Article

Factual Summary: Pursuant to their US $67 million contract to provide supplies and services in the construction of a power plant in Columbia, Supplier provided a performance standby to the owner in lieu of the retention of 10% of progress payments. In addition to fees of 1.5%, Applicant retained a deposit of two thirds of the LC's value. Prior to the drawing, these funds amounted to US $2.26 million which were applied by Issuer to an unrelated loan to Applicant.

When Applicant became insolvent and was placed in bankruptcy, Issuer gave notice that it would not renew the standby even though Applicant had continued to perform its contractual obligations. Beneficiary then drew on the LC for US $3,344,450, an amount in excess of payments that would be due for the outstanding work. Although it initially refused to pay and unsuccessfully petitioned for emergency relief from the bankruptcy court, Issuer paid when threatened with an action for wrongful discharge.

Subsequently, Beneficiary reached a settlement with Applicant regarding disputed a claim related to the drawing, paying US$3.335 million and US$ 159,000 into escrow for the estate.

Legal Analysis:

1. Independence; Entitlement of Funds; LC Proceeds: Creditor contended that the trial court ignored principles of letter of credit law in determining that the funds were the property of Issuer and not the estate. Looking to the LC application which was subject to New York law, the appellate court considered the ramifications of the doctrine of independence. It stated "There are a number of policy considerations behind the independence principle. Chiefly, the principle facilitates the use of letters of credit to shift credit risk by relieving issuers and other banks from having to investigate the underlying transaction, and allow the financial intermediaries to ascertain their liability to pay on the instrument quickly and with minimal expense." The court cited "Mennen v. J.P. Morgan & Co., 91 N.Y.2d 13, 689 N.E. 2d 869, 875, 666 N.Y.S.2d 975 (N.Y. 1997)" for the proposition that "Significantly, the court stated that the principle barred an issuer from suing the beneficiaries for return of funds paid where the issuer's claims 'inescapably flow from and implicate the separate, underlying contract' between the customer and the beneficiaries. 'To give legal cognizance and effect to [the issuer's claims] would pierce the protective shield of the particular clauses and financial instruments arranged by and among these sophisticated parties.' Id."

2. Proceeds: The appellate court considered in particular the case law related to LC proceeds. It noted that "[t]here are a number of cases purporting to stand for the proposition that 'proceeds from a letter of credit are not part of the debtor's bankruptcy estate'." The court, however, indicated that "all of the cited cases merely reaffirm that notwithstanding the fact that the bank customer has gone into bankruptcy, a bank that, prior to the filing of the bankruptcy petition, has issued a letter of credit is required to fulfill its obligations under the letter of credit by paying the beneficiary upon request. The cases merely indicate that a bankruptcy debtor has no claim to any funds that an issuer pays to a beneficiary, and accordingly the court cannot enjoin the payment of the funds pursuant to the letter of credit." In the one decision which required return of excess proceeds to the issuer in the case of a postpetition drawing by the beneficiary, ITT Commercial Financial Corp. v. Bethel Marine, Inc., No. 3-87- 3247, Adv. No. 3-88-37 (Bankr. D. Minn. Jun. 1, 1988 & Oct. 4, 1988), the appellate court noted that the LC itself expressly required a certification that the amount of the drawing did not exceed the amount that was actually owed. The court indicated that the effect of the independence principle with respect to proceeds was that there should be no reference to the underlying contract with respect to the interpretation of the LC. It stated that the LC in this case "contains no language limiting the amount of funds that Los Amigos can draw down at any one time, prior to the expiration of the LC." Consequently, the court stated the formula that the proceeds of the LC are not part of the estate was "neither remarkable nor relevant to this case. All that means is that a debtor in bankruptcy cannot claim letters of credit issued on its behalf as assets of the bankruptcy estate. While the $ 3.3 million that [Beneficiary] sought to give to [Applicant] was traceable to the letter of credit funds, the funds were not, technically speaking, 'proceeds of the letter of credit.' Once [Issuer] performed under the letter of credit and gave the funds to [Beneficiary], all obligations under the letter of credit were satisfied. [Issuer] can only look to [Applicant] for repayment under the letter of credit agreement - and therefore [Issuer] must be treated like any other creditor."

3. Independence: Barclay's Bank maintained that the principles of independence inherent to LC obligations prevent such a ruling. The court, looking to New York law, cited precedent confirming Barclay's argument that once the beneficiary receives payment under an LC, it becomes a fully executed contract that is not subject to restraints by other contracts between Issuer and Applicant or Applicant and Beneficiary. While Issuer cited a number of cases purporting to establish that LC proceeds are not part of a debtor's bankruptcy estate, the court interpreted these to reaffirm the rule that an issuer is obligated to pay under a proper LC draw if the applicant subsequently files for bankruptcy. It concluded that the applicant/debtor has no ability to enjoin payment due to his bankruptcy. Noting that while the payment that Beneficiary made to Applicant was traceable to the LC funds, the funds were not "proceeds" of the LC. The court stated:

"Once (Issuer) performed under the letter of credit and gave the funds to (Beneficiary), all obligations under the letter of credit were satisfied. (Issuer) can only look to (Applicant) for repayment under the letter of credit agreement B and therefore (Issuer) must be treated like any other creditor."

4. Excessive Draw; Arms-Length Transactions; Sophisticated Parties to Transaction; Judgments in Equity: Issuer tried to demonstrate that Beneficiary's draw exceeded that amount to which it was entitled under the supply contract with Applicant. Payments had been made from Beneficiary to Applicant pursuant to the underlying contract, satisfying all but about US$ 350,000 of the full contract price. In this light, Issuer argued, Beneficiary's draw for US$ 3.35 million was excessive, and Issuer was entitled to the "unneeded surplus". The bankruptcy court relied on what the appellate court characterized as "unspecified principles of equity" in entering judgment against Creditor. The appellate court noted that bankruptcy courts are essentially courts of equity but stated that INSTITUTE OF INTERNATIONAL BANKING LAW & PRACTICE 8 "the record contains no evidence of grounds for an imposition of a constructive trust on the [claimed] funds. Neither [Applicant] nor [Beneficiary] owed any fiduciary duties to [Issuer], a sophisticated party with whom [Applicant] dealt at arms' length. The case law emphasizes that the parties to the letter of credit are, more often than not, sophisticated parties. [Issuer] could have included language that limited the amount of funds available under the letter of credit, or specified that [Beneficiary] could only draw an amount that it reasonably knew was needed to secure performance by [Applicant], or contracted for additional collateral. It did none of these things. Courts have declined to use equity to grant rights to an LC issuer where the issuer could have contracted for those rights."

5. Fraud: The court noted that the Bankruptcy Court was "troubled by the fact that [Beneficiary], realizing that [Applicant] was in bankruptcy proceedings, ran out to draw down the LC to the limit, even though under the terms of the underlying ... contract, the amount left to be paid to [Applicant] was a mere fraction of the funds drawn. But it is important to note that at the time of the draw-down, final acceptance under the ... contract had not yet occurred. In all likelihood, [Beneficiary] was aware that [Applicant] was in bankruptcy, and the LC issued by [Issuer] was about to expire. [Beneficiary] probably sought to take possession of the full amount of the LC proceeds to which it was entitled in order to protect itself if, prior to final acceptance, it was discovered that [Applicant] work had been deficient, or [Applicant] had caused damages to the project." In relation to the $67.8 million contract, it was not unreasonable or fraudulent that Beneficiary would draw $3.35 million to protect itself from as yet unforeseen construction flaws or damage.

COPYRIGHT OF THE INSTITUTE OF INTERNATIONAL BANKING LAW & PRACTICE

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.