Letters Of Credit: Tool or Trap for Trade Vendors Dealing With Customers at Risk for Bankruptcy

Obermayer Rebmann Maxwell & Hippel LLP
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Obermayer Rebmann Maxwell & Hippel LLP

The impact of the internet on brick-and-mortar retail, compounded by the economic devastation of the COVID-19 crisis, has created an unpredictable environment for trade vendors and service providers amid an uptick in commercial bankruptcy filings that is all but certain to intensify as the pandemic continues. In response, many trade vendors are demanding or being offered letters of credit as a condition to or incentive for continued business relations with troubled customers. However, letters of credit, which on their face appear simple and straightforward in their promise of ironclad payment, pose hidden threats to the unwary. Letters of credit can be an effective loss mitigation tool for the savvy trade creditor who understands their risks and limitations arising from a customer bankruptcy and who can best structure the letter of credit to provide the broadest protection under a variety of circumstances.

OVERVIEW OF LETTERS OF CREDIT

Standby letters of credit are a tool that trade creditors frequently rely upon as a backstop to protect themselves from the risk of nonpayment of their invoices by a financially troubled customer. A letter of credit transaction typically involves three parties and three independent contracts:

  • The first contract is the underlying contract for the sale of goods between the seller and its customer that the parties intend to be the subject of the letter of credit;
  • The second contract involves the application for an agreement between the issuing bank (“Issuer”) and its customer (“Applicant”) for the issuance of a letter of credit. This contract includes the bank’s agreement to issue the letter of credit, the terms of the letter of credit, the customer’s obligation to reimburse the bank for payments made to the beneficiary upon the presentation of conforming documents, the bank’s charges and commissions for issuing the letter of credit, and any pledge of collateral as security for the Applicant’s reimbursement and other obligations to the bank; and
  • The third contract is the actual letter of credit, which is issued by the Issuer-bank in favor of the trade vendor (“Beneficiary”). The Issuer is required to pay the amount requested by the Beneficiary upon presentation of documents establishing the right to payment under the terms of the letter of credit. The Issuer-bank, in turn, may seek reimbursement from the Applicant for its draw payment to the Beneficiary in accordance with its agreement. 

Strict compliance by the Beneficiary with the terms of the letter of credit in presenting conforming documents is required in order to trigger the Issuer-bank’s obligation to make a payment under the letter of credit. The Issuer-bank’s obligation to honor a conforming draw request on a letter of credit, however, is independent of both the performance of the underlying contract for which the letter of credit was issued as well as the Issuer-bank’s ultimate ability to obtain reimbursement from the Applicant-buyer for its draw payment. The Issuer-bank is required to pay the Beneficiary upon the presentation of all of the documents required by a letter of credit, regardless of any contractual dispute between the seller and buyer and/or the bank’s inability to obtain payment of its reimbursement claim from the buyer.

IMPLICATIONS OF APPLICANT BANKRUPTCY

The demand against a letter of credit involving a solvent and non-bankrupt Applicant is relatively straightforward and predictable in accordance with its explicit terms and conditions. However, a host of issues arises when an Applicant files for bankruptcy, jeopardizing not only retention of payments made prior to the bankruptcy petition but constraining the ability to make post-petition draw demands. These issues include:

  • Whether a letter of credit and its proceeds are property of the Applicant’s bankruptcy estate;
  • Instances when post-petition draw demands violate the bankruptcy automatic stay; and
  • Circumstances where pre-petition payments made under the letter of credit are subject to avoidance as preferences.

The answers to these questions depend, in large part, on the specific terms and timing of the letter of credit and if or when the Issuer-bank took a security interest in the assets of the Applicant-debtor to back its reimbursement rights. Each of these specific scenarios will be discussed below, along with practical tips on how to best structure the letter of credit from the seller’s viewpoint.

Letters of credit and their proceeds are not typically considered property of debtor’s bankruptcy estate.

