Letter Of Credit And Its Proceeds Are Not Property Of The Estate
In re Oakwood Homes Corp., 342 B.R. 59 (Bankr. D. Del. 2006) (Judge Peter J. Walsh)
Defendants moved to dismiss an adversary complaint seeking recovery of funds related to a surety bond and to a letter of credit.
The Court dismissed the counts in the complaint that sought to recover the letter of credit and the proceeds of the letter of credit as neither was property of the estate. However, the Court denied the motion to dismiss counts which sought to recover for alleged contract breaches between the debtors and the Defendants because the estate had a recognized interest in the contractual and equitable claims of the debtor, which were property of the estate.
The Court also granted leave to amend two fraudulent transfer counts.
The agreement required the debtor to provide security. Security took the form of two bonds, one issued by the U.S. Fire Insurance Company and the other by the American International Group, Inc. In 2002, AIG did not renew the bond and the debtor replaced the AIG bond with a letter of credit from Wells Fargo Bank, N.A. in favor of the Defendant.
During the last policy period, the Defendants had $16 million accessible to them through the bond and letter of credit. By May 2004, the Defendants had drawn down the full amount of the surety bond. By June 2004, the Defendants had drawn down the entire balance of the letter of credit. Yet, by March 31, 2005, the Defendants had paid out only $1.4 million to the claimants.
The debtors filed bankruptcy petitions on November 15, 2002 and confirmed their Chapter 11 Plan on March 31, 2004. The Plan provided for the creation of the OHC Liquidating Trust, which was given the right to prosecute and settle turnover, avoidance, and all other unsettled estate causes of action. The Defendants continued to hold approximately $14.6 million from the bond and letter of credit and the Liquidating Trust commenced an adversary proceeding to recover the $14.6 million being held by the Defendants.
The Defendants filed a motion to dismiss the complaint.
The Defendants argued that the entire action had been filed in an improper forum. The Court found that there was no exclusive language indicating the choice of forum, and, as such, the forum selection clause mandating that all actions would take place in the state of Connecticut, or in any federal court located in the state of Connecticut, was permissive and not a mandatory forum selection clause. There was ample precedent holding that the phrase “irrevocably submit” only meant that the parties had consented to jurisdiction. As such, suit was not required to be brought in Connecticut.
The Court then reviewed Count I of the complaint which sought an estimation of the Defendants’ claim pursuant to §502(c)(1) and recovery of the funds pursuant to §105(a). The court found that Count I failed to state a claim upon which relief could be granted because §502(c)(1) had no application where the Plaintiff seeks recovery against a non-creditor Defendant and similarly, §105(a) only supplemented a court’s enumerated powers under the Code and did not give the Court the power to create a substantive right.
Turning to Count II, which sought recovery of estate property under §§ 541 and 542, the Court found that neither section covered the property that the Plaintiff wanted to recover because the letter of credit and its proceeds were not property of the estate.
The Court explained that a letter of credit has three separate contracts. The first contract is between a buyer and a seller. In this case, the debtor purchased insurance policies from the Defendants. The second is between the account party, the debtor, and the bank or the issuer, Wells Fargo. The third contract arises between the issuer, Wells Fargo, and the beneficiaries of a letter of credit, the Defendants in this case. Each contract supports the other, but each transaction is independent, which preserves the viability of letters of credit, whose purpose is to allow the beneficiary to draw on funds before obtaining a judgment. The independence principal protects the letter of credit and allows it to function as a quick and certain payment mechanism.
It is well established that a letter of credit and the proceeds of a letter of credit are not property of the debtor’s estate. However, under Third Circuit precedent, collateral pledged as a security interest in a letter of credit is considered property of the estate. The Third Circuit recognizes that there is an apparent conflict between these two principals. In order to remedy the resulting confusion, the Third Circuit has held that when the claim centers around the collateral pledged to the bank and not the distribution of the proceeds themselves, the collateral is property of the estate and is subject to turnover. The Bankruptcy Court found, however, that if the Plaintiff is seeking turnover of the letter of credit’s proceeds, and not the pledged collateral, the funds are not recoverable under §§ 541 and 542. Furthermore, the Court found that § 542 would be inappropriate because the recovery was disputed and unliquidated. For those reasons, Count II was dismissed for failure to state a claim.
