RESEARCH PAPER ON
BANKRUPTCY/INSOLVENCY LAW IN VARIOUS COUNTRIES GENERALLY
WITH PARTICULAR ATTENTION FOCUSED ON
THE EFFECTS AND CONSEQUENCES OF BANKRUPTCY OF THE APPLICANT AND INSOLVENCY OF THE ISSUING BANK IN RELATION TO LETTERS OF CREDIT UNDER UNITED STATES LAW
Course: International Commercial Transactions
BY: Metchi Palaniappan
Masters Program in International Trade Law 2002 – 2003
This paper focuses on a study of:
In the United States, bankruptcy procedures, rights and obligations of the parties involved in such proceedings, the status of the parties and their assets, the rights of third parties with respect to the debtors and matters incidental and relating to priority and preferences to claims are set out in the U.S. Bankruptcy Code – Chapter 7, 11 and 13.
Chapter 7 of the Bankruptcy Code governs the liquidation of financially distressed companies and sets out the procedures for the distribution of liquidated assets to the debtor’s creditors. Chapter 7 is distinct from Chapter 11 in that, with a view to assist in rehabilitations, Chapter 11 provides for restructure and reorganization of a distressed company whereas Chapter 7 does not contemplate the retention of the debtor’s assets or the debtor’s rehabilitation.1
A case under Chapter 7 may be commenced voluntarily by a company or involuntarily by its creditors. The basis for a distressed company or its creditors to commence insolvency proceedings under Chapter 7 would be where the company lacks feasibility for successful reorganization of the business operation. Many Chapter 7 cases are ‘no-asset’ cases with little or no prospects of any meaningful distributions to unsecured creditors.
Upon the commencement of a Chapter 7 case, a trustee will be appointed who will then manage the debtor’s financial affairs. The trustee has broad statutory powers to manage the debtor’s business operation, to collect, liquidate and distribute the company’s assets and property to the creditors. This situation is similar to the bankruptcy law in Malaysia.
Also where the court determines cause e.g. where the debtor does not have reasonable proposals for a reorganization plan, a Chapter 11 case may be converted to a Chapter 7 case. Factors that courts would consider in determining ‘cause’ include continuing loss to or diminution of the value of the estate, inability to effectuate a plan of reorganization under Chapter 11 or unreasonable or prejudicial delay by the debtor.2
Under Chapter 7, an individual debtor would generally be entitled to apply for a discharge from insolvency and his debts unless there are instances of attempts to defraud creditors or conceal his assets. Similar provisions of law exist in India in this respect.
However a corporation or partnership debtor that liquidates under Chapter 11 is not entitled to a discharge, though in effect its assets are liquidated and distributed to creditors and thereafter the entity dissolves.3
Upon a voluntary or an involuntary Petition under Chapter 7 there will be automatic stay which prevents any commencement or continuation of litigation against the debtor, enforcement of a judgment against a debtor, any act to obtain possession or control of the debtor’s property or any act to collect, assess or recover a claim against the debtor.4 Similar provisions of Bankruptcy Laws apply in Malaysia.
Exceptions to the automatic stay principle are actions by government to enforce its police and regulatory powers.5
The assets of the insolvent will be distributed in the following order of priority:
It appears that the holders of highest priority claims must be paid in full before the trustee distributes to holders of claims in the subsequent priority class.7
Chapter 11 is a ‘reorganization’ provision of the Code comprising provisions for the debtor’s restructuring. Example, Section 1145 provides for issuing new shares under the plan. Chapter 11 may be used to facilitate an orderly liquidation of the debtor. The debtor need not be ‘insolvent’ for the purposes of Chapter 11. Chapter 11 liquidations usually involves a sale of all or substantially all of the debtor’s assets to a single buyer or bulk asset sales such as inventory or leases to several purchasers. The court generally conducts a competitive auction process under section 363(b) of the Code. Professionals such as investment bankers are retained by the debtor in possession under Section 327 of the Code to assist in the sales process. Under Section 1125 a disclosure statement must be filed and the ‘feasibility’ and ‘best interest’ tests must be met. Therefore Chapter 11 process would appear to be a better process to liquidate an ongoing business debtor.8
There are numerous cases, which interpret and explain these statutory provisions and procedures as reflected in some of the cases set out here.
1) Artis v Builder’s Transport, Inc., 1998 U.S. Dist. Lexis 18622 (E.D.N.C. 1998) deals with the principle of automatic stay in bankruptcy law and whether the enforcement of judgment for damages in tort would thereby be affected.
The defendant in the case sought voluntary bankruptcy protection under Chapter 11. The issues that arose before the court were whether there was an automatic stay of all further action by virtue of the bankruptcy/insolvency proceedings and whether the Plaintiff, an unsecured creditor in the circumstances, could nevertheless recover payment on the Letter of Credit issued.
The facts briefly: The Plaintiff’s son was killed in a road accident involving the Defendant’s truck. Pursuant to a settlement agreement, consent Judgment was entered against the Defendant for the sum of $100,000/- which was payable in four (4) installments. The Defendant posted a Letter of Credit under the US transportation law which required a self-insuring transportation company to file a ‘bond, insurance policy or other type of security. The terms of the Letter of Credit required the defendant to certify that (a) the plaintiff/claimant had obtained a final non-appealable judgment against the defendant, (b) the claim had not been paid for thirty (30) business days after a demand for it had been made by the plaintiff. The settlement agreement provided, inter-alia that in the event of default of payment, the Defendant would assist the Plaintiff to obtain the proceeds of the Letter of Credit. Then defendant defaulted on the final payments and filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. The Plaintiff claimed payment under the Letter of Credit from the trustee/beneficiary, whose duty is to look out for unsecured creditors. The trustee refused to pay and the defendant, for its part, refused to provide the required certification to enable the plaintiff to seek payment under the Letter of Credit.
The issue before the Court was what effects the defendant’s voluntary filing of the bankruptcy proceedings would have on the plaintiff’s claim for payment under the Letter of Credit which was posted by the defendant prior to the bankruptcy proceedings being initiated. And the Court held that:
“The letter of credit serves the same purpose as a surety bond. It was an emergency source of money for those injured by a self-insuring company, which was accessible to the plaintiff in the event the defendant defaulted liability.” The Court ruled that, because of this statutory purpose, the letter of credit should be regarded as outside the Bankruptcy Estate in the same fashion as a surety bond. Therefore an order requiring the judgment debtor to supply the required certifying statement did not violate the automatic stay principle.
2) Development Specialists, Inc. v Hamilton Bank, N.A. (In re: Model Imperial, Inc.) 250 B.R. 776(Bankr.S.D. Fla. 2000) deals with a Chapter 11 bankruptcy proceeding and preferences of transfers of assets subsequent to the initiation of bankruptcy proceedings and as to whether these assets ought to have been subordinated.
The facts briefly: Model Imperial Liquidating Trust Company (Model) had ongoing business operations at the material time. ‘Model’ secured all its assets to obtain substantial revolving credit facilities from three (3) lenders, namely, NationsBank, BankBoston and South Trust. This credit facility restricted Model from borrowing from other financial sources. The Lenders refused to increase Model’s credit line, and Model obtained credit facilities from Hamilton Bank creating a ‘shell’ company, which existed only on paper with no assets whatsoever. Hamilton Bank also issued a Letter of Credit to enable Model to purchase “gift sets” for the Christmas season. The goods purchased through the financing from Hamilton were held as collateral and security for the credit facilities granted. The Lenders were never notified of this arrangement. Later, when the Lenders discovered this arrangement, Model reported losses of more than US$20 million. The Lenders thereupon recalled their loan/credit facilities. In the interim and during the process of all these transactions, an agreement was concluded whereby Hamilton could take possession of the goods in the bonded warehouse if the indebtedness was not cured by a certain date. Model filed for protection under Chapter 11 of the Bankruptcy Code. Following this Hamilton liquidated and sold the inventory and received in excess of US$1.2 million. Hamilton also extended short-term credit to Model including Letters of Credit and bankers’ acceptances. Hamilton then filed a proof of claim in the bankruptcy proceedings. The trustee objected on the grounds that the transfers of the inventory by Hamilton were with the intent to hinder, delay and defraud creditors and hence were avoidable and recoverable. Accordingly the trustee filed an adversary proceeding asking that Hamilton’s claim be equitably subordinated to other creditors’ claims. The trustee also contended that certain post-petition transfer were avoidable.
The United States Bankruptcy Court, Hyman, J., overruled the trustee’s objections and concluded that under the circumstances of the matter, the trustee was not entitled to recover any post-petition transfers.
The Court stated in obiter that “it is certainly consistent with the policies of the Bankruptcy Code to equitably subordinate Hamilton’s allowed claim, to Model’s allowed unsecured claims if the bank had acted according to the industry standards in which event Hamilton Banks’ claim might have been contractually subordinated.”
It appears from the language of the cases cited above and in particular, the Hamilton Bank’s case, that, assets held as collateral by the secured creditor may be sold, transferred and/or liquidated subsequent to the debtor/applicant filing an insolvency petition. Consequently such assets cannot be traced by the trustee for the benefit of the unsecured creditors in the general pool. The Bankruptcy Court in the Hamilton Bank case stated further, in obiter, that the secured creditor’s claim might have been subordinated by contractual arrangement in accordance with the norm of the industry.
EFFECT AND CONSEQUENCES OF THE APPLICANT’S BANKRUPTCY IN RELATION TO THE LETTER OF CREDIT ISSUED TO THE BENEFICIARY
The need for letters of credit arose because of the uncertainty involved when a seller ships his goods to an unknown customer, especially if located in a foreign jurisdiction. The seller undertakes the risk of having to obtain his payment in the foreign jurisdiction. Hence the letter of credit was developed to remove this uncertainty and shift the risk of non-payment for the goods in international sales transactions. Letters of credit are governed by Article 5 of the Uniform Commercial Code (U.C.C) and the Uniform Customs and Practice for Documentary Credits (U.C.P.)
There are three parties to a letter of credit transaction i.e.
(a) the applicant, who is usually the buyer and is the party requesting for the issuance of the letter of credit and ultimately funds the same;
(b) the issuing bank, who is the applicant’s bank and the intermediary who makes the payment to the beneficiary; and
(c) the beneficiary, who is usually the seller and the party receiving payment under the letter of credit.
Also there are three distinct and separate contracts involved in the letter of credit transaction:
(a) An agreement between the issuing bank and the applicant that governs the terms by which the bank will issue the letter of credit and under which the bank will honor the drafts presented against the letter of credit. A debtor-creditor relationship is created between the issuing bank and the applicant when the bank issues the letter of credit.
(b) A contract between the issuing bank and the beneficiary embodied in the terms of the letter of credit itself that governs how and when the beneficiary may request for payment.
(c) The underlying agreement between the applicant and the beneficiary which creates the need for the letter of credit, which is in fact independent from the letter of credit, i.e. the issuing bank is obligated to honor the letter of credit regardless of the status of the underlying transaction.
The main function of the letter of credit is to shift the risk in a transaction from the beneficiary to the issuing bank. The theory is that the issuing bank is in a better position to assess the creditworthiness of the applicant. The primary essence of the letter of credit is the fact that the letter of credit is independent of the underlying transaction. It is this “independence” doctrine that makes the letter of credit a viable and effective commercial device. Because of the independence of the letter of credit, the issuing bank is bound to pay the beneficiary based solely on the terms of the letter of credit. In a documentary letter of credit transaction, the issuing bank is obligated to pay when present with proper documents regardless of any dispute between the beneficiary/seller and the applicant/buyer. The risk of non-payment is thus shifted from the beneficiary to the issuing bank. The beneficiary receives payment and the issuing bank must look to the applicant for reimbursement or pre-payment.
The mechanics of a standby letter of credit differ from a regular commercial/documentary letter of credit though the purpose remains the same, i.e. to reallocate the risk of the transaction to the party most able to evaluate the circumstances and bear the risk. Under a standby letter of credit, the beneficiary is using the letter of credit to secure the performance of the obligations by the applicant rather than to obtain direct payment in a sales transaction. Therefore the beneficiary only draws on a standby letter of credit when the applicant fails to perform his obligations under the contract. Hence the standby letter of credit usually requires an affidavit of non-performance from the beneficiary rather than presentment of documents of sale.
