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...