Factual Summary: In order to support future purchases from a supplier, a department store buyer applied for an "evergreen" standby letter of credit. The supplier-beneficiary drew when the issuer gave a 60-day notice of nonrenewal. As required by the standby, the drawing certificate recited that funds received under the letter of credit would be held and applied against the applicant's obligations to the beneficiary as they came due. Apparently, the supplier in fact held the funds as cash collateral securing sales to the applicant made after the drawing. Within a few days of that drawing, the applicant filed a Chapter 11 petition in bankruptcy and sought to recover the amounts it paid to the issuer contemporaneously with the drawing.

Legal Analysis:

Payments made by a soon-to-be bankrupt applicant to an issuer as reimbursement for the issuer's payments under a letter of credit may be deemed preferential to the extent the reimbursement obligation was unsecured. Bankruptcy preference law and letter of credit law are clear and consistent in treating the contingent obligation of an issuer to honor its letter of credit and of an applicant to reimburse the issuer as arising upon issuance of the letter of credit. Accordingly, the issuer's failure to take security at the outset renders the issuer vulnerable to a preference challenge on payments or collateral later received from the applicant.


Bankruptcy preference law and letter of credit law are not so clear or consistent as to the circumstances, if any, under which the issuer may defend against a preference challenge based on the fact that the bankrupt applicant's estate was not diminished by the reimbursement because the issuer's payment freed up collateral held by the beneficiary or caused the beneficiary to transfer assets of equivalent value to the bankrupt applicant. Bankruptcy preference case law sometimes ignores the letter of credit independence principle for purposes of determining whether a beneficiary may retain funds received under a letter of credit. Revised UCC Article 5 expressly recognizes post-honor subrogation as a qualification to the independence principle. This decision deals with this topic in a rather limited, summary fashion. Those looking for a sophisticated analysis of preference issues as they arise in this and other circumstances involving bankrupt applicants will need to look elsewhere.



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.