Letters of credit seem to pose a dilemma in the bankruptcy system because of the conflict that arises between the two important commercial and bankruptcy policies, namely, the “Independence Doctrine of Letters of Credit” law and the “Preference Provisions” of the Bankruptcy code.
On the one hand, the effectiveness of a Letter of Credit is based on the fact that the obligation of the issuing bank to pay the beneficiary is independent of the underlying transaction between the beneficiary and the applicant under the “Independence Doctrine: of letters of credit law. And on the other hand, bankruptcy law prohibits transfers at the eve of bankruptcy by the debtor, which may benefit one creditor to the detriment of the other similarly situated creditors. The preference provisions of the Bankruptcy Code allow the debtor or trustee to void pre-bankruptcy transfers and recover the property to the debtor's estate for the benefit of all creditors in equality.
The dilemma arises when the applicant of a letter of credit becomes a debtor in bankruptcy.
In the case of In re: Commco Tech (Commco Techjnology, LLC v Science Applications Int’l Corporation 258 B.R. 63; 2001 Bankr. LEXIS 77 (Bankr. D. Conn. 2001)[USA]
Facts: the applicant purchased computer software and hardware from the beneficiary and the bank issued a standby Letter of Credit to assure payment. Consequent to a repayment dispute between the applicant and the beneficiary, the parties entered into a settlement agreement to restructure the debt and the applicant issued a corresponding promissory note. The beneficiary refused to agree to the insertion of a clause in the promissory note stating that the letter of credit would be honored only ‘in the event the applicant fails to pay the note in full when due’. The parties also incorporated a statement recognizing the beneficiary’s right to draw on the letter of credit in whole or in part at any time with a view to partially satisfy amounts owed by the payee. The letter of credit had expired by the time applicant and the beneficiary had entered into the settlement agreement and the promissory note. Consequently the applicant caused the issuer to extend the expiration date of the letter of credit and was charged a fee for the extension of the letter of credit. The applicant did not contest the fee. Thereafter the applicant rearranged its financial affairs and sued the issuer and the beneficiary in the state court for a temporary restraining order prohibiting payment on the letter of credit on the grounds that any attempt to draw on the letter of credit by the beneficiary would be fraudulent because the settlement agreement stipulated that the letter of credit only secured payments that were outstanding prior to the settlement agreement. The state court granted the restraining order on the grounds that the beneficiary’s drawing on the letter of credit would cause irreparable harm. Subsequently the applicant commenced Chapter 11bankruptcy proceedings. The beneficiary then applied to the US Bankruptcy court to vacate the temporary restraining order, which was granted. The applicant’s response and request for a permanent injunction was denied.
Arguments before the Court:
Applicant: if the funds held by the issuer collateral for the letter of credit were applied to reimburse a drawing by the beneficiary, it would cause irreparable harm to efforts for liquidating.
Court: rejecting the argument, “there was no persuasive evidence” of such harm because the applicant could not show that efforts to liquidate its assets would be affected by the beneficiary’s drawing on the letter of credit.
Applicant: drawing on the letter of credit would be fraudulent
Court: the applicant would have to prove the likelihood of success on the merits of such a contention.
In the case of Prime Motor Inn; In re: Metrobility Optical systems, Inc. 268 B.R. 326; 2001 Bankr. LEXIS 1382 (Bankr. D.N.H. 2001)[USA]:
Facts: the applicant/debtor in bankruptcy proceedings applied for a preliminary injunction to prevent the beneficiary from drawing on the Letter of Credit. The underlying transaction involved a lease of real property. A standby Letter of Credit for US$1,792,000/- was issued. The letter of credit was silent as to the governing rules.
The letter of credit required that the beneficiary/lessor certify that the applicant had failed to pay or perform one or more of its obligations under the lease. The lease itself envisaged the filing of voluntary bankruptcy in the event of default. The lease provided that the beneficiary was entitled to draw against the letter of credit to satisfy itself with an amount equal to the total rent reserved for the balance of the term in the event of an uncured default. When the applicant filed for protection during its reorganization under Chapter 11 of the US Bankruptcy Code, the beneficiary served a notice of default and notice of intent to draw the full amount of the letter of credit despite the fact that the applicant was current on its lease payments. The Applicant then moved for a temporary restraining order and preliminary injunction in the bankruptcy action to prevent the beneficiary from drawing upon the letter of credit.
The United States bankruptcy court granted the applicant/debtor’s motion for a preliminary injunction, enjoining the beneficiary and its assignees from certifying that default existed on the part of the applicant or that the lease had terminated.
The rationale for the court’s decision as such was that, where a drawing on a letter of credit results from the exercise of an ipso facto clause in violation of the US Bankruptcy code, there is irreparable injury and a likelihood of success on the merits. As such an injunction would lie where the applicant is an immediate party to the transaction that gave rise to the letter of credit.
Arguments before the Court:
Beneficiary: the bankruptcy court lacked jurisdiction to enjoin payment on a letter of credit because the bankruptcy court did not have jurisdiction to interfere with separate and independent contracts to which the debtors were not parties on the authority of the case of Fidelity Bank, N.A. Prime Motors Inns, Inc. (In re Prime Motor Inns, Inc.), 130 B.R. 610 (S.D. Fla. 1991).
Court: the case cited involved letters of credit, issued on the debtor’s behalf, to secure bond indentures to which the debtors were not parties. In the present case, however, the court’s granting of a preliminary injunction stems from the terms of the lease to which the debtor is a party. The court is therefore well within its jurisdictional authority to make a determination about the terms of a lease between a debtor and a third party.
The Court proceeded to hold that there are four factors involved in considering the appropriateness of injunctive relief namely:
(1) whether the plaintiff would suffer irreparable injury without the injunction;
(2) whether the injury would outweigh harm that could occur if the injunction were granted;
(3) whether the plaintiff showed likelihood of success on the merits of its case; and
(4) whether the public interest would be adversely affected by the grant of a preliminary injunction.
Applying the requisite factors to the case:
(1) Likelihood of success:
the Bankruptcy Code embraces the policy of preventing the enforcement of ipso facto clauses, which automatically terminate a contract or a lease or allow the other party to terminate in the event of a bankruptcy filing, therefore the debtor had demonstrated likelihood of success. Since the debtor was current on its lease payments, the filing of the bankruptcy triggered the default, making the notices of default without basis since they violated the Bankruptcy Code.
(2) Irreparable Injury:
because the amount of the letter of credit exceeds the amount that the landlord might be able to claim under the bankruptcy proceedings and the issuer would draw on the security provided by the debtor, the debtor would suffer irreparable harm;
(3) Independence of Bankruptcy Policy:
an injunction would further the policy of the Bankruptcy Code in preventing ipso facto clauses. The issuance of a preliminary injunction would not affect the integrity of Letters of Credit.
This case seems to put forth the view that Letters of Credit may not be protected against insolvency notwithstanding the fact that there is no clear evidence of fraud and the beneficiary is rendered incapable of realizing under the letter of credit. This may be because based on the specific facts of the case where the Court found that irreparable harm would be occasioned if the beneficiary were permitted to draw on the letter of credit.
Thus, the general trend of bankruptcy laws in the United States would appear to be that Letters of Credit are/should be protected against insolvency unless there is fraud or where irreparable harm would be occasioned.
Consequently the beneficiary of the letter of credit should be at liberty to draw and realize the benefit under the letter of credit.
By necessary implication, it probably could be concluded that the monies/funds deposited as collateral for the issuance of a Letter of Credit would be deemed to be monies paid out and having ‘reached the hands’ of the intended beneficiary. Hence such monies would not be retraceable/retractable in the event of the applicant’s insolvency unless fraud or consequential irreparable harm can be shown.
Necessary implication would also indicate that the monies paid by the applicant to collaterize the issuance of the letter of credit does not form part of the applicant/insolvent’s estate in the event of the applicant’s insolvency prior to the letter of credit being realized.
The underlying goal in bankruptcy law is that similarly situated creditors must receive equal treatment. To effectuate this goal the Bankruptcy Code allows the trustee or debtor to avoid certain ‘preferential’ transfer and to recover the amounts transferred. Hence, certain transaction that give an advantage to one creditor over the others can be undone, and the property traced and returned to the debtor’s estate for the benefit of all unsecured creditors in the general pool.
Principles of preference in bankruptcy law involves two step procedure:
(a) The trustee/debtor must prove that a preferential transfer occurred as provided in Section 547 of the Code.
(b) The trustee/debtor must ascertain from whom to recover the preferentially transferred property as provided in Section 550 of the Code.
To establish that a preferential transfer has been made, the transfer must have taken place during one of the preference “reach-back” periods as envisaged in Section 547(c)(4) of the Code. The preference reach-back period establishes a specified timeframe before the filing of the bankruptcy/insolvency petition during which timeframe, the debtor or the trustee can “reach back” and undo the transfer, i.e. in the event the transfer is considered to have been effectuated on the eve of the bankruptcy.
On the other hand Section 547(c) sets out situations where preferential transfers may be exempted from preference treatment. The effect of Section 547(c) is to exempt certain transactions between a debtor and a creditor exempt from preference treatment under circumstances where the transactions in question do not deplete the debtor’s estate to the detriment of the other unsecured creditors.
Therefore the trustee or debtor must prove that the property of the debtor was transferred within the prescribed preference period for an antecedent debt and that the said transfer enabled the creditor to receive more that he would have received under liquidation of the debtor.
Once the debtor or trustee proves that a preferential transfer has taken place, Section 550(a) enables recovery of the property transferred. Consequently the debtor or trustee may recover the amount from the person to whom the transfer was initially made or from the person who benefited from the transfer. Accordingly the debtor’s estate would be restored to its pre-preference state and all equally situated unsecured creditors may have an equal share in the distribution of the bankrupt’s estate.
The issue that arises here is whether the debtor/trustee can recover payment:
(a) from the beneficiary as an indirect transferee; or
(b) from the issuing bank as the direct transferee.
A brief study of several cases cited below sheds light on these issues:
In Matter of Marine Distributors, Inc.,522 F.2d 791 (9th Cir.1975)
The trustee argued that the bank, although unsecured on the letters of credit, should be enjoined from honoring the letters of credit because the letters of credit were assets of the debtor’s estate and that the estate would be irreparably harmed if the issuing bank honored drafts against the letters of credit.
The Bankruptcy court granted the injunction and the district court affirmed. On appeal the 9th Circuit held that the letters of credit were not the property of the estate and that the bankruptcy court did not have jurisdiction over the irrevocable letters of credit or the monies.
This case therefore, confirms the independence doctrine for unsecured letters of credit.
But it must be noted that this decision was prior to the coming into force of the Bankruptcy Code.
In re Twist Cap, Inc., 1 Bankr.284 (Bankr.D.Fla.1979)
This case deals with secured letters of credit. In March 1978, the Twist Cap entered into a security agreement with its bank to secure any payments by the bank on Twist Cap’s behalf. The bank issued letters of credit on Twist Cap’s account in December 1977, June 1978 and March 1979. Twist Cap filed its bankruptcy petition in August 1979 prior to any drawings being made on the letters of credit. The bankruptcy court issued temporary restraining orders prohibiting the bank from honoring the letters of credit. The court distinguished the Marine Distributors’ case where the letters of credit were not secured whereas in the Twist Cap case, the letters of credit were secured.
The court in In re Twist Cap case held that: “to permit these two unsecured creditors to receive a payment, possibly in full, on the pre-petition indebtedness owed to them by the debtor would amount to an impermissible preferential treatment of these two unsecured creditors which is contrary to the scheme of Chapter XI.” The court held further that when a letter of credit is secured by the property of the debtor, an indirect preference would occur to the benefit of the unsecured creditor if the issuing bank were not enjoined from honoring the letter of credit. In effect, the secured letters of credit were the same as property of the debtor because some property of the debtor would be required to reimburse the issuing bank.
The Twist Cap case therefore represents the possibility that the independence of the letter of credit could be nullified in bankruptcy.
But this decision appears to give rise to a dilemma because the effectiveness of a letter of credit as a financing device depends on the independence of the letter of credit from the underlying transaction, including the insolvency of the applicant.
