Contributed by Debra A. Dandeneau.
A decision involving a malpractice action against counsel for a debtor could create troubling law relating to the treatment of letters of credit in bankruptcy.  Although the bankruptcy court decision in Rafool v. Evans, et al. (In re Central Illinois Energy, L.L.C.), 2010 WL 2491019 (Bankr. C.D. Ill. Jun. 16, 2010), specifically involved whether the court should abstain from hearing a malpractice action against a debtor’s former counsel in favor of the state court, the nature of the underlying malpractice action should raise concerns about the application of bankruptcy law to letters of credit.  In the underlying action, the chapter 7 trustee for the debtor’s estate is alleging that the debtor’s former counsel committed malpractice when it did not advise the debtor to draw on letters of credit that the debtor held as a beneficiary prior to the commencement of the debtor’s chapter 11 case.
The bankruptcy court decision does not explain precisely why the debtor was unable to draw on the letters of credit in its chapter 11 case.  It notes, though, that the complaint alleges that the letters of credit constituted “financial accommodations” to the debtor within the meaning of section 365(c)(2) of the Bankruptcy Code, the debtor could not, therefore, assume them in its bankruptcy case, and, therefore, the debtor’s estate was harmed in the amount of the undrawn letters of credit ($8.8 million).
Because the bankruptcy court was focused on abstention, the opinion does not dwell on what constitutes a “financial accommodation.”  It does state, without citation, that “[w]hether a letter of credit is an executory contract within the scope of Section 365, and whether it is a contract to extend ‘financial accommodations,’ are often difficult issues of bankruptcy law” and characterizes the issue in the complaint as an unsettled issue of bankruptcy law.
However one looks at the issue, the decision and the underlying action are troubling.  If the debtor is holding a letter of credit as the beneficiary, then the letter of credit was issued as a financial accommodation to another entity, the account party, apparently to secure the obligations of the account party.  In Central Illinois Energy, that is precisely what happened – two contractors caused letters of credit to be issued to secure their performance obligations.  That a financial institution has an existing obligation to a debtor to make a payment to a debtor upon the occurrence of certain circumstances does not render that obligation a “financial accommodation” to the debtor.  The purpose of the financial accommodation provision in section 365 is to prevent an entity from being forced to make a loan or extend other financing to a debtor in possession.  Where, however, the debtor in possession is the beneficiary of the letter of credit, the credit already has been extended to another entity.  This should not be an unsettled issue of bankruptcy law.
Even if the situation were reversed and the debtor in possession was the account party under an existing letter of credit, the issue likewise would not be unsettled.  Any characterization of a letter of credit issued prepetition on behalf of the debtor as a “financial accommodation” preventing draw by the non-debtor beneficiary would run squarely up against the “independence principle”— viz., that a letter of credit, once issued, is an independent obligation of the issuer to the beneficiary, and its draw cannot be enjoined upon the occurrence of the debtor’s bankruptcy filing.  The only decision to ever hold otherwise – Twist Cap, Inc. v. Southeast Bank of Tampa (In re Twist Cap, Inc.), 1 B.R. 284 (Bankr. M.D. Fla. 1979) – was universally rejected and roundly criticized.
The only situation in which the notion of financial accommodation should be relevant in the letter of credit context is where the letter of credit has not been issued as of the petition date.  In that situation, the debtor’s lender has no obligation to issue a letter of credit after the filing.
None of these basic principles of bankruptcy law, however, appear to be involved in Central Illinois Energy.  Instead, in the context of a malpractice action, the bankruptcy court runs the risk of venturing close to a twist on Twist Cap territory.  Surprisingly, this time, no one seems to be reacting.