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CREDIT COLUMN A Standby Letter Of Credit Payment Within The Preference Period Is Not A Preference

BRUCE S. NATHAN, ESQ.

ne of the most frequently asked questions payment was not a preference. The court’s analysis from trade creditors is whether a drawing is equally applicable to trade creditors who are and a payment on a standby letter of beneficiaries of standby letters of credit that secure O credit during the 90-day preference payment of the purchase price of goods or services period is recoverable as a preference. A letter of provided to a customer. credit is a security device where a bank or other Hear Bruce speak at entity agrees to pay up to the amount of the letter Overview Of Standby Letters Of Credit the teleconference: of credit to a beneficiary that presents all of the A standby letter of credit is used in many transac- Reclamation and documents required by the letter of credit. A tions as a backstop that protects a letter of credit Stoppage of Delivery standby letter of credit is intended to serve as a beneficiary from a default in its transaction with a June 27, 2005 backstop to secure payment or performance of a third party, usually the letter of credit applicant. A

For more information, please separate independent transaction between the letter of credit arrangement involves three parties contact the NACM Meetings letter of credit beneficiary—and frequently—the and three independent contracts. First is the Dept. at 410.740.5560. person that arranged for the issuance of the letter underlying contract between the letter of credit of credit, the letter of credit applicant. For exam- applicant and beneficiary, such as a sale of goods ple, a seller of goods or provider of services could or provision of services. The bank’s agreement, be a beneficiary under a standby letter of credit to usually with the letter of credit applicant, is the secure the payment of the purchase price of goods second contract. This contract provides for the sold or services provided to a buyer that arranged issuance and the terms of the letter of credit, the for the issuance of the letter of credit. applicant’s obligation to reimburse the bank for payments made to the beneficiary upon the presen- In ITXS, Inc., a Chapter 11 case pending in the tation of conforming documents under the letter of United States Bankruptcy Court for the Western credit as well as the bank’s charges and commis- District of Pennsylvania, a Chapter 11 debtor had sions earned from issuing the letter of credit, and brought a preference action against a landlord that the collateral security for the applicant’s reim- made a drawing under, and received payment of, a bursement obligation to the bank. The third standby letter of credit within 90 days of ITXS’s contract is the standby letter of credit that the 2005 bankruptcy. The standby letter of credit was issued bank issues in favor of the beneficiary. When the

JUNE for ITXS’s account in favor of ITXS’s landlord as a beneficiary presents all of the documents required partial security deposit to secure ITXS’s obligation by the standby letter of credit, usually consisting to pay rent and other sums due under ITXS’s lease of a draft and a statement or certification of with the landlord. The Bankruptcy Court held the default in the underlying transaction, with the