In Page, 18 Bankr. 713 (D.D.C.1982), the bankruptcy court enjoined payment under secured letters of credit. The District court reversed the decision of the bankruptcy court and held that the secured letters of credit were not the property of the debtor and not part of the debtor’s estate, even though they were secured by the property of the debtor. No doubt, the issuing bank, upon honoring the letter of credit, would resort to the collateral pledged by the debtor and thereby reduce the assets in the debtor’s estate in bankruptcy. However the court noted that the automatic stay principle would prevent the issuing bank from acting without the court’s approval.
The decision in the Page case reaffirms the independence doctrine in relation to letters of credit. However the question remains as to whether the pledging of property of the debtor to secure a letter of credit during the preference reach-back period would constitute a preferential transfer.
Sabratek Corp. v. LaSalle Bank, N.A. (In re: Sabratek Corp.)257 Bankr. 732 (B. D. Del. 2001) [U.S.A.]
Facts: The seller provided a Letter of Credit to the buyer to assure minimum share price at an agreed date with respect to the sale of a subsidiary. The Letter of Credit required a statement that the applicant defaulted on its payment obligations. The Letter of Credit stated that the beneficiary had no right to payment from the sale of the stock until 1 July 2000. Seller/Applicant failed to register the stock in a timely fashion as required by the agreement. Thereupon the parties entered into a Forbearance Agreement whereby the beneficiary agreed not to commence any legal action to enforce its rights under the Letter of Credit until an agreed date. But the new agreement provided that if applicant filed for bankruptcy, the beneficiary could immediately draw on the Letter of Credit. On 17 December 1999, applicant filed for Chapter 11 reorganization bankruptcy. Shortly thereafter, the beneficiary demanded payment on the Letter of Credit. As required by the Letter of Credit, the beneficiary’s demand included the required statement. The issuing bank, however, refused to pay on the grounds that the beneficiary’s demand constituted fraud since the Letter of Credit said no default could occur under the agreement until 1 July 2000. The beneficiary sued the issuing bank for wrongful dishonor. The applicant then sought an injunction in federal bankruptcy court preventing the beneficiary from proceeding with the state action in federal bankruptcy court. The bankruptcy court denied the motion.
Rationale: Where the bankrupt has procured a Letter of Credit for a third party, it is not part of the estate, and in the absence of unusual circumstances, a bankruptcy court will not enjoin a state action by the beneficiary against the issuer to collect on the Letter of Credit.
On the issue of the application for injunction the trial court noted four criteria for granting an injunction:
(1) the likelihood that the plaintiff will prevail on the merits at final hearing;
(2) the extent to which the plaintiff is being irreparably harmed by the conduct complained of;
(3) the extent to which the defendant will suffer irreparable harm if the preliminary injunction is granted; and
(4) the public interest” citing Duraco Procucts, Inc. v. Joy Plastic Enterprises, Ltd., 40 F.3d 1431 (3d Cir. 1994).
Noting that the letter of credit is not property of the estate and that the Debtor has no interest in either the letter or its proceeds, the bankruptcy court reasoned that the state action and a ruling for the beneficiary would not adversely impact the estate. Therefore, the court concluded that the applicant would not be likely to succeed on the merits.
The applicant argued that it would suffer irreparable harm if the state action continued. It claimed that it could not be certain that the issuing bank would aggressively raise its interests. The bankruptcy court pointed out that avenues of participation were open to the applicant and refused to grant an injunction. Moreover, because the time stated in the Letter of Credit had passed, the court observed that the beneficiary could draw on the Letter of Credit under the terms of the original Registration Rights Agreement.
The beneficiary argued that it would suffer irreparable harm from an injunction because it could not collect the Letter of Credit proceeds and thus could not fund its other initiatives.
While such an argument ordinarily does not constitute a defense against an injunction, the bankruptcy court stated that the involvement of an Letter of Credit distinguishes this case. The court reasoned that parties insist upon receiving letters of credit specifically so that they will not have to wait for payment or, even worse, sue and wait for payment. Consequently, the court concluded that any delay in the beneficiary’s right to draw on the letter of credit constitutes ‘irreparable harm’ because it eliminates the benefit of having obtained the letter of credit – the assurance of prompt payment.
The applicant argued that the public interest requires an injunction to preserve the integrity of letter or credit transactions.
The bankruptcy court disagreed noting that the underlying rule of letters of credit is “pay first, litigate later.” Therefore, the court concluded, “the public policies behind letter of credit transactions do not favor issuance of an injunction.”
Consequently because a letter of credit is an irrevocable obligation between the issuing bank and the beneficiary and because the letter of credit is independent of the underlying transactional relationship between the debtor and the beneficiary, the principle would be that the collateral posed to secure the letter of credit:
(i) is not the property of the debtor or the debtor’s estate;
(ii) is not a preferential transfer; and
(iii) is not subject to automatic stay.
Two cases that illustrate the above principles are as follows:
(a) In re M.J. Sales & Distributing Co., Inc., 25 Bankr. 608 (Bankr.S.D.N.Y.1982), the debtor pledged a Treasury bond as security for a standby letter of credit. The trustee argued that the pledge of the bond was an indirect preference for the benefit of an unsecured creditor because the issuing bank would use the debtor’s collateral to set off its obligation under the letter of credit to pay the beneficiary. The court held that the payment by the issuing bank to the beneficiary was not a preferential transfer.
(b) In re Price Chopper Supermarkets, Inc., 40 Bankr.816 (Bankr.S.D.Ca.1984), the debtor caused a secured standby letter of credit to be issued as security for a promissory note. When the beneficiary drew on the letter of credit subsequent to the debtor’s bankruptcy petition, the trustee argued that the payment from the issuing bank to the beneficiary was an indirect preferential transfer for the benefit of an unsecured creditor because the bank had recourse against the property of the debtor that is held as collateral for the letter of credit. The court held that the payment by the issuing bank to the beneficiary was an independent transaction and was not a preferential transfer because the bank paid the obligation form its own funds, and not from the funds of the debtor. The court affirmed the independence of letters of credit in bankruptcy and the importance of the independence doctrine to commerce and stated:
“Accepting the Trustee’s and Bank’s argument would mean that the beneficiary of a letter of credit could never rely on a letter of credit as an absolute guarantee of repayment. The consequent result would be that in every case, a beneficiary would have to investigate the source of funds used by a bank to pay it in order to assure that the beneficiary was insulated from any later claims by a trustee in bankruptcy of the non-bank debtor. To hold as the Trustee contends, would inject an element of uncertainty in a long-standing commercial practice designed to eliminate uncertainty.”
These cases appear to protect the contract between the beneficiary and the issuing bank. Courts have held that payment by the issuing bank was from its own funds and therefore no a preferential transfer of property of the debtor.
However when the debtor pledges property to secure the letter of credit, courts have held that collateral securing a letter of credit is the property of the debtor’s estate.
(a) In re W.L. Mead, 42 Bank. 57 (Bank.N.D.Ohio 1984), the court held that “it has not been decided whether or not the issuer may ‘foreclose’ on its collateral once performance on the letter has been rendered.” The court held further that the collateral, which has been pledged by a debtor as security for a letter of credit, is the property of the bankruptcy estate and the automatic stay principle prevents a pledgee from assuming title to the collateral.
This case thus establishes the rule that collateral pledged to secure a letter of credit is the property of the debtor and is subject to the automatic stay principle when the issuing bank seeks to foreclose on it after the debtor files a bankruptcy petition.
(b) In re Air Conditioning, Inc., 845 F. 2d 293 (11th Cir.1988), the issuance of the secured letter of credit occurred one month before the debtor filed his bankruptcy petition. The bankruptcy court held that the debtor’s transfer of collateral to secure the letter of credit was a voidable preference because the letter secured an antecedent debt and therefore the transfer of property of the debtor to secure the letter of credit benefited the unsecured creditor. The court nullified the letter of credit transaction as an indirect preferential transfer because it was used by the parties to transfer the debtor’s property to the unsecured creditor through the bank as an intermediary.
On appeal, the court held that the debt owed by the debtor to the creditor existed prior to the issuance of the letter of credit, i.e. it was an antecedent debt. Thus if the debtor had given the creditor an additional security interest of any kind to secure payment of the debt, rather than providing for the issuance of the letter of credit, the transfer would clearly have been subject to being avoided as a preference by the trustee under 11 U.S.C. S. 547(b). The question that then arises is whether a debtor should be able to secure payment of an antecedent debt, through the recognized sanctity of a letter of credit, when he could not do so through any other type of security interest. The court held further that the nullification of the letter of credit was not the proper remedy because it failed to recognize the independence of the letter of credit. Based on the affirmation of the validity of the independence doctrine, the court held that recovery of the preference must be obtained from the unsecured creditor who directly benefited from it, and not from the issuing bank.
Therefore the effect of the Air Conditioning decision lays down the principles that:
(1) an indirect preference occurs when a debtor pledges property to secure a letter of credit if all the elements of a preference are present; and
(2) recovery of the preference must be from the beneficiary of the letter of credit and not the issuing bank.
The case of Matter of Compton Corporation, 831 F.2d 586 (5th Cir.1987) strongly endorses the policy of interpreting bankruptcy law in a manner that does not interfere with the sanctity of letters of credit.
Facts: One day before filing a bankruptcy petition, the debtor caused a secured standby letter of credit to be issued to guarantee a missed payment for goods. The letter of credit was secured by a future advances clause in a prior security agreement with the debtor’s issuing bank. The court held that the letter of credit was, actually, an indirect preference and that the trustee could recover from the creditor, but not from the issuing bank. The court held that ‘a creditor cannot secure payment of an unsecured antecedent debt through a letter of credit transaction when it could not do so through any other type of transaction.
In the Matter of Val Decker Packing Company, 61 Bankr. 831 (Bankr.S.D.Ohio 1986), the bank had a blanket security agreement that covered all of the debtor’s liabilities to the bank. The debtor caused the bank to issue a standby letter of credit on April 22, 1977. A note covering the letter of credit and other existing indebtedness was executed and secured by a new security agreement in June 1980. The debtor filed a bankruptcy petition on August 8, 1980. The court held that a transfer of the debtor’s property occurred when the collateral was pledged to secure the letter of credit, and not when the bank looked to the collateral for reimbursement. The court held further that the letter of credit was unsecured when originally issued and that it was secured within the ninety-day preference reach-back period. Therefore the pledge of the collateral during the reach-back period was voidable preference for the benefit of the bank. As a direct preference, it was recoverable only from the bank.
Thus it appears that bankruptcy courts have held that the transfer of the debtor’s property under a letter of credit occurs when the issuing bank perfects a secured interest in the collateral and not when the bank makes payment on the letter of credit. Even though the bank’s claim on the debtor’s property is contingent, it is considered a transfer at the time it is perfected. Therefore, in order to constitute a preferential transfer, the transfer of collateral to secure the letter of credit must occur during or within the preference reach-back period and not the payment from the issuing bank to the beneficiary.
Section 547(c) provides for exceptions, which can operate to exempt an apparent preferential transfer from being avoided. Bankruptcy courts have held that regular commercial letters of credit are not preferential transfers based on the Section 547(c) exceptions.
For example, in re AOV Industries, Inc., 64 Bankr. 933 (Bankr.D.Col.1986), the court held that the ordinary course exception of Section 547(c)(2) protected the use of commercial letters of credit in an international sale transaction. The court’s rationale was that the commercial letters of credit were used by the parties as a method of payment in the ordinary course of selling and purchasing the goods. The court held that the judgment was in accordance with the general policies for facilitating commerce and maintaining the strength of the letter of credit as a national and international financing device.
In Matter of Fuel Oil Supply Terminaling, Inc., 837 F.2d 224 (5th Cir.1988), it was held that the ‘new value’ exception of Section 5437(c)(1) covered certain secured standby letters of credit. In this case, the secured standby letters of credit were used to guarantee payment in an oil exchange agreement. The debtor returned previously borrowed oil within the preference reach-back period and the creditor allowed the letters of credit to lapse/expire because the debtor had returned the oil. The court held that although the transfer of the debtor’s oil occurred within the preference reach-back period, the creditor’s release of the secured letters of credit constituted ‘new value’ and therefore exempted from preference attack.
