Are Letters of Credit Securing a Surety’s Potential Exposure Not as Safe
as Once Believed?
August 2003
Sureties generally prefer letters of credit
as collateral in connection with the issuance of bonds because they are believed
to be protected if their principals file bankruptcy and attempt to recover the
proceeds of a LOC as a preferential transfer. A few court cases by the Tenth
and Elevent Circuits raise serious questions as to this belief and the the safety
of LOCs in bankruptcy situations.
by Marilyn
Klinger
Sedgwick,
Detert, Moran & Arnold LLP
For many years, sureties who required collateral in connection with the issuance
of bonds always preferred letters of credit over other forms of collateral.
The reason was related to the laws of preference in the bankruptcy context.
Sureties believe they are protected if their principals or indemnitors file
bankruptcy and attempt to recover the proceeds of a letter of credit as a preferential
transfer.
Unfortunately, there exist a few cases that raise serious questions as to
the safety of a letter of credit. Nonetheless, at least when a letter of credit
is taken at the time the bond is issued,
letters of credit arguably continue to be the preferred form of collateral.
Letters of Credit and the Bankruptcy Code
Letters of credit are considered an obligation of the bank which issued the
letter of credit, not of the bank’s customer which arranged for the bank to
issue the letter of credit. See In re AOV Indus., Inc.,
64 BR 933 (Bankr DDC 1986); Westinghouse Credit
Corp. v Page, 18 BR 713 (DC DC 1982) (a letter of credit and its proceeds
are not "property of the estate."); Pro-Fab, Inc. v
Vipa, Inc., 772 F2d 847 (11th Cir 1985) (a letter of credit is an undertaking
between the issuing bank and the beneficiary and is independent of the relationship
between the bank and the account party).
Therefore, if the bank customer, the bond principal, filed for bankruptcy
protection, the surety could draw on the letter of credit with impunity as it
related to the bankruptcy proceeding. It was the bank which needed to deal with
the preference rules in the bankruptcy.
Letters of Credit as a Preferential Transfer
The reason for the preference law, see below, is to even out the playing
field for all creditors. Outside the bankruptcy context, debtors are allowed
to prefer one creditor over another. However, within the bankruptcy context,
all creditors in a particular class are to be treated alike.
To prevent a debtor that contemplates bankruptcy from preferring creditors
just before it files a bankruptcy petition, the Bankruptcy Code allows the trustee
or debtor-in-possession to reach back in time to require creditors to disgorge
payments received prior to the bankruptcy petition. In the case of strangers
to the debtor, the reach-back period is 90 days. In the case of an insider to
the debtor, the reach-back period is 1 year.
The Law of Preferential Transfer
Section 547(b) of the Bankruptcy Code provides for the trustee or
a Chapter 11 debtor in possession to avoid any transfer of property
of the debtor
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before
such transfer was made;
(3) made while the debtor was insolvent;
(4) made—
(A) on or within 90 days before the date of the filing of the
petition; …
(5) that enables such creditor to receive more than such creditor
would receive if—
(A) the case were a case under chapter 7 of this title;
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent
provided by the provisions of this title.
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In re Air Conditioning, Inc.
of Stuart. The case of American Bank of
Martin County v Leasing Service Corporation (In re Air Conditioning, Inc. of
Stuart), 845 F2d 293 (11th Cir 1988), is one of the only cases that has
found that a creditor who has drawn on a letter of credit from a collateralized
bank must return the proceeds of the letter of credit as an indirect preferential
payment. In coming to its decision, the court did acknowledge that neither a
letter of credit nor its proceeds are property of the debtor’s estate. It did
find, however, that collateral which the debtor has pledged as security for
a letter of credit is property of the estate.
Relying on the case of In re Compton Corp.,
831 F2d 586 (5th Cir 1987), the court further found that a transfer of such
collateral to the bank is "to or for the benefit" of the creditor (the beneficiary
of the letter of credit). The court found that it is "an indirect benefit" sufficient
to meet the requirement of the preference law.
The key in In re Air Conditioning, Inc. of Stuart
is that the letter of credit was collateralized. If it were not, arguably,
there would be no indirect preferential transfer of the "property of the
estate."
