IMPACT OF A BANKRUPTCY FILING BY A TENANT ON THE LANDLORD S RIGHTS AS A BENEFICIARY OF THE TENANT S LETTER OF CREDIT SECURITY DEPOSIT

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1 IMPACT OF A BANKRUPTCY FILING BY A TENANT ON THE LANDLORD S RIGHTS AS A BENEFICIARY OF THE TENANT S LETTER OF CREDIT SECURITY DEPOSIT Villanova, PA 19085I. INTRODUCTION Professor Walter J. Taggart Villanova Law School Landlords sometimes accept standby letters of credit when a lease is originally negotiated 1

2 as all or part of the Tenant s security deposit. If financial difficulty befalls the Tenant, the Landlord may ask some questions about the Bankruptcy Code and letters of credit. Here are some possible questions. Assume that when the lease was entered into a letter of credit was provided. Two years later, the Tenant files a chapter 11 case. Question One. Does the automatic stay prohibit the Landlord from drawing down on the letter of credit? Answer. No Question Two. If the letter of credit is paid to the Landlord, is the payment an avoidable preference? Answer. No. Assume a letter of credit was not provided when the lease was executed two years ago. One month ago, the Tenant was in default and four months past due in rent. Tenant offered and the Landlord accepted a letter of credit equal to six months rent in exchange for the Landlord not formally declaring a default. Question Three. If the Landlord draws down the credit and the Tenant then files a chapter 11 the next day, is the payment to the Landlord an avoidable preference? Answer: No, if the Issuer is unsecured. Yes, if the Issuer is secured. Question Four. If the Tenant files a chapter 11 case, and the Landlord later draws down the credit, is the payment to the Landlord an avoidable preference? Answer: No, if the Issuer is unsecured. Yes, if the Issuer is secured. The determining fact in Questions Three and Four is whether the Issuer of the letter of credit was secured by the Tenant s property. If the Issuer was secured and the value of the collateral was adequate to fully cover the draw, the Tenant has received an indirect preference that is unavoidable. 2

3 II. FILING OF CHAPTER 11 CASE: IMPACT ON LANDLORD S RIGHT TO PAYMENT OF LETTER OF CREDIT A. Automatic Stay: Current Law Collier on Bankruptcy under the heading Acts Against Nondebtors Not Stayed states the law as follows: Section 362(a)(6) stays collection from the debtor. It does not stay actions against sureties to recover property in which the debtor has no interest.... Similarly, the stay does not apply to a draw under a letter of credit. The letter of credit represents an obligation of the issuer, not the debtor. Therefore, a creditor may draw on a letter of credit free of any automatic stay restriction. As with guaranties, the draw under a letter of credit is not stayed even if the issuers right of reimbursement from the debtor is secured by property of the debtor or property of the estate. 5 Collier on Bankruptcy, [8][b] (Lawrence King 15 th ed.). This conclusion is based on the legal relationship of the applicant (the Tenant), the Issuer, and the beneficiary (the Landlord) under the letter of credit. The central concept of a letter of credit is the independence principle. In the 1995 revision of Article 5 of the Uniform Commercial Code, which governs letters of credit, the independence principle is stated in 5-103(d). Rights and obligations of an issuer to a beneficiary or a nominated person under a letter of credit are independent of the existence, performance, or nonperformance of a contract or arrangement out of which the letter of credit arises or which underlies it, including contracts or arrangements between the issuer and the applicant and between the applicant and the beneficiary. The description primarily relates to a commercial letter of credit issued as part of a sales transaction in which the letter of credit is paid if the required documents are presented, even if the buyer of the goods has a rock-solid case that the goods supplied by the seller are nonconforming. A standby letter of credit that is used in the landlord-tenant situation involves the same basic idea except the letter of credit only comes into play if the Tenant defaults. The Issuer pays the letter of credit as long as the documents presented by the Landlord appear... on their face strictly to comply with the terms and conditions of the letter of credit, 1 relating to the documents the Landlord must present. 1 There is a narrow exception to the independence principle. Section 5-109(b) authorizes an injunction against payment of a letter of credit to prevent actual fraud. Rigorous procedural requirements, including protection of the beneficiary from loss, must be followed. 3