In re Metro Communication, Inc., 115 Bankr. 849 (Bankr.W.D.Pa.1990), the court held that payments to a beneficiary under an unsecured letter of credit did not constitute a preferential transfer. In dicta, the court stated that any transfer of a debtor’s property occurs when the letter of credit is issued, not when the issuing bank pays.
In re Zenith Laboratories, Inc., 104 Bankr. 667 (Bankr.D.N.J.1989), the court held that letters of credit were not the property of the debtor’s estate. Payments made to the beneficiary were from the issuing bank’s funds and therefore the bankruptcy court could not enjoin payment to the beneficiary.
In re Gates Community Chapel of Rochester,Inc.,123 Bankr.700 (Bankr W.D.N.Y.1991), the court held that a secured letter of credit issued during the preference reach-back period to guarantee payment on an unsecured antecedent debt was an indirect preferential transfer for the benefit of the beneficiary.
Thus, from the trend of the cases it is apparent that in order to constitute indirect preferences, the letters of credit must be given to guarantee or secure payment on an unsecured or under-secured antecedent debt. In addition, any transfer of the debtor’s property to secure the letter of credit must occur within the preference reach-back period. Also, the debtor must have been insolvent at the time of the transfer and the transfer must have given the issuing bank a greater return than it would have received in a Chapter 7 liquidation.
It is evident that the problem facing the bankruptcy system in regard to letters of credit is to maintain the independence of letters of credit while applying the preference powers available in the Bankruptcy Code. This is of great concern because of the extensive use of letters of credit in international commerce. If courts were to allow recovery of direct payments to beneficiaries under letters of credit as preferential transfers, the effectiveness of letters of credit as a commercial financing system would be undermined. The impact of the bankruptcy action would be to interfere with the allocation of risk sought by the parties to the letter of credit transaction. In effect, the risk of the applicant’s insolvency would be shifted back to the creditor thereby neutralizing the very reason the letter of credit was used in the first place.
As seen from the case of re AOV Industries, Inc., most letter of credit transactions are protected from preference attack because of the ‘new value’ contemporaneous exchange and ordinary course provisions of Section 547(c) of the Bankruptcy Code. This is why a commercial letter of credit used to purchase goods or services is not a preferential transfer. Under a commercial letter of credit, the creditor is giving ‘new value’ to the debtor contemporaneously with the issuance of the letter of credit. The aforementioned exceptions under Section 547(c) also protect most transfers between the issuing bank and the debtor because courts consider the letter of credit to be ‘new value’ contemporaneously exchanged at the time it is issued and secured by property of the debtor. Most standby letters of credit are also protected by these exceptions because they are issued and secured at the same time as the underlying contract between the debtor and the unsecured creditor.
It is also evident from the cases cited above that the letter of credit contract between the issuing bank and the beneficiary is not subject to preference attack, i.e. the payment from the issuing bank to the beneficiary is never a preferential transfer. This is based on the fact that the letter of credit itself is not the property of the debtor. Further when the issuing bank honors a draft under a letter of credit, it does so from its own funds, and not from the funds of the debtor. Consequently, the payment from the issuing bank to the beneficiary of the letter of credit is not recoverable as a preferential transfer. Also the payment from the issuing bank to the beneficiary is not subject to the automatic stay provisions of Section 362 of the Bankruptcy code and in the absence of fraud, such payments cannot be restrained by the courts.
An analysis of the cases cited above appears to indicate that an unsecured letter of credit is generally not subject to preference attack. Therefore when the debtor causes a standby letter to be issued to an otherwise unsecured creditor for an antecedent debt within the preference reach-back period, it is not a preferential transfer because there has been no transfer of property of the debtor.
However an issuing bank under an unsecured letter of credit may be subject to preference attack if during the preference reach-back period, the bank honors a draft against the letter of credit and is reimbursed by the debtor whereby the payment can be avoided as a preferential transfer.
An issuing bank may also be subject to preference attack if it receives and perfects a security interest in collateral of the debtor during the preference reach-back period because the collateral pledged to secure the letter of credit is the property of the debtor. Therefore a transfer of property of the debtor occurs when the security interest is perfected. Hence the timing of the perfection of the security interest by the issuing bank is very important and crucial. However if the security interest is perfected at the time the letter of credit is issued, the issuing bank would not be subject to a preference attack because ‘new value’ has been given by way of the letter of credit for the collateral given by the debtor in a contemporaneous exchange.
On the other hand if an unsecured letter of credit is issued and is secured at a later date, sometime during the preference reach-back period, then the transfer of the collateral to secure the letter of credit would be a direct preference vis a vis the bank. This is because the bank would have received a secured position in place of its unsecured position without any ‘new value’ being given for the same.
CONSEQUENCES AND EFFECTS OF INSOLVENCY OF AN ISSUING BANK IN RELATION TO THE LETTER OF CREDIT
Having made a somewhat comprehensive study of the effects and consequences of the applicant’s bankruptcy in relation to the Letter of Credit, the question that arises is the effects and consequences of the issuing bank becoming insolvent.
The questions that now arise in this context are:
1. What is the fate of the Letter of Credit issued by the Issuing Bank to the beneficiary in the event the issuing bank becomes insolvent?
2. What happens to the issuing bank’s contractual obligations?
The letter of credit itself is a third agreement in the transaction as described above. This agreement is between the issuing bank and the recipient of money, i.e. "the beneficiary." If the letter of credit is a commercial letter of credit, it is treated as a deposit, and the bank expects to pay the beneficiary upon presentment of the required documents. The letter of credit provides that the issuing bank will pay the prescribed amount upon certain preconditions being met such as submission of specified documentation together with the demand for payment, the draft. The letter of credit will further stipulate an expiry date after which date, the liability of the issuing bank ceases. And in such contracts time is necessarily considered to be of the essence. The applicant, using the commercial letter of credit as a payment device, promises to pay the bank immediately after the beneficiary presents the draft, or to repay the bank soon after the bank pays on the commercial letter of credit. The applicant’s promise to pay may be fulfilled by actual reimbursement or by an offset against the applicant’s deposit accounts.
On the other hand, a standby letter of credit functions like a guarantee. Under this, the beneficiary must establish that the applicant has not in fact performed his part of the obligation which consequently gives rise to an obligation on the part of the issuing bank to pay on the standby letter of credit and seek reimbursement from the applicant. When a standby letter of credit is involved, the applicant generally has made no deposit and is under no obligation to pay the bank unless the applicant defaults on its underlying obligation with the beneficiary. Although the bank may hold a conditional security interest, promissory note, or repayment agreement, these are unenforceable against the applicant unless the bank has first paid on the standby letter of credit. The beneficiary of a standby letter of credit is in a different position from the beneficiary of a commercial letter of credit if the issuing bank is declared insolvent. A standby letter of credit is an engagement by a bank to make payment on account of indebtedness undertaken by the bank's customer or to make payment upon default by the customer in the performance of an obligation.
Insolvency of the issuing bank is governed by another legal system, i.e. Banks are expressly excluded from the coverage of the Bankruptcy Code. (See 11 U.S.C. Section 109).
Banks are insured by the Federal Deposit Insurance Corporation (F.D.I.C.) pursuant to the Federal Deposit Insurance Corporation Act. The F.D.I.C. acts in a dual capacity as both receiver and insurer of the insolvent bank. (See 12 U.S.C. Section 1821) and, in its capacity as the insurer, it is authorized by the Federal Deposit Insurance Corporation to purchase the failed bank's assets as receiver in order to facilitate an assumption of the failed bank's assets and liabilities. (See 12 U.S.C. Section 823(c)(2)(A).*2
Legislative history shows that the FDIC was created to stabilize the financial system, to enhance the public's confidence in the banks and to protect the public from the 'failure- prone independent banking system.*3
The term “deposit insured” under the Act is defined as follows:
“The unpaid balance of money or its equivalent received or held by a bank in the usual course of business and for which it . . . is obligated to give credit, either conditionally or unconditionally . . . which is evidenced by . . . a letter of credit . . .on which the bank is primarily liable: Provided, That without limiting the generality of the term 'money or its equivalent', any such . . . instrument must be regarded as evidencing the receipt of the equivalent of money when credited or issued in exchange . . . for a promissory note upon which the person obtaining any such credit or instrument is primarily or secondarily liable . . .. (See 12 U.S.C. Section 1813(l)(1).
The Act protects money or its equivalent submitted to an insured bank when the depositor relied on the bank to keep his or her money safe. Thus, the purpose of the Act is fulfilled when it protects money or its equivalent that otherwise would be lost in a bank failure. The customer relies on the bank to hold the funds, and the FDIC insures that reliance.
Decisions in several cases have handed down legal principles that in the event of the issuing bank becoming insolvent, a standby letter of credit issued by the bank, which is a form of bank financing, is an insured deposit under the F.D.I.C. The land mark cases are as follows:
1. Philadelphia Gear Corp. v. FDIC 751 F.2d 1131
Facts: Philadelphia Gear was an oil pump part supplier. The Orion Manufacturing Corporation, a producer of oil drilling equipment, entered into a supply contract with Philadelphia Gear. Penn Square Bank issued an irrevocable standby letter of credit for Orion. The letter of credit provided that drafts drawn upon it must be accompanied by copies of invoices to Orion (the applicant) and a signed statement by Philadelphia Gear (the beneficiary) to the effect that the invoices had remained unpaid for at least fifteen days. The standby letter of credit issued by Penn Square was supported by a promissory note executed by Orion. The promissory note was due to mature when the letter of credit expired on August 1, 1982. On July 5, 1982, the Comptroller of the Currency declared Penn Square Bank insolvent and appointed the FDIC as receiver. Two days later, Philadelphia Gear presented the drafts and the necessary documents for payment on the standby letter of credit. The FDIC refused to pay on the drafts because of Penn Square Bank's insolvency. Philadelphia Gear instituted proceedings to seek enforcement of payment on the letter of credit.
The district court held that standby letters of credit were insured deposits within the meaning of section 1813(l)(1). Although Penn Square's letter of credit was not exchanged for money, it was held that the exchange of the letter of credit for Orion's promissory note was sufficient consideration. The Court held further that a standby letter of credit is the issuing bank’s primary obligation.
The decision was affirmed by the Tenth Circuit Court of Appeals. The court of appeal held that, although payment on the promissory note supporting the standby letter of credit might be contingent upon payment on the letter of credit, the bank made funds available 'for the benefit of its customer.'
The rationale was that such funds were the customer's protected interest and therefore, the promissory note constituted funds for deposit under the Act and that the FDIC must pay the beneficiary. The court held further that a standby letter of credit is a primary, not a secondary, obligation of the issuing bank.
2. Allen v. FDIC 599 F. Supp. 104 (E.D. Tenn. 1984)
Facts: The applicant, (the Butcher Group) acquired the Farmers Deposit Bank. The Butcher Group paid each of the bank's former shareholders cash and a promissory note. A standby letter of credit issued by the United American Bank (the issuing bank) to secure each promissory note. The Butcher Group executed an additional promissory note to United American to support each standby letter of credit that had been issued. The Tennessee Commissioner of Financial Institutions closed United American and appointed the FDIC as receiver. The FDIC subsequently notified each former shareholder of Farmers Deposit Bank that it refused to affirm any obligation to honor the standby letters of credit. Three months later, the Butcher Group defaulted on the underlying transaction and failed to pay the promissory notes issued to the former Farmers Deposit Bank shareholders. The former shareholders attempted to draw on their standby letters of credit and thereupon instituted proceedings.
The issue before the court was whether the Butcher Group's note was a promissory note within the meaning of 12 U.S.C. Section 1813(l)(1) which describes a promissory note as a category of "money or its equivalent' . . . upon which the person . . . is primarily or secondarily liable.'
The FDIC argued that the Butcher Group's note was not a promissory note but a simple contract to reimburse because payment to the issuer was contingent upon the issuer's payment on the standby letter of credit. According to the FDIC, an instrument could not be a promissory note if payment was contingent upon the occurrence of another event.
The district court held that, although the note may not have been a negotiable promissory note as defined by the Uniform Commercial Code, (See U.C.C. Section 3-104(1)(a)-(d), it was a promissory note for purposes of the Act.