In re Sunset Sales. In the case of In re Sunset Sales, 195 F3d 568
(10th Cir 1999); 220 BR 1005 (10th Cir BAP 1998), a case which focused on sureties
as opposed to creditors generally, the court found that letters of credit provided
to coal reclamation bond sureties within 1 year of the bankruptcy filing of
the bond principal were preferences, requiring the sureties to return to the
bankruptcy trustee the funds received in drawing on the letters of credit.
In this case, at the time that the sureties issued their reclamation bonds,
the principal agreed to provide collateral with one-half to be paid when the
bonds were issued and the other half to be paid later (the court referred to
these as "Collateral Payments"). In addition, the president and sole shareholder
agreed to indemnify the sureties. Almost a year after the bonds were issued,
the principal made its first Collateral Payment by providing a letter of credit.
Then, almost a year and a half after the bonds were issued, the principal made
another Collateral Payment by providing a second letter of credit. The bank
issuing the letters of credit was secured by certificates of deposit from the
principal.
Upon the principal’s bankruptcy, the sureties drew on the letters of credit.
The bank, after receiving leave of the bankruptcy court, foreclosed on the certificates
of deposit and reimbursed itself the amount it paid out on the letters of credit.
Thereafter, the trustee brought a preference action against the sureties
for the return of the letter of credit proceeds. The bankruptcy court held that
the Collateral Payments in the form of the letters of credit were preferential
transfers and ordered the sureties to disgorge the proceeds. As noted above,
the crucial element is that it is the letters of credit themselves that were
considered the transfers—not the sureties’ receipt of the proceeds upon drawing
on the letters of credit. Thus, because the letters of credit satisfied the
principal’s antecedent debt, the obligation to make Collateral Payments, the
letters of credit were subject to the preference rules.
As to this aspect of this case, the lesson to be learned is that if a surety
is to take collateral in connection with the issuance of a bond, the surety
should insist that it receive that collateral prior to or simultaneously with
issuing the bond. Otherwise, the surety runs the risk that the letters of credit
are found to be in satisfaction of an antecedent debt. This caution does not
alter, however, the traditional wisdom that letters of credit, if properly and
timely received, are the preferred form of collateral.
Post-Bond Issuance of a Letter of Credit
These cases do not provide an answer regarding the application of the preference
rule in those situations where collateral, in the form of a letter of credit,
is provided after the bonds are issued in conjunction with a place in funds/collateral
deposit provision in an indemnity agreement.
The question is whether the new collateral is to secure an antecedent debt—that
is, the obligation under the indemnity agreement—or whether the new collateral
is being supplied pursuant to the principal’s obligation to provide collateral
at any time the surety, in its sole discretion, requests same. Unfortunately,
the answer to this question is beyond the scope of this commentary.
Timing of Payment
There is one other aspect of the In re Sunset Sales case that is of concern. The transfers at issue all occurred between 90 days
and 1 year before the bankruptcy filing. Typically, transfers occurring during
that time period (1 year prior to the bankruptcy filing) are considered preferential
transfers only if made to insiders; sureties are not considered insiders. In
this case, however, the court relied on the insider rule.
The court analogized those cases holding that the 1-year reach-back period
may apply if the transfer benefited an insider who was a guarantor or co-debtor
to an indemnitor on a bond. Thus, because the transfer benefited the sole shareholder/president,
an insider who had guaranteed or was a co-debtor to the bond principal, the
court applied the 1-year rule.
Needless to say, this line of reasoning could apply to any indemnity payment
that a principal makes to a surety where (1) the principal files bankruptcy
within 1 year of that indemnity payment, and (2) the surety has obtained the
indemnity of an insider, such as the president of the principal, a practice
that sureties follow as a matter of course.
Caveat
One caveat to this analysis is that, in bankruptcy court, we often find the
various circuits at odds with each other, with the U.S. Supreme Court choosing
not to reconcile the differences. Thus far, the Tenth and Eleventh Circuits
appear to be alone in their views. The surety industry should cross its fingers
that more circuits do not follow suit.
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