Factual Summary: To secure applicant's obligations under a lease of real property, a standby LC in the amount of US$1,792,000.00 was issued payable to lessor. The LC required that beneficiary/lessor certify that applicant "has failed to pay or perform one or more of its obligations under the Lease...". The lease itself listed as an event of default the filing of voluntary bankruptcy. The lease provided that beneficiary was entitled to draw against the LC, "to satisfy itself with an amount equal to the total rent reserved for the balance of the term..." in the event of an uncured default. When applicant filed for protection during its reorganization under Chapter 11 of the U.S. Bankruptcy Code, beneficiary served a notice of default and notice of its intent to draw the full amount of the LC despite the fact that applicant was current on its lease payments. Applicant then moved for a temporary restraining order and preliminary injunction in the bankruptcy action to prevent beneficiary from drawing upon the LC. The bankruptcy court granted applicant's motion..

Legal Analysis:

1. Jurisdiction of Bankruptcy Court: The beneficiary argued that the bankruptcy court lacked jurisdiction to enjoin payment on an LC, citing First Fidelity Bank, N.A. v. Prime Motor Inns, Inc. (In re Prime Motor Inns, Inc.), 130 B.R. 610 (S.D. Fla. 1991) for the proposition that "'the bankruptcy court did not have jurisdiction to interfere with these separate and independent contracts to which the Debtors were not parties.' Id. at 612". The court, however, distinguished Prime Motors on the basis that the case "involved letters of credit, issued on the Debtor's behalf, to secure bond indentures to which the debtors were not parties". It stated that "in the present case, however, the Court's grant of a preliminary injunction stems from the terms of the Lease to which the Debtor is a party. The Court is well within its jurisdictional authority to make a determination about the terms of a Lease between a Debtor and a third-party."

2. Injunction, Grounds for: The court indicated that four factors were involved in considering the appropriateness of injunctive relief. They included whether plaintiff would suffer irreparable injury without the injunction, whether the injury would outweigh harm that could occur if the injunction were granted, whether the plaintiff showed likelihood of success on the merits of its case, and whether the public interest would be adversely affected by the grant of a preliminary injunction.

3. Injunction, Likelihood of Success: Noting that "the Bankruptcy Code embraces the policy of preventing the enforcement of ipso facto clauses, which automatically terminate a contract or a lease or allow the other party to terminate in the event of a bankruptcy filing," the court indicated that the debtor had demonstrated likelihood of success. It indicated that since the debtor was current on its lease payments, the filing of the bankruptcy triggered the default, making the notices of default without basis since they violated the Bankruptcy Code.

4. Irreparable Injury: Because the amount of the LC exceeds the amount that the landlord might be able to claim under the bankruptcy proceeding and the issuer would draw on security provided by the debtor, the court concluded that the debtor would suffer irreparable harm.

5. Bankruptcy Policy, Independence: The court concluded that an injunction would further the policy of the Bankruptcy Code in preventing ipso facto clauses. It also concluded that "the issuance of a preliminary injunction will not affect the integrity of Letters of Credit. The Court's determination is based on the Lease provisions and their treatment under the Bankruptcy Code, and not contract principles relating to Letters of Credit".

6. Injunction: The court concluded that since the required notices of default were void under bankruptcy law, the beneficiary had no basis for drawing on the LCs and that an injunction to prevent their honor was justified.

Comment: This decision is troubling on many grounds. 1. The court ignored the unique grounds on which injunctive relief is available with respect to LCs. Payment on an LC may only be enjoined where there is LC fraud. While the normal equitable tests are also applicable, there is an additional test in the case of an LC. It may be that the court's discussion of the lack of a basis for drawing would satisfy that test, but the court did not even consider whether the drawing is fraudulent. As a result, it seriously weakened the role of LCs as a source of protection against insolvency. 2. In distinguishing Prime Motors on the basis that the debtor was not a party to the underlying transaction that gave rise to the LC, the court marginalized the independence principle. The transaction to which the debtor was not a party was the LC itself. It is to the LC that the quoted phrase in Prime Motors refers and not the underlying transaction. Whether it was a party to the underlying transaction or not is irrelevant since the applicant is not a party to the LC. The reality,.63 2001 LC CASE SUMMARIES however, is that LCs are independent from the underlying transaction even in the rarified atmosphere of bankruptcy. Said one prominent LC lawyer, the case is "partially wrong - i.e., that the draw itself should not be enjoinable, but perhaps the proceeds should be returned or damages sought for wrongful draw," comparing it to Kellogg v. Blue Quail Energy, Inc. (In re Compton, Inc.), 831 F.2d 586 (5 th Cir. 1987) and American Bank v. Leasing Service Corp. (In re Air Conditioning, Inc.), 845 F.2d 293 (11 th Cir. 1988). 3. Said another well-known LC attorney, "the Court seems to be trying to stay away from Rev. [UCC Section] 5-109 and enjoining honoring a presentation or granting similar relief. Leave aside the bankruptcy law questions of whether the Lessor is entitled to terminate a real estate lease upon a voluntary bankruptcy filing by the Lessee and whether the Lessor is entitled to accelerate the entire balance of the remaining rent payments. If the LC had provided that the Lessor could draw simply by presenting (i) a draft, (ii) a certificate stating that a voluntary bankruptcy filing had been made by the Lessee, or (iii) a certificate stating that an "Event of Default" as defined in the Lease had occurred (assuming the Lease defined a voluntary bankruptcy filing as one of the Events of Default), would this Court have allowed a drawing on the LC (issued by the bank to the Lessor - both non-bankruptcy debtors) even if it would not have allowed a Lease termination? The discussion of irreparable injury seems notable for its focus on monetary items rather than on factors that cannot ordinarily be addressed by money damages."


The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.