Letter of Credit: Not A Financial Accommodation, Executory Contract Or Even A Contract?

Rafool v. Evans, 497 B.R. 312 (C.D. Ill. 2013) –

A chapter 7 trustee brought a legal malpractice case against a debtor’s prepetition attorneys for failing to advise the debtor to draw on letters of credit prior to filing bankruptcy.  The case turned on whether the letters of credit could have been drawn after the bankruptcy was filed.

The debtor had a construction contract with a general contractor that required the general contractor to provide the debtor with letters of credit as a mechanism for providing retainage in connection with monthly progress payment.  In November 2007 the debtor received two letters of credit that expired on December 15, 2008.  On December 13, 2007, the debtor filed a chapter 7 bankruptcy petition.  The letters of credit were never drawn and expired.

Under applicable state law, the elements of a legal malpractice claim were (1) attorney/client relationship giving rise to a duty, (2) negligent act or omission constituting breach of the duty, (3) proximate cause, and (4) damages.  The chapter 7 trustee contended that the attorneys should have caused the debtor to draw on the letters of credit prior to filing bankruptcy, and sought damages in the amount of the letters of credit.  In response, the attorneys argued that they were not the proximate cause of any damages because the debtor could have drawn on the letters of credit after the bankruptcy filing.

The critical question was whether a letter of credit was an “executory contract” that constituted “financial accommodations, to or for the benefit of the debtor,” so that Section 365(c)(2) of the Bankruptcy Code prevented the trustee from assuming the letter of credit.  The bankruptcy court concluded that Section 365(c)(2) was not applicable because the letters of credit in this case (a) were not contracts of the debtor, (b) were not executory contracts, and (c) were not contracts to extend financial accommodations.  Consequently, they could have been drawn postpetition prior to their expiration.  On appeal, the district court agreed.

As outlined by the district court, a letter of credit involves three parties:  the applicant (or account party), the issuer and the beneficiary.  These parties are involved in three relationships that are independent of each other:  (1) the relationship between the applicant and the beneficiary, which is typically documented in an agreement that requires the applicant to provide the letter of credit; (2) the relationship between the applicant and the issuer of the letter of credit, which is typically documented in an agreement that establishes the applicant’s obligation to reimburse the issuer for any draws on the letter of credit (and sometimes to provide security for the reimbursement obligations); and (3) the relationship between the issuer and the beneficiary, which is typically reflected only in the terms of the letter of credit itself, including the conditions for a draw.

Most bankruptcy letter of credit cases involve a debtor as the applicant (including matters such as whether the automatic stay prevents the non-debtor beneficiary from drawing on the letter of credit, and whether draws on the letter of credit and/or the debtor’s payment of its reimbursement obligations constitute preferences).  However, in this case the debtor was the beneficiary, which gave rise to a different analysis.

In reaching its determination that the letters of credit did not constitute a contract of the debtor, the court focused on the fact that the debtor as beneficiary had no obligations to the issuer, so that there was no mutuality.  In other words, the debtor did not provide the consideration required to support a contract under ordinary contract law.

Although that conclusion was sufficient to resolve the malpractice case, the court also addressed whether the letters of credit would be an executory contract (assuming they were contracts).  The Seventh Circuit uses the Countryman definition of executory – namely whether there are unperformed obligations of both parties so that the failure to complete performance by a party would constitute a material breach excusing performance by the other party.  In this case, the debtor did not owe any obligations to the issuer that it could breach, so the issuer would not be excused from performance.  The failure to meet conditions for a draw simply meant that the draw could not be made until the conditions were met, not that the issuer was excused from performing at a later time when the conditions were met.

Finally, even if the letters of credit were executory contracts, the court did not agree that they would constitute a financial accommodation to or for the benefit of the debtor.  The court noted cases that narrowly define financial accommodations as limited to the extension of money or credit to accommodate another, as well as cases that distinguished contracts where the extension of credit is a primary purpose of the contract, as opposed to only an incidental part.

Rejecting arguments based on legislative history suggesting that letters of credit are always financial accommodations, the court concluded that the letters of credit were only an incidental component of the underlying contract and that classifying letters of credit as financial accommodations “does not serve §365(c)(2)’s purpose to permit lenders to escape from uncreditworthy borrowers because the beneficiary of a letter of credit will never owe repayment to the issuer.”

Consequently: the debtor’s interest under the letters of credit was part of the bankruptcy estate and draws could have been made postpetition.  So the failure of the pre-bankruptcy attorneys to cause the debtor to draw on the letters of credit was not the proximate cause of any damages arising from the debtor’s failure to draw before the letters of credit expired.

Frequently it can be difficult to predict where cases involving letters of credit will come out.  Regardless of whether the debtor is a beneficiary or the applicant/account debtor, it would be prudent to move with caution when determining how to deal with a letter of credit after a bankruptcy has been filed.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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