BUSINESS CREDIT 1 CREDIT COLUMN letter of credit applicant (such as the buyer’s/applicant’s fail- The court ruled that the letter of credit bank’s payment to F&S ure to timely pay for goods sold or services provided by the was not a preference because it was not made from assets of seller), the issuing bank must pay the amount of the draft to the debtor, ITXS, as required by Section 547(b). A letter of the beneficiary, or else breach the bank’s payment obligation credit issuer pays from its own funds, rather than from the funds under the letter of credit. of its customer/debtor, when the issuer honors a drawing under a letter of credit. Under the independence principle, a One of the central tenets of letter of credit law is the princi- letter of credit bank has an independent obligation to make ple of independence. Each of the contracts in a letter of credit payment to the beneficiary upon the latter’s presentation of transaction is independent of the other. And a letter of credit all documents required by the letter of credit. ITXS never issuing bank deals only in documents. For example, if the possessed any property interest in the proceeds payable by beneficiary presents all documents required by the letter of the letter of credit issuing bank to F&S as a result of the credit, the issuing bank must pay the letter of credit. The latter’s proper drawing. Therefore, ITXS did not satisfy one of existence of disputes between the beneficiary and the appli- the required elements of a preference claim and its lawsuit cant, and/or the applicant’s financial inability to reimburse was dismissed. the bank for letter of credit payments and charges, has no bearing on the bank’s obligation to pay a beneficiary that The court rejected ITXS’s argument that the payment to F&S presents all documents required by the letter of credit. And under the letter of credit amounted to an indirect preference the applicant has a defense to the bank’s reimbursement claim because of ITXS’s pledge of collateral in exchange for the if the bank makes payment to the beneficiary based upon issuance of the letter of credit in favor of F&S. ITXS did not presentation of noncomplying documents. argue that the potentially preferential indirect transfer to F&S had arisen from the bank’s payment to F&S. Rather, ITXS The ITXS Case claimed the preference occurred as a result of ITXS’s grant of The debtor, ITXS, a lessee of real property, had arranged for the a security interest in its property in order to obtain the issuance of a standby letter of credit in the amount of $62,360, issuance of the letter of credit in favor of F&S. in favor of its landlord, F&S Hayward LLC. The standby letter of credit was intended as a partial security deposit to secure The court rejected ITXS’s preference claim because the trans- fer of ITXS’s property occurred outside the preference period. payment of rent and other sums due under ITXS’s lease with The bank’s payment to F&S during the preference period was F&S. ITXS had pledged collateral with the bank as security for not the operative transfer that gave rise to a preference claim ITXS’s obligation to reimburse the bank for payments made to in favor if ITXS. The transfer occurred when ITXS granted a F&S under the letter of credit. security interest in its assets to the bank prior to the prefer- ence period, to secure the payment of ITXS’s reimbursement F&S claimed that ITXS had defaulted under the lease, drew on obligation for any payment under the letter of credit, which the letter of credit and received payment of the sum of induced the bank to issue the letter of credit. $62,360 from the letter of credit issuing bank. ITXS filed Chapter 11 within 90 days of F&S’s receipt of payment from the Of course, a debtor’s grant of a security interest in its prop- bank. The letter of credit had been issued in favor of F&S and erty so as to obtain the issuance of a letter of credit in favor ITXS had pledged collateral with the issuing bank well outside of a creditor would be an avoidable preference if the security the 90-day preference period. interest was granted within the 90-day preference period to secure payment of antecedent indebtedness owing to that The Bankruptcy Court considered whether the letter of credit creditor. That is precisely what happened in In re Air payment F&S had received during the 90-day preference Conditioning, Inc. of Stuart, that was decided by the Eleventh period was recoverable as a preference. A debtor in posses- Circuit Court of Appeals in 1988. The debtor had caused its sion or a trustee can recover a payment of other transfer, as bank to issue a standby letter of credit in favor of one of its a preference under Section 547(b) of the Bankruptcy Code, by creditors within 90 days of the debtor’s bankruptcy filing. The satisfying all of the following requirements: (a) the debtor, letter of credit was issued to secure the debtor’s payment of a ITXS, had transferred its property; (b) the transfer was made preexisting obligation to the creditor/letter of credit benefi- to a creditor of ITXS, F&S; (c) the transfer was made on ciary. The debtor obtained the issuance of the letter of credit account of antecedent indebtedness owing by ITXS to F&S by granting the bank a security interest in a certificate of (i.e., the payments due under the lease between them); (d) deposit as collateral security for the debtor’s obligation to the payment was made within 90 days of ITXS’s bankruptcy reimburse the bank for payments made under the letter of filing for payments to noninsider creditors, such as F&S; (e) credit. The Eleventh Circuit Court of Appeals ruled that the the payment was made while ITXS was insolvent (ITXS’s debtor’s pledge of the certificate of deposit to the issuing liabilities exceeded its assets), which is presumed within the bank amounted to an indirect transfer of the debtor’s assets 90-day preference period; and (f) the payment enabled ITXS for the creditor’s benefit during the 90-day preference period to recover more than it would have recovered in a Chapter 7 to secure the debtor’s obligation to pay antecedent indebted- BUSINESS CREDIT liquidation case (always satisfied if creditors receive less ness. The debtor’s creditor, as letter of credit beneficiary, was than a full recovery). The issue the court had to consider benefited by the debtor’s pledge of its certificate of deposit was whether the letter of credit bank’s payment of its own to the letter of credit issuing bank, which induced the bank funds, rather than the funds of ITXS, to F&S was a transfer of to issue the letter of credit to the creditor. This transfer was

ITXS’s property, which is a threshold requirement for a pref- a preference, and the court ordered the creditor/letter of JUNE erence under Section 547(b). credit beneficiary, as the entity for whose benefit the security 2005 2 CREDIT COLUMN

interest was granted, to turn over the payment it had received debtor’s pledge of collateral during the preference period, if under the letter of credit. the letter of credit was issued to induce future extensions of credit by the creditor/letter of credit beneficiary to the Unfortunately for the debtor/ITXS and fortunately for F&S, debtor, and not to secure payment of the antecedent indebt- the issuance of the letter of credit, and ITXS’s pledge of edness owing by the debtor to the creditor. The specter of collateral securing payment of its reimbursement obligations preference risk arises only where the letter of credit was under the letter of credit, occurred long before the onset of issued and collateral was pledged during the preference the 90-day preference period. There was no indirect prefer- period to secure payment of existing indebtedness of the ence in favor of F&S! debtor to the creditor. I

Conclusion A standby letter of credit is an effective device to ensure the payment of a trade creditor’s claims. Non-insider trade cred- itors can rest assured, after the ITXS decision, that they are Bruce S. Nathan, Esq. is a Partner in not necessarily exposed to preference risk for payments they the law firm of Lowenstein Sandler PC had received during the 90-day preference period under a in New York, NY. He is also a member of standby letter of credit issued for the debtor’s account. Trade NACM and is a Co-Chair of the American creditors escape preference risk altogether where the letter Bankruptcy Institute Unsecured Trade of credit was issued, and collateral was pledged by the Creditor Committee. He can be reached debtor/letter of credit applicant, before the preference via e-mail at [email protected]. period. Trade creditors are also free from preference risk, despite the issuance of the letter of credit during the prefer- ence period, where the debtor/letter of credit applicant did This is reprinted from Business Credit magazine, a publication of the not pledge collateral security for its reimbursement obliga- National Association of Credit Management. This article may not be tion under the letter of credit. Trade creditors also duck pref- forwarded electronically or reproduced in any way without written erence risk, despite the issuance of a letter of credit and a permission from the Editor of Business Credit magazine. 2005 JUNE

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