Understanding Letters of Credit and Bankruptcy

Letter of Credit Basics

A letter of credit (LC) is an independent undertaking, typically of a bank and issued at the bank’s customer’s request, to pay another against the timely presentation of documents conforming to the LC’s terms. When a seller, lessor, or lender is uncomfortable extending credit to the other party, the buyer, lessee, or borrower may apply to a bank for an LC. With an LC, the issuer’s credit is on the line in addition to the applicant’s, and there are few defenses to payment on an LC. LCs can be divided into two categories: commercial LCs, which are payment mechanisms for the sale of goods, and standby LCs, which support financial obligations.

LC transactions consist of three relationships: (1) the underlying transaction between a buyer and seller of goods, borrower and lender, lessor and lessee, etc.; (2) the reimbursement agreement between the buyer/borrower (applicant) and the bank (issuer); and (3) the LC issued for the benefit of the seller/lessor (beneficiary).

LCs are “independent,” meaning the issuer’s undertaking is not subject to suretyship defenses, and “documentary,” meaning payment is based on documents, not performance or default on the underlying transaction.

Uniform Commercial Code (UCC) Article 5 is the source of LC law in the United States. LCs are also subject to practice rules published by the International Chamber of Commerce (ICC): UCP600 – Uniform Customs and Practice for Documentary Credits, 2007 revision, ICC Pub. No. 600, and ISP98 – International Standby Practices 1998, ICC Pub. No. 590.

LCs fit uneasily with the US Bankruptcy Code; the Bankruptcy Code does not have special rules for LCs, and UCP600 and ISP98 do not address bankruptcy. Additionally, issuing bank insolvency, governed by the National Bank Act and bank regulatory rules, can raise LC issues.

Applicant Bankruptcy

Automatic Stay

LC draw proceeds are the issuing bank’s funds and not the bankrupt applicant’s, so they are not subject to the automatic stay. However, relief from the stay may be required if the beneficiary must notify the applicant of a default, declare a default, terminate a lease, etc., before drawing. Still, such notices may be informational only or not relevant to whether the LC draw should be honored.

Ipso Facto Clause

The Bankruptcy Code prohibits enforcement of ipso facto clauses in executory contracts and unexpired leases. However, notwithstanding such a clause, even when payments are made timely on the underlying agreement, a beneficiary may still be able to draw on an LC posted by its bankrupt debtor based on the wording of the LC and the underlying agreement.

LC Proceeds as Preference

If the drawing triggers an “indirect” preference, the amount of the drawing may have to be returned to the bankrupt’s estate. A preference is not created if an LC is issued at the same time as the debt it supports is incurred, or if the LC is issued to secure an antecedent debt before the preference period commences.

Avoiding Preferences

If the debtor’s reimbursement obligation is fully secured, the beneficiary can argue that by receiving payment outside the LC, the debtor’s collateral is, in effect, released. If the reimbursement obligation is unsecured at the time of the debtor’s bankruptcy, the beneficiary received payments in the preference period directly from the debtor instead of from the LC, and no other exception to preference applies, the debtor’s estate may recover those payments as a preference.

Expiring LCs

A bankruptcy court may determine that the automatic stay prevents the beneficiary from enforcing a pre-bankruptcy covenant against the bankrupt applicant-debtor, requiring the debtor or its trustee to extend the LC.

Issuing Bank’s Reimbursement

If the reimbursement obligation is fully secured and perfected contemporaneously with the LC’s issuance, the issuing bank’s liens should not be subject to a preference action. If the LC is drawn after bankruptcy, the lender needs relief from the automatic stay to realize on its collateral or seek adequate protection of it.

Consequences of Section 363 Sale

If an asset purchase agreement and the bankruptcy court order approving it do not ensure the LC is replaced or fully collateralized, the issuer may lose its collateral.

Beneficiary Bankruptcy

Drawing on Bankrupt Beneficiary’s Nontransferable LC

The beneficiary’s rights under an LC are transferable by operation of law. A trustee in bankruptcy or court-appointed receiver is a transferee by operation of law.

Beneficiary’s Insolvency Being Used Against It

If the applicant can file an action to enjoin the draw, it must show not only material fraud but also the procedural requirements for injunctive relief.

Perfected Security Interest

A creditor’s security interest in the beneficiary’s LC rights is effective if it timely (i) perfects a security interest in the account, chattel paper, instrument, or general intangible the LC supports; or (ii) obtains an assignment of proceeds from the beneficiary that the LC issuer acknowledges.

Assignment of Proceeds as Preferential

If the assignment of proceeds is perfected before the preference period or contemporaneously with the applicant-debtor creating the debt to the assignee, the assignment should not be considered preferential.

Transferee Beneficiary

In some cases, the secured party may become the transferee beneficiary or even direct beneficiary of the LC issued for its debtor’s benefit.

Issuer Insolvency

Traditional LC Issuers

Banks and other depository institutions issue most LCs.

FDIC’s Role and Authority as to LCs Issued by Insolvent Banks

The Federal Deposit Insurance Act gives the Federal Deposit Insurance Corporation (FDIC) broad authority over failed banks, including broad authority to repudiate contracts, including LCs, that the FDIC deems burdensome, at its sole discretion. This is similar to, but broader than, the power of a debtor-in-possession or trustee appointed by the bankruptcy court to reject unwanted executory contracts. The FDIC can repudiate the contract by sending a letter to the counterparty without court approval and without prior notice.

FDIC Approach to LCs Issued by Insolvent Banks

The FDIC traditionally repudiated most LCs issued by failed banks. However, recently, the FDIC established “bridge” banks in the failures of Silicon Valley Bank and Signature Bank, indicating in a financial institution letter (FIL-10-2023) that each “bridge bank is performing under all failed bank contracts and expects all counterparties to similarly fulfill their contractual obligations.” It further indicated that “[a]ll obligations of the bridge [banks] are backed by the FDIC and the Deposit Insurance Fund.”

Going Forward

The FDIC responded to the SVB and Signature failures by putting the banks put into receivership under the Dodd-Frank Act’s systemic risk exception. These seem to be unique cases of the FDIC stepping in and establishing bridge banks to take over all the bank’s assets and liabilities to stem a more systemic risk to the financial system, which has not typically occurred. It is unclear to what extent the FDIC will retreat to its prior practice in handling LCs issued by banks that enter receivership or stand behind the contracts (or some subset of them) in future bank receiverships.

This article is related to a CLE program titled “Disaster Preparedness: Letters of Credit and Bankruptcy” that was presented during the ABA Business Law Section’s 2023 Fall Meeting. To learn more about this topic, listen to a recording of the program and read its in-depth materials, free for members.


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