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RESEARCH PAPER ON
BANKRUPTCY/INSOLVENCY LAW IN
VARIOUS COUNTRIES GENERALLY
WITH PARTICULAR ATTENTION FOCUSED
ON
THE EFFECTS AND CONSEQUENCES OF
BANKRUPTCY OF THE APPLICANT AND INSOLVENCY OF THE ISSUING BANK IN RELATION TO
LETTERS OF CREDIT UNDER UNITED STATES LAW
Course: International Commercial
Transactions
BY: Metchi
Palaniappan
Masters Program in
International Trade Law 2002 – 2003
Under the supervision and
valuable guidance of Professor Boris Kozolchyk
INTRODUCTION
This paper
focuses on a study of:
In the
United States, bankruptcy procedures, rights and obligations of the parties
involved in such proceedings, the status of the parties and their assets, the
rights of third parties with respect to the debtors and matters incidental and
relating to priority and preferences to claims are set out in the U.S.
Bankruptcy Code – Chapter 7, 11 and 13.
Chapter 7
of the Bankruptcy Code governs the liquidation of financially distressed
companies and sets out the procedures for the distribution of liquidated assets
to the debtor’s creditors. Chapter 7 is distinct from Chapter 11 in that, with
a view to assist in rehabilitations, Chapter 11 provides for restructure and
reorganization of a distressed company whereas Chapter 7 does not contemplate
the retention of the debtor’s assets or the debtor’s rehabilitation.1
A case
under Chapter 7 may be commenced voluntarily by a company or involuntarily by
its creditors. The basis for a distressed company or its creditors to commence
insolvency proceedings under Chapter 7 would be where the company lacks
feasibility for successful reorganization of the business operation. Many
Chapter 7 cases are ‘no-asset’ cases with little or no prospects of any
meaningful distributions to unsecured creditors.
Upon the
commencement of a Chapter 7 case, a trustee will be appointed who will then
manage the debtor’s financial affairs. The trustee has broad statutory powers
to manage the debtor’s business operation, to collect, liquidate and distribute
the company’s assets and property to the creditors. This situation is similar
to the bankruptcy law in Malaysia.
Also where
the court determines cause e.g. where the debtor does not have reasonable
proposals for a reorganization plan, a Chapter 11 case may be converted to a
Chapter 7 case. Factors that courts would consider in determining ‘cause’
include continuing loss to or diminution of the value of the estate, inability
to effectuate a plan of reorganization under Chapter 11 or unreasonable or
prejudicial delay by the debtor.2
Under
Chapter 7, an individual debtor would generally be entitled to apply for a
discharge from insolvency and his debts unless there are instances of attempts
to defraud creditors or conceal his assets. Similar provisions of law exist in
India in this respect.
However a
corporation or partnership debtor that liquidates under Chapter 11 is not
entitled to a discharge, though in effect its assets are liquidated and
distributed to creditors and thereafter the entity dissolves.3
Upon a
voluntary or an involuntary Petition under Chapter 7 there will be automatic
stay which prevents any commencement or continuation of litigation against the
debtor, enforcement of a judgment against a debtor, any act to obtain
possession or control of the debtor’s property or any act to collect, assess or
recover a claim against the debtor.4 Similar provisions of
Bankruptcy Laws apply in Malaysia.
Exceptions
to the automatic stay principle are actions by government to enforce its police
and regulatory powers.5
The assets of the insolvent will
be distributed in the following order of priority:
It appears
that the holders of highest priority claims must be paid in full before the
trustee distributes to holders of claims in the subsequent priority class.7
Chapter 11
is a ‘reorganization’ provision of the Code comprising provisions for the
debtor’s restructuring. Example, Section 1145 provides for issuing new shares
under the plan. Chapter 11 may be used to facilitate an orderly liquidation of
the debtor. The debtor need not be ‘insolvent’ for the purposes of Chapter 11.
Chapter 11 liquidations usually involves a sale of all or substantially all of
the debtor’s assets to a single buyer or bulk asset sales such as inventory or
leases to several purchasers. The court generally conducts a competitive
auction process under section 363(b) of the Code. Professionals such as
investment bankers are retained by the debtor in possession under Section 327
of the Code to assist in the sales process. Under Section 1125 a disclosure
statement must be filed and the ‘feasibility’ and ‘best interest’ tests must be
met. Therefore Chapter 11 process would appear to be a better process to
liquidate an ongoing business debtor.8
There are
numerous cases, which interpret and explain these statutory provisions and
procedures as reflected in some of the cases set out here.
1)
Artis v
Builder’s Transport, Inc., 1998 U.S. Dist. Lexis 18622 (E.D.N.C. 1998) deals
with the principle of automatic stay in bankruptcy law and whether the
enforcement of judgment for damages in tort would thereby be affected.
The
defendant in the case sought voluntary bankruptcy protection under Chapter 11.
The issues that arose before the court were whether there was an automatic stay
of all further action by virtue of the bankruptcy/insolvency proceedings and
whether the Plaintiff, an unsecured creditor in the circumstances, could
nevertheless recover payment on the Letter of Credit issued.
