October 2010

Elegant & Effective … Letters of Credit in Commercial Loans and Bankruptcy (Part 3 of 3)

For many years, letters of credit have been used to facilitate sales of goods and to provide credit enhancement for all kinds of contractual obligations. Despite the widespread use of letters of credit over the years, many view letters of credit as complicated and esoteric instruments. Part II of this series addresses security interests in letters of credit and the role of letters of credit in syndicated transactions. The third and final portion of this article focuses on the roles of letters of credit in commercial loans and bankruptcy. This part examines the treatment of letters of credit in bankruptcy.

Tensions Between Letters of Credit and Bankruptcy Law

As noted in the previous parts of this article, letter of credit law in the United States is generally found in Article 5 of the Uniform Commercial Code (the UCC). Since the UCC is a matter of state law, it does not override the federal Bankruptcy Code on those topics where the Bankruptcy Code does not give deference to state law. Additionally, the independence principal sets letters of credit apart from guaranties and causes problems for letters of credit in meshing with the Bankruptcy Code. And since letters of credit have a fixed term, intervening bankruptcy proceedings might delay the rights of a beneficiary under a letter of credit to the point where the letter of credit is no longer effective. For all of these reasons, the principles of letters of credit (particularly standby letters of credit) have an uneasy fit with bankruptcy law.

Problems Presented by Intersection of Bankruptcy Law and Letters of Credit

Automatic Stay. The automatic stay imposed upon the commencement of a bankruptcy case restricts enforcement action by creditors against the debtor and its assets. Given the independence of letters of credit from the underlying transaction between the beneficiary and the applicant and the primary nature of the issuing bank’s obligation to pay the beneficiary under the letter of credit, the letter of credit normally allows the beneficiary to receive payment from the issuer notwithstanding the automatic stay.

The courts have generally repudiated the decision in the case In re Twist Cap, 1 B.R. 284, 1979 Bankr. LEXIS 781 (Bankr. M.D. Fla. 1979) in which the court held that the letters of credit issued on behalf of the debtor applicant were “properties” of the estate of the debtor and therefore subject to injunction and the automatic stay. See In re Lancaster Steel Co., 284 B.R. 152 (S.D. Fla. 2002); In re Graham Square, 126 F.3d 823 (6th Cir. 1997); In re Milford Group, Inc., 197 B.R. 956 (E.D. Va. 1991); In re Skylark Travel, Inc., 120 B.R. 352 (Bankr. S.D.N.Y. 1990); In re Zenith Laboratories, 104 B.R. 667 (D.N.J. 1989). But see In re Builders Transport, Inc., 471 F.3d 1178 (11th Cir. 2006); In re Outboard Marine Corp., 2002 U.S. Dist. LEXIS 8433 (N.D. Ill. 2002)..

Nevertheless, in certain circumstances, the automatic stay can hinder the right of a beneficiary to receive payment under a letter of credit. One such situation is where the beneficiary is required to give notice to the applicant of the beneficiary’s intention to make demand under the letter of credit. The automatic stay may prevent the beneficiary from giving such a notice to the applicant/debtor without leave of the bankruptcy court. One way to avoid this risk is for the letter of credit to authorize draws if the beneficiary submits a certificate to the issuer that a bankruptcy petition has been filed by or against the applicant. While so-called “ipso facto” clauses based upon the debtor’s bankruptcy generally are invalid, this drawing right does not constitute an ipso facto clause. See Federal Deposit Insurance Corporation v. United States Trust Co., 793 F. Supp. 368 (D. Mass. 1992), holding that a draw on a letter of credit with a statement that the applicant is insolvent is not an ipso facto clause under FIRREA (the debtor was a bank).

Section 105. Section 105(a) of the U.S. Bankruptcy Code provides that “[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” This position has been interpreted by some courts to permit an injunction against a draw on a letter of credit posted by the applicant-debtor where such draw would have a negative impact on the debtor. See Wysko Investment Co. v. Great American Bank, 131 B.R. 146 (D. Ariz. 1991). However, the weight of the authority appears to be that, in the letter of credit scenario, a draw on a letter of credit will not be enjoined under §105 so long as there is not any action being taken directly against the debtor. See In re Prime Motors Inns, 130 B.R. 610 (S.D. Fla. 1991).

Preferences. Several cases have held that the issuance of letters of credit to a creditor within 90 days of the applicant’s bankruptcy as credit enhancement for a pre-existing debt of the applicant to the creditor constitutes a voidable preference. See, e.g., In re Compton Corp., 831 F. 2d 586 (5th Cir. 1987), modified 835 F. 2d 584 (5th Cir. 1988) and In re Airconditioning, Inc., 845 F. 2d 293 (11th Cir. 1988). The theory of these cases is that the giving of the letter of credit to the beneficiary may itself be a transfer, which is subject to the preference rules. However, to preserve the independence of the letter of credit, the creditor is entitled to draw under the letter of credit but then must turn over the proceeds of the letter of credit to the debtor’s bankruptcy estate as a preference. See also D. Carlson and W. Widen, Letters of Credit, Voidable Preference, and the “Independence” Principle, 54 Bus. Law 1616 (1999).

