Financial Services Report Fall 1999

Bank Thinks it Issued a Guarantee, But Court Finds it Was a Letter of Credit

U.S. Supreme Court Decision Signals Shift in Lender's Bargaining Power

In June 1996, one-and-a-half years after Orange County declared bankruptcy, the County sued Standard & Poor's, a publisher and leading rating agency, claiming its 1993 and 1994 ratings of the County's notes and bonds were too high. The suit was one of many filed by Orange County seeking recovery of its investment losses; in addition to Standard & Poor's, Orange County sued broker-dealers, financial advisors, accountants, bond counsel and others. Orange County's theory against Standard & Poor's was that the ratings given to 11 of the County's debt issues in 1993 and 1994 were allegedly "too high," and allowed County Treasurer Robert Citron to pursue his risky investment strategy with the proceeds of those debt issues. Orange County's investment strategy, in turn, ultimately led to its financial meltdown in December 1994.

Orange County attempted to characterize Standard & Poor's as its advisor who could be held liable on the same basis as any other "financial professional." The County contended Standard & Poor's was liable for the consequences of allegedly erroneous "advice" in the form of ratings . including its bankruptcy and more than $1.8 billion in investment losses and damages.

Standard & Poor's vigorously challenged Orange County's charges on the grounds that Standard & Poor's . a publisher of ratings, commentary and other financial information . is not an advisor. While Standard & Poor's issues public finance ratings on request and for a fee, those same ratings are published in Standard & Poor's publications such as CreditWeek and CreditWire, its online service, and widely disseminated in the media. The securities markets look to Standard & Poor's published ratings as unbiased and independent opinions as to the likelihood that a particular debt will be repaid to investors.

In essence, Orange County's suit challenged the independent role of rating agencies . and that challenge was soundly defeated. In an April 21, 1999 ruling, the District Court Judge rejected Orange County's claims that the ratings were "financial advice" to the County and subject to ordinary negligence and breach of contract liability. Instead, the Court found that Standard & Poor's ratings were published speech on a matter of public concern and therefore protected by the First Amendment. The ratings could be the basis of liability only if Orange County proved by clear and convincing evidence that Standard & Poor's acted with "actual malice" . that is, knowledge that the ratings were false . or reckless disregard of their truth or falsity. This ruling established an extremely onerous burden for Orange County to meet in its attempt to recover damages from Standard & Poor's.

Following the District Court's ruling, the Ninth Circuit Court of Appeals refused to permit an expedited appeal and, in June 1999, Orange County agreed to dismiss its $2 billion-plus lawsuit against Standard & Poor's in exchange for the nominal sum of $140,000, namely, a partial refund of rating fees paid by Orange County during 1994.

The Orange County suit against Standard & Poor's is emblematic of the continuing efforts of plaintiffs in commercial litigation . and particularly securities litigation . to find new ways to expand the liability of professionals for losses due to allegedly defective disclosures and professional opinions. Orange County's attempt to add rating agencies to the list of defendants typically sued in such cases ultimately fell short because, as the District Court found, rating agencies do not . through their published ratings of debt . provide financial advice or services to the issuers of such debt. The result in the Orange County litigation against Standard & Poor's has clarified both the independence of rating agencies in the securities markets, and the role of ratings as protected speech under the First Amendment.

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BANK THINKS IT ISSUED A GUARANTEE, BUT MUST MAKE MILLION DOLLAR PAYMENT WHEN COURT FINDS IT IS A LETTER OF CREDIT
W. Toliver Besson & Reed Hamzeh, Summer Associate

The Court distinguished this case from Ninth Circuit and Texas appellate court cases that treated certain instruments entitled "letter of credit" as mere guaranty contracts. In those cases, the courts held that the instruments strayed too far from the basic purpose of letters of credit, namely "to assure payment cheaply by eliminating the need for the issuer to police the underlying contract." Teleport Communications Group, Inc., 176 F.3d at 414. The Court noted that the issuer must pay on a letter of credit if the proper documents are presented by the beneficiary, regardless of the status of the underlying contract between the customer and beneficiary. Id. The two cases the Court distinguished involved instruments that required the issuer-bank, in effect, to police the conduct of the beneficiary in performing the underlying contract between the beneficiary and the customer. See Wichita Eagle & Beacon Pub'l Co., Inc. v. Pacific Nat'l Bank of San Francisco, 943 F.2d 1285 (9th Cir. 1974) (instrument not letter of credit despite label because payment expressly conditioned on beneficiary's compliance with the terms of the underlying lease); Gunn-Olson-Stordahl Joint Venture v. Early Bank, 748 S.W. 2d 316 (Tex. App. 1988, writ denied) (instrument required issuer before paying to verify that beneficiary had factually performed on underlying contract).

