Exploring The Boundaries Of The 'Independence Principle'
Much has been written recently about the impact of a bankruptcy filing on the right of a nondebtor landlord to draw on a letter of credit posted as security for the tenant's obligations under a lease of nonresidential real property. The focus of recent court rulings and commentary, however, has generally been directed to various restrictions, such as the statutory cap placed on damage claims under commercial leases, on the lessor's ability to apply the full amount of the proceeds of a letter of credit to the lessee's obligations, notwithstanding the common-law "independence principle" that, as a general rule, operates to make a lessor's remedies under a letter of credit inviolate in the event of a bankruptcy filing by the lessee.
A recent decision by the Eleventh Circuit Court of Appeals illustrates another potential hazard for lessors who believe their rights under a real property lease are fully secured by a letter of credit. In In re Builders Transport, Inc., the court of appeals held that a standby letter of credit beneficiary was required under section 542 of the Bankruptcy Code to turn over proceeds of a letter of credit improperly retained after the commencement of a bankruptcy case by the lessee.
Drawdown and Distribution of Letter of Credit Proceeds
A typical letter of credit transaction securing a lease involves three independent sets of obligations: (a) the lessee's obligations to perform under the terms of the lease; (b) the letter of credit issuer's obligation to pay the amount of any draw under the letter of credit when presented by the lessor beneficiary; and (c) the lessee's obligation to reimburse the letter of credit issuer for the amounts drawn on the letter of credit. Under what is commonly referred to as the "independence principle," the obligation of the issuer to pay the beneficiary upon presentment of the letter of credit is independent from the lessee's obligations under the lease. As a result, the letter of credit is not property of the debtor's bankruptcy estate and, as a general rule, the automatic stay does not prevent the beneficiary from presenting and drawing on the letter of credit after the lessee files for bankruptcy. Once the letter of credit is drawn, however, distribution of the cash proceeds is subject to the terms of the lease that the letter of credit secures. The Court of Appeals for the Eleventh Circuit addressed certain complications that arise once a letter of credit is drawn during the course...
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