Each of the contracts in a letter of credit transaction is independent of one another. As such, the Issuer-bank’s obligation to pay the Beneficiary is separate and independent from the contractual obligations between the Issuer and the Applicant. The letter of credit shifts the risk of transacting with the debtor to the Issuer, requiring the Issuer to honor a properly presented and conforming draw demand by paying the Beneficiary of the letter of credit with its own funds, not the debtor’s assets. Therefore, most courts hold that a letter of credit and its proceeds are not property of the bankruptcy estate.

When properly drafted, a Beneficiary may draw upon a letter of credit without violating the automatic stay in the bankruptcy of the Applicant.

Whether a Beneficiary may make a draw demand following the bankruptcy filing of the Applicant depends of the specific terms of the letter of credit. As will be discussed further, a properly-drafted letter of credit enables a demand to the Issuer-bank for a draw without violating the prohibitions of the automatic stay when the Applicant-buyer is in bankruptcy. The ability of a Beneficiary to take advantage of payment in full through a letter of credit has significant financial implications since many trade creditors receive only pennies on the dollar in distribution on claims presented in the bankruptcy case.

However, the ability to successfully draw on the letter of credit without conflicting with the automatic stay, requires the avoidance of the following trap in drafting. A letter of credit that conditions the draw on a prior demand for payment upon the debtor, requires the Beneficiary or a third party to provide notice to debtor, or directs some other kind of action against the debtor or debtor’s property likely cannot be exercised post-petition without obtaining an order of court granting relief from the automatic stay. To avoid the cost, delay and uncertainty of obtaining such stay relief, letters of credit should avoid any requirement of action by or notice to the debtor and should require only that the Beneficiary certify to the Issuer that the Applicant is in bankruptcy.

Preference avoidance of a letter of credit payment in a subsequent bankruptcy of the Applicant

Payment on a successful draw demand on a letter of credit does not necessarily mark the end of the story. A subsequent bankruptcy by the Applicant enables the avoidance and recovery of certain payments, known as preferences, made before the filing of the bankruptcy petition. Preference avoidance is, by far, the most common form of bankruptcy litigation and demands for the return of such payments occur in most every commercial business bankruptcy case.

As defined in the Bankruptcy Code, a preference is a transfer of an interest of the debtor in property; made to or for the benefit of a creditor; on account of a pre-existing debt obligation; made while the debtor was insolvent; 90 days before the filing of the bankruptcy petition (or within one year, if made to an insider of the debtor); that enables the creditor to receive more than it would have received in a hypothetical Chapter 7 bankruptcy liquidation proceeding had the transfer not been made. 11 U.S.C. § 547. The statutory intention of the preference statute is to cause the return of certain payments made to creditors on the eve of bankruptcy to the estate for redistribution to creditors as a whole in accordance with the statutory hierarchy of distribution.

Even though payments to the Beneficiary on a letter of credit are made by the Issuer-bank using its own funds — and not those of the Applicant-debtor — there are specific circumstances when the payment on a letter of credit can be clawed back from the Beneficiary as an avoidable preference in a subsequent bankruptcy by the Applicant. We will discuss below those circumstances where the letter of credit payment is vulnerable to preference avoidance as well as instances where the payment will be safe from challenge.

  1. When payment on a letter of credit may be vulnerable to preference avoidance.

 While a letter of credit and its proceeds are not property of the estate, any collateral pledged by the debtor to secure its obligations to the Issuer is property of the estate. In connection with the pledge of debtor’s assets as security for the Issuer’s reimbursement claim, there are bankruptcy scenarios where the payment made to the Beneficiary may be challenged as an avoidable preference. These circumstances include the following:

  • Pre-existing indebtedness to letter of credit and pledge of collateral made during preference period. If during the preference period, the letter of credit is issued and collateral is pledged to secure payment of pre-existing indebtedness of the debtor to the creditor, payments made on the letter of credit may be subject to preference challenge.
  • Beneficiary as an indirect transferee on pledge of collateral. Where a letter of credit is issued during the preference period to support unsecured pre-existing debt of the Applicant to the Beneficiary, and the Issuer had a long-standing perfected security interest in Applicant’s assets to secure future advances, courts have viewed the Beneficiary as being an indirect transferee of that granted security interest which results in payments made under the letter of credit being vulnerable to preference challenge.
  • Issuer-bank subject to avoidance. The Issuer-bank may itself be subject to preference attack if it (i) honors a draft against an unsecured letter of credit and is reimbursed by the debtor in the 90 day period prior to the petition or (ii) obtains a security interest in the debtor’s property during the preference reach-back period.
  1. Safe harbor from preference avoidance.