Accordingly, the court held that the standby letters of credit constituted deposits within the meaning of section 1813(l)(1).
It is interesting to note from the facts of the cases above, that the FDIC, as the receiver of a failed institution, seems to attempt to terminate standby letters of credit by giving notices to the customer, the beneficiary, and the confirming bank that it will reject claims related to letters of credit it retains.
In fact, as will be seen in the cases to follow, the FDIC usually enters into a purchase and assumption (P & A) agreement that specifically excludes standby letters of credit from the list of liabilities assumed by the acquiring bank. Furthermore, the acquiring bank, after reviewing the liabilities of the failed bank, may exercise its option to return to the FDIC any letter of credit that it deems to be of questionable value.*4
The impact of this FDIC action is especially harsh in situations where the transaction involves an unsecured letter of credit and the beneficiary has performed its obligations pursuant to the underlying contract and submits a draft demanding payment and in the interim the bank has been declared insolvent.
This attempt by the FDIC to unilaterally cancel and avoid liability on letters of credit it retains has been challenged in the courts, especially after the case of Penn Square.
The following cases illustrate the Courts’ views on these issues:
1. First Empire Bank, New York v. FDIC. 572 F.2d 1361 (9th Cir.1978)
Facts: FDIC had entered into a P & A agreement with Crocker National Bank as the acquiring bank of United States National Bank of San Diego (USNB). Among the assets and liabilities of USNB were some standby letters of credit issued by USNB for the benefit of some creditors that had lent money to USNB's controlling shareholder and certain other USNB shareholders and companies associated with him. These letters of credit were viewed as presenting an unacceptable banking risk, to be rejected unless the
FDIC-corporation guaranteed their value. Concerned with the fact that, by guaranteeing these letters of credit, the deposit insurance fund would be used to make good the "tainted" transactions of the shareholders, the FDIC-corporation refused to guarantee the value of these obligations. Consequently, the P & A agreement between the FDIC and Crocker did not include these letters of credit. The creditors, two banks, refused the FDIC’s demand for deposits of USNB held by them and instead retained the deposits to offset them against the amounts owed to them by USNB on the standby letters of credit. The FDIC argued that standby letters of credit were not provable in a national bank receivership because such claims were contingent on the date of the bank's insolvency. The court held that beneficiaries of standby letters of credit possess provable claims in the receivership even when no drafts were presented prior to insolvency if three conditions were met:
a) The claims were in existence before insolvency and were not dependent on new contractual obligations arising after insolvency;
b) Total liability was certain at the time the beneficiaries sue the issuer's receiver; and
c) The claims were made in a timely manner, before assets were distributed from the receivership estate, other than the distribution made through the purchase and assumption agreement.
Since these three conditions were met, the court held that the creditors were entitled to a ratable dividend of 100 % of the value of each letter of credit on the date each letter matured.
The decision in this case has been interpreted to mean that, under a P & A agreement, a standby letter of credit must be treated like a commercial letter of credit and should either be included in the P & A agreement or be paid in full by the FDIC.
2. Bryant v. Kerr, 726 S.W.2d 373 (Mo.Ct. App. 1987).
Facts: A national bank was declared insolvent, and the FDIC was appointed its liquidator. Shortly after being appointed as liquidator, the FDIC sent a letter to the beneficiary of an irrevocable standby letter of credit stating that it intended to disaffirm any obligation under the letter of credit. In that letter, the FDIC stated that letters of credit were considered contractual obligations that were executory in nature and, therefore, were contingent on the occurrence of some future event. In consequence, the beneficiary sought to terminate her contract with the bank customer alleging that, under the terms of their contract, the non acceptance of the letter of credit by the allowed her to rescind the contract.
The court held that the beneficiary could not terminate the contract because the FDIC had improperly terminated the letter of credit.
The court based its holding on Article 5 of the U.C.C., which provides that:
“Unless otherwise agreed once an irrevocable credit is established as regards the customer it can be modified or revoked only with the consent of the customer and once it is established as regards the beneficiary it can be modified or revoked only with his consent.”
The court considered three important factors:
a) The letter of credit at issue was an irrevocable standby letter of credit;
b) As a receiver, the FDIC "stands in the shoes" of the failed bank and is afforded no special privileges or rights greater than those possessed by the bank with respect to its creditors; and
c) The letter of credit at issue stated that the terms and conditions of the credit shall be binding upon the bank's "representatives, successors and assigns."
Under these circumstances, the court was of the opinion that the FDIC had no authority to unilaterally disaffirm the letter of credit without the parties' consent. As a result, the letters of credit remained in "full force and effect." Since a claim that has been proven is one that is owing whether or not it can be satisfied, the FDIC's disaffirmance did not strip away the beneficiary's legal rights of enforcement. The court was of the opinion that the beneficiary could potentially receive the distributions from the liquidation of the bank's assets.
Therefore it is apparent from the decisions in the cases cited above that the FDIC is obligated to pay on the letters of credit even though the liabilities were "contingent" at the time the failed institution was declared insolvent. Hence it is an established principle of law that the bank's rights and liabilities are fixed at the declaration of the bank's insolvency and no additional rights can be created after insolvency.
This principle is further illustrated in the U.S. Supreme Court case of White v. Knox, 111 U.S. 784 (1884) where the court held that:
“The business of banking must stop when insolvency is declared. No new debt can be made after that. The only claims the Comptroller can recognize in the settlement of the affairs of the bank are those which are shown by proof satisfactory to him or by the adjudication of a competent court to have had their origin in something done before the insolvency. “
Thus, it is evident that a letter of credit, though a contingent liability as far as the issuing bank is concerned, it is nonetheless a statutory obligation of the issuing bank to honor demands on the letter of credit upon reliance of which other parties have performed or will perform their separate contractual obligations. When claims are based on letters of credit, those claims are in existence before insolvency and are, therefore, not dependent on any "new" contractual obligation arising after the insolvency.
When the failed bank, prior to its insolvency, issues the letter of credit, it undertakes the responsibility of honoring drafts properly presented independent of the underlying contract between the applicant and the beneficiary. Therefore, in the absence of fraud, the presenting of documents prescribed in the letter of credit obligates the issuing bank to honor the drafts pursuant to the engagement the bank had entered into prior to its insolvency. This should not be altered simply because the FDIC has taken over the failed institution. The FDIC stands in the shoes of the insolvent bank and, should not be permitted to enjoy any greater right than the insolvent issuing bank with respect to letters of credit.
The basis for commencing insolvency proceedings is a default in payment of a debt due to 2 or more creditors. The petition is filed by either the debtor or creditors with the Commercial Court. The Court then adjudicates the debtor a bankrupt. Bankruptcy law is an alternative remedial action available for creditors to recover their debts. Instead of filing a civil claim against the debtor, the creditor could seek to have the debtor declared a bankrupt, whereupon the assets and property of the debtor will be liquidated and distributed to the creditors.
Once bankruptcy petition, the clerk of the court will register the petition on the date it is filed. The petition is submitted to the Chairman of the Commercial Court not later than one day from the date of registration. Within two days from the date of registration of the petition, the court will determine the date for the hearing of the petition. In the event the Commercial Court accepts the bankruptcy petition, a receiver will undertake the settlement of the bankrupt’s debts under the supervision of a Supervisory Judge.
As from the date of declaration of bankruptcy, all the assets of the debtor, including any assets acquired whilst the bankruptcy proceedings were pending are deemed to be the assets of the bankrupt’s estate.
There is a settlement process, which allows the possibility for the corporate debtor to be restructured and reorganized by the receiver to maximize and if possible increase, the value of the bankrupt’s assets. This has some similarities to the United States Bankruptcy system.
Following the settlement of debts with the bankrupt’s assets, the insolvent corporate debtor can either be liquidated or retain its existence as a dormant legal entity.10
The bankruptcy declaration does not mean the debtor is insolvent. This is in contrast to the meaning of this term in other jurisdictions where a state of insolvency may lead to a declaration of bankruptcy. In Indonesia, the bankruptcy declaration occurs first. A bankruptcy declaration must contain:
a) Legal considerations that form the basis of the decision11 and
b) The appointment of a Supervisory Judge and receiver and the court’s fee12
Upon a bankruptcy declaration, the authority/ability to manage the bankrupt’s assets shifts from the debtor to a receiver appointed by the Commercial Court. The debtor is still entitled to propose a composition plan within a certain period. If the creditors accept this plan, then the debtor is not adjudicated insolvent.
a) The debtor forfeits its right to manage its assets;
b) All assets of the debtor, including those assets acquired during the bankruptcy proceeding, are subject to the jurisdiction of the commercial Court and to bankruptcy proceedings;
c) Any contract entered into by the bankrupt debtor after issuance of the bankruptcy declaration cannot be paid with the assets of the bankrupt’s estate unless there is a benefit to the estate from such contract;
d) A lawsuit concerning the rights and obligations of the bankrupt debtor on its assets shall be filed by or against the receiver or the state receiver (the ‘Balai Harta Peninggalan’);
e) Any judgment against any part of the assets of the debtor in effect before the declaration of bankruptcy is immediately suspended and cannot be executed or enforced against the bankrupt debtor or its assets;
f) Any judicial decision for the forfeiture of assets, whether or not executed, is null and void;
g) Any agreement remaining unfulfilled by the parties at the time of the bankruptcy declaration may be confirmed for performance by the receiver upon petition by the other contracting party.14
h) Employees of the bankrupt debtor may resign or the receiver may dismiss them subject to employment periods stipulated in employment contracts and subject to their rights under manpower laws. Six weeks’ termination notice must be given. As from the effective date of the bankruptcy declaration, remuneration due to the employees becomes a debt due and accruing from the bankrupt’s estate.15
When bankruptcy of a corporation is as a result of a mistake or negligence on the part of the board of directors, and the company’s assets are insufficient to cover the losses occasioned by such bankruptcy, each member of the board of directors would be jointly responsible for such losses.16 However, if it can be proved that the bankruptcy was not due to the director’s mistake or negligence, then that director would not be jointly responsible for the losses. A clear statutory meaning of ‘mistake or negligence is not available from the statutes.
Generally, after a bankruptcy declaration, the debtor, including a corporate debtor, forfeits the right to manage its assets. The entire management and settlement of the bankrupt’s estate is placed under the control of the receiver who is supervised by a Supervisory Judge. The Commercial court must hear the opinion of the Supervisory Judge before deciding upon any matter relating to the management and settlement of the bankrupt’s estate. Any appeal against the decision of the supervisory judge may be made to the Commercial court within five days.17
Secured assets are not included in the bankrupt’s estate. Any creditors holding security rights, pledges, or collateral rights over other property may execute such rights as if no bankruptcy has occurred.18 Security interests are not substantively affected by the proceedings. However the secured creditors may not execute their rights for a maximum period of 90 days from the date of the bankruptcy declaration.19 The purpose of this stay is to:
a) Increase the possibility of a composition plan being agreed upon;
b) Increase the possibility of maximizing the value of the bankrupt’s assets; and/or
c) Allow the receiver to carry out his/her duties in an optimal manner.
The 90 days stay will not apply when:
a) Claims of creditors are secured by cash and there exists rights of creditors to reconcile by the exercise of set-off rights;
b) During the period of the stay, the receiver uses the property of the bankrupt’s estate under his/her supervision to continue the debtor’s business, provided reasonable protection is given to creditors and to third parties;
c) There is an earlier termination of bankruptcy, or the debtor is deemed insolvent before the expiration of ninety days; or
d) A creditor or third party files a petition with the receiver to remove such stay/deferment or to change the conditions of such stay.
Where a court has ordered a stay of the proceedings, before the adjudication of bankruptcy, any creditor or the public prosecutor may file a petition with the Commercial Court to: 20
a) Seize all or part of the assets of the debtor; or
b) Appoint an interim receiver to:
(i) Supervise the management of the debtor’s business;
(ii) Supervise payments to creditors and transfers or encumbrances of any assets of the debtor that require the approval of the receiver for seizure or appointment of an interim receiver.