The Court commented on the fact that the complaint asked for estimation of the amount owed and the Plaintiff repeatedly referenced entitlement to the excess of an amount, as opposed to a certain amount, which demonstrated that the claim had not yet been liquidated. Furthermore, the Court found there was a clear contractual dispute as to how much the Defendant owed, and the debtor may not use a turnover action to circumvent contract claims and recover a disputed unliquidated claim.
The Court then turned to Count III, a breach of contract claim alleging the Defendants refused to return funds in excess of those needed to operate under the agreements and that the refusal was a breach of the agreements. The Court found that it was being presented with a question of fact as to whether or not industry custom, applicable under Connecticut law, would support the Plaintiff’s interpretation of the dispute or not, a question which was inappropriate for resolution on a motion to dismiss.
Count IV of the complaint alleged a breach of the implied covenant of good faith and fair dealing. The Court held that bad faith was a question of fact and reviewing the complaint in the light most favorable to the Plaintiff, bad faith would be inferred. The Court found that allegations in the complaint inferred that the Defendants knew that the funds belonged to the Plaintiff, but improperly withheld the funds. These allegations produced an inference that supported the claim for breach of covenant of good faith and fair dealing.
Reviewing Counts V and VI of the complaint, which alleged a fraudulent transfer under §544 and applicable state law, the Court found that both counts would be dismissed with leave to amend the complaint within 30 days. The Court found that the Plaintiff appeared to allege that the transfer was the draw on the letter of credit and also implied that it was prepared to argue that the transfer was the pledge by the debtor of the collateral to the bank.
The Court found the touchstone of the fraudulent transfer analysis to be whether the transfer was the draw on the letter of credit or the pledge of the collateral by the debtor to the bank. The Court also found this inquiry important from the standpoint of determining the operative dates for the statute of limitations and the dates by which to determine insolvency and reasonable equivalence. The Court further found that affidavits and factual representations in the Plaintiff’s brief were not adequate to identify what transfers were at issue.
Finally, the Court then turned to Count VII of the complaint, which the Court held stated a claim for unjust enrichment.
The Court rejected arguments by the Defendants that Count VII failed to state a claim because the complaint indicated that an express contract covered the disputed subject matter. The Court noted that Federal Rule of Civil Procedure 8(e)(2) authorized a Plaintiff to plead inconsistent theories in the alternative.
Furthermore, the Court was not persuaded by the Defendants’ argument that the count focused on the proceeds of the letter of credit, which were not property of the estate, because the estate has a recognized interest in the contractual and equitable claims of the debtor which is property of the estate. A theory of unjust enrichment did not violate the independence principle any more than a breach of contract claim. The Defendants also argued that the Plaintiff would not be able to meet the three requirements of unjust enrichment. The Court stated, however, that the issue in reviewing a motion to dismiss was not whether a Plaintiff will ultimately prevail, but whether there is enough presented to allow the claimant to offer evidence to support the claim. The Court further held that unjust enrichment is a broad and flexible equitable doctrine, which is highly fact-intensive. The Plaintiff’s claim that the agreement did not cover the excess funds, the funds held by the Defendants clearly exceeded the amount of any possible liability of the Plaintiff, and that the excess held by the Defendants was earning interest for the Defendants at the expense of the Plaintiffs, all supported an unjust enrichment claim.
Thus, the Court granted the Defendants’ motion to dismiss with respect to Counts I, II, V and VI, but denied it with respect to Counts II, IV and VII and allowed the Plaintiff leave to file an amended complaint to properly identify the transfers at issue in Counts V and VI.