4 B. The Automatic Stay: Some History Section 362(a) of the Bankruptcy Code provides that the filing of a chapter 11 petition stays all acts to recover property of the debtor, to enforce a lien against property of the debtor, or to obtain legal remedies against the debtor. The issue is whether the letter of credit itself or the payment by the Issuer are property of the debtor. The fundamental premise of the letter of credit is that the Landlord frees itself of the credit risk of the Tenant by substituting the independent obligation of the bank Issuer. The letter of credit itself is not to be property of the Tenant because the Tenant has no rights to draw on the credit, and the Issuer s payment is not property of the Tenant because the Issuer pays the credit with its funds. In general, the bankruptcy courts had little or nothing to say about letters of credit until Judge Paskay entered a preliminary injunction against an issuer barring payment of a letter of credit in In re Twist Cap, 1 B.R. 284 (Bank. D. Fla. 1979). The court reasoned that property of the debtor was involved because the issuer was secured and the payment of the letter of credit would increase the amount of the debt secured by the collateral. The commercial world regarded this case as undermining the entire purpose of the letter of credit. 2 Judge Paskay substantially repudiated Twist Cap in In re Petersburg Hotel Asso. Ltd., 37 B.R. 380 (Bank. MD. Fla. 1984). In 1987, the Fifth Circuit in Kellogg v. Blue Quail Energy, Inc., 831 F.2d 273 (5 th Cir. 1987), amended, 835 F.2d 584 (5 th Cir. 1988), declared the law to be as follows: It is well established that a letter of credit and the proceeds therefrom are not property of the debtor's estate under 11 U.S.C When the issuer honors a proper draft under a letter of credit, it does so from its own assets and not from the assets of its customer who caused the letter of credit to be issued. As a result, a bankruptcy trustee is not entitled to enjoin a post petition payment of funds under a letter of credit from the issuer to the beneficiary, because such a payment is not a transfer of debtor's property (a threshold requirement under 11 U.S.C. 547(b)). A case apparently holding otherwise, In re Twist Cap., Inc.,... has been roundly criticized and otherwise ignored by courts and commentators alike. 831 F.2d at Courts have not deviated from this recognition of the independence principle and a recent case, as the Collier quote suggested, treats the point as settled. In re Papio Leno Club, Inc., 247 B.R. 453 (8 th Cir. B.A.P. 2000). Another aspect of the stay deserves attention. Assume the Landlord must certify as part 2 The district court in Page v. First Nat l Bank (In re Page), 18 B.R. 713 (D.DC 1982), quickly sought to allay these fears by squarely rejecting Twist Cap. 4

5 of the documentation of the draw that the Landlord has given notice to the Tenant of the Tenant s right to cure the default and that 20 days have past without cure. If the chapter 11 case is filed before the notice is given, the automatic stay prohibits giving the notice. See Arrow Air, Inc. v. United Airlines (In re Arrow Air, Inc.), 70 B.R. 245 Bankr. (S.D. Fla. 1987). Ordinarily, courts grant relief from the stay in this type of situation precisely because the debtor s property is not involved. Nonetheless, it is better to craft the certification requirement so that there is a right to draw down the credit even if the notice to the Tenant cannot be given because of the filing of the chapter 11 case. C. General Equity Injunction Under 105 Section 105(c) of the Bankruptcy Code authorizes the entry of any order... or judgment that is necessary or appropriate to carry out the Bankruptcy Code. This wellspring of equity power has only generated two decisions in which the courts acknowledged the independence principle but enjoined payment of a letter of credit in order to accommodate the exigencies of the chapter 11 process. In Wysko Inv. Co. v. Great Amer. Bank, 131 B.R. 141 (D. Ariz. 1991) and In re Delaware River Stevedores, Inc., 129 B.R. 38 (Bank. E.D. Pa. 1991), the courts enjoined payment of a letter of credit on the ground that payment of the letter of credit would interfere with the reorganization. There is no doubt that the bankruptcy courts have the raw authority to enjoin payment of a letter of credit under 105(a). The issue is when, if ever, should injunctive relief be granted. Both the Wysko and Delaware River courts adopted an unusual circumstances test, but both failed to articulate a persuasive argument for issuing an injunction other than, what at bottom appears to be the simple premise, that the debtor believes the dynamics of negotiating a plan will be easier. Other cases have examined the 105(a) issue and denied or reversed injunctions barring payment of letters of credit in part because such injunctions would undermine the commercial utility of letters of credit. Lower Brule Construction Co., v. Sheesle s Plumbing & Heating Co., Inc., 84 B.R. 638 (D.S.D. 1988); In re Duplitronics, 183 B.R (N.D. Ill. 1995). III. MAY PAYMENT OF A LETTER OF CREDIT TO LANDLORD BE A PREFERENCE UNDER THE BANKRUPTCY CODE A. Letter of Credit as Part of Original Lease Transaction. If a Tenant gives a Landlord $10,000 as a security deposit as part of the original lease transaction, the Landlord holds the money as security and the Landlord s claim for rent in the Tenant s chapter 11 case would be an allowed secured claim to the amount of the deposit. The lease transaction and the security deposit are one exchange for new value. Even if the Tenant filed a chapter 11 case within 90 days of the payment of the $10,000 deposit, there would be no preference. There is no transfer for or on account of an antecedent debt. No other avoiding 5