The facts
briefly: The Plaintiff’s son was killed in a road accident
involving the Defendant’s truck. Pursuant to a settlement agreement, consent
Judgment was entered against the Defendant for the sum of $100,000/- which was
payable in four (4) installments. The Defendant posted a Letter of Credit under
the US transportation law which required a self-insuring transportation company
to file a ‘bond, insurance policy or other type of security. The terms of the
Letter of Credit required the defendant to certify that (a) the
plaintiff/claimant had obtained a final non-appealable judgment against the
defendant, (b) the claim had not been paid for thirty (30) business days after
a demand for it had been made by the plaintiff. The settlement agreement
provided, inter-alia that in the
event of default of payment, the Defendant would assist the Plaintiff to obtain
the proceeds of the Letter of Credit. Then defendant defaulted on the final
payments and filed for bankruptcy protection under Chapter 11 of the U.S.
Bankruptcy Code. The Plaintiff claimed payment under the Letter of Credit from
the trustee/beneficiary, whose duty is to look out for unsecured creditors. The
trustee refused to pay and the defendant, for its part, refused to provide the
required certification to enable the plaintiff to seek payment under the Letter
of Credit.
The issue before the Court was what effects the
defendant’s voluntary filing of the bankruptcy proceedings would have on the
plaintiff’s claim for payment under the Letter of Credit which was posted by
the defendant prior to the bankruptcy proceedings being initiated. And the
Court held that:
“The letter of credit serves the same purpose as a
surety bond. It was an emergency source of money for those injured by a
self-insuring company, which was accessible to the plaintiff in the event the
defendant defaulted liability.” The Court ruled that, because of this statutory
purpose, the letter of credit should be regarded as outside the Bankruptcy
Estate in the same fashion as a surety bond. Therefore an order requiring the
judgment debtor to supply the required certifying statement did not violate the
automatic stay principle.
2)
Development
Specialists, Inc. v Hamilton Bank, N.A. (In re: Model Imperial, Inc.) 250 B.R.
776(Bankr.S.D. Fla. 2000) deals with a Chapter 11 bankruptcy proceeding and
preferences of transfers of assets subsequent to the initiation of bankruptcy
proceedings and as to whether these assets ought to have been subordinated.
The facts
briefly: Model Imperial Liquidating Trust Company (Model) had
ongoing business operations at the material time. ‘Model’ secured all its
assets to obtain substantial revolving credit facilities from three (3)
lenders, namely, NationsBank, BankBoston and South Trust. This credit facility
restricted Model from borrowing from other financial sources. The Lenders
refused to increase Model’s credit line, and Model obtained credit facilities
from Hamilton Bank creating a ‘shell’ company, which existed only on paper with
no assets whatsoever. Hamilton Bank also issued a Letter of Credit to enable
Model to purchase “gift sets” for the Christmas season. The goods purchased
through the financing from Hamilton were held as collateral and security for
the credit facilities granted. The Lenders were never notified of this
arrangement. Later, when the Lenders discovered this arrangement, Model
reported losses of more than US$20 million. The Lenders thereupon recalled
their loan/credit facilities. In the interim and during the process of all
these transactions, an agreement was concluded whereby Hamilton could take
possession of the goods in the bonded warehouse if the indebtedness was not
cured by a certain date. Model filed for protection under Chapter 11 of the
Bankruptcy Code. Following this Hamilton liquidated and sold the inventory and
received in excess of US$1.2 million. Hamilton also extended short-term credit
to Model including Letters of Credit and bankers’ acceptances. Hamilton then
filed a proof of claim in the bankruptcy proceedings. The trustee objected on
the grounds that the transfers of the inventory by Hamilton were with the
intent to hinder, delay and defraud creditors and hence were avoidable and
recoverable. Accordingly the trustee filed an adversary proceeding asking that
Hamilton’s claim be equitably subordinated to other creditors’ claims. The
trustee also contended that certain post-petition transfer were avoidable.
The United
States Bankruptcy Court, Hyman, J., overruled the trustee’s
objections and concluded that under the circumstances of the matter, the
trustee was not entitled to recover any post-petition transfers.
The Court
stated in obiter that “it
is certainly consistent with the policies of the Bankruptcy Code to equitably
subordinate Hamilton’s allowed claim, to Model’s allowed unsecured claims if
the bank had acted according to the industry standards in which event Hamilton
Banks’ claim might have been contractually subordinated.”
It appears from the language
of the cases cited above and in particular, the Hamilton Bank’s case, that,
assets held as collateral by the secured creditor may be sold, transferred
and/or liquidated subsequent to the debtor/applicant filing an insolvency
petition. Consequently such assets cannot be traced by the trustee for the
benefit of the unsecured creditors in the general pool. The Bankruptcy Court in
the Hamilton Bank case stated further, in obiter, that the secured creditor’s
claim might have been subordinated by contractual arrangement in accordance
with the norm of the industry.
