Letters of Credit in Bankruptcy
May 3, 2022
In an earlier blog post, we discussed letters of credit in general. In this post we will focus on the impact of the principal’s bankruptcy on a letter of credit. When the surety’s principal files a bankruptcy case and becomes a debtor, what happens to the surety’s letter of credit? What happens to the surety’s rights to draw on the letter of credit, and what happens to the surety’s rights to use the letter of credit proceeds once it gets them? There are two main concepts that the surety must keep in mind in connection with this discussion. First, under section 541 of the Bankruptcy Code, it defines property of the debtor’s estate, and such property includes all of the principal’s or debtor’s legal or equitable interest in property as of the commencement of the bankruptcy case, wherever that property is located and by whomever that property is held. The second main concept under the Bankruptcy Code is section 362, the automatic stay. An automatic stay arises as of the commencement of the bankruptcy case and prevents actions by all of the creditors to enforce their rights against property of the estate. This automatic stay includes any action that a surety may take against property of the debtor’s estate in which the surety may have an interest, including a security interest. So, how do the concepts of property of the estate and the automatic stay affect the surety’s collateral that is a letter of credit? You have to look at three questions:
- Is the letter of credit itself property of the debtor’s estate? The answer is no. Because of the Independence Principle the letter of credit is a contract between the issuing bank and the surety beneficiary in which the principal or debtor has no property rights or interest.
- Are the proceeds of the letter of credit property of the debtor’s estate? Generally, the cases say no, and the reason it is no is because it is the bank’s money, not the principal debtor’s property.
- Assuming that the surety can comply with any conditions in the letter of credit in order to draw on the letter of credit proceeds, does the automatic stay prevent the surety from drawing on the letter of credit? The answer is “no.” The letter of credit proceeds are not property of the debtor’s estate, and therefore the automatic stay does not apply.
Now practically, how should the surety proceed with respect to the letter of credit and drawing on the letter of credit during the debtor’s bankruptcy case? First, unless there is some deadline or emergency, we have found that it is important for the surety before it draws on the letter of credit to at least discuss that draw with the debtor and its counsel prior to taking such action. They are going to appreciate it and it’s going to smooth things over. Second, when should the surety draw on the letter of credit proceeds? Obviously, if the bank provides notice to the surety that it is not going to renew the letter of credit after the petition date at some point, then the surety should draw fully on the letter of credit before the expiration date of the letter of credit. As a result, when you have such a case and you know you have a letter of credit as collateral, you should become very much aware of the expiration date and the time for the bank to provide notice. You may have to start fishing around to find out whether notice has been given because knowing who the notice goes to can be a problem and sometimes that notice will go to underwriters or somebody else, and you don’t learn of it timely. You really have to keep track of that.
Furthermore, if there are claims being made post-petition against the bonds, and assuming that the surety can make multiple draws under the same letter of credit, the surety should draw on the letter of credit in an amount to cover the expected bond loss plus expenses and attorneys’ fees. If during that very time, you get notice from the bank of non-renewal, then of course, you should draw on the whole letter of credit. Finally, how can the surety use what it has drawn? The surety’s use of the proceeds of a letter of credit are not subject to the automatic stay because such proceeds are not property of the bankruptcy estate. The surety is free to use the proceeds in accordance with its rights under the indemnity agreement and/or collateral agreement. These agreements continue to define the rights and obligations of the surety and principal even during the bankruptcy case.
The rules regarding proceeds of letters of credit may change as the bankruptcy drags on and the surety is holding proceeds for an extended period of time. Basically, the scenario is you have received the letter of credit, after a while, reasons pop up for drawing down on the letter of credit, such as the principal goes into bankruptcy; claims are made or the bank advises it is no longer going to renew the letter of credit. After a while, you’ve got some claims and some LAE costs and expenses; so you reimburse yourself for that. Now you’re sitting there and you’re holding a pot of money and you don’t have any claims coming in at the moment and you’re just sitting there. The question is what happens to that pot of money? Who gets those funds? Are they “excess proceeds”? Some bankruptcy courts have held that although letters of credit are not property of the bankruptcy estate, excess proceeds from a letter of credit can become property of the estate.