A debtor may request the Commercial Court to suspend debt payments during the bankruptcy proceedings. If this request is granted, the debtor will have a maximum period of 270 days to put forward a settlement proposal to unsecured creditors in order to restructure its debts. If the unsecured creditors accept the settlement proposal, then the bankruptcy proceedings will come to an end. But if the unsecured creditors refuse to accept the settlement proposal during such period, the Commercial Court will declare the debtor bankrupt.21
During the 270 days period, the secured creditors may not foreclose on their collateral. Thereafter, the secured creditors must exercise their rights to foreclose within two months after the debtor is deemed to be insolvent which is upon declaration of bankruptcy and the receiver takes over control of the assets. The date of insolvency is deemed to be the date on which the receiver determines that there are insufficient assets to pay all unsecured creditors in full.22 If the secured creditors do not commence foreclosure proceedings within this period the receiver will foreclose the secured assets. If the collateral security is not sufficient to cover the debts, secured creditors will have to share the proceeds realized from the sale of unsecured assets with the unsecured creditors.
v Judges handling bankruptcy cases would be judges at the Commercial Courts located in the local jurisdictions where the judgment debtor resides or carries on business.
v The first creditors’ meeting must be held within fifteen days from the date of the bankruptcy declaration23
v The creditors may form a creditors’ committee, which is a committee of representatives of creditors to oversee the management of the corporate debtor during a composition proceeding.
v Within five days from the date of the decision declaring bankruptcy, the receiver must notify the creditors by registered letter or courier.24
v Late filings of claims are allowed so long as the settlement for payment from the proceeds of the sale of bankruptcy assets has not yet been finalized. If a creditor files its claim after such settlement is finalized, the creditor may obtain payment only from the balance of any undistributed proceeds realized from the sale of assets.
The assets of the bankrupt’s estate would be applied to the creditors’ claims in the order of priority (1) Court and auction costs, (2) Taxes, (3) Claims of secured creditors, (4) Privileged creditors and (5) Unsecured creditors.
Pursuant to the Indonesia Civil Code, secured creditors are those holding (a) security on land pursuant to the Security rights Law, (b) pledges pursuant to the Indonesia Civil code, or (c) fiduciary securities pursuant to Law No. 42 of 1999.
Secured creditors have priority rights to their collateral security over other creditors. Bankruptcy Law provides that secured creditors may exercise their rights over their collateral security, subject to the temporary stay period, as if there were no bankruptcy proceedings.26
Unsecured creditors have access only to the unsecured assets of a bankrupt debtor on a pro rata basis.
There are no penal sanctions in the Bankruptcy Law in Indonesia.27
If a bankrupt debtor is a lessee, in a bankruptcy proceeding the receiver and/or the lessor may terminate the lease, provided that the termination is in accordance with local business practices. A maximum period of three months notice must be given. If the rental has been paid in advance, the lease cannot be terminated prior to the end of the period for which the advance rent was paid. As from the date the bankruptcy declaration becomes effective, the rent is a debt the bankrupt’s estate.
A bankruptcy may be terminated by either settlement of payment of all debts of the bankrupt debtor, or an approval of the unsecured creditors ratified by the Commercial Court of a composition plan submitted and offered by the debtor upon the bankruptcy declaration.28
The bankruptcy proceeding in the Commercial Court must be completed within thirty days from the date of registration of the bankruptcy petition in the court. Appeals must also be decided within a thirty-day period.29
The laws governing bankruptcy proceedings are enumerated in the Bankruptcy Act and the Bankruptcy Regulations/Code. As for corporate judgment debtors, the Companies Act and the Rules and Regulations govern winding-up/liquidation proceedings.
In Malaysia bankruptcy proceedings is a form of execution proceedings to enforce a judgment obtained against the defendant who has defaulted payment on the judgment. Bankruptcy proceedings have a foothold on the platform of a judgment, which is a prerequisite for filing a Bankruptcy Notice.
In order to initiate bankruptcy proceedings against an individual judgment debtor, the minimum amount of the judgment debt due and outstanding must be RM10, 000/-. If the judgment debt is less than the minimum statutory amount, the judgment creditor would not have recourse in bankruptcy against the judgment debtor. As against a corporate judgment debtor, the judgment creditor may institute winding up proceedings. Only the High Court has original jurisdiction against in bankruptcy and winding-up proceedings.
Procedure: involves filing an ex-parte Request for Issue of Bankruptcy Notice supported by the original judgment, which gave rise to the judgment debt and a Bankruptcy Notice directing the judgment debtor to show cause within 7 days why Adjudicating and Receiving Orders should not be made against him/her. It must be shown to the court that there has been a default in the payment of the judgment debt. These cause papers will bear the official seal of the court and need to be served personally on the judgment debtor or by substituted service upon prior leave of court having been obtained.
Immediately upon instituting the bankruptcy proceedings, all the assets of the judgment debtor vest in the Official Receiver. Bank accounts are ‘frozen’ and cannot be operated by the judgment debtor and everything comes to a standstill.
Upon service of the Bankruptcy Notice and if no cause is shown, a Bankruptcy/Creditors’ Petition is filed and is issued by the court with an endorsement of a date for the hearing of the bankruptcy claim. The judgment debtor/respondent may respond to the Petition by filing an Affidavit to show cause or object to the proceedings. These papers and all cause papers filed in the matter need to be served on the Official Receiver as well. The matter is then heard before a High Court Judge. The Official Receiver is present in these proceedings. Upon conclusion of the proceedings, if the court finds in favor of the judgment creditor, Adjudicating Order and Receiving Order would be granted. Thereafter the judgment creditor must file a Proof of Debt with the Official Receiver. The adjudication of the bankruptcy must be advertised in the national newspapers and in the Federal Gazette promptly to give notice to all current and prospective creditors. All other creditors who were not parties to the initial claim or the bankruptcy proceedings may now file their proofs of debt. Subsequent to the adjudication of bankruptcy, any action either by or against the bankrupt can only be initiated with leave of the Official Receiver.
The Official Receiver then carries out investigation through his/her office and collects all relevant information pertaining to the judgment debtor’s assets and liabilities to determine the extent of the estate of the bankrupt. The bankrupt is also required to file a Statement of Affairs with the Official Receiver.
The Official Receiver then holds periodic Creditors’ Meetings and finalizes the distribution of the estate of the bankrupt. The Adjudicating and Receiving Orders remain until the judgment debtor’s debts are fully settled in which case the judgment debtor may be discharged. In some circumstances the Official Receiver will seek the consensus of all the creditors who have filed their respective Proofs of Debt to grant the judgment debtor a discharge where it is evident that there is absolutely no way the judgment debtor is going to be able to pay and settle off all his assets.
One pertinent consequence of an adjudication of bankruptcy is that the judgment debtor ‘loses’ his identity immediately upon Adjudicating and Receiving Orders being made against him. His passport would be impounded and he would not be permitted to travel out of the country. The immigration authorities are kept duly informed of the bankruptcy. The bankrupt will not be able to own any property, motor vehicle, have a bank account or receive any independent income or operate any business in his name. He is only entitled to apparel and basic living needs. To circumvent this several bankrupts purchase property in the names of their nominees or operate businesses in the nominee’s name and go on as such without the least concern to pay off the debts and discharge the bankruptcy.
It appears that initially Bankruptcy Law (hasan ho) and Corporate Reorganization Law (kaisha kosei ho) were very territorial in Japan and did not extend to assets located in foreign countries. Then when the UNCITRAL31 drafted a Model Law for cross-border insolvency, the General Assembly of the United Nations resolved that the Model Law be introduced into the member countries’ domestic laws. Accordingly, bankruptcy practitioners in Japan increased their efforts to include international concepts in their insolvency laws and procedures to recognize foreign insolvency proceedings based upon the Model Law of UNCITRAL were introduced.
Under these procedures, the foreign representative is required to file a petition for appropriate assistance on a case-by-case basis and obtain a court order for such assistance. A foreign representative is entitled to file a petition for recognition of the relevant foreign insolvency proceeding. The court will then issue a recognition order if it is convinced that the foreign insolvency proceeding is qualified for assistance within Japan. The requirements to be met in order for the foreign proceeding to be qualified are:
1. That the debtor has an address of residence or place of business or other office in the country where the foreign insolvency proceeding is pending;
2. That there is a formal order for the commencement of the foreign insolvency proceeding;
3. That there are no causes for rejection such as (a) failure to deposit the procedural deposit, (b) the effect of the foreign proceeding which does not extend to the assets located within Japan, (c) if there would be violation of public order of Japan if assistance towards the foreign proceedings is provided, (d) if it is clear that no assistance is necessary for the foreign insolvency proceeding, (e) if the foreign representative fails to report to the court regarding the status of the development of the foreign insolvency proceeding, except where there is no material violation, (f) if the petition has been filed in bad faith or with undue objectives32
Where a recognition order has been issued, assistance orders that may be issued include:
The distribution of assets under the foreign insolvency proceedings may not always be made in the same priority as the Japanese insolvency proceedings. With a view to protecting local creditors, the Court may order that prior court’s approval be obtained for disposition or outbound delivery of the debtors’ assets within Japan.
A debtor can be subject to only one insolvency proceeding and where there are two or more proceedings (a) a local insolvency proceeding shall generally prevail over foreign insolvency proceedings, (2) where the foreign insolvency proceeding is for the foreign main proceeding; providing assistance to such foreign insolvency proceeding conforms to the general interests of creditors and where providing assistance to such foreign insolvency proceeding will not impair the interests of creditors within Japan, then the foreign insolvency proceeding shall prevail over the local insolvency proceeding, (3) a foreign main proceeding shall prevail over a foreign non-main proceeding. (A foreign main proceeding means the proceeding in the place where the debtor has its main office of business), (4) as between/among foreign non-main proceedings, the proceeding that conforms to the general interests of creditors shall prevail over the others.
The Japanese court has jurisdiction over an insolvency case so long as the debtor has either an address for correspondence, residence, business or other office, or assets or civil rehabilitation proceedings within Japan.
Insolvency Proceedings under the Corporate Reorganization Law (Kaisha Kosei Ho) 34
Corporate reorganization proceedings are intended to be used for the rehabilitation of large corporate debtors. This bears some similarities to the Chapter 11 proceedings in the United States. Under these proceedings, creditors’ rights are more restricted than in other insolvency procedures and better ensure effective and actual rehabilitation rather than rendering it futile. The restrictions include:
(a) Secured creditors may not exercise their foreclosure right or receive payments outside the corporate reorganization proceedings;
(b) The secured creditors’ claims are treated as secured claims only up to the value of the collateral as evaluated by the trustee or as finally determined by the Court;
(c) The secured creditors’ claims will be paid in accordance with the proposed plan;
(d) Secured creditors do not have the right to seek relief from a stay.
Only a stock/publicly held corporation may be a debtor under these proceedings.
A debtor corporation may file for relief if:
(a) It is unable to pay its debts when due and payable without the business operations being adversely affected or significantly impaired; or
(b) An event of bankruptcy occurs with respect to the debtor corporation.
A petition for the commencement of corporate reorganization proceedings may be filed by (a) a corporate debtor; (b) a creditor or creditors holding aggregate claims equal to 10% or more of the paid-in capital of the debtor; or (c) a shareholder or shareholders owning 10% or more of the issued and outstanding shares of the debtor company.
The Petitioner must file a written petition with the competent District Court before the case can be heard.
Prior to filing the proceedings, the petitioner will informally discuss the case ex parte with the court. The court analyzes the case with a view to issuing preservative injunction immediately upon filing of the petition. Preservative Injunction (Hozen Meirei) will be issued either upon request or upon the court’s own volition. Petitioning under the corporate reorganization proceedings does not have the effect of an automatic stay.
Immediately upon filing of a petition for reorganization, the court contacts major creditors to ascertain their position concerning the rehabilitation of the debtor. Unless there is some particularly strong opposition to rehabilitation, the court will issue the required injunction on the day following the day of filing of the petition for reorganization which include (a) prohibition against payment of pre-injunctive debts, (b) prohibition against disposition of the debtor’s assets; and (c) prohibition against borrowing money.
(a) Any creditor who receives a payment for a pre-injunction debt, with knowledge that an injunction order has been issued, must return the payment to the debtor.
(b) In practice, usually, the debtor stops payment of all pre-injunction debts and in addition thereto, gives notice of the injunction to all of its creditors immediately upon issuance of the injunction.