EFFECT AND CONSEQUENCES OF THE
APPLICANT’S BANKRUPTCY IN RELATION TO THE LETTER OF CREDIT ISSUED TO THE
BENEFICIARY
The need
for letters of credit arose because of the uncertainty involved when a seller
ships his goods to an unknown customer, especially if located in a foreign
jurisdiction. The seller undertakes the risk of having to obtain his payment in
the foreign jurisdiction. Hence the letter of credit was developed to remove
this uncertainty and shift the risk of non-payment for the goods in
international sales transactions. Letters of credit are governed by Article 5
of the Uniform Commercial Code (U.C.C) and the Uniform Customs and Practice for
Documentary Credits (U.C.P.)
There are
three parties to a letter of credit transaction i.e.
(a) the
applicant, who is usually the buyer and is the party requesting for the
issuance of the letter of credit and ultimately funds the same;
(b) the
issuing bank, who is the applicant’s bank and the intermediary who makes the
payment to the beneficiary; and
(c) the
beneficiary, who is usually the seller and the party receiving payment under
the letter of credit.
Also there
are three distinct and separate contracts involved in the letter of credit
transaction:
(a) An
agreement between the issuing bank and the applicant that governs the terms by
which the bank will issue the letter of credit and under which the bank will
honor the drafts presented against the letter of credit. A debtor-creditor relationship
is created between the issuing bank and the applicant when the bank issues the
letter of credit.
(b) A contract
between the issuing bank and the beneficiary embodied in the terms of the
letter of credit itself that governs how and when the beneficiary may request
for payment.
(c) The
underlying agreement between the applicant and the beneficiary which creates
the need for the letter of credit, which is in fact independent from the letter
of credit, i.e. the issuing bank is obligated to honor the letter of credit
regardless of the status of the underlying transaction.
The main
function of the letter of credit is to shift the risk in a transaction from the
beneficiary to the issuing bank. The theory is that the issuing bank is in a
better position to assess the creditworthiness of the applicant. The primary
essence of the letter of credit is the fact that the letter of credit is
independent of the underlying transaction. It is this “independence” doctrine
that makes the letter of credit a viable and effective commercial device.
Because of the independence of the letter of credit, the issuing bank is bound
to pay the beneficiary based solely on the terms of the letter of credit. In a
documentary letter of credit transaction, the issuing bank is obligated to pay
when present with proper documents regardless of any dispute between the
beneficiary/seller and the applicant/buyer. The risk of non-payment is thus
shifted from the beneficiary to the issuing bank. The beneficiary receives
payment and the issuing bank must look to the applicant for reimbursement or
pre-payment.
The
mechanics of a standby letter of credit differ from a regular
commercial/documentary letter of credit though the purpose remains the same,
i.e. to reallocate the risk of the transaction to the party most able to
evaluate the circumstances and bear the risk. Under a standby letter of credit,
the beneficiary is using the letter of credit to secure the performance of the
obligations by the applicant rather than to obtain direct payment in a sales
transaction. Therefore the beneficiary only draws on a standby letter of credit
when the applicant fails to perform his obligations under the contract. Hence
the standby letter of credit usually requires an affidavit of non-performance
from the beneficiary rather than presentment of documents of sale.
Letters of
credit seem to pose a dilemma in the bankruptcy system because of the conflict
that arises between the two important commercial and bankruptcy policies,
namely, the “Independence Doctrine of Letters of Credit” law and the
“Preference Provisions” of the Bankruptcy code.
On the one hand, the
effectiveness of a Letter of Credit is based on the fact that the obligation of
the issuing bank to pay the beneficiary is independent of the underlying
transaction between the beneficiary and the applicant under the “Independence
Doctrine: of letters of credit law. And on the other hand, bankruptcy law
prohibits transfers at the eve of bankruptcy by the debtor, which may benefit
one creditor to the detriment of the other similarly situated creditors. The
preference provisions of the Bankruptcy Code allow the debtor or trustee to
void pre-bankruptcy transfers and recover the property to the debtor's estate
for the benefit of all creditors in equality.
The dilemma arises when the
applicant of a letter of credit becomes a debtor in bankruptcy.
In the case of In re: Commco Tech (Commco Techjnology, LLC v Science Applications Int’l Corporation 258
B.R. 63; 2001 Bankr. LEXIS 77
(Bankr. D. Conn. 2001)[USA]
Facts: the
applicant purchased computer software and hardware from the beneficiary and the
bank issued a standby Letter of Credit to assure payment. Consequent to a
repayment dispute between the applicant and the beneficiary, the parties
entered into a settlement agreement to restructure the debt and the applicant
issued a corresponding promissory note. The beneficiary refused to agree to the
insertion of a clause in the promissory note stating that the letter of credit
would be honored only ‘in the event the applicant fails to pay the note in full
when due’. The parties also incorporated a statement recognizing the
beneficiary’s right to draw on the letter of credit in whole or in part at any
time with a view to partially satisfy amounts owed by the payee. The letter of credit
had expired by the time applicant and the beneficiary had entered into the
settlement agreement and the promissory note. Consequently the applicant caused
the issuer to extend the expiration date of the letter of credit and was
charged a fee for the extension of the letter of credit. The applicant did not
contest the fee. Thereafter the applicant rearranged its financial affairs and
sued the issuer and the beneficiary in the state court for a temporary
restraining order prohibiting payment on the letter of credit on the grounds
that any attempt to draw on the letter of credit by the beneficiary would be
fraudulent because the settlement agreement stipulated that the letter of
credit only secured payments that were outstanding prior to the settlement agreement.