Another preference issue was raised in the case In re Cooper Manufacturing Corp., 344 B.R. 496 (Bankr. S.D. Tex. 2006). There the question was whether an assignment of letter of credit proceeds was a preference where the assignment was made outside the preference period but the payment to the assignee upon draw under the letter of credit was within the preference period. The court held that the transfer for preference purposes occurred when the assignment of proceeds was perfected, even though the letter of credit was not yet drawn at that time.

In the bizarre and counterintuitive case of Committee of Creditors Holding Unsecured Claims v. Koch Oil Co., In re Powerine, 59 F.3d 969 (9th Cir. 1995), cert. denied 116 S. Ct. 973 (1996), Judge Kozinsky, writing the majority opinion for the Ninth Circuit, stated “Law can be stranger than fiction in the Preference Zone.” In the case, the creditor took a letter of credit to support a series of transactions with its counterparty. The letter of credit could be drawn if the counterparty failed to make payments in the underlying transactions. However, the counterparty made all the underlying payments before going into bankruptcy. Unfortunately, some of the payments were made within 90 days of the bankruptcy filing. Those payments were attacked as preferences. The creditor responded that it had been fully secured at the time of the payments because of the letter of credit. (Of course, the letter of credit had subsequently expired after the filing of the petition but before the preference claim was filed.)

The issue boiled down to whether, under Bankruptcy Code §547(b)(5), the creditor received more than it would have received in a hypothetical Chapter 7 liquidation. The court’s answer was that the letter of credit was from an independent third party and that undertakings from third parties did not count in the §547(b)(5) analysis. Hence, the creditor found itself in a worse position because the counterparty had performed. If the counterparty had not performed, the creditor could have drawn down on the letter of credit before it expired and kept the money without being subject to a preference attack.

Cap on Claims. Standby letters of credit are frequently used to provide assurance to a landlord in lieu of a “security deposit.” Because of the long-term nature of many leases, §502(b)(6) of the Bankruptcy Code provides a cap on the amount of damages that a landlord can claim for unpaid future rent in the tenant’s bankruptcy. Section 502(b)(7) provides a similar cap with respect to the claims of an employee for damages resulting from the termination of employment. Where the lease obligation or the employment obligation is supported by a letter of credit in favor of the landlord or employee, the question then becomes whether the proceeds of any draw on the letter of credit are subtracted from the amount of the cap or whether the amount of the proceeds is subtracted only from the total amount of damages and the remainder is then subject to the cap.

One of the primary cases involving §502(b)(6) is In re Mayan Networks Corp., 306 B.R. 295, 53 UCC Rep. Serv. 2d 105 (9th Cir. BAP 2004). The Ninth Circuit Court of Appeals held that the letter of credit would be treated exactly like a security deposit, that is, that the proceeds of the letter of credit would be subtracted from the amount of the cap, with the result that the landlord’s claim in bankruptcy was diminished by the amount of the letter of credit proceeds. See also In re PPI Enterprises (U.S.), Inc., 324 F.3d 187 (3d Cir. 2003).

The case In re Stonebridge Technologies, Inc., 430 F.3d 260 (5th Cir. 2005) involved a letter of credit issued to support a tenant’s long-term rent obligation. After drawing down on the letter of credit, the landlord did not make a claim in the tenant’s bankruptcy. The lower court held the situation should be treated the same way as in Mayan Networks. However, on appeal, the landlord prevailed on the argument that, since it had made no claim in the bankruptcy, there was no claim to cap. Therefore, §502(b)(6) was not applicable. The lesson of the Stonebridge case is for the landlord to have a letter of credit for the full or a major portion of the potential future damages so that there is no need to make a claim in the tenant’s bankruptcy in the event that the tenant becomes bankrupt. See also G.A. Hisert, “Stonebridge Technologies: A Sequel to Mayan Networks,” 21 Real Estate Finance Jour. 87 (Spring 2006); Laura B. Bartell, The Lease Cap and Letters of Credit: A Reply to Professor Dolan, 120 Banking LJ 828 (2003).

In the case In re Condor System, Inc., 296 B.R. 5 (B.A.P 9th Cir. 2003), the Ninth Circuit held that the cap related to employee damages under §502(b)(7) is not applicable to letter of credit supporting the obligations under a golden parachute. The court reasoned that, unlike in the landlord/tenant situation, in the employer/employee situation, a letter of credit does not function as a security deposit.