The way the courts have looked at it is they have reasoned that once the letter of credit has been drawn down, the independence principal is no longer at issue and the funds that are held by the beneficiary become subject to the underlying relationship between the beneficiary (in this case the surety) and the principal. So, some courts treat the proceeds as property of the bankruptcy estate. The courts have defined “excess proceeds” generally as proceeds of a letter of credit in excess of what is owed or what the beneficiary is legally entitled to receive or what the beneficiary needs to satisfy the underlying obligation. So, if the surety is holding funds that the court believes is in excess of what the surety is entitled to or what the surety needs to secure itself then the court may look at those proceeds as being excess proceeds.
In the suretyship context, because the surety continues to have that contingent or potential liability under its bonds, the funds up to the penal sum of the bonds should not be viewed as excess proceeds. We have fought this issue a number of times and we beat Skadden, Arps in a national bankruptcy case on this issue. In that case, the surety drew down on a letter of credit after the principal went into bankruptcy and the surety was holding $5 million in cash. The surety used about $1 million to pay claims and LAE. The bankruptcy trustee tried to recover the letter of credit proceeds. Of course, the whole purpose of the letter of credit in the first place is to secure the surety against potential losses that the principal cannot indemnify or reimburse, so that purpose remains in place until the surety’s liability under the bond is extinguished. The question then that is generated is when is the surety’s liability extinguished? This issue of the excess proceeds really brings up the point that the surety needs to have a detailed collateral agreement; a document that clearly defines what the collateral is being held for, and when that collateral is going to be released, under what terms and to whom. The surety really needs to have those issues addressed in a good, thorough and detailed collateral agreement before getting the collateral in the first place.
In the absence of a collateral agreement, the surety must look to other factors to determine when its contingent liability will cease. It could be that upon the discharge of the bond by the obligee, the surety’s liability will cease. That would be true for the bonds where there is only one potential claimant – the obligee. If the obligee discharges or releases the bond, then there’s no further liability. Liability under a bond can also be extinguished upon payment of the penal sum of the bond. In other cases, the surety’s liability under its bonds might not happen until the expiration of the applicable statute of limitations. That is particularly true in cases where there are third-party claimants potentially under the bond – for instance a contractor’s licensing bond or a payment bond or even a liability for latent defects under the performance bond. With potential exposure under the bonds, the statute of limitations may be the best way to have confidence that liability has been extinguished.
Of course, there can be confusion surrounding statutes of limitations. For one thing, statutes of limitation vary by jurisdiction. There can also be an issue as to when does the limitations period begin to accrue? Is it discovery or breach? What type of bond is at issue; is it a specialty, is it an instrument under seal, which statute of limitations is going to apply? In some cases there is no limitations period under the doctrine of Nullum Tempus – time does not run against the sovereign. Limitations can become really murky.
If the proceeds are excess and you have looked at the issue and you are convinced that your contingent liability is extinguished and you have this situation now where there’s excess money, who gets the money? Does the bank that issued the letter of credit get the money? Are they entitled to the return of the funds? Does the principal get the money? Are they out their collateral and they want to be reimbursed? Do they have a right to the funds? Does the trustee in bankruptcy have a right to get the funds back? This is a situation where the surety may find itself in the middle of two parties disputing who gets the money, and so the advice there is that the surety not take a risk and pay the wrong party, and that instead, an action be brought in the nature of an interpleader or some kind of declaratory judgment in order to determine where the money should be paid to protect the surety. Regardless, holding too much collateral is a good problem to have.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (email@example.com) or George Bachrach (firstname.lastname@example.org) or any member of the Surety and Fidelity Practice Group.
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