The state court granted the restraining order on the grounds that the
beneficiary’s drawing on the letter of credit would cause irreparable harm.
Subsequently the applicant commenced Chapter 11bankruptcy proceedings. The
beneficiary then applied to the US Bankruptcy court to vacate the temporary
restraining order, which was granted. The applicant’s response and request for
a permanent injunction was denied.
Arguments before the Court:
Applicant: if the funds
held by the issuer collateral for the letter of credit were applied to
reimburse a drawing by the beneficiary, it would cause irreparable harm to
efforts for liquidating.
Court: rejecting the
argument, “there was no persuasive evidence” of such harm because the applicant
could not show that efforts to liquidate its assets would be affected by the
beneficiary’s drawing on the letter of credit.
Applicant: drawing on the
letter of credit would be fraudulent
Court: the applicant
would have to prove the likelihood of success on the merits of such a contention.
In the case of Prime Motor Inn; In re: Metrobility Optical
systems, Inc. 268 B.R. 326; 2001 Bankr. LEXIS 1382 (Bankr. D.N.H.
2001)[USA]:
Facts: the
applicant/debtor in bankruptcy proceedings applied for a preliminary injunction
to prevent the beneficiary from drawing on the Letter of Credit. The underlying
transaction involved a lease of real property. A standby Letter of Credit for
US$1,792,000/- was issued. The letter of credit was silent as to the governing
rules.
The letter of credit required that
the beneficiary/lessor certify that the applicant had failed to pay or perform
one or more of its obligations under the lease. The lease itself envisaged the
filing of voluntary bankruptcy in the event of default. The lease provided that
the beneficiary was entitled to draw against the letter of credit 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 the applicant filed for
protection during its reorganization under Chapter 11 of the US Bankruptcy
Code, the beneficiary served a notice of default and notice of intent to draw
the full amount of the letter of credit despite the fact that the applicant was
current on its lease payments. The Applicant then moved for a temporary
restraining order and preliminary injunction in the bankruptcy action to
prevent the beneficiary from drawing upon the letter of credit.
The United States bankruptcy court
granted the applicant/debtor’s motion for a preliminary injunction, enjoining
the beneficiary and its assignees from certifying that default existed on the
part of the applicant or that the lease had terminated.
The rationale for the court’s
decision as such was that, where a drawing on a letter of credit results from
the exercise of an ipso facto clause in violation of the US Bankruptcy code,
there is irreparable injury and a likelihood of success on the merits. As such
an injunction would lie where the applicant is an immediate party to the
transaction that gave rise to the letter of credit.
Arguments before the Court:
Beneficiary: the bankruptcy
court lacked jurisdiction to enjoin payment on a letter of credit because the
bankruptcy court did not have jurisdiction to interfere with separate and
independent contracts to which the debtors were not parties on the authority of
the case of Fidelity Bank, N.A. Prime
Motors Inns, Inc. (In re Prime Motor Inns, Inc.), 130 B.R. 610 (S.D. Fla.
1991).
Court: the case cited
involved letters of credit, issued on the debtor’s behalf, to secure bond
indentures to which the debtors were not parties. In the present case, however,
the court’s granting of a preliminary injunction stems from the terms of the
lease to which the debtor is a party. The court is therefore well within its
jurisdictional authority to make a determination about the terms of a lease
between a debtor and a third party.
The Court proceeded to hold that there are four
factors involved in considering the appropriateness of injunctive relief
namely:
(1) whether
the plaintiff would suffer irreparable injury without the injunction;
(2) whether
the injury would outweigh harm that could occur if the injunction were granted;
(3) whether
the plaintiff showed likelihood of success on the merits of its case; and
(4) whether
the public interest would be adversely affected by the grant of a preliminary
injunction.
Applying the requisite factors to the case:
(1) Likelihood of success:
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, therefore the debtor had demonstrated likelihood
of success. 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.
(2) Irreparable Injury:
because the amount of the letter of credit exceeds
the amount that the landlord might be able to claim under the bankruptcy
proceedings and the issuer would draw on the security provided by the debtor,
the debtor would suffer irreparable harm;
(3) Independence of Bankruptcy Policy:
an
injunction would further the policy of the Bankruptcy Code in preventing ipso facto clauses. The issuance of a
preliminary injunction would not affect the integrity of Letters of Credit.
This case
seems to put forth the view that Letters of Credit may not be protected against
insolvency notwithstanding the fact that there is no clear evidence of fraud
and the beneficiary is rendered incapable of realizing under the letter of
credit. This may be because based on the specific facts of the case where the
Court found that irreparable harm would be occasioned if the beneficiary were
permitted to draw on the letter of credit.
