05/20/2011 – Defendant’s Motion to Dismiss filed in the National Sports Attraction, LLC Adversary Proceedings by Heisman Trophy Trust before Judge Drain in the Southern District of New York (Manhattan). On March 11, 2011, the Chapter 7 Trustee National Sports Attraction, LLC d/b/a Sports Museum of America d/b/a National Sports Museum and National Sports Museum Management, LLC (collectively, the “Debtor”) filed the Complaint seeking various forms of relief in connection with the Heisman Trust’s draw against a $750,000 letter of credit obtained by the Debtor and issued in favor of the Heisman Trust (the “LC”). The draw occurred on February 25, 2009 and approximatey 2 weeks later the Debtor’s filed Chapter 7.

The Chapter 7 Trustee’s claims included turnover and accounting under Section 542 of the Bankruptcy Code, avoidance and recovery as a fraudulent and/or preferential transfer under Sections 547, 548 and 550 of the Bankruptcy Code and New York Debtor & Creditor Law, and unjust enrichment and restitution under New York law. Defendant based its motion to dismiss on the failure of either the LC or the proceeds from the LC to be property of the Debtor’s estate under Section 541.

The Defendant’s legal arguments were concentrated in the following paragraphs of its brief:

The Complaint also seeks to compel turnover of the proceeds from the Signature LOC on the basis that those proceeds are property of the Debtors’ estates. See Compl., ¶ 28. Courts, however, have recognized the well-established rule of bankruptcy law that a letter of credit and the proceeds therefrom are not property of the debtor’s estate. In re M.J. Sales & Distributing Co., 25 B.R. 608 (Bankr. S.D.N.Y. 1982); see also Int’l Finance Corp. v. Kaiser Group Int’l, Inc. (In re Kaiser Group Int’l, Inc.), 399 F.3d 558, 566 (3d Cir. 2005); Matter of Compton Corp., 831 F.2d 586, 589-90 (5th Cir. 1987).

The law regarding letters of credit in bankruptcy was discussed in detail by the Honorable Peter J. Walsh in OHC Liquidation Trust v. Discover Re (In re Oakwood Homes Corp.), 342 B.R. 59, 67 (Bankr. D.Del. 2006). There, Judge Walsh noted:

A letter of credit comprises three separate contracts. The first generally arises between a buyer and a seller; here, the Debtor purchased insurance policies from the defendants. The second arises between the account party, here the Debtor, and the bank or issuer. … Finally the third contract arises between the issuer, … , and the beneficiaries of the letter of credit, the defendants.

The relationship between each pair of parties involved in a letter of credit transaction is entirely independent, although each relationship is necessary to support a letter of credit, somewhat like the three legs of a tripod. This rule is predicated on the letters of credit, whose purpose is to allow the beneficiary to draw on the money before obtaining a judgment. This [independence] 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.

In light of the fact that each of these three relationships is independent, it is ‘well established’ that a letter of credit and the proceeds therefrom are not property of the debtor’s estate.

The United States Court of Appeals for the Fifth Circuit similarly has held that proceeds of a letter of credit posted by a debtor are not property of the debtor’s estate. Matter of Compton Corp., 831 F.2d at 586, 589-90 (5th Cir. 1987). In that case, the Fifth Circuit specifically held:

It is well established that a letter of credit and the proceeds therefrom are not property of the debtor’s estate under 11 U.S.C. § 541. When the issuer honors a proper draft under a letter of credit, it does so from its own assets and not from the assets of its customer who caused the letter of credit to be issued. As a result, the bankruptcy trustee is not entitled to enjoin a post petition payment of funds under a letter of credit from the issuer to the beneficiary, because such a payment is not a transfer of the debtor’s property.

Based on that authority, it is clear that when Signature Bank paid the proceeds from the Signature LOC to the Heisman Trust, it used its own property to make those payments and not property of the Debtors’ estates. Because the proceeds of the Signature LOC are not property of the estate under Section 541 of the Bankruptcy Code, they are not recoverable under
Section 542.