AStandby Letter of Credit Payments

Can Be Hazardous to Your New Value Preference Defense

Bruce NathaN, esq.S e l e c t e d t o p i c

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S e l e c t e d t o p i cBruce NathaN, esq.

A creditor defending a preference claim can assert numerous defenses to reduce its exposure. One such defense, the subsequent new value defense arising under Section 547(c)(4) of the Bankruptcy Code, allows a creditor to reduce its preference liability on a dollar-for-dollar basis by the amount of new value the creditor had extended to the debtor subsequent to an alleged preference payment.

Well what happens if a trade creditor, wise in the ways of risk mitigation, obtains a standby letter of credit to reduce the risk of non-payment from a troubled cus-tomer? Following the customer’s bankruptcy filing, the creditor obtains payment of its claim from the letter of credit issuing bank by presenting all of the documents required by the letter of credit. The letter of credit pay-ment should not be recoverable as a preference. How-ever, what about the payments the creditor received from the debtor within 90 days of the bankruptcy? They

are at risk of recovery as preferences, subject to the creditor’s defenses, such as the subsequent new value defense. But what if the creditor’s invoices subject to its new value defense are paid from the proceeds of the creditor’s letter of credit draw prior to the bankruptcy?

The United States Bankruptcy Court for the Southern District of Florida, in In re All American Semiconductor, Inc., recently addressed this question. While the credi-tor had no preference liability as a result of the payment it had received on the letter of credit, the creditor’s pref-erence risk increased as a result of the loss of the new value defense for the invoices paid from the proceeds of the letter of credit.

Preference claims and the New Value DefenseA trustee can recover a preference by satisfying all of the requirements of Bankruptcy Code Section 547(b). A creditor can assert one or more defenses to preference liability under Section 547(c) of the Bankruptcy Code. One such defense is the subsequent new value defense arising under Bankruptcy Code Section 547(c)(4). A creditor can prove the new value defense to the extent of the new goods and/or services that the creditor had sold and delivered to the debtor, on credit terms, subsequent to the preference.

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One of the requirements of the subsequent new value defense, contained in section 547(c)(4)(B), is that the creditor’s new value was not paid by an otherwise unavoidable transfer by the debtor to or for the creditor’s benefit.

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The subsequent new value defense protects a creditor from preference risk because the debtor’s creditors were not harmed by a preference where the creditor had provided new inven-tory and/or services to the debtor after the payment. The cred-itor’s new value repaid the preference and, therefore, did not deplete or diminish the debtor’s bankruptcy estate. The new value defense is also supposed to encourage creditors to con-tinue extending credit to financially troubled companies and promote equality of treatment among creditors.

One of the requirements of the subsequent new value defense, contained in Section 547(c)(4)(B), is that the creditor’s new value was not paid by an otherwise unavoidable transfer by the debtor to or for the creditor’s benefit. In All American Semicon-ductor, Inc., the creditor received payment of a portion ($1 million) of the invoices, included as part of its new value defense, as part of the creditor’s draw on a standby letter of credit that All American Semiconductor had caused Harris Bank to issue for the creditor’s benefit. The court ruled that the creditor’s invoices that were subsequently paid by Harris Bank did not count as eligible new value to reduce the credi-tor’s preference liability.

Overview of standby Letters of creditTrade creditors frequently rely on a standby letter of credit as a backstop to protect them from the risk of nonpayment of their invoices by a financially troubled customer. A letter of credit arrangement involves three parties and three indepen-dent contracts.

The first contract frequently involves a sale of goods or provi-sion of services between a seller and a buyer. The wrinkle is that a seller may condition extending credit or otherwise doing business with a buyer upon the buyer’s obtaining a let-ter of credit in favor of the seller.

As part of the second contract, the buyer, as the letter of cred-it applicant, enters into an agreement with the bank issuing the letter of credit. The buyer agrees to repay the bank, fre-quently on a secured basis, for the bank’s payments made to the beneficiary upon the presentation of conforming docu-ments, together with the bank’s charges and commissions earned from issuing the letter of credit.

