Graham Square, Inc., In re, s. 96-4003

Citation126 F.3d 823
Decision Date17 October 1997
Docket NumberNos. 96-4003,96-4080,s. 96-4003
Parties, Bankr. L. Rep. P 77,507, 33 UCC Rep.Serv.2d 883 In re: GRAHAM SQUARE, INC., Debtor. Michael DEMCZYK, Trustee, Appellant/Cross-Appellee, v. The MUTUAL LIFE INSURANCE COMPANY OF NEW YORK, Appellee/Cross-Appellant.
CourtUnited States Courts of Appeals. United States Court of Appeals (6th Circuit)

Kenneth L. Gibson (argued and briefed), Weick, Gibson & Lowry, Cuyahoga Falls, OH, for Appellant/Cross-Appellee.

Stephen L. Black (argued and briefed), Graydon, Head & Ritchey, Cincinnati, OH, for Appellee/Cross-Appellant.

Before: MARTIN, Chief Judge; RYAN and GIBSON, * Circuit Judges.

OPINION

RYAN, Circuit Judge.

The plaintiff, Michael Demczyk, a trustee in bankruptcy, appeals the district court's judgment that the trustee could not recover the proceeds of a letter of credit. The defendant, The Mutual Life Insurance Company of New York (MONY), a creditor, cross-appeals the district court's order remanding to the bankruptcy court for a recalculation of MONY's losses.

The trustee claims the district court erred in holding that the trustee had no right to recover a deposit made pursuant to contract, because the deposit was made via a standby letter of credit and that recovery was precluded by the doctrine of "independence." The trustee also claims the court erred in holding that the proceeds from the letter of credit were not property of the bankrupt estate, and thus not recoverable by the trustee. MONY argues in its cross-appeal that the court erred in remanding the cases to the bankruptcy court for a recalculation of MONY's damages.

For the reasons that follow, we will reverse in part and affirm in part.

I.

Before filing in bankruptcy, Graham Square, Inc., sought $8,300,000 in financing from MONY for completion of a building project. MONY and the debtor, Graham, executed a loan application that obligated the debtor to pay to MONY a refundable loan commitment fee of $332,000 either in cash, or via a standby letter of credit. The debtor contacted his local bank, nonparty Union National Bank (UNB), and arranged for UNB to open a letter of credit in MONY's favor. MONY subsequently approved a loan for $7,800,000. For various reasons, the debtor was unable to consummate the loan agreement, even after several extensions of the closing date. Pursuant to the terms of the loan application, MONY then presented a draft to UNB for payment of the loan commitment fee against the letter of credit. UNB found the documents to be in order and paid the draft. Thereafter, the debtor filed for bankruptcy protection under chapter 11 and, as a debtor in possession, filed an adversary action under relevant bankruptcy code provisions seeking recovery of the commitment fee from MONY. Before trial, the debtor's bankruptcy petition was converted to a chapter 7 case and the trustee was substituted for the debtor as the plaintiff.

In its decision, the bankruptcy court assumed, without deciding, that the commitment fee clause was an impermissible penalty clause under Ohio contract law. Given that assumption, the court found that the fee was not recoverable, first, because the doctrine of "independence" prevented the trustee from recovering the commitment fee, and, second, because the fee was paid to MONY by letter of credit out of the property of UNB as principal and on behalf of the debtor, it did not, therefore, constitute property of the estate.

The district court affirmed the bankruptcy court's decision on slightly different grounds. That court held that there was no property of the debtor's for the trustee to recover; that is, that the funds transferred to MONY via the letter of credit had been distributed from the assets of UNB. The court held that since the mortgage given by the debtor to finance the letter of credit was worthless, nothing of value had been transferred from the estate and thus there was nothing to restore to the estate.

The trustee and MONY then filed this timely appeal and cross-appeal.

II.

We first examine whether the lower courts erred in holding that the trustee had no right to recover the commitment fee because the fee was paid via a standby letter of credit and recovery was precluded by the doctrine of independence.

