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Draw on Letter of Credit Has Same Effect As Cash Forfeiture

By Adam C. Rogoff, Steven M. Herman and Deborah Piazza
May 27, 2004

It is well-settled that “property of the estate” is broadly defined under section 541 of the Bankruptcy Code as including all legal and equitable interests of a debtor. Therefore, the breadth of property of the estate includes a debtor's indirect, residual or reversionary interest in the return of funds. It is also equally acknowledged that, in general, a letter of credit (LC) is an independent obligation of the issuing bank and, under the “independence principle,” is not necessarily property of the estate. From time to time, these two concepts — broad estate interest in property versus the treatment of a LC — clash in bankruptcy. In these instances, some courts will look at “substance” and not “form” to determine whether the debtor's residual interest in an LC is property of its estate.

LCs are routinely posted by debtors as a form of collateral. Rarely — if ever — is an LC posted unrelated to the debtor's obligation to the “beneficiary” (it's not a “gift”). As with any form of collateral, a creditor does not have an absolute right to keep the collateral apart from the underlying debt. As such, the debtor continues to have a residual interest in any such collateral in excess of the allowed secured claim, which residual interest should be made available to satisfy claims of other creditors

The “independence principle” for LCs should not necessarily affect this end result. Therefore, whether or not collateral is in the form of an LC, courts should look to the parties' underlying rights to determine the ultimate ownership interest in the LC's proceeds. Where a creditor is holding LC proceeds that clearly exceed its allowed secured claim, it should not be permitted to retain those funds simply because the funds constitute the “proceeds” of an LC. In performing this analysis, a court may also examine the impact the draw on an LC would have on a debtor's estate.

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