Thus, the general trend of
bankruptcy laws in the United States would appear to be that Letters of Credit
are/should be protected against insolvency unless there is fraud or where
irreparable harm would be occasioned.
Consequently the beneficiary
of the letter of credit should be at liberty to draw and realize the benefit
under the letter of credit.
By
necessary implication, it probably could be concluded that the monies/funds
deposited as collateral for the issuance of a Letter of Credit would be deemed
to be monies paid out and having ‘reached the hands’ of the intended
beneficiary. Hence such monies would not be retraceable/retractable in the
event of the applicant’s insolvency unless fraud or consequential irreparable
harm can be shown.
Necessary
implication would also indicate that the monies paid by the applicant to
collaterize the issuance of the letter of credit does not form part of the
applicant/insolvent’s estate in the event of the applicant’s insolvency prior
to the letter of credit being realized.
The underlying goal in
bankruptcy law is that similarly situated creditors must receive equal
treatment. To effectuate this goal the Bankruptcy Code allows the trustee or
debtor to avoid certain ‘preferential’ transfer and to recover the amounts
transferred. Hence, certain transaction that give an advantage to one creditor
over the others can be undone, and the property traced and returned to the
debtor’s estate for the benefit of all
unsecured creditors in the general pool.
Principles
of preference in bankruptcy law involves two step procedure:
(a) The
trustee/debtor must prove that a preferential transfer occurred as provided in
Section 547 of the Code.
(b) The
trustee/debtor must ascertain from whom to recover the preferentially
transferred property as provided in Section 550 of the Code.
To
establish that a preferential transfer has been made, the transfer must have
taken place during one of the preference “reach-back” periods as envisaged in
Section 547(c)(4) of the Code. The preference reach-back period establishes a
specified timeframe before the filing of the bankruptcy/insolvency petition
during which timeframe, the debtor or the trustee can “reach back” and undo the
transfer, i.e. in the event the transfer is considered to have been effectuated
on the eve of the bankruptcy.
On the
other hand Section 547(c) sets out situations where preferential transfers may
be exempted from preference treatment. The effect of Section 547(c) is to
exempt certain transactions between a debtor and a creditor exempt from
preference treatment under circumstances where the transactions in question do
not deplete the debtor’s estate to the detriment of the other unsecured
creditors.
Therefore
the trustee or debtor must prove that the property of the debtor was
transferred within the prescribed preference period for an antecedent debt and
that the said transfer enabled the creditor to receive more that he would have
received under liquidation of the debtor.
Once the
debtor or trustee proves that a preferential transfer has taken place, Section
550(a) enables recovery of the property transferred. Consequently the debtor or
trustee may recover the amount from the person to whom the transfer was
initially made or from the person who benefited from the transfer. Accordingly
the debtor’s estate would be restored to its pre-preference state and all
equally situated unsecured creditors may have an equal share in the distribution
of the bankrupt’s estate.
The issue
that arises here is whether the debtor/trustee can recover payment:
(a) from the
beneficiary as an indirect transferee; or
(b) from the
issuing bank as the direct transferee.
A brief
study of several cases cited below sheds light on these issues:
In Matter of Marine Distributors, Inc.,522 F.2d 791 (9th
Cir.1975)
The trustee argued that the bank,
although unsecured on the letters of credit, should be enjoined from honoring
the letters of credit because the letters of credit were assets of the debtor’s
estate and that the estate would be irreparably harmed if the issuing bank
honored drafts against the letters of credit.
The Bankruptcy court granted the
injunction and the district court affirmed. On appeal the 9th
Circuit held that the letters of credit were not the property of the estate and
that the bankruptcy court did not have jurisdiction over the irrevocable
letters of credit or the monies.
This case
therefore, confirms the independence doctrine for unsecured letters of credit.
But it
must be noted that this decision was prior to the coming into force of the
Bankruptcy Code.
In re Twist Cap, Inc., 1 Bankr.284 (Bankr.D.Fla.1979)
This case deals with secured
letters of credit. In March 1978, the Twist Cap entered into a security
agreement with its bank to secure any payments by the bank on Twist Cap’s
behalf. The bank issued letters of credit on Twist Cap’s account in December
1977, June 1978 and March 1979. Twist Cap filed its bankruptcy petition in
August 1979 prior to any drawings being made on the letters of credit. The
bankruptcy court issued temporary restraining orders prohibiting the bank from
honoring the letters of credit. The court distinguished the Marine Distributors’ case where the
letters of credit were not secured whereas in the Twist Cap case, the letters of credit were secured.
The court in In re Twist Cap case held that: “to permit these two unsecured
creditors to receive a payment, possibly in full, on the pre-petition
indebtedness owed to them by the debtor would amount to an impermissible
preferential treatment of these two unsecured creditors which is contrary to
the scheme of Chapter XI.” The court held further that when a letter of credit
is secured by the property of the debtor, an indirect preference would occur to
the benefit of the unsecured creditor if the issuing bank were not enjoined
from honoring the letter of credit. In effect, the secured letters of credit
were the same as property of the debtor because some property of the debtor
would be required to reimburse the issuing bank.
