Letters of Credit and Applicant Bankruptcy

This article explores certain potential effects on a letter of credit transaction of the applicant for the credit becoming the subject of a bankruptcy proceeding under the United States Bankruptcy Code (Title 11 of the United States Code).

What Is a Letter of Credit?

A letter of credit (LC) is an undertaking by an issuer, typically a bank (Issuer), at the request or for the account of its customer (Applicant) or, in rare cases, for itself, to a beneficiary (Beneficiary), to pay or otherwise honor a documentary presentation made by the Beneficiary (Uniform Commercial Code (UCC) § 5-102(a)(10)). A classic use of an LC is for a buyer of goods to pay the purchase price for the goods by arranging for its bank to issue an LC to the seller, payable against the seller’s presentation to the bank of a copy of the seller’s invoice for the goods and an original or copy of the transport document covering the shipment of the goods to the buyer. In this example, the buyer would be the Applicant, the bank would be the Issuer, and the seller would be the Beneficiary. Another common use of an LC is as a standby in case of a default in payment or performance of an obligation, such as an LC payable against the Beneficiary’s statement that the Applicant has defaulted in performing a specified obligation to the Beneficiary.

It is important to note two key features of LCs. First, although an LC can serve the same purpose as an ordinary guaranty in assuring a Beneficiary of payment, an LC is not a secondary obligation like a guaranty or other suretyship undertaking. It is an independent obligation of the Issuer to the Beneficiary separate from the arrangements relating to it, such as the reimbursement arrangement between the Applicant and the Issuer and the underlying purchase and sale transaction between the Applicant and Beneficiary (UCC § 5-103(d)). Second, an LC is a documentary undertaking. The Issuer’s obligation to honor is triggered by the presentation of one or more documents that appear on their face strictly to comply with the terms and conditions of the LC (UCC § 5-108(a)). In our first example above, the Issuer’s payment obligation would be triggered by the Beneficiary’s presentation of its invoice and the requisite transport document; payment would not be triggered by the fact that the Beneficiary had shipped the goods to the Applicant. The Issuer checks the presented documents, not whether the Beneficiary actually shipped the goods; neither is the Issuer responsible for any breach of contract by the Beneficiary (UCC § 5-108(f)).

Applicant’s Bankruptcy

U.S. courts have overwhelmingly held that an LC and its proceeds are not property of the Applicant’s bankruptcy estate within the meaning of 11 U.S.C. § 541. Thus, neither the Beneficiary’s presentation of drawing documents under the LC nor the Issuer’s payment of the LC would violate the automatic stay under 11 U.S.C. § 362 that prohibits, among other things, taking the property of or enforcing claims against the bankrupt. E.g., Elegant Merch., Inc. v. Republic Natl. Bank (In re Elegant Merch., Inc.), 41 B.R. 398, 399 (Bankr. S.D.N.Y. 1984). An LC is an independent undertaking running from the Issuer to the Beneficiary; the payment of the LC is by the Issuer, not by the bankrupt Applicant.

Practice tip: If the Beneficiary wants to make sure it can draw on the LC in the event of the Applicant’s bankruptcy, the LC should avoid specifying any drawing conditions that require taking action against the bankrupt or its property (e.g., do not require presentation of a statement that the Beneficiary has demanded payment from the bankrupt).

While the Applicant’s bankruptcy will not, in and of itself, prevent the Beneficiary from drawing on the LC and being paid in the first instance, will the Beneficiary be entitled to keep the LC payment? In most cases, the Beneficiary will be entitled to keep the LC payment, and whether or not the Applicant reimburses the Issuer will be the Issuer’s problem. However, there are bankruptcy scenarios in which the Beneficiary will not be allowed to keep the LC proceeds. These scenarios typically involve LCs supporting an antecedent debt owed to the Beneficiary by the Applicant, and the Issuer’s issuing the LC to the Beneficiary within the 90-day (one year in the case of an insider) bankruptcy preference period (see 11 U.S.C. § 547(b)). The following are two leading cases in which payment of an LC was seen as a preference and could be recovered by the bankruptcy estate from the Beneficiary:

• Kellogg v. Blue Quail Energy, Inc. (In re Compton Corp.), 831 F.2d 586 (5th Cir. 1987), modified, 835 F.2d 584 (5th Cir. 1988) (LC issued just prior to bankruptcy to support unsecured antecedent debt of Applicant to Beneficiary, where Issuer had long ago perfected a security interest in Applicant’s assets to secure future advances; court viewed Beneficiary as an indirect transferee of that security interest granted by Applicant to Issuer and, arguably, in effect transferred to Beneficiary when Issuer issued the LC; indirect preference may be recovered from Beneficiary).
• Bank v. Leasing Servs. Corp. (In re Air Conditioning, Inc. of Stuart), 845 F.2d 293, 298 (11th Cir. 1988) (Beneficiary can be subject to preference “clawback” where Applicant granted a security interest to Issuer contemporaneously with issuance of an LC to support antecedent debt of Applicant to Beneficiary).

The Beneficiary is not the only party worried about whether it can keep a payment when the Applicant becomes bankrupt. An Issuer would want to know whether it can be reimbursed and keep the reimbursement if the Applicant becomes bankrupt. In this regard, an Issuer that has paid an LC drawing is much like a lender that has made a loan to the Applicant and wants to be repaid—if the Issuer was unsecured or undersecured, and then reimbursed by the Applicant during the preference period, that reimbursement may be a preference. Similarly, if the Issuer issued an LC and later (non-contemporaneously) obtained collateral from the Applicant during the preference period, that transfer may be a preference. See, e.g., Luring v. Miami Citizens Nat’l Bank (In re Val Decker Packing Co.), 61 B.R. 831, 841-43 (Bankr. S.D. Ohio 1986).

Novices to this area often assume that the Beneficiary is better off if the Applicant pays its debts to the Beneficiary rather than defaults; however, that is not always the case. As the court said in Comm. of Unsecured Creditors v. Koch Oil Co. (In re Powerine Oil Co.), “Can an unsecured creditor be better off when the debtor defaults rather than paying off the debt? Yes. Law can be stranger than fiction in the Preference Zone.” 59 F.3d 969, 971 (9th Cir. 1995) (Payment by Applicant to Beneficiary could be preferential even though Beneficiary would have been able to draw on the LC and be paid in full had Applicant failed to pay Beneficiary.)

Practice tip: There are at least two ways for the Beneficiary to structure its transaction to avoid the Powerine trap of being unable to draw on its LC: (i) use a direct-draw or direct-pay LC (where drawing on the LC is the intended payment mechanism rather than the LC standing by to be drawn on only if the Applicant defaults), or (ii) use a standby LC that permits a drawing if the Applicant becomes bankrupt within 90 days (one year in the case of an insider) after making a payment to Beneficiary (but this can be a costly option, as it requires keeping the LC outstanding for a longer period after the date on which payment is due from the Applicant to the Beneficiary).

This brief article is only an introduction to a complicated subject. If you find the subject interesting and want to learn more, feel free to check out the American Bar Association Business Law Section’s March 29, 2019, CLE Program “Letters of Credit & Applicant Bankruptcy: U.S. & Canadian Bankruptcy Provisions and Cases for Beneficiaries, Issuers, Applicants & Others,” presented by Michael Evan Avidon (Moses & Singer LLP), Mark N. Parry (Moses & Singer LLP), Patricia A. Redmond (Stearns Weaver Miller Weissler Alhadeff & Sitterson P.A.), and Natalie E. Levine (Cassels Brock & Blackwell LLP).