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Note: Factory Sales & Engineering, Inc. (Applicant/Debtor) contracted with Electrica Nueva Energia S.A. (Contractor/Beneficiary) to build a facility in Chile to produce energy. Beneficiary required an advance payment standby letter of credit for USD 1.526 million, which was issued by JPMorgan Chase Bank, N.A. (Issuer). According to the terms of the contract, Beneficiary could draw on the letter of credit if (1) Applicant/Debtor defaulted, (2) the Applicant/Debtor did not rectify the default within the rectification period, and (3) Beneficiary terminated for cause. Termination required Beneficiary to give 60 days written notice.

An involuntary bankruptcy petition was filed under U.S. Bankruptcy law for liquidation against Applicant/Debtor. Applicant/Debtor filed a motion to convert the case to a Chapter 11 proceeding, in which Applicant/Debtor remained in possession during reorganization. The court entered an order for relief, and an automatic stay was issued which prohibited any actions against the Applicant/Debtor or the property of the estate. Applicant/Debtor then obtained debtor-in-possession financing to complete the contract.

Beneficiary subsequently sent Applicant/Debtor a letter detailing the problems with the project but did not request that Applicant/Debtor stop working. Two months later, Beneficiary drew on the standby. The next day, Beneficiary sent an email to Applicant/Debtor stating that it was terminating the contract for cause. Applicant/Debtor then moved in the bankruptcy proceedings to enjoin Beneficiary from drawing on the standby. The United States Bankruptcy Court for the Eastern District of Louisiana, Brown, J., granted a preliminary injunction.

The Judge ruled that Beneficiary had not properly cancelled the contract since it had failed to give 60 days notice of termination as required by the contract. The 14 June letter sent by Beneficiary did not constitute notice since it did not request that Applicant/Debtor cease working. Furthermore, the Judge ruled that Beneficiary’s attempt to terminate the contract came a month after an order for relief in favor of Applicant/Debtor, staying any act to obtain possession of property of the bankruptcy estate. Executory contracts and leases are property of the bankruptcy estate, and are therefore protected against termination or other interference.

Beneficiary argued the stay did not apply to the standby because it was not Applicant/Debtor’s property. The Judge ruled that “[Applicant/Debtor’s] rights under the contract between it and [Beneficiary] are undeniably property of the estate and those rights are protected by the automatic stay”, noting the automatic stay precluded any attempt by Beneficiary to terminate the contract without first applying to the bankruptcy court for relief from the stay.

Beneficiary also argued that the payment on the standby could not be enjoined, and Issuer could only dishonor a presentation “if a required document is forged or materially fraudulent or honor of the presentation would facilitate a material fraud by the beneficiary.” Beneficiary argued that there was no fraud, and that Beneficiary had bargained for the right to draw on the letter of credit in the event that Applicant/Debtor failed to perform under the contract. The Judge disagreed, ruling that Beneficiary had committed material fraud in trying to draw on the standby because Beneficiary did not give a written 60day notice of termination. Since Beneficiary had not terminated the contract, it was therefore not entitled to draw on the letter of credit without seeking permission from the bankruptcy court.

Comment: Does an action in breach of the underlying contract constitute LC fraud warranting injunctive relief? Here, the alignment of the parties differs from an ordinary situation. The contractor gets to keep the advance payment pending resolution of the various issues. Perhaps that is the risk allocation intended by the parties.

Text: The standby letter of credit contained the following term:

“Subject to availability for drawing of the letter of credit as above provided, payment under this letter of credit is available upon presentation of beneficiary’s signed and dated statement reading as follows:”

The required Drawing Statement was:

“Factory Sales and Engineering, Inc., d/b/a FSE Energy has:

  1. Materially failed to and defaulted in the performance its (sic) obligations in accordance with that certain contract between Factory Sales and Engineering, Inc. d/b/a FSE Energy and Electrica Nueva Energia, S.A., entitled, “Agreement for Purchase and Sale of Equipment,” dated August 10, 2015, for the supply of equipment, component parts and related performance of specified services relating to Escuadron Power Plant, located at Parque Industrial Escuadron–II KM 17.5 Concepcion–Coronel Highway, Coronel, Chile;
  2. Any applicable cure or rectification period available to Factory Sales and Engineering, Inc., d/b/a FSE Energy has expired without its default having been cured or rectified; and
  3. Pursuant to Article XV of the said contract, Electrica Nueva Energia, S.A. has terminated for cause the right of Factory Sales and Engineering, Inc., d/b/a FSE Energy to continue its performance under the contract, such that Electrica Nueva Energia, S.A. is therefore entitled to draw under letter of credit No. CTCS–867822 for refund of the down payment. We hereby demand the amount of USD___________ under JPMorgan Chase Bank, N.A. letter of credit number CTCS–867822.”

[KEC]

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The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of the ICC or Coastline Solutions.