The Twist Cap case therefore represents the
possibility that the independence of the letter of credit could be nullified in
bankruptcy.
But this
decision appears to give rise to a dilemma because the effectiveness of a letter
of credit as a financing device depends on the independence of the letter of
credit from the underlying transaction, including the insolvency of the
applicant.
In Page, 18 Bankr. 713 (D.D.C.1982), the bankruptcy court enjoined
payment under secured letters of credit. The District court reversed the
decision of the bankruptcy court and held that the secured letters of credit
were not the property of the debtor and not part of the debtor’s estate, even
though they were secured by the property of the debtor. No doubt, the issuing
bank, upon honoring the letter of credit, would resort to the collateral
pledged by the debtor and thereby reduce the assets in the debtor’s estate in
bankruptcy. However the court noted that the automatic stay principle would prevent
the issuing bank from acting without the court’s approval.
The
decision in the Page case reaffirms
the independence doctrine in relation to letters of credit. However the
question remains as to whether the pledging of property of the debtor to secure
a letter of credit during the preference reach-back period would constitute a
preferential transfer.
Sabratek
Corp. v. LaSalle Bank, N.A. (In re: Sabratek Corp.)257
Bankr. 732 (B. D. Del. 2001)
[U.S.A.]
Facts: The seller provided a Letter of Credit to the buyer to assure
minimum share price at an agreed date with respect to the sale of a subsidiary.
The Letter of Credit required a statement that the applicant defaulted on its
payment obligations. The Letter of Credit stated that the beneficiary had no right
to payment from the sale of the stock until 1 July 2000. Seller/Applicant
failed to register the stock in a timely fashion as required by the agreement.
Thereupon the parties entered into a Forbearance Agreement whereby the beneficiary agreed not to commence any
legal action to enforce its rights under the Letter of Credit until an agreed
date. But the new agreement provided that if applicant filed for bankruptcy,
the beneficiary could immediately draw on the Letter of Credit. On 17 December
1999, applicant filed for Chapter 11 reorganization bankruptcy. Shortly
thereafter, the beneficiary demanded payment on the Letter of Credit. As
required by the Letter of Credit, the beneficiary’s demand included the
required statement. The issuing bank, however, refused to pay on the grounds
that the beneficiary’s demand constituted fraud since the Letter of Credit said
no default could occur under the agreement until 1 July 2000. The beneficiary
sued the issuing bank for wrongful dishonor. The applicant then sought an
injunction in federal bankruptcy court preventing the beneficiary from
proceeding with the state action in federal bankruptcy court. The bankruptcy
court denied the motion.
Rationale: Where the bankrupt has procured a Letter
of Credit for a third party, it is not part of the estate, and in the absence
of unusual circumstances, a bankruptcy court will not enjoin a state action by
the beneficiary against the issuer to collect on the Letter of Credit.
On the issue of the application for
injunction the trial court noted four criteria for granting an injunction:
(1) the
likelihood that the plaintiff will prevail on the merits at final hearing;
(2) the
extent to which the plaintiff is being irreparably harmed by the conduct
complained of;
(3) the
extent to which the defendant will suffer irreparable harm if the preliminary
injunction is granted; and
(4) the public interest” citing Duraco Procucts, Inc. v. Joy Plastic
Enterprises, Ltd., 40 F.3d 1431 (3d
Cir. 1994).
Noting that the letter of credit is not property
of the estate and that the Debtor has no interest in either the letter or its
proceeds, the bankruptcy court reasoned that the state action and a ruling for
the beneficiary would not adversely impact the estate. Therefore, the court
concluded that the applicant would not be likely to succeed on the merits.
The applicant argued that it would suffer
irreparable harm if the state action continued. It claimed that it could not be
certain that the issuing bank would aggressively raise its interests. The
bankruptcy court pointed out that avenues of participation were open to the
applicant and refused to grant an injunction. Moreover, because the time stated
in the Letter of Credit had passed, the court observed that the beneficiary
could draw on the Letter of Credit under the terms of the original Registration
Rights Agreement.
The beneficiary argued that it would
suffer irreparable harm from an injunction because it could not collect the
Letter of Credit proceeds and thus could not fund its other initiatives.
While such an argument ordinarily does
not constitute a defense against an injunction, the bankruptcy court stated
that the involvement of an Letter of Credit distinguishes this case. The court
reasoned that parties insist upon receiving letters of credit specifically so
that they will not have to wait for payment or, even worse, sue and wait for
payment. Consequently, the court concluded that any delay in the beneficiary’s
right to draw on the letter of credit constitutes ‘irreparable harm’ because it
eliminates the benefit of having obtained the letter of credit – the assurance
of prompt payment.
The applicant argued that the public
interest requires an injunction to preserve the integrity of letter or credit
transactions.
The bankruptcy court disagreed noting that the
underlying rule of letters of credit is “pay first, litigate later.” Therefore,
the court concluded, “the public policies behind letter of credit transactions
do not favor issuance of an injunction.”
