Standby Letter of Credit Proceeds Belong To Creditor Not Bankruptcy Estate

Good News for Standby Letter of Credit

You receive an e-P.O. from a customer requesting a six-figure credit purchase. You analyze the customer's limited financial and operating information and determine the customer is too much risk for a credit sale. If you insist on a cash sale, however, the customer will buy from a competitor. You are looking for a way to reduce the credit risk, but make the sale - a credit enhancement, such as a standby letter of credit (L/C) which allows for ready conversion to cash should the customer fail to pay. The customer agrees to have its bank issue a standby L/C, and you sell on 30 days credit. 45 days later the customer has not paid. You receive an e-mail that the customer has just filed Chapter 11. You go to the issuing bank with the L/C documentation. The documentation conforms, but the bank officer has also received notice that the customer has paid. Must the bank honor the L/ C or does the automatic stay bar the bank from paying you? If the bank pays, may a bankruptcy trustee recapture the L/C proceeds from you? A bankruptcy court recently considered whether a trustee may recover from a creditor the proceeds from an L/C that was drawn down postpetition. The bankruptcy court dismissed the trustee's lawsuit.

Vendor Looking For Guaranteed Payment

The creditor obtained an irrevocable standby L/C to guarantee payment in the event the debtor failed to pay. The debtor failed to pay and an involuntary bankruptcy petition was filed against the debtor. The trustee sent a letter to the creditor advising that the L/C was property of the bankruptcy estate and a draw-down of the proceeds would violate the automatic stay. The creditor drew down on the L/C postpetition. The bankruptcy trustee sued the creditor to recover the L/C proceeds. The creditor objected, complaining that the L/C was an independent obligation of the bank, and that trustee could not recover the L/C proceeds as they were not property of the bankruptcy estate.

Letter Of Credit

An L/C is a promise by an issuer, the bank, to pay the vendor, as beneficiary, when the customer has defaulted on the sale. The customer uses its assets as collateral for the L/C, so that the credit of the bank is substituted for the credit of the customer in favor of the vendor. The customer pays the issuing bank a fee to issue the L/C. If the vendor submits proper documents upon default, the bank will pay the L/C and the customer reimburses the bank. An L/C may be either revocable or irrevocable. An irrevocable L/C can be modified only with consent of the vendor. A revocable L/C can be modified by the bank without the consent of the vendor. The vendor can obtain a standby L/C, which assures payment after the customer's default. The vendor should insist on an irrevocable L/C with the customer sale.

L/C's are independent from the underlying contract between the customer and the vendor. The bank honoring the L/C is concerned only to see that the documents conform with the requirements in the L/C. If the documents conform, the bank will pay, and obtain reimbursement from the customer. The bank need not look past the documents to examine the underlying sale of goods. Thus, a vendor is given protections that the issuing bank must honor its demand for payment (which complies with the terms of the L/C), regardless of whether the goods conform to the underlying sale contract.

What Is Property Of Bankruptcy Estate?

The Bankruptcy Code defines property of the estate expansively to include virtually all property in which a debtor has an interest. But does the property interest include proceeds from an irrevocable L/C drawn-down postpetition?

Bankruptcy And Letters Of Credit

The Farm Fresh court agreed with the creditor that its draw-down of the L/C postpetition did not violate the automatic stay and the proceeds were not property of the bankruptcy estate. The court stated:

"[N]either the letter of credit nor the proceeds were property of the debtor's estate, and therefore the trustee may not maintain the instant lawsuit to recover them. . . The payment under the letter of credit was not a postpetition transfer that required court approval. This is because �property of the estate does not include the proceeds of a letter of credit paid to a creditor of the debtor who is a beneficiary of the letter. (Citation omitted)"

The court dismissed the trustee's lawsuit and the creditor kept the L/C's proceeds. The court recognized that the L/C is independent from the underlying contract between the debtor and the creditor, and because of this independence principle, the creditor's draw-down of the L/C postpetition did not violate the automatic stay.

L/C Can Make The Sale

Credit professionals are in the business of "making the sale", which may mean looking to a credit enhancement, such as an L/C, to reduce or eliminate credit risk. An L/C may provide the credit professional with the opportunity to make the sale, and also maximize the recovery in the event of a customer's liquidation or bankruptcy, thereby maximizing the sale and minimizing the risk.

2. In re Farm Fresh Supermarkets of Maryland, Inc., 257 B.R. 770 (Bankr. D. Md. 2001).

3. Farm Fresh Supermarkets, 257 B.R. 773.

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP Fall 01