Letter of Credit Forum

The California Court of Appeals has spoken in California Bank & Trust V. Piedmont Operating Partnership and the result should be compared to the treatment of LC's in bankruptcy. A little background. 

The law we are dealing with is the FIRREA, the 1989 enacted Financial Institutions Reform, Recovery, and Enforcement Act which allows the FDIC to “alter contractual rights `in order to stem the disruption of banking services within communities”. Similar to a bankruptcy proceeding FIRREA gives the FDIC broad powers in resolving the affairs of a failed bank. This includes the express power to repudiate, or "disaffirm," contracts to which the failed bank is a party. 

 

In the case at bar the failed bank/applicant (Alliance Bank) leased premises from the defendant who, as is typical in commercial leases, secured the rent by a letter of credit issued by Union Bank of California.  In 2009 the FDIC closed Alliance, took over the bank, disaffirmed the lease, and sold the assets  “as is” to California Bank. The landlord/defendant calculated that the damages due to the disaffirmation amounted to 1 million dollars in lost future rents and filed a claim to recover. In addition it presented a draft amounting to $ 500,000 to the issuer of the letter of credit. 

 

California Bank as the bank which acquired certain assets of the applicant, had received among others, an account holding $ 500,000  that was formerly used as collateral for the letter of credit. When the landlord demanded payment from the issuer (Union Bank), the issuer paid and debited California bank accordingly. 

 

The court discusses in particular

a) Effect of the disaffirmation under FIRREA

b) Independence of letters of credit. 

 

FIRREA effects

To the uninitiated the FIRREA proceedings look at lot like bankruptcy, and after some discussions, the court agrees. (“ a failed bank receivership is akin to a bankruptcy proceeding and the receiver functions much like a trustee in bankruptcy. (Unisys Finance Corp. v. Resolution Trust Corp., supra, 979 F.2d at p. 611.)”).

Under a bankruptcy proceeding a lessor cannot claim damages if the bankruptcy trustee disaffirms executory (i.e. still unperformed) contracts; the same applies in FIRREA cases.

 

 

Independence

The beneficiary vigorously argued that letters of credit are independent of the underlying transaction, the court however did follow this argument. The court simply asked: “Is the beneficiary entitled to keep the $ 500,000 if effectively seized already.” and subsequently negated it. One of the cornerstones of this case is that the beneficiary landlord breached its lease when demanding payment based on the disaffirmance of the lease. Citing Resolution Trust Corp. v. United Trust Fund, Inc., 57 F.3d 1025, the court finds that the disaffirmance of the Alliance Bank lease did not constitute a breach of the lease and did not give rise to a claim of damages for future rent, and that the beneficiary Piedmont did not have a claim to the proceeds of the letter of credit. 

Later, when deciding that beneficiary has to pay plaintiff's attorney fees, the court finds that beneficiary breached the lease when asking for money after the disaffirmance. 

 

Even though I do not agree with the reasoning, the result is correct. The landlord exceeds the bounds of chutzpah and enters a fraud zone when demanding damages for a trustee's repudiation of an executory contract. When presenting the drafts to the issuing bank the landlord/beneficiary knew that it was not entitled to damages. Furthermore, the letter of credit in this case seems to be akin to a standby letter of credit, since the only document presented was a draft. Under principles developed for SBLCs, fraud exists if the demand for payment is not covered by the objective of the SBLC. In this case the SBLC was supposed to secure the tenant's performance; at the time of the demand for payment, the tenant however did not have any obligation to perform since the lease had been repudiated. 

 

I disagree with the judges insofar they mix and match the parties. German law would more closely follow the contractual relationships of the parties. This means that a German court would most likely confirm the independence principle and seek restitution via the various relationships applicant/successor ? issuing bank ? beneficiary. The typical construct in these cases is to find fiduciary duties between applicant and issuing bank which were breached when the issuing bank honored a fraudulent demand for payment. 

 

Despite my qualms, this is a well-reasoned decision that is worth reading.