Consequently because a letter of credit is an irrevocable
obligation between the issuing bank and the beneficiary and because the letter
of credit is independent of the underlying transactional relationship between
the debtor and the beneficiary, the principle would be that the collateral
posed to secure the letter of credit:
(i)
is not the property of the debtor or the debtor’s estate;
(ii)
is not a preferential transfer; and
(iii)
is not subject to automatic stay.
Two cases that illustrate the
above principles are as follows:
(a) In re M.J. Sales & Distributing Co., Inc.,
25 Bankr. 608 (Bankr.S.D.N.Y.1982), the debtor pledged a Treasury bond as
security for a standby letter of credit. The trustee argued that the pledge of
the bond was an indirect preference for the benefit of an unsecured creditor
because the issuing bank would use the debtor’s collateral to set off its
obligation under the letter of credit to pay the beneficiary. The court held
that the payment by the issuing bank to the beneficiary was not a preferential
transfer.
(b) In re Price Chopper Supermarkets, Inc., 40
Bankr.816 (Bankr.S.D.Ca.1984), the debtor caused a secured standby letter of
credit to be issued as security for a promissory note. When the beneficiary
drew on the letter of credit subsequent to the debtor’s bankruptcy petition,
the trustee argued that the payment from the issuing bank to the beneficiary
was an indirect preferential transfer for the benefit of an unsecured creditor
because the bank had recourse against the property of the debtor that is held
as collateral for the letter of credit. The court held that the payment by the
issuing bank to the beneficiary was an independent transaction and was not a
preferential transfer because the bank paid the obligation form its own funds,
and not from the funds of the debtor. The court affirmed the independence of
letters of credit in bankruptcy and the importance of the independence doctrine
to commerce and stated:
“Accepting the Trustee’s and Bank’s argument would
mean that the beneficiary of a letter of credit could never rely on a letter of
credit as an absolute guarantee of repayment. The consequent result would be
that in every case, a beneficiary would have to investigate the source of funds
used by a bank to pay it in order to assure that the beneficiary was insulated
from any later claims by a trustee in bankruptcy of the non-bank debtor. To
hold as the Trustee contends, would inject an element of uncertainty in a
long-standing commercial practice designed to eliminate uncertainty.”
These cases appear to protect
the contract between the beneficiary and the issuing bank. Courts have held that
payment by the issuing bank was from its own funds and therefore no a
preferential transfer of property of the debtor.
However when the debtor
pledges property to secure the letter of credit, courts have held that collateral
securing a letter of credit is the property of the debtor’s estate.
(a)
In re W.L. Mead,
42 Bank. 57 (Bank.N.D.Ohio 1984), the court held that “it has not been decided
whether or not the issuer may ‘foreclose’ on its collateral once performance on
the letter has been rendered.” The court held further that the collateral,
which has been pledged by a debtor as security for a letter of credit, is the
property of the bankruptcy estate and the automatic stay principle prevents a
pledgee from assuming title to the collateral.
This case thus establishes the
rule that collateral pledged to secure a letter of credit is the property of
the debtor and is subject to the automatic stay principle when the issuing bank
seeks to foreclose on it after the debtor files a bankruptcy petition.
(b)
In re Air
Conditioning, Inc., 845 F. 2d 293 (11th Cir.1988), the issuance
of the secured letter of credit occurred one month before the debtor filed his
bankruptcy petition. The bankruptcy court held that the debtor’s transfer of
collateral to secure the letter of credit was a voidable preference because the
letter secured an antecedent debt and therefore the transfer of property of the
debtor to secure the letter of credit benefited the unsecured creditor. The
court nullified the letter of credit transaction as an indirect preferential
transfer because it was used by the parties to transfer the debtor’s property
to the unsecured creditor through the bank as an intermediary.
On appeal, the court held that the debt owed by the
debtor to the creditor existed prior to the issuance of the letter of credit,
i.e. it was an antecedent debt. Thus if the debtor had given the creditor an
additional security interest of any kind to secure payment of the debt, rather
than providing for the issuance of the letter of credit, the transfer would
clearly have been subject to being avoided as a preference by the trustee under
11 U.S.C. S. 547(b). The question that then arises is whether a debtor should
be able to secure payment of an antecedent debt, through the recognized
sanctity of a letter of credit, when he could not do so through any other type
of security interest. The court held further that the nullification of the
letter of credit was not the proper remedy because it failed to recognize the
independence of the letter of credit. Based on the affirmation of the validity
of the independence doctrine, the court held that recovery of the preference
must be obtained from the unsecured creditor who directly benefited from it,
and not from the issuing bank.
Therefore
the effect of the Air Conditioning
decision lays down the principles that:
(1)
an indirect preference occurs when a debtor pledges property
to secure a letter of credit if all the elements of a preference are present;
and
(2)
recovery of the preference must be from the beneficiary of
the letter of credit and not the issuing bank.
The case of Matter of Compton Corporation, 831 F.2d 586 (5th
Cir.1987) strongly endorses the policy of interpreting bankruptcy law in a
manner that does not interfere with the sanctity of letters of credit.
