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 Eleventh Circuits raise serious questions as to this belief and the the safety of LOCs in bankruptcy situations.
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 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.
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.
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.
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.
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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