In most instances, the Issuer’s payment to the Beneficiary on a letter of credit does not constitute a preference. This is because the Issuer’s payment is based on its independent relationship with the Beneficiary, under which it has a separate contractual obligation to pay the Beneficiary from its own assets. The letter of credit and its proceeds (as opposed to pledged collateral) are not property of the estate. The Issuer honors the letter of credit from its own assets and not those of the Applicant-debtor, who caused the letter of credit to be issued. Such a transfer falls outside of the definition of a preference, which requires a transfer of the debtor’s interest in property.

  • Issuer-bank is unsecured. If the Issuer-bank is unsecured with respect to its reimbursement rights, payments made pursuant to the letter of credit during 90-day period preceding the bankruptcy filing of the Applicant should not constitute a voidable preference. This is because the Applicant-debtor is merely substituting one creditor (the Issuer-bank) for another (the Beneficiary-seller), and there is no diminution of the debtor’s property, even if the letter of credit is issued within the 90-day preference period and the payment is drawn prior to the bankruptcy filing.
  • Letter of credit and pledge of collateral made outside of preference period. When the pledge of collateral and issuance of the letter of credit occurred more than 90 days (or one year in the case of an insider transferee) before the filing of Applicant’s bankruptcy there is no preference liability to the Beneficiary who receives payment on the letter of credit during the preference period.
  • Letter of credit contemporaneous with sale by Beneficiary. Where the letter of credit is issued contemporaneously with an initial extension of credit by the Beneficiary, the transfer is not preferential as to the Beneficiary because a preference requires a payment on an antecedent debt.
  • Letter of credit to induce future transactions. Trade creditors also dodge preference avoidance risk, despite the issuance of a letter of credit and a debtor’s pledge of collateral during the preference period, if the letter of credit was issued to induce future extensions of credit by the Beneficiary, and not to secure payment of any antecedent indebt­edness owing by the Applicant-debtor to the Beneficiary.

DRAFTING STRATEGIES FOR LETTERS OF CREDIT

In addition to drafting the letter of credit to avoid potential preference avoidance liability in the event of a subsequent bankruptcy by the Applicant, there are some additional drafting considerations that will enhance the effectiveness and utility of the letter of credit.

Letters of credit often have a fixed expiration date. Problems may arise in the event of a bankruptcy filing by the Applicant near the stated expiration date. To enable greater flexibility in exercising rights under the letter of credit, the expiration date should be drafted as the latter of a specified expiration date or sixty days after the petition date of any Applicant’s bankruptcy case filed prior to such specified expiration date.

A standing letter of credit typically enables a draw only after an Applicant default or when account receivables have aged beyond a specified term. The draw conditions should be drafted to include payment for any invoice(s) that are due and owing for goods and/or services sold, performed and/or delivered to or for the Applicant on or prior to the date filing of a petition under section 301, 303 or 1504 of title 11 of the United States Code commencing a bankruptcy case for the Applicant.

A direct payment by the debtor during the 90-day period preceding the bankruptcy filing subjects the trade creditor to potential preference avoidance exposure despite the existence of a letter of credit. To guard against this possibility, and to the extent that the bank is agreeable, a provision in the letter of credit should be added that expressly permits a drawing for preference liability on top of unpaid amounts due for such invoices that were paid by the Applicant within ninety days prior to its petition date where Beneficiary has returned such payments to the bankruptcy estate of the Beneficiary.

Additionally, consideration should be made of an alternate form of letter of credit known as the direct-draw or direct-pay letter of credit where drawing on the letter of credit is the intended primary payment mechanism.

CONCLUSION

Armed with knowledge about the limitations and risks of letters of credit, trade creditors may make well-informed decisions on whether to demand or accept letters of credit as a condition to or inducement for continued dealings with troubled customers.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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