Facts: One day
before filing a bankruptcy petition, the debtor caused a secured standby letter
of credit to be issued to guarantee a missed payment for goods. The letter of
credit was secured by a future advances clause in a prior security agreement
with the debtor’s issuing bank. The court held that the letter of credit was,
actually, an indirect preference and that the trustee could recover from the
creditor, but not from the issuing bank.
The court held that ‘a creditor cannot secure payment of an unsecured
antecedent debt through a letter of credit transaction when it could not do so
through any other type of transaction.
In the Matter of Val Decker Packing Company, 61 Bankr. 831 (Bankr.S.D.Ohio
1986), the bank had a blanket security agreement that covered all of the
debtor’s liabilities to the bank. The debtor caused the bank to issue a standby
letter of credit on April 22, 1977. A note covering the letter of credit and
other existing indebtedness was executed and secured by a new security
agreement in June 1980. The debtor filed a bankruptcy petition on August 8,
1980. The court held that a transfer of the debtor’s property occurred when the
collateral was pledged to secure the letter of credit, and not when the bank looked
to the collateral for reimbursement. The court held further that the letter of
credit was unsecured when originally issued and that it was secured within the
ninety-day preference reach-back period. Therefore the pledge of the collateral
during the reach-back period was voidable preference for the benefit of the
bank. As a direct preference, it was recoverable only from the bank.
Thus it
appears that bankruptcy courts have held that the transfer of the debtor’s
property under a letter of credit occurs when the issuing bank perfects a
secured interest in the collateral and not when the bank makes payment on the
letter of credit. Even though the bank’s claim on the debtor’s property is
contingent, it is considered a transfer at the time it is perfected. Therefore,
in order to constitute a preferential transfer, the transfer of collateral to
secure the letter of credit must occur during or within the preference
reach-back period and not the payment from the issuing bank to the beneficiary.
Section
547(c) provides for exceptions, which can operate to exempt an apparent
preferential transfer from being avoided. Bankruptcy courts have held that
regular commercial letters of credit are not preferential transfers based on
the Section 547(c) exceptions.
For example, in re AOV Industries, Inc., 64 Bankr. 933
(Bankr.D.Col.1986), the court held that the ordinary course exception of
Section 547(c)(2) protected the use of commercial letters of credit in an
international sale transaction. The court’s rationale was that the commercial
letters of credit were used by the parties as a method of payment in the
ordinary course of selling and purchasing the goods. The court held that the
judgment was in accordance with the general policies for facilitating commerce
and maintaining the strength of the letter of credit as a national and
international financing device.
In Matter of Fuel Oil Supply Terminaling, Inc., 837 F.2d 224 (5th
Cir.1988), it was held that the ‘new value’ exception of Section 5437(c)(1)
covered certain secured standby letters of credit. In this case, the secured
standby letters of credit were used to guarantee payment in an oil exchange
agreement. The debtor returned previously borrowed oil within the preference
reach-back period and the creditor allowed the letters of credit to
lapse/expire because the debtor had returned the oil. The court held that
although the transfer of the debtor’s oil occurred within the preference
reach-back period, the creditor’s release of the secured letters of credit
constituted ‘new value’ and therefore exempted from preference attack.
In re Metro Communication, Inc., 115 Bankr. 849 (Bankr.W.D.Pa.1990),
the court held that payments to a beneficiary under an unsecured letter of
credit did not constitute a preferential transfer. In dicta, the court stated
that any transfer of a debtor’s property occurs when the letter of credit is
issued, not when the issuing bank pays.
In re Zenith Laboratories, Inc., 104 Bankr. 667 (Bankr.D.N.J.1989),
the court held that letters of credit were not the property of the debtor’s
estate. Payments made to the beneficiary were from the issuing bank’s funds and
therefore the bankruptcy court could not enjoin payment to the beneficiary.
In re Gates
Community Chapel of Rochester,Inc.,123 Bankr.700 (Bankr W.D.N.Y.1991), the
court held that a secured letter of credit issued during the preference
reach-back period to guarantee payment on an unsecured antecedent debt was an
indirect preferential transfer for the benefit of the beneficiary.
Thus, from
the trend of the cases it is apparent that in order to constitute indirect
preferences, the letters of credit must be given to guarantee or secure payment
on an unsecured or under-secured antecedent debt. In addition, any transfer of
the debtor’s property to secure the letter of credit must occur within the
preference reach-back period. Also, the debtor must have been insolvent at the
time of the transfer and the transfer must have given the issuing bank a
greater return than it would have received in a Chapter 7 liquidation.
It is evident that the problem facing the bankruptcy system in regard to letters of credit is to maintain the independence of letters of credit while applying the preference powers available in the Bankruptcy Code. This is of great concern because of the extensive use of letters of credit in international commerce. If courts were to allow recovery of direct payments to beneficiaries under letters of credit as preferential transfers, the effectiveness of letters of credit as a commercial financing system would be undermined. The impact of the bankruptcy action would be to interfere with the allocation of risk sought by the parties to the letter of credit transaction. In eff