6 power is available to recover the security deposit for the estate. Timing is important. A long delay in receipt of the security deposit, say six months after the lease was signed and the Tenant took possession, would result in the security deposit being a transfer on account of an antecedent debt which would not be protected by the contemporaneous exchange defense of 547(c)(1) of the Bankruptcy Code. If the Tenant files a chapter 11 case within 90 days, the security deposit could be recovered as an avoidable preference. If the Landlord obtained a security interest in collateral at the time the lease began, the result would be the same. The security interest would not be avoidable as a preference or under any other avoiding power. The same result also applies if the Tenant posts a letter of credit rather than cash or other property. There is no preference because there is no antecedent debt or antecedent obligation to post the letter of credit. If there is only a modest delay in posting the letter of credit, the transfer would also be protected under the contemporaneous exchange rule of 547(c)(1). But what if the Landlord draws down the credit and within 90 days the Tenant files a chapter 11 case? The Tenant would like the draw to be separate from the original posting of the letter of credit so that there is a transfer within 90 days of the filing of the Tenant s chapter 11 case. The Tenant s problem is that in order for there to be a preference, there must be a transfer of the Tenant s property. The cases noted in Section I establish the legal point that neither the letter of credit nor any money paid under the letter of credit are property of the debtor. Thus, when the credit is drawn down within 90 days of the Tenant s chapter 11 case, or after the filing of the chapter 11 case, there is no transfer of the Tenant s property and thus no preference. B. Tenant Provides Unsecured Letter of Credit After Lease Default If a Tenant is four months in arrears in rent and makes a lump sum cure payment in cash, the payment is an avoidable preference if the Tenant files a chapter 11 case within 90 days of the payment. What if instead of taking cash, the Landlord accepts a letter of credit from the Tenant. The Landlord draws down the credit under either of two scenarios: (1) within 90 days of the Tenant s chapter 11 filing or (2) the Landlord draws down after the chapter 11 filing. Has the Landlord received a transfer of the Tenant s property? As noted earlier, neither the letter of credit itself nor payment under the letter of credit involve the transfer of property of the estate. The result appears sound. 3 Landlord is paid in full by funds loaned by the Issuer to the Tenant. The payment does not disadvantage other creditors because there is no reduction in the assets of the estate. Landlord s claim is satisfied and the Issuer has an unsecured reimbursement 3 The no transfer of the debtor s property rationale is criticized, but the result supported by David Carlson and William Widen, Letters of Credit, Voidable Preferences, and the Independence Principle, 54 BUS. LAWYER, 1661, (1999). 6

