The Letter of Credit Conundrum: When a Debtor’s Default May Be Preferable to Its Late Payment

With lease defaults on the rise, commercial landlords and other creditors are examining the terms of letters of credits that support their tenants’ obligations. Oddly, the beneficiary of a letter of credit sometimes may be better off if the debtor defaults (triggering the right to draw on the letter of credit) rather than if the debtor otherwise pays its debt outside the contract terms (e.g., late). This is because if the debtor files for bankruptcy within ninety days after the debtor’s payment, then such payment may be challenged as a preference for up to two years after the bankruptcy filing. Under cases like In re Powerine Oil Company discussed below, this is the case, even though the landlord would have been paid in full under the letter of credit had the debtor tenant, instead, not paid the untimely rent and defaulted, and no preference action would lie.

Letters of Credit and Preferential Transfers

A security deposit is property of the tenant debtor’s bankruptcy estate and is subject to the automatic stay; meaning that bankruptcy court approval must be obtained before the landlord or other creditor can apply a security deposit to satisfy unpaid rent. In contrast, letters of credits are an attractive alternative because the beneficiary can draw on it after and despite the tenant’s bankruptcy. This is because neither the letter of credit nor its proceeds are property of the debtor’s estate and as such, draws are not subject to the automatic stay provisions of the Bankruptcy Code.

A preference is a transfer by the debtor to a creditor (e.g., tenant to landlord) during the ninety days before the bankruptcy that enables the creditor to receive more than it would have received, had the payment not been made and, instead, a chapter 7 liquidation had occurred (which will usually be the case if the debtor was insolvent at the time of payment). Fact-intensive defenses exist, such as “ordinary course” payments, and are outside the scope of this alert, which assumes such defenses (and others) would not exist or would be expensive and risky to litigate.

Law Can Be Stranger Than Fiction in the Preference Zone

In In re Powerine Oil Company, 59 F.3d 969, 971 (9th Cir. 1995), Koch Oil Company agreed to sell crude oil to Powerine. To secure its obligation, Powerine designated Koch as the beneficiary of two standby letters of credit. Powerine’s reimbursement obligation to the issuing bank was, in turn, secured by a lien on Powerine’s property. Within ninety days of paying Koch $3.2 million from cash flow for crude oil, Powerine filed a chapter 11 case. The committee of unsecured creditors eventually sued Koch to recover the $3.2 million payment, claiming it was a preference under section 547(b) of the Bankruptcy Code.

The bankruptcy court held that the $3.2 million payment to Koch was not recoverable because of the so-called “contemporaneous exchange for new value” exception of section 547(c)(1) of the Bankruptcy Code. That defense protects a payment to the extent of any new value given to the debtor in contemporaneous exchange for the payment. The reasoning behind the exception is that, to the extent a creditor provides new value in exchange for a payment, the prospective bankruptcy estate has not been diminished. In Powerine, the bankruptcy court apparently reasoned that the $3.2 million payment resulted in a contemporaneous release of or reduction to the issuing bank’s contingent reimbursement claim, which was secured by Powerine’s assets.

On appeal, the bankruptcy appellate panel or “BAP” (an appellate alternative to U.S. district courts in some jurisdictions) affirmed the bankruptcy court on a different ground. It held that the payment was not a preference because it did not enable Koch to recover more than it would in a chapter 7 liquidation. It reasoned that even if Powerine had not made the payment from cash flow, Koch would have still been paid in full by drawing on the letters of credit.

The U.S. Court of Appeals for Ninth Circuit reversed. It found that Koch’s recourse against a third party (the letter of credit issuing bank) had no bearing on whether Koch received more than it would in a chapter 7 liquidation of Powerine, because “the relevant inquiry focuses . . . [on] whether the creditor would have received less than a 100% payout from the debtor’s estate” and not 100% payout “from any source whatsoever.”

The Ninth Circuit also rejected the BAP’s application of a “rule of reason” to avoid what the BAP viewed as an inequitable result (i.e., that Koch was worse off because Powerine paid its bill rather than defaulted). It found that the statute provided no basis for the BAP’s “rule of reason,” and concluded that the lower court erred in considering the right to draw on letters of credit in deciding whether Koch had received a preference. Although the Ninth Circuit’s reasoning aligns with the statute, the BAP’s reasoning is arguably more equitable and practical, because creditors may be able to avoid Koch’s unfortunate outcome by drawing on the letter of credit prior to its expiration (as most letters of credit permit drawing if the letter of credit is about to expire). This in turn may only result in the creditor returning the potentially preferential payment to the debtor—an inefficient and impractical outcome for all involved (including potentially the courts if parties seek approval of stipulations or comfort orders to document the recirculating of cash).

However, all was not necessarily lost by Koch, because the court did not completely reject the bankruptcy court’s application of the contemporaneous new value defense. Instead, the Ninth Circuit held that Koch would benefit from the defense to the extent the debtor’s prepetition payment to Koch was less than the value of the collateral securing the bank’s reimbursement claim. Thus, to the extent the amount paid to Koch exceeded the issuing bank’s collateral, Koch received (or Powerine paid) more than it would have in the hypothetical liquidation, and the excess had to be returned to the bankruptcy estate. The record did not enable the Ninth Circuit to determine the issuing bank’s collateral position. Accordingly, it remanded to the bankruptcy court to determine the bank’s collateral position, and correspondingly, what portion of the $3.2 million payment could be recovered from Koch.

Lessons Learned From This Letter of Credit Conundrum

Because the debtors’ reimbursement obligation to the bank for payments made under the letter of credit are usually secured by the debtor’s assets, even after Powerine, the contemporaneous exchange for new value exception should protect creditors in a situation like Koch’s (up to the value of the issuing bank’s collateral). This is because when the debtor pays the creditor, the issuing banks’ reimbursement claim against the debtor’s assets is released or reduced, giving the debtor new value equal to the bank’s collateral or claim reduction. Put differently, where the bank’s reimbursement claim is oversecured, its release of (or reduction in claims against) the debtor’s pledged assets offsets the debtor’s pre-bankruptcy payment to the creditor (e.g., landlord), resulting in no net depletion of the debtor’s estate. But in cases where the issuing bank is unsecured, the exception will likely not apply, and where the bank is undersecured, the exception will be capped at its collateral value; meaning the creditor/landlord will likely have to return the portion of the payment that exceeds the collateral value.

Powerine provides valuable lessons in an environment where defaults and bankruptcy filings are on the rise. Commercial landlords and other creditors should balance the benefits of drawing on a letter of credit against the risk of accepting an untimely payment from an obligor on the brink of bankruptcy. Even if the letter of credit is secured by the debtor’s assets, fluctuations in market values may leave the issuing bank undersecured and reduce or eliminate the creditor’s ability to rely on the contemporaneous new value exception. Also, because most letters of credit permit drawing if the letter of credit is about to expire, a creditor in Koch’s situation might consider drawing on the letter of credit and holding the funds as cash collateral while engaging the debtor and other relevant parties to consensually resolve any preference exposure.