" as referenced in Section 365(c)(2).

Therefore, the District Court Judge agreed with the Bankruptcy Court that the LCs did not constitute contracts of the Beneficiary. Since it had ruled on this issue, it was unnecessary for the District Court Judge to consider whether the LCs were executory contracts. Section 365(c)(2) only prohibits the assumption of "contracts of the Debtor", so if the LCs were not such contracts, they could have been assumed by the bankruptcy Trustee.

Although this conclusion made it unnecessary to consider where the LCs were executory contracts, the District Court Judge affirmed the Bankruptcy Court's holding that the LCs were not executor contracts. He noted that an executory contract is one in which substantial performance remains due by both parties, such that one party's failure to perform would constitute a material breach and excuse the other party's performance. Beneficiary argued that the obligation owed by Issuer to Beneficiary constituted an executory contract: it argued that it owed an obligation to Issuer to present conforming documents and Issuer owed an obligation to Beneficiary to pay. The Judge held that Beneficiary did not owe such an obligation to Issuer. If Beneficiary failed to present conforming documents, Issuer still owed its obligation to Beneficiary to pay upon the later presentation of conforming documents (until the date of expiration). As a result, even if the obligation owed by Issuer to Beneficiary could be considered under Section 365(c)(2), it did not constitute an executor contract.

Finally, the District Court Judge also considered whether the LCs were "contract[s] to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor." The Judge first noted that Section 365(c) (2) had been interpreted by most courts to refer to "contracts to make loans and other traditional kinds of debt financing arrangements." The Judge found that the LCs were not contracts to make a loan to Beneficiary, but instead were a form of payment to Beneficiary. The Judge stated, "under well-settled principles of contract law, a letter of credit cannot constitute a contract between the beneficiary and the issuer, because the beneficiary owes no obligation of payment or performance to the issuer -there is no "mutuality" between the beneficiary and the issuer."

The District Court Judge specifically refused to follow the holding of the United States Court of Appeals for the Ninth Circuit in In re: Swift Aire Lines, Inc., 30 B.R. 490 (9th Cir. 1983), to the affect that letters of credit are within the terms of Section 365(c)(2) and therefore, are not assumable. The Ninth Circuit cited to a statement by the drafters of Section 365(c)(2) that "under the provision, contracts such as . . . letters of credit are non-assignable, and may not be assumed by the trustee."

The District Court Judge in this case held that reference to the drafters' statement was inappropriate since the terms of the Section clearly do not include letters of credit as "contracts of the Debtor." Moreover, even if reference to that statement was appropriate, the Judge noted that the statement does not distinguish between situations where the debtor is the applicant and those where the debtor is the beneficiary. In the former, the letter of credit might constitute a financial accommodation to the debtor, because the issuer substitutes its credit for the applicant's. But in the latter, the letter of credit is certainly not a financial accommodation to the debtor.

As a result, the District Court Judge agreed with the Bankruptcy Court that the LCs did not fall within the terms of Section 365(c)(2), and as a result, the bankruptcy Trustee could have drawn upon them. The Defendants, therefore, did not proximately cause Beneficiary's damages, and summary judgment was appropriately granted.

Comment: The District Court's discussion of and rejection of In re: Swift Aire Lines, Inc., 30 B.R. 490 (9th Cir. 1983) is particularly helpful. The statement by the drafters of Section 365(c)(2) cited in the Swift Aire opinion undoubtedly referred to a commitment by a bank to issue a letter of credit on behalf of an insolvent applicant, not to a letter of credit issued to an insolvent beneficiary. Allowing an insolvent beneficiary to draw on a letter of credit does not create any new liability to the beneficiary, as would occur if the beneficiary drew on a loan commitment. Indeed, allowing an insolvent beneficiary to draw on the letter of credit enhances the bankrupt estate. As a result, assuming the beneficiary can comply with the terms of the letter of credit, Section 365(c)(2) should not prohibit an insolvent beneficiary from drawing on the letter of credit.

[JAM/jbb]

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