The third contract is the standby letter of credit that the bank issues in favor of the seller, as beneficiary. When the benefi-ciary submits documents to the issuing bank, the bank’s sole duty is to examine the documents and determine whether they comply with the terms of the letter of credit. When the bank determines that the beneficiary has presented all of the documents required by the letter of credit, the issuing bank must pay the amount requested by the beneficiary.

The bank’s obligation to pay a conforming draw on a letter of credit is independent of the beneficiary’s performance of the underlying contract for which the letter of credit was issued and the bank’s ability to recover its reimbursement claim against the buyer/letter of credit applicant. The bank must pay

the beneficiary upon the presentation of all of the documents required by a letter of credit, regardless of any contractual dis-pute between the seller and buyer and/or the bank’s inability to obtain payment of its reimbursement claim. In addition, if the bank rejects a beneficiary’s presentation of conforming documents, the bank is in breach of its obligation to pay on the letter of credit and is subject to the beneficiary’s assertion of a wrongful dishonor claim.

the Facts of the all american semiconductor caseOn April 25, 2007, (the “petition date”), All American Semi-conductor and its affiliates filed their Chapter 11 petitions with the United States Bankruptcy Court for the Southern District of Florida. In April 2009, the bankruptcy court approved the creditors’ committee’s Chapter 11 plan of liqui-dation, which transferred all preference claims to a liquidat-ing trust created under the plan.

That same month, the liquidating trustee commenced a law-suit against Samsung Semiconductor Inc. (“Samsung”) to recover, as preferences, certain payments by All American Semiconductor totaling approximately $4.9 million that Samsung had received during the 90-day period prior to the petition date. Samsung filed an answer to the complaint, asserting several defenses, including the subsequent new value defense. Samsung claimed, as new value, approximately $4 million of new goods that Samsung had sold and delivered to All American Semiconductor subsequent to the alleged preferential payments.

The problem with Samsung’s subsequent new value defense was that Samsung was the beneficiary of a standby letter of credit that Harris Bank had issued at the request of All Amer-ican Semiconductor. Harris Bank’s reimbursement claim against All American Semiconductor for letter of credit pay-ments was secured by cash collateral (funds in a bank account) that All American Semiconductor had pledged to Harris Bank. Shortly before the petition date, Samsung drew on the letter of credit and applied the payment received from Harris Bank toward certain invoices comprising Samsung’s claimed new value. Harris Bank then set off its secured reimburse-ment claim against All American Semiconductor, arising from its $1 million payment to Samsung, against the $1 mil-lion of All American Semiconductor’s cash collateral pledged to Harris Bank.

There was no question that Samsung’s receipt of payment for its proper letter of credit draw was not subject to preference risk. However, that did not address Samsung’s preference risk for the payments it had received from All American Semicon-ductor within 90 days of the petition date. The All American

the problem with samsung’s subsequent new value defense was that samsung was the beneficiary of a standby letter of credit.

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Semiconductor court addressed whether Samsung’s subse-quent new value preference defense included the invoices that were paid from the proceeds of Samsung’s draw on the letter of credit.

the All American Semiconductor court’s DecisionThe All American Semiconductor court ruled that Samsung’s new value defense was reduced by the letter of credit pay-ments Samsung had received from Harris Bank. The court relied on Section 547(c)(4)(B)’s requirement that any new value claimed by a preference defendant cannot be repaid by an otherwise unavoidable transfer by the debtor.

The court noted that Harris Bank had set off the amount it had paid to Samsung ($1 million), in satisfaction of the bank’s reimbursement claim against All American Semiconductor, from All American Semiconductor’s bank account pledged to Harris Bank. The net effect of Samsung’s receipt of payment from Harris Bank left the All American Semiconductor bank-ruptcy estate in precisely the same position that it would have been in if Samsung had not extended any new value to All American Semiconductor. As a result, All American Semi-conductor derived no benefit from its receipt of $1 million of new goods from Samsung that Samsung had claimed as new value. Granting Samsung the benefit of the new value defense under these circumstances would have afforded Samsung an undeserved windfall.