Excess Letter of Credit Proceeds. Applicants frequently obtain letters of credit in favor of the beneficiary to support long-term obligations whose liquidated amount might be uncertain for some time in the future. An example of this is a standby letter of credit issued in connection with retrospectively rated insurance policies where the final premium on the insurance policy cannot be calculated until all claims are made against the policy and claims are resolved.

In such situations, when the applicant becomes bankrupt, the beneficiary draws under the letter of credit and holds the proceeds as cash collateral for the applicant’s obligations. If the total obligations turn out to be less than the cash collateral, the question then becomes whether excess proceeds are to be returned to the applicant or to the issuer (which may not have been reimbursed by the applicant). The answer usually depends upon the terms of the letter of credit, the reimbursement agreement and the underlying contract read as a whole. However, absent some specific language, which points towards the excess proceeds being returned to the issuer, the logic of the situation usually is that, if there are excess proceeds, the applicant would be entitled to the excess amounts just as if cash collateral had been posted instead of a letter of credit. See In re Spring Ford Industries, Inc., 338 B.R. 255, 2006 U.S. Dist. LEXIS 4037 (E.D. Pa. 2005); Homemaker Industries Inc. v. Official Committee of Unsecured Creditors of HMKR, Inc., 2004 U.S. Dist. LEXIS 6682 (S.D.N.Y. 2004).

Bankruptcy of Beneficiary. Prior to the adoption of revised UCC Article 5, the cases were split as to whether a trustee in bankruptcy had the right to draw on a letter of credit issued in the name of a debtor. Normally only the named beneficiary is entitled to draw. Section 5-113 of revised UCC Article 5 provides that a “successor of a beneficiary” (which is defined in §5-102(a)(15) to include a “trustee in bankruptcy, debtor-in-possession, liquidator, and receiver”) may undertake various actions, including signing and presenting documents under a letter of credit, in the name of the beneficiary or in its own name.

Insolvency of Issuer. Although letters of credit may be issued by entities other than banks, as a practical matter, the vast majority of letters of credit issued in the United States are issued by banks that are not subject to the Bankruptcy Code but to the National Bank Act and other bank regulatory statutes. The vast majority of insolvencies of letter of credit issuers has involved banks insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC has the responsibility of acting as receiver of any insured depository institution that becomes insolvent. The general stance of the FDIC has been that a claim on a letter of credit in the bank insolvency proceedings will not be permitted if the claim is inchoate when the bank is declared insolvent. In other words, unless a draw is actually made on the letter of credit prior to the bank being placed in insolvency proceedings, a claim on the letter of credit will not be recognized. This policy results in the FDIC repudiating most letters of credit issued by insolvent depository institutions. Any beneficiary that takes a letter of credit should have a mechanism in place so that the letter of credit will be issued by a new issuer in case certain specified events occur, which indicate that the original issuer may be heading towards insolvency.


The bankruptcy of an applicant under a letter of credit results in an uneasy interplay between state letter of credit law and federal bankruptcy law. As an independent obligation of a party (the issuer) that is not embroiled in bankruptcy proceedings, the letter of credit ordinarily is payable to the beneficiary without violation of the automatic stay imposed upon the commencement of a bankruptcy case involving the applicant.

However, in cases where the applicant’s consent or assistance is necessary to allow a drawing under the letter of credit, the beneficiary is not free to draw under the letter of credit without concern for the automatic stay. If the automatic stay delays a beneficiary from making a draw under a letter of credit, there is a risk that the letter of credit will expire by its terms before the beneficiary is permitted to draw under the credit.

Additionally, the preference provisions, equitable provisions and damage cap provisions of the federal Bankruptcy Code may present risks to a creditor with a security interest in a beneficiary’s rights under a letter of credit. Lastly, the risk of issuer insolvency, an increasing concern in the current economy, requires that a beneficiary monitor the financial condition of its letter of credit issuer and, if necessary, demand the issuance of a replacement letter of credit from a stronger issuer.

Anthony Callobre is a co-chair of Bingham McCutchen, LLP’s Banking and Leveraged Finance Group. Collobre practices in the areas of commercial lending and corporate finance. His clients include commercial banks, commercial finance companies, hedge funds, private equity groups, business development companies, small business investment companies, and other institutional investors and lenders. He practices across a broad spectrum of the commercial and industrial sector, and has considerable experience in asset-based lending, entertainment finance and letters of credit. In addition to representing credit providers, he represents the firm’s corporate clients as borrowers in debt financing transactions. He earned an Artis Baccalaureate from Brown University in 1982, a Juris Doctor and a Master of Laws, both from Boston University School of Law in 1985 and 1986, respectively.

This article incorporates portions of articles and outlines previously written by the author’s colleague, George A. Hisert, Esq. of Bingham McCutchen, LLP. The author gratefully acknowledges the permission of Hisert to include such materials in this article.