7 claim in the same amount. 4 C. Tenant Provides Secured Letter of Credit After Lease Default If Tenant is four months in arrears in rent and posts a secured letter of credit, the analysis is more complicated. The letter of credit and any payments under the letter of credit do not involve property of the Tenant. The Issuer obtains a security interest in the Tenant s property, but the Issuer gives new value, the letter of credit, in exchange. Even if the Tenant files a chapter 11 case within 90 days of the issuance of the letter of credit to the Landlord, there does not appear to be any preferential transfer of property of the Tenant. There should be a preference in this situation because there would be a preference if the Tenant granted a security interest in its property to the Landlord instead of the Issuer. The letter of credit transaction and the granting of a security interest to the Landlord are functionally the same. In the letter of credit case, the Landlord s unsecured claim against the Tenant is extinguished by payment under the letter of credit but it is replaced by the Issuer s fully secured reimbursement claim. But where is the transfer that is the preference? The answer lies in the distinction between direct and indirect preferences. When the Tenant granted a security interest in its property in favor of the Issuer, there was no preference to the Issuer because new value was given issuance of the letter of credit. Landlord was, however, the indirect beneficiary of the transfer of the Issuer. The leading case is Kellogg v. Blue Quail Energy, Inc. (In re Compton Corp.), 831 F.2d 581 (5 th Cir.1987), in which a creditor obtained a letter of credit from the debtor to secure an overdue debt. The next day an involuntary chapter 11 case was filed against the debtor. The bankruptcy and district courts both held there was no preference because the letter of credit and its payment were not transfers of the debtor s property and the security interest granted to the issuer of the letter of credit was a transfer exclusively for the benefit of the Issuer. The Fifth Circuit reversed relying on the well-developed concept that, when a transfer produces a benefit to a third party who is not the transferee of the property, the estate may recover the benefit from the third party if the other preference criteria are satisfied..indeed, it is possible that the recipient of the direct transfer does not receive a preference but the indirect beneficiary of the transfer does receive a preference. 4 If the Issuer of an unsecured letter of credit pays the Landlord and then receives full reimbursement from the Tenant within 90 days of the Tenant s filing a chapter 11 case, the reimbursement payment to the Issuer is an avoidable preference. P.A. Bergner & Co. v. Bank One, Milwaukee NA (In re Pa Bergner & Co.), 140 F.3d 1111 (7 th Cir. 1998). 7

8 We hold that a creditor cannot secure payment of an unsecured antecedent debt through a letter of credit transaction when it could not do so through any other type of transaction. The purpose of the letter of credit transaction in this case was to secure payment of an unsecured antecedent debt for the benefit of an unsecured creditor. This is the only proper way to look at such letters of credit in the bankruptcy context. The promised transfer of pledged collateral induced the bank to issue the letter of credit in favor of the creditor. The increased security interest held by the bank clearly benefited the creditor because the bank would not have issued the letter of credit without this security. A secured creditor was substituted for an unsecured creditor to the detriment of the other unsecured creditors. We also hold, therefore, that the trustee can recover under 11 U.S.C. 550(a)(1) the value of the transferred property from "the entity for whose benefit such transfer was made." In the case at bar, this entity was the creditor beneficiary, not the issuer, of the letter of credit even though the issuer received the direct transfer from the debtor. The entire purpose of the direct/indirect doctrine is to look through the form of a transaction and determine which entity actually benefited from the transfer. 831 F.2d at The Eleventh Circuit adopted this analysis in American Bank of Martin County v. Leasing Services Corporation (In re Air Conditioning, Inc. of Stuart), 845 F.2d 293 (11 th Cir. 1998), cert. denied sum nom, First Interstate Credit Alliance, Inc. v. American Bank,484 U.S. 993 (1988). 5 D. Tenant s Payment of an Antecedent Debt may be a Preference Even if Landlord Holds a Letter of Credit in an Amount Greater than the Payment A transfer within the 90-day preference period on account of antecedent debt is avoidable as a preference only if that payment to the creditor is greater than the payment the creditor would receive in a chapter 7 case. Thus, the everyday rule is that a payment to a fully secured creditor is not a preference because the fully secured creditor would be fully paid in a chapter 7 case. In a letter of credit security deposit arrangement, the Landlord is not secured by property of the debtor but by the letter of credit. Does this change the result? Assume the Landlord holds an unsecured letter of credit, which was provided two years 5 There is a strong argument under 550(a)(1), which the Compton court relied on, that once the transfer is found to confer an avoidable indirect preference on the beneficiary of the letter of credit, of necessity the transfer of the security interest to the Issuer is also avoidable under 550(a)(1). See Levit v. Ingersoll Rand Fin. Corp. (In re VN Deprizio Const. Co.), 874 F.2d 1186, n (7 th Cir. 1989). To date, no court has held that the transfer of collateral to the Issuer is an avoidable preference. See John F. Dolan, The Law of Letters of Credit, 7.03[3][a] (rev. ed. 2000). 8