Other courts have reached the same conclusion as the court did in All American Semiconductor. The United States Bank-ruptcy Court for the Eastern District of Pennsylvania, in In re Lease-A-Fleet, Inc., similarly ruled that a creditor’s receipt, prior to the bankruptcy, of payment on its standby letter of credit for certain of the new value that the creditor had previ-ously supplied to the debtor reduced the creditor’s subsequent new value defense on a dollar for dollar basis. There too the court relied on the fact that the letter of credit issuing bank, that was the source of payment of the new value claimed by the beneficiary/creditor, was fully secured by the debtor’s assets. As a result, the debtor received no benefit from the creditor’s new value, which was no different than if the debtor had directly paid for the creditor’s new value.

The All American Semiconductor court also relied upon the decision of the United States Bankruptcy Court for the Eastern District of Michigan in In re Formed Tubes, Inc. In that case, the creditor asserting the new value defense to reduce its pref-erence liability was also the beneficiary of a standby letter of credit that the debtor had caused to be issued in the creditor’s favor prior to the bankruptcy. However, the letter of credit

issuing bank had an unsecured reimbursement claim against the debtor for payments made on the letter of credit. As a result, the creditor’s receipt of payment on the letter of credit had no impact on the debtor’s bankruptcy estate and, there-fore, the invoices paid from the letter of credit proceeds were properly included as part of the creditor’s new value defense. That was in contrast to the diminution of the All American Semiconductor bankruptcy estate where Harris Bank had obtained full reimbursement of the $1 million letter of credit payment that Samsung had applied toward invoices claimed as part of Samsung’s new value defense.

another aspect of the all american semiconductor caseThe trustee and Samsung were also at loggerheads over wheth-er Samsung’s subsequent new value defense was reduced by $198,969 of merchandise returns made by All American Semiconductor to Samsung during the preference period. The liquidating trustee argued that the returns reduced the amount of Samsung’s new value defense on a dollar for dollar basis because Samsung had received the returns after delivering to All American Semiconductor the goods claimed as part of Samsung’s subsequent new value defense. Samsung rejected the trustee’s attempt to reduce Samsung’s new value defense because the trustee did not prove that any of the returns relat-ed to the goods comprising Samsung’s new value defense.

The court refused to decide whether All American Semicon-ductor’s returns reduced Samsung’s subsequent new value defense and left the issue to be determined at trial.

conclusionThe holding in All American Semiconductor is a cautionary tale for trade creditors holding a standby letter of credit to pro-tect against the risk of nonpayment by a financially troubled customer. When the letter of credit issuing bank’s reimburse-ment claim against the debtor is fully secured by the debtor’s assets, the creditor loses its new value defense for the invoices paid as part of the debtor’s pre-petition drawing on the letter of credit.

An intriguing unanswered question is whether Samsung would have fared better by making its letter of credit drawing post-petition. The Delaware bankruptcy court, in In re Fried-man’s, Inc., ruled that a creditor’s subsequent new value defense includes new value that was paid post-petition. Could Samsung have relied on the Friedman’s case to argue that its new value invoices paid by a post-petition drawing on a letter

the All American Semiconductor court ruled that samsung’s new value defense was reduced by the letter of credit payments samsung had received from Harris Bank.

the holding in All American Semiconductor is a cautionary tale for trade creditors holding a standby letter of credit to protect against the risk of nonpayment by a financially troubled customer.

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of credit are still eligible new value? Time and the right case might offer an answer.

A creditor can also avoid or reduce preference risk by obtaining a letter of credit that covers both nonpayment and preference risk. Unfortunately this is not necessarily so easy to obtain.

Bruce Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandler PC. He is a member of NACM and is on the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI’s Unsecured Trade Creditors Committee. Bruce is also the co-chair of the Avoiding Powers Advisory Committee working with ABI’s commission to study the reform of Chapter 11. He can be reached via email at bnathan@lowenstein.com.

*This is reprinted from Business Credit magazine, a publication of the National Association of Credit Management. This article may not be forwarded electronically or reproduced in any way without written permission from the Editor of Business Credit magazine.