9.6 Letters of Credit in Bankruptcy

• Library: Enforcement of Liens and Judgments in Virginia (Virginia CLE) (2019 Ed.)

9.6 LETTERS OF CREDIT IN BANKRUPTCY

9.601 In General. Letters of credit have long been used as a method of payment when goods are sold internationally. Standby letters of credit are often the most effective type of collateral for a debt. The issuing bank makes an irrevocable agreement with the letter of credit beneficiary that, upon presentation of a draft together with other documents specified in the letter of credit, the issuing bank will honor the draft. In the context of an international sales transaction, these documents generally include a negotiable document of title such as a bill of lading.

The letter of credit is an independent obligation of the issuing bank to the beneficiary. The issuer is primarily liable to the beneficiary and must honor the letter of credit upon the beneficiary's compliance with its terms.

In the typical standby letter of credit transaction, the source of the principal means for payment (the customer) agrees with the other party to

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the underlying transaction (the vendor and beneficiary of the letter of credit) to secure its performance through a letter of credit. The customer contracts with its bank to issue the letter to the beneficiary. The bank, having knowledge of the creditworthiness of its customer, issues the letter of credit for a fee and, typically, also takes a security interest in some or all the customer's property, to which the bank will have recourse if the letter of credit is drawn upon. The beneficiary receives the letter of credit and generally has the right to draw under it upon certification of the customer's default in the underlying transaction. Once the issuing bank honors the draw, the amount of its contingent secured claim against its customer is determined, and its claim against the customer ceases to be contingent.

9.602 Enforcement: Twist Cap and Beyond. The holding in In re Twist Cap, Inc.³³² stood to render all letters of credit unenforceable upon a debtor's bankruptcy filing. ³³³ However, Twist Cap was harshly criticized by commentators, ³³⁴ and as similar cases arrived before the courts, Twist Cap was largely repudiated or ignored. ³³⁵ Later decisions regarding letters of credit have been based on one or more of the following lines of reasoning:

1. A letter of credit issued by a bank in favor of a creditor of the bankruptcy estate is not property of the bankruptcy estate and, if honored, solely involves bank funds. Thus, the automatic stay provisions contained in section 362

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