(c) The debtor’s assets are prohibited from being disposed. The prohibition is recorded against the real estate registrations and other registered assets of the debtor.
(d) Any transaction involving the registered assets of the debtor conducted after the injunction is recorded will be unenforceable as against the debtor’s estate.
(e) The debtor must obtain the court’s approval before borrowing money. Usually the debtor also obtains the court’s approval to treat the new debt as an administrative expense, which then takes priority for claim in the reorganization proceedings.
Cease and Desist Order (Chushi Meirrei)38
Since an injunction is addressed only to the debtor, foreclosure or other proceedings against the debtor or the debtor’s assets are not automatically stayed or prohibited even after the injunction has been issued. When necessary, the court may issue a cease and desist order in respect of such proceedings.
Some contracts include a clause which provides that filing of a petition for corporate reorganization procedures constitutes cause for cancellation of the contract i.e. an ipso facto clause. Such clauses are not always enforceable, especially when they are deemed to violate the public policy that the Corporate Reorganization Law is intended to promote. A supplier under an executory contract containing such a clause may refuse to perform its contractual obligation unless adequate assurance of the debtor’s performance of the obligations on its part is given.n3
Indian Commercial Law is derived from the British Law of Merchants, which provides for the rights, liabilities and obligations of creditors and debtors.
There is no explicit definition for the term ‘unsecured creditor under the Indian Insolvency Laws but by necessary implication and analogy from the definition assigned to the terms ‘secured creditor’ and ‘creditor’, it could be inferred that an unsecured creditor is a creditor who does not hold a mortgage, charge or lien on the property of the debtor or any thereof as a security for a debt due to him from the debtor.
Unsecured creditors must establish their debt.41 A ‘creditor’ includes a decree-holder, ‘debt’ includes a judgment debt, and ‘debtor’ includes a judgment debtor. A ‘secured creditor’ is defined as a person holding a mortgage, charge or lien on the property of the debtor or any part thereof as a security for a debt due to him from the debtor. The remedies available to the secured creditor include:
(a) realization upon the security and bring a claim for the balance due
(b) surrender the security to the official assignee for the general benefit of the creditors and bring a claim for the whole debt
(c) Before ranking for dividend, the secured creditor may state in the proof of claim the particulars of security, the date when it was given and the value at which the secured creditor assesses it. The creditor shall be entitled to receive a dividend only in respect of the balance due to the secured creditor after deducting the value so assessed. 42
The laws relating to the creditors of a company fall within the ambit of the Companies Act 1956 and the Companies Court Rules.
(a) Every creditor must prove its debt unless the judge in a particular matter directs that any creditor/class of creditors be admitted without proof43
(b) A debt has to be proved and must be proved in presenti
(c) Future debts are not admissible unless the company carries on business for the beneficial winding up of the company through the official liquidator and the claims of secured creditors are continuing obligations
(d) The court after hearing all evidence may adjudicate the claim and settle upon a list of creditors44
(e) Once the claims are adjudicated, the distributable assets are ordered to be distributed pursuant to proof of debt
(f) Since the secured creditors would not participate in the winding up and remain outside the winding up process, their property is not distributable by the winding up court
(g) If the secured creditor has relinquished the security then it would receive payment from the court equally without preference
(h) If the secured creditor decides to realize the security, the secured creditor shall be liable to pay their portion of the expenses incurred by the liquidator/provisional liquidator for the preservation of the security before its realization by the secured creditor. 45
Rights of Foreign Creditor:
Foreign creditors are not given any specific special treatment for priority of payment of outstanding dues. The debts due to foreign creditors must have been lawfully incurred and debt must have been agreed to be paid in repatriable currency as declared at the time of taking the consent from the Ministry of Finance or the Reserve Bank of India, then the decree can be in foreign currency. The procedure for contracting a foreign debt is set out in the Foreign Exchange Management Act, 1999 and the Guidelines issued by the Indian Central Bank and the Reserve Bank of India. The laws of India or the laws governing the company would be applicable in determining the claim and the normal procedure of a proof of a claim will be applicable.
The Indian Contract Act, sections 1 to 75 apply to all contracts in general. The principles of English law cannot be imported to assist the interpretation of the Contract Act unless it is not possible to interpret it otherwise.
Indian Courts have held that parties to a contract are bound according to the law as they understood and adopted at the time of the making of a contract even though the interpretation proved erroneous. Whether the proper law is the law lex loci contractus or lex loci solutionis is a matter of presumption, but where the parties have expressed an intention, the expressed intention overrides any presumption. Where there is no express intention, the applicable law is to be inferred from the intentions appearing from the terms and the nature of the contract and from the general circumstances surrounding the matter.
In India, a foreign judgment is generally held to be conclusive as to any matter thereby adjudicated upon between, inter alia, the same parties.46
In order for insolvency order against an Indian company to be recognized it has to be passed by the company court. No foreign court has authority to declare an Indian company as being wound up. A foreign court can pass a judgment against assets within its own jurisdiction. If the judgment is unsatisfied, then based upon rules of reciprocity and recognition of foreign judgment, either the foreign judgment or decree may be executed in relation to reciprocating territories or a new cause of action may be founded based upon the judgment in India. When a judgment is granted and the judgment debt remains unsatisfied, insolvency procedures may be commenced in India before the Company Court. No foreign court has authority to render a judgment or order of winding up of an Indian company in a foreign judgment. Therefore the question of a foreign insolvency judgment of an Indian company being recognized in India does not arise.
Indian insolvency procedures do not discriminate against debts due to foreign creditors provided such debts have been lawfully incurred. Only judgments from a reciprocating country as noted in the Indian Official Gazette are recognized. In the absence of such reciprocity, the judgment would not be recognized for purposes of execution a new civil suit in India would have to be initiated. Therefore an Indian court would not recognize the appointment of a receiver, trustee, or liquidator from a non-reciprocating territory. In relation to reciprocating territories when the judgment is transferred or execution of a decree from such territory is commenced, Indian courts would give assistance and appoint local agents of the foreign trustee or receiver as requested. When such decree remains unsatisfied, the Indian court, on a petition or a notice of an unsatisfied judgment or decree, may commence winding up of the Indian business in India with the Indian court having jurisdiction.47
India is not a party to any special international conventions on insolvency. In the light of existing Indian law, international conventions would not be applicable because rules of private international law declare that no convention has priority over domestic private law that is inconsistent with provisions of the convention or treaty. Due to the limited reciprocating treaties, there are severe disabilities in instituting foreign insolvency actions with respect of Indian companies. Consequently a committee set up by the Government of India to examine the existing laws relating to winding up practice, has recommended that Part VII of the Companies should incorporate new substantive provisions to adopt the UNCITRAL Model Law on Cross-Border Insolvency as approved by the United Nations in 199748 whereby the Model Law itself would be incorporated as a Schedule to the Companies Act applicable to all cross-border insolvency cases.
Indian Insolvency Laws are incorporated in the Provincial Insolvency Act, which provide for rehabilitative, distributive and penal provisions. Pursuant to Section 6 (1) 49 a debtor commits an act of insolvency:
Pursuant to the proviso to the sub-section, no insolvency notice shall be served on a debtor residing outside India, whether permanently or temporarily, unless the creditor obtains leave of the District Court for such service out of jurisdiction.
An insolvency notice under Section 6(2)50 shall:
The insolvency notice shall not be deemed invalid by reason only that the sum specified therein as the amount due under the decree or order exceeds the amount actually due, unless the debtor, within the period specified in the insolvency notice for its compliance, gives notice to the creditor that the sum so specified does not correctly represent the amount due and owing under the decree or order.
Pursuant to Section 6(5)51, a debtor may apply, within the period specified in the Insolvency Notice, to set aside the insolvency notice, on the grounds that:
o the decree or order is not executable under the provisions of any law on the date of the application;
and where such application is allowed by the District Court, the debtor shall not be deemed to have committed an act of insolvency.
Insolvency proceedings in India may be voluntary or involuntary and a debtor or a creditor may initiate the proceedings. Even a single creditor is entitled to maintain an insolvency petition. The insolvency laws serve a two-fold purpose:
The statute therefore provides machinery by which all creditors are equitably satisfied. The object is to seize the property of an insolvent before the assets are squandered off and to distribute the property amongst the debtor’s creditors. The property of an insolvent vests in the Official Assignee immediately upon an act of bankruptcy being committed.
The jurisdiction of the court commences when an act of insolvency takes place, which gives a right to the creditors to apply to the court to adjudicate the debtor insolvent. The primary objective of the insolvency court is to decide:
a) question of title;
b) question of priority
c) matters of law and/or fact that may arise in any case of insolvency coming within the cognizance of the court.
A proceeding under Insolvency laws is a proceeding between the creditors represented by the official receiver and the insolvent and not proceedings as between the insolvent and the proving creditor. When a creditor claims to include a debt due, the court or the official receiver of the estate of the insolvent has to be satisfied that (a) there in fact exists a debt, (b) the amount due, (c) its particulars and (d) that the debt is provable in insolvency. The standard of proof is very high. Before adjudicating a person as insolvent, the court has to be satisfied that all the requirements for adjudication are established very convincingly and beyond reasonable doubt. No petition, whether presented by the creditor or the debtor may be withdrawn without the leave of the court.
Insolvency of Corporation is governed by the Companies Act 1956, which adopts the Insolvency Rules enumerated in the Insolvency Laws. Part III, Chapter IV of the Companies Act, 1956 provides for the winding up of a company subject to supervision of court. The process commences by passing of the necessary resolution by the company. A petition for the continuance of a voluntary winding up subject to the supervision of the court shall be deemed to be a petition for winding up by the court.
An unregistered company may be wound up:
a) if the company is dissolved or has ceased to carry on business, or is carrying on business only for the purpose of winding up its affairs;
b) if the company is unable to pay its debts; and
c) if the court is of the opinion that it is just and equitable that the company should be wound up.54
Pursuant to Section 10,55 a debtor shall not be entitled to present an insolvency petition unless:
Pursuant to the Insolvency Rules, a prima facie inquiry is carried out so that the court may be satisfied that the debtor is unable to pay his debts. The proviso to Section 10 provides that the court shall not be bound to hear any further evidence if it is satisfied that there are prima facie grounds for believing the evidence of the petitioner. The petitioner must, prima facie, prove that he is unable to pay his debts in order for him to be adjudged an insolvent. A debtor who has sufficient assets but no liquidated assets with which to pay his debts must be held to be not able to pay his debts and therefore liable to adjudication as an insolvent.
Under the Companies Act, a company may be voluntarily wound up if the court is of the opinion that it is just and equitable that the company should be wound up under circumstances where:
Ø the company has, by special resolution, resolved that the company may be wound up by the court;
Ø default is made in delivering the statutory report to the registrar or in holding the statutory meeting;
Ø the company does not commence its business within one year from its incorporation, or suspends its business for a whole year;
Ø the number of members is reduced, in the case of a public company, below seven, and in the case of a private company, below two; and
Ø the company is unable to pay its debts.56
An application to the court for the winding up of a company shall be presented by the company, any creditor(s) including any contingent or prospective creditor(s), any contributory, the registrar, or by any person authorized by the Central Government in a case related to oppression and mismanagement.
A voluntary winding up shall be deemed to commence at the time when the resolution for voluntary winding up is passed.57 Within 14 days of passing the resolution for voluntarily winding up the company, the company shall give notice of the resolution by advertisement in the Official Gazette and a local newspaper.58
The company shall, from the commencement of the voluntary winding up, cease to carry on its business, except so far as may be required for the beneficial winding up of such business. But the corporation’s state and corporate powers shall continue until it is dissolved.59
Under the Insolvency Laws, a creditor shall not be entitled to present an insolvency petition against a debtor unless:
The debt must be of a liquidated sum, which is capable of arithmetic calculation. The debts must be owing by the debtors in their own right and not as an executor or otherwise. The debt must continue to exist up to the date of the order of adjudication. A creditor is not entitled to maintain a petition if his debt was not in existence on the date of the alleged act of insolvency but was incurred later. A claim for non-liquidated damages for breach of contract is not a debt within the meaning of the section. The amount of debt, which can sustain an insolvency petition, must be a definite ascertained sum so that the court would not have to assess it. A secured debt cannot be included in an insolvency petition unless the secured creditor has released the security.