Initially we note that subject-matter jurisdiction in these cases arises out of 28 U.S.C. § 158(d), and this appeal ultimately requires us to determine whether the fee is property of the estate pursuant to 11 U.S.C. § 542. To determine the extent of an estate's interest in property, we must look to property rights defined under state law. See Nobelman v. American Sav. Bank, 508 U.S. 324, 329, 113 S.Ct. 2106, 2110, 124 L.Ed.2d 228 (1993) (citing Butner v. United States, 440 U.S. 48, 54-55, 99 S.Ct. 914, 917-18, 59 L.Ed.2d 136 (1979)). It is not disputed that Ohio law governs. We review de novo the district court's determination of Ohio substantive law. J.C. Wyckoff & Assocs. v. Standard Fire Ins. Co., 936 F.2d 1474, 1483 (6th Cir.1991); see Salve Regina College v. Russell, 499 U.S. 225, 231, 111 S.Ct. 1217, 1221, 113 L.Ed.2d 190 (1991). Where the relevant state law is unsettled, we determine how we think the highest state court would rule if faced with the same case. Commissioner v. Bosch's Estate, 387 U.S. 456, 465, 87 S.Ct. 1776, 1782-83, 18 L.Ed.2d 886 (1967).

A letter of credit transaction comprises three separate contracts. The first arises from the underlying contract, ordinarily between a buyer and seller, and creates the basis for the letter of credit. That contract is represented in these cases by the financing agreement between the debtor (buyer) and MONY (seller). The second contract arises between the account party, here the debtor, and the bank issuing the letter of credit (UNB). The third contract arises between the issuing bank (UNB) and the beneficiary of the letter of credit, MONY.

The parties used an instrument known as a "standby" letter of credit. This document does not function the same as a commercial letter of credit in that the latter is used in a sale of goods transaction as a payment device, while the standby letter of credit is used in a nonsales transaction as a guarantee against default on contractual obligations. Gerald T. McLaughlin, Standby Letters of Credit and Penalty Clauses: An Unexpected Synergy, 43 OHIO ST. L.J. 1, 6 (1982). It is well established that once a beneficiary complies with the terms of the letter of credit, an account party may not prevent the issuing bank from distributing the proceeds of the letter of credit, absent fraud in the underlying contract. Banque Paribas v. Hamilton Indus. Int'l, Inc., 767 F.2d 380, 385 (7th Cir.1985). The doctrine of independence recognizes this principle, and requires that a letter of credit be kept separate from the underlying contract that generates it. This "insulates the letter of credit from disputes over performance of collateral agreements and allows the letter of credit to function as a swift and certain payment mechanism." Gerald T. McLaughlin, Letters of Credit and Illegal Contracts: The Limits of the Independence Principle, 49 OHIO ST. L.J. 1197, 1197 (1989); JOHN F. DOLAN, THE LAW OF LETTERS OF CREDIT: COMMERCIAL AND STANDBY CREDITS § 2.09 (2d ed.1991). Critically, and of great importance here, the doctrine of independence protects only the distribution of the proceeds of the letter of credit. It prohibits an attack on the issuing bank's distribution to the beneficiary and does not address claims respecting the underlying contract. In these cases the trustee has not challenged the distribution of the proceeds by UNB, but instead, has challenged MONY's right to retain the commitment fee and has brought an action on the underlying contract between the debtor and MONY.

While the fee was paid through the vehicle of a standby letter of credit, and may thus be considered "proceeds" of the letter of credit, it is significant that MONY has already received those funds. It is one thing to attempt to prevent the distribution of the proceeds of a letter of credit, an attempt the doctrine of independence is designed to prevent; but it is quite another to bring an action on the underlying contract that created the letter of credit.

If the debtor had paid MONY the commitment fee in cash, the debtor could seek a refund by challenging the fee provision in the underlying contract as an illegal penalty. All of MONY's arguments aside, there is no principled reason for allowing a challenge to the underlying contract when the fee is paid in cash, and not allowing such a challenge after the fee is paid via a standby letter of credit. In other words, challenging the distribution of the proceeds of a letter of credit is different than challenging the underlying contract. The ultimate result may be the same (refund of the fee), but in one case the method of recovery is permissible and in the other it is barred.

We hold that the doctrine of independence does not apply to this case, and the lower courts erred in so holding.

III.

The bankruptcy court also assumed, without deciding, that the commitment fee clause was an impermissible penalty clause under Ohio's law on contracts. We think the court erred in that assumption. Because the district court did not correct the error, and because our ultimate decision is to reverse and remand this case, it is appropriate to explain why the commitment fee provision is not a penalty clause.

As a general rule in Ohio, parties are free to enter into contracts that contain provisions which apportion damages in the event of default:

The right to contract freely with the expectation that the contract shall endure according to its terms is as fundamental to our society as the right to write and to speak without restraint. Responsibility for the exercise, however improvident, of that right is one of the roots of its preservation.

Blount v. Smith, 12 Ohio St.2d 41, 231 N.E.2d...

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