9 ago. Tenant is in arrears four months in the rent but at the last minute pays the full arrearage. Tenant files a chapter 11 case 60 days later. The letter of credit expires during the chapter 11 case. The debtor later pursues a preference action against the Landlord to recover the rent arrearage payment. The real estate lawyer s intuition is no problem. The Landlord was fully secured by the letter of credit and the Tenant s payment was, therefore, not a preference. The Ninth Circuit s holding is that there is a problem. The Landlord has received a preference. Comm. of Creditors Holding Unsecured Claims v. Koch Oil Co. (In re Powerine Oil Co), 59 F.3d 969 (9 th Cir. 1995), cert denied, 516 U.S (1996) holds that in determining whether a payment to a creditor enables the creditor to obtain more than the creditor would have obtained in a chapter 7 case, the letter of credit is ignored. Only property of the debtor is considered. Since the Landlord is not secured by any of the Tenant s property, in a Chapter 7 case the Landlord would be an unsecured creditor. From this it follows that the Tenant s payment to the Landlord is a preference. The Fifth Circuit had decided this issue the earlier in Gulf Oil Corp. v. Fuel Oil Supply and Terminaling, Inc., 837 F.2d 224 (5 th Cir. 1988). What is the typical attitude of the Issuer of the letter of credit if the letter of credit has expired? Sorry, our letter of credit expired some time ago. Plus, you were paid. This is a nasty problem. There is an argument that the Issuer received an indirect preference when the Tenant paid the Landlord because the Issuer s potential obligation under the letter of credit was extinguished. This analysis is explored in depth by Michael Baxter in Letters of Credit & The Powerine Preference Trap, 53 BUS. LAWYER 65 (1997). The result is different if the Landlord obtained the letter of credit outside the preference period and the Issuer was fully secured when the letter of credit was issued. The payment by the Tenant of the rent arrearage eliminates the default and thereby eliminates the Issuer being called on to pay the letter of credit. This in turn is the equivalent of releasing the Tenant s property from the Issuer s potential security interest. In sum, there is a wash. Cash out the door to the Landlord, property of an equal value freed from the Issuer s security interest. Of course, an Issuer may be partially secured. Powerine involved a partially secured Issuer and the court remanded for the bankruptcy court to work out how much of the letter of credit was secured. To the extent the letter of credit was not secured, the payment would be a preference. How does a Landlord manage this preference risk? The simple approach is to monitor defaults and consider the pros and cons of drawing down under a letter of credit rather than encouraging the Tenant to pay up. Another aspect of the problem is how the expiration of the letter of credit can be arranged to provide greater protection to the Landlord. Baxter suggests the following approach to the Powerine problem. 9

10 A properly drafted standby letter of credit can ensure that the creditor will receive its payment regardless of the disposition of any preference action that may be subsequently filed against the creditor. The root of the problem in Powerine was the expiration of the standby letters of credit before the commencement of the preference action against the creditor. To address this problem, the standby letter of credit should provide for the extension of the expiration date of the letter of credit to afford the creditor a reasonable period to learn of and act upon the debtor's subsequent bankruptcy. To avoid the Powerine trap, a creditor may insist that the standby letter of credit remain open for a stipulated period following the debtor's final payment of an obligation guaranteed by a letter of credit. Not only must this period be sufficiently long to include the preference period, but an additional amount of time must be provided for the creditor to receive or obtain notice of any voluntary or involuntary bankruptcy filing in respect of the debtor

11 Furthermore, it is essential that the standby letter of credit expressly permit the creditor to return any payment made by the debtor during the preference period and to seek recovery against the issuer under the letter of credit. Otherwise, the issuer may take the position that the debtor's payment discharged the issuer's obligation under the letter of credit and, as a result, that any decision by the creditor to return the payment to the debtor is of no legal consequence to the issuer. One way to accomplish this in the standby letter of credit is to provide for alternative means of drawing under the letter of credit. The first means of drawing essentially would be triggered by the debtor's payment default under the underlying contract. The second means would be triggered by the bankruptcy of the debtor within a stipulated period following the debtor's payment of its obligation to the creditor. Of course, this period must be sufficiently long to include the preference period plus a reasonable opportunity for the creditor to receive or obtain notice of the debtor's bankruptcy. 53 BUS. LAWYER at These terms are particularly well suited to business relationships in which a large payment could be due but the creditor does not necessarily appreciate that debtor is in dire financial straits. In the lease context, understanding the Powerine risk is substantial protection for the landlord. When a rent arrearage develops and the Landlord holds a letter of credit, the amount at stake is modest and there is ample time to evaluate the pros and cons of negotiating for a cash cure of the arrearage versus drawing down on the letter of credit. If the Landlord elects to accept a cash cure, the 90-day period begins to run. On the other hand, if the Tenant is about to exercise an expensive early termination right, the Landlord might want to do some background investigation to ascertain the Tenant s financial condition and if it is suspect the Landlord might be better off drawing down the credit. Of course, the letter of credit may or may not permit a draw in the case of the Tenant s exercise of an early termination right. 11