In the creditors’ petition the creditor must specify the acts of insolvency and the dates of their commission. Where two or more insolvency petitions are presented against the same debtor, or where separate petitions are presented against joint debtors, the court may consolidate the proceedings.60
Insolvency of a company under the Companies Act has the same effect as insolvency of a natural person under the Insolvency Laws and suspends the rights of the directors of the company in dealings with its assets other than under the supervision of the court. Under the Companies Act, the Official Liquidator is the only liquidator that can be appointed in winding up proceedings by the court. Only the Official Liquidator can enter into fresh legal contracts on behalf of the company.
Receivership is a procedure available under the Insolvency laws. The appointment of a receiver is regulated by the rules of the High Court.61
Only secured creditors can prove against the Official Liquidator or the receiver outside of the insolvency law in normal civil proceedings. Remedies of persons in contractual relationships are only available with the leave of the court as no execution, distress or warrant can be issued or executed against the company without the leave of the court.
After the initiation of insolvency proceedings, the insolvent must assist in the process of insolvency, including administration of his properties. The duties of the insolvent as set out in Section 33 62 are:
The common law principle that the personal earnings of the insolvent derived from his personal labor, to the extent necessary for the support of the insolvent and his family do not vest in the assignee, is applicable in India. There is a further rider added to the common law principles to the effect that the balance of the personal earnings, after deducting what is necessary for the balance of the personal earnings, after deducting what is necessary for the support of the insolvent and his family, does not automatically vest in the assignee but is subject to the orders that may be passed by the relevant court.
Assessment of domestic needs of the insolvent and his family will depend on the facts and circumstances of each case. Whilst the court has to take a humane approach towards honest insolvents, the court must also be weary of undue exploitation of the principles and provisions of the law by unscrupulous individuals who are adjudicated as insolvents. If over a period, there is a surplus or excess out of the amounts allowed by the court for the support of the insolvent and his family, then the creditors or the assignee can apply to the court for a review of the previous order.
Under the Insolvency Laws,63 where a debtor is adjudged or re-adjudged insolvent, he shall be disqualified from:
These disqualifications shall be removed and shall cease to have effect if:
The court may grant or refuse such certificate as it thinks fit, but any order of refusal shall be subject to appeal.
The Insolvency Laws 1920 are a complete code self-sufficient to determine questions such as whether (a) a person is an insolvent or not or (b) an insolvent may be discharged or not and subject to what conditions.
After an adjudication order is made, the whole of the insolvent’s property shall vest in the court or in the receiver appointed by the court and shall become divisible among the creditors. If the insolvent has no present right of disposal over certain assets, he has no such property as would vest in the court or the official receiver. Thereafter no creditor to whom the insolvent is indebted in respect of any debt provable shall, during the pendency of the insolvency proceedings have any remedy against the property of the insolvent with respect to the debtor or commence any suit or other legal proceedings, except with the leave of the court and on such terms and conditions as the court may impose.64
The estate of the insolvent vests in the receiver only for the purpose of its administration and to pay off the debts to the creditors. The receiver acquires no personal interest of his own in the property. If the insolvent or any other person is aggrieved by any act or decision of the receiver, the party may apply to the court for relief, and the court may confirm, reverse or modify the decision complained of. Such an application has to be made within twenty-one days of the date of the act or decision complained of.65
On a winding up order of a company being made in respect of a company, an official liquidator, who is an official of the Central Government attached to each High Court, shall become the liquidator of the company. The powers of the official liquidator as provided in the Companies Act, 1956 and the Company Court Rules, 1959, Part III, 66, include:
The official liquidator can seek directions from the Company court for exercise of its powers and for the orderly winding up of the affairs of the company. The official liquidator has to realize assets, pay out dividends to the creditors equitably, call for proofs of the debts and report generally.67
When an order of adjudication is passed under the Insolvency Laws, all creditors of the insolvent must tender proof of their respective debts by producing evidence of the amount and particulars thereof.
Where an insolvency petition is admitted, the court shall make an order fixing a date for hearing the petition and give notice to the creditors. Where the debtor is not the petitioner, notice of the order shall be served on him in the same manner as for service of summons.68 Service of notice is imperative and lack of notice vitiates the order. An ex-parte order of adjudication without the service of notice is liable to be set aside. The creditors to whom the notice is given are entitled to appear at the hearing and to oppose the maintainability of the petition by the creditor or debtor.
Pursuant to Section 6169 the property of the insolvent shall be paid and distributed in the order of priority of:
Where there is any surplus after payment of the priority debts, it shall be applied in payment of interest from the date on which the debtor was adjudged insolvent at the rate of six percent per annum on all debts entered.
Under Section 529A70 the order of overriding preferential payments which should be paid in full unless the assets are insufficient to meet them, (in which case they shall abate in equal proportions) are:
In the case of partners:
a) The partnership property shall be applicable in the first instance in payment of the partnership debts.
b) The separate property of each partner shall be applicable in the first instance in payment of his separate debts.
c) Where there is a surplus of the separate property of the partners, it shall be dealt with as part of the partnership property.
d) Where there is surplus of the partnership property, it shall be dealt with as part of the respective separate property in proportion to the rights and interest of each partner in the partnership property.
Under the Insolvency Laws, the debtor shall be punishable, on conviction, with imprisonment which may extend up to one year if the debtor (a) willfully fails to perform the duties imposed upon him or (b) to deliver up possession of his property which is divisible among his creditors, or (c) fraudulently with intent to conceal the state of his affairs or to defeat the objects of the Act, has destroyed or otherwise willfully prevented or purposefully withheld the production of any document relating to such affairs, or (d) has kept or caused to be kept false books, or has made false entries, or (e) willfully altered or falsified any document relating to his financial affairs, or (f) fraudulently with intent to diminish the sum to be divided among his creditors or give an undue preference to any of his creditors has discharged or concealed any debt due to or from him, or (g) has made away with, charged, mortgaged or concealed any part of his property.
An undischarged bankrupt/insolvent obtaining credit to the extent of 50 rupees or upwards from any person without informing such person that he is an undischarged insolvent shall, on conviction, be punishable with imprisonment for a term which may extend to six months or fine or both. The courts may either of its own motion or at the instance of the official assignee or of any creditor cause an insolvent to be arrested and committed to the civil prison if it appears to the court that there is probable reason to believe that the debtor has or is about to abscond or that he is about to remove his property with a view to avoiding, delaying or embarrassing the insolvency proceedings against him.
Under the Insolvency laws, a debtor may at any time before the order of adjudication and within the period specified by the court, apply to the court for an order of discharge. The court shall fix a date, notice whereof shall be given in the prescribed manner to hear the application and objections thereto. After considering the objections of any creditor and the report of the receiver, the court may grant or refuse an absolute order of discharge or suspend the operation of the order for a specified time or grant a conditional order of discharge.73
Pursuant to Section 4274, the court will refuse to grant an absolute order of discharge if, inter-alia, the insolvent’s assets are not equivalent to 25% of his unsecured liabilities, or the insolvent has omitted to keep proper accounts and books to sufficiently disclose his business transactions and financial position for three years preceding his insolvency, or the insolvent has continued to trade after knowing that he is insolvent, or the insolvent has brought about his insolvency by rash and hazardous speculations or by unjustifiable extravagance in living or by gambling or by culpable neglect of his business affairs etc.
An order of discharge shall not release an insolvent from any debt due to the government, any debt or liability incurred by means of any fraud or fraudulent breach of trust to which he was a party.
Pursuant to Section 3875 provisions for composition and arrangement between the creditors and the debtor may be made where a debtor, after being adjudicated an insolvent, submits a proposal for a composition in satisfaction of his debts or a proposal for a scheme of arrangement of his affairs.
The court then fixes a date for the consideration of the proposal in the presence of all the creditors and shall be deemed to be accepted if the proposal is accepted by a majority of creditors present. At the meeting the debtor may amend the terms of his proposal if the amendment is, in the opinion of the court, calculated to benefit the general body of creditors.
An insolvency procedure under the Insolvency Laws may take up to twenty years to be finally decided and settled as per the order of the court. Instances of parties settling out of court are common. Under the Companies Act, the winding up of a corporation can take up to twenty years to achieve whereas ideal case processes for compromises, arrangements, amalgamations and reconstructions under Chapter V of the Companies Act have been concluded in five years.
The study and analysis of the Insolvency Laws in the several jurisdictions above shows the similarities and disparities between the general insolvency laws, the procedures involved, and the rights and obligations of the parties. One argument that may be put forth to explain the apparent disparity is that there exists distinct social, economic, political and cultural differences in the various countries. These play a crucial role in the enacting, adopting and application of the laws relating to property and personal rights of the citizens.
1.Collier International Business Insolvency Guide P.4.01 – see pg 1
2.Id – see pg 2
3. 11 U.S.C. Section 1141
4.11U.S.C. Section 362(a)
5.11U.S.C. Section 362(b)
6.11U.S.C. Section 507
7.Collier International Business Insolvency Guide P.4.09
8.Collier International Business Insolvency Guide P.4.12
9. Collier International Business Insolvency Guide P.26.04 – see pg 1
10. Collier International Business Insolvency Guide P.26.04 - see pg 2
11. Article 6 paragraph 6, Bankruptcy Law
12.Article 13 paragraph 1, Bankruptcy Law
13. Collier International Business Insolvency Guide P.26.04 - see pg 2
14. Article 39 Bankruptcy Law
16. Article 90 paragraph 2 Company Law
17. Collier International Business Insolvency Guide P.26.04 - see pg 3
18. Article 56 Bankruptcy Law
19.Article 56A Bankruptcy Law
20.Article 7 Bankruptcy Law
21. Collier International Business Insolvency Guide P.26.04 - see pg 4
22. Article 57 Bankruptcy Law.
23.Article 77A, Bankruptcy Law
25. Collier International Business Insolvency Guide P.26.04 - see pg 7
26. Article 56 Bankruptcy Law
27. Collier International Business Insolvency Guide P.26.04 - see pg 8
28. Collier International Business Insolvency Guide P.26.04 - see pg 12
29. Collier International Business Insolvency Guide P.26.04 - see pg 13
30. Collier International Business Insolvency Guide P.29.04 - see pg 1
31. UNCITRAL is an intergovernmental body of the General Assembly that prepares international commercial law instruments designed to assist the international community in modernizing and harmonizing laws dealing with international trade – (explanatory note by UNCITRAL Secretariat on the UN Convention)
32. Collier International Business Insolvency Guide P.29.10 - see pg 1 - 2
34. Collier International Business Insolvency Guide P.29.04 - see pg 1 – 2
38. Collier International Business Insolvency Guide P.29.04 - see pg 3
40. Collier International Business Insolvency Guide P.25.02
41. Provincial Insolvency Act, 1920
43. Rule 149 Companies Rules
44. Rule 174 Companies Rules
45. Section 529(2) Companies Act 1956
46.Part 1 Section 13 Indian Civil Procedure Code
47. Sections 13 & 44A of the Indian Civil Procedure Code
48.Section 433 Companies Act 1956
49. Provisional Insolvency Act, 1920
52. Collier International Business Insolvency Guide P.25.04 – see pg 3-4
54. Section 583(4) Companies Act 1956
55. Provisional Insolvency Act, 1920
56. Section 433 Companies Act, 1956
57. Section 486 Companies Act, 1956
58. Section 485 Companies Act, 1956
59. Section 487 Companies Act, 1956
60. Section 15 Provisional Insolvency Act 1920
61. Rule 40 Civil Procedure Code 1908
62. Provisional Insolvency Act, 1920
63. Section 73 Provisional Insolvency Act, 1920
64. Section 28 Provisional Insolvency Act, 1920
65. Section 68 Provisional Insolvency Act, 1920.
66. Rules 95 to 338
67. Section 451 Provisional Insolvency Act, 1920
68. Section 19 Provisional Insolvency Act, 1920
69. Provisional Insolvency Act, 1920
71. Collier International Business Insolvency Guide P.25.06 - pg – 18
73. Section 41 Provisional Insolvency Act, 1920
74. Provisional Insolvency Act, 1920
76. Collier International Business Insolvency Guide P.25.06 - pg - 24