United States: Part II: Why Letters Of Credit Are A Preferred Form Of Collateral In Bankruptcy

Raymond Patella and Michael Viscount write:

This is the second of a three-part series on letters of credit by attorneys in Fox Rothschild's Financial Restructuring & Bankruptcy Practice. In Part I, we focused on the advantages of letters of credit as a credit enhancement tool. Here, in Part II, we explore the use of letters of credit as collateral in bankruptcy proceedings.

Letters of credit, or LCs, are frequently preferred over other credit enhancements — such as third-party guarantees, security deposits and liens on assets — because LCs are likely to be unaffected by a party's bankruptcy case.

For example, the automatic stay provisions triggered by the filing of a bankruptcy would prevent a vendor from taking any action to enforce a secured claim — even if it held a security deposit or lien on assets — without a bankruptcy court order granting it relief from the automatic stay. Similarly, the third party guarantee, if secured, may be essentially worthless if the guarantor also files a bankruptcy case.

General principles of bankruptcy law reinforce the independence of the issuing bank's obligation to honor drafts under an LC transaction as opposed to the bank's rights against the now-in-bankruptcy customer/account party. Even after a bankruptcy petition is filed, creditors remain free to transact among themselves, including the ability to freely trade claims. A bank honoring an LC is just that, substituting one creditor for another.

Bankruptcy law automatically stays any act to obtain a debtor's property once the debtor files bankruptcy. However, the general rule is that if a vendor's customer defaults on its obligations to the vendor, and subsequently files for bankruptcy, the vendor's ability to make a draw under an LC securing the customer's obligation to the vendor generally should be unaffected by the bankruptcy and should not be stayed or enjoined.

There are exceptions, however. Since the Bankruptcy Code was enacted in 1978, some courts have held that a bankruptcy court has the power to halt payment on a letter of credit by a bank (a non-debtor party) to a debtor's customer (again, a non-debtor party) under certain circumstances. These exceptions are premised on the notion that payment of the LC would somehow have a negative impact on the debtor's bankruptcy reorganization efforts.

The general rule regarding preferences is that any draws on an unsecured LC within the 90 days immediately preceding the bankruptcy filing generally should be immune from attack in a bankruptcy case as a preference. LCs, however, are not absolutely immune from avoidance as a preference. One example would be, in response to an issuance of an LC during the 90-day preference period that improves the position of the debtor's customer, this may constitute an avoidable preference under the Bankruptcy Code.

Some courts have also reasoned that if the purpose of the LC transaction is to secure payment of a debt previously owed to the creditor, and there is a simultaneous pledge of collateral to secure the issuing bank, this may be disallowed as a "preferential transfer" because a secured vendor (the issuing bank) would be substituted for an unsecured creditor (here, the vendor) to the detriment of other unsecured creditors.

Courts generally characterize a beneficiary-creditor's payment demand under an LC as not involving property of the debtor's estate. Therefore a draw should not be enjoined.

Exceptions to the General Rule

At times, however, bankruptcy courts have prevented a draw on an LC post-petition. In one such case, a debtor convinced the court that the collateral that backed the LC was absolutely necessary for the reorganization of the estate and that the estate would be irreparably harmed if the beneficiary was permitted to draw. Other courts have cited the debtor's ability to claim "irreparable injury" arising from a higher rate of interest payable on the reimbursement obligation to the issuing bank as compared to the rate of interest, if any, that may be payable to the beneficiary under its contract and thus enjoined draws under the LCs.

Critics of these cases argue that if an LC draw could be enjoined simply because of an account party's bankruptcy, the LC would lose its defining features of independence and prompt payment, and that there is a great public interest in upholding LCs because, without them, many types of financing could or would not occur.

Some courts also reason that they will enjoin a draw on an LC because bankruptcy is intended to promote equality among similarly situated creditors, and in the case of a draw under an LC, one unsecured creditor will be treated more favorably than the other. Of course, critics of these cases argue that the creditors are not similarly situated, that one bargained for additional credit protection as compared to the other. Most cases enjoining draws on LCs in bankruptcy appear to be in the minority and these decisions have been criticized by authors discussing the cases.

Part III concludes the series with an outline of important fraud exceptions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.