The Court in Teleport Communications held that the fraud provision in the agreement before it was different because it could be construed to refer to the dealings between the beneficiary and the issuer as to the instrument, and not to the dealings between the beneficiary and the customer as to the underlying contract. The Court rejected the argument that the fraud provision required the issuer bank to police the underlying agreement between the beneficiary and customer. Instead, the Court found that the fraud provision in the instrument merely allowed the bank to refuse payment based on any fraudulent activity by the beneficiary in the presentation of a sight draft to the issuer. Thus, because the Court found that payment was conditioned only on the proper presentation of documents, the Court determined that the instrument was a letter of credit and thus, the bank was required to make payment in full to the beneficiary.

The Court further noted that if the bank and its customer were concerned about the ability of the beneficiary to perform on the underlying contract, they should have inserted clear language in the instrument conditioning payment on the satisfactory performance by the beneficiary, not on the absence of fraud. Such language would have required the issuer bank to police the underlying contract between its customer and the beneficiary, which would have prevented a finding that the instrument was a letter of credit. The case underscores the importance of careful drafting in the preparation of bank documents, and emphasizes that an instrument labeled a "letter of credit" is likely to be found to be a letter of credit if its ambiguous terms can be construed as consistent with the purpose of a letter of credit.

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U.S. SUPREME COURT DECISION SIGNALS SHIFT IN LENDER'S BARGAINING POWER
Daniel A. Sonenshine

The U.S. Supreme Court has armed senior creditors with a new weapon against debtors who default, file for relief under Chapter 11 and then attempt to unilaterally impose "cramdown" reorganization plans on their creditors. In a much anticipated decision, the U.S. Supreme Court severely limited the use of the new-value exception to the absolute-priority rule.

In Bank of America National Trust 203 North Lasalle Street Partnership, 119 S.Ct. 1411 (1999), the Court considered whether a debtor's prebankruptcy equity holders may be given the exclusive opportunity to contribute new capital and receive ownership interests in the reorganized entity, over the objections of a senior class of impaired creditors. The Court held plans that provide junior interest holders with the exclusive opportunity to own the reorganized entity . free from competition and without the benefit of market valuation . fail to satisfy the "absolute priority rule" under the Bankruptcy Code. Thus, debtors cannot infuse new capital in exchange for sole equity ownership in the reorganized entity without that same opportunity being offered simultaneously to the senior creditors.

The Bankruptcy Plan

Creditor Bank of America National Trust's $93 million loan to the debtor, 203 North Lasalle Street Partnership, was secured by a 15-floor office building in downtown Chicago. When the debtor defaulted and the bank began foreclosure proceedings in state court, the debtor filed a voluntary petition for relief under Chapter 11 . which had the immediate effect of staying the foreclosure proceedings. Because the value of the building was less than the balance due, the bank elected to divide its undersecured claim into secured and unsecured deficiency claims. Because the building was valued at $54.5 million, the unsecured deficiency was $38.5 million. While the debtor's plan called for the $54.5 million secured claim to be paid in full to the creditor over 7 to 10 years, the creditor would only receive 16 percent of the $38.5 million unsecured claim. However, in exchange for a contribution of $6.125 million in new capital over the course of five years, the debtor's equity partners would receive sole ownership of the reorganized debtor.

The Court held that this plan violated the "absolute priority" rule of Bankruptcy Code § 1129(b)(2)(B)(ii), which states that "the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property." Although the new value exception is not explicitly mentioned in the Code, the Court discussed lower court decisions that found the exception part of the "on account of" language in § 1129. The court considered various interpretations of the "on account of" language, ultimately deciding it meant either: (1) that junior claim holders could not retain their interests under a reorganization plan "because of" their status as junior claim holders; or (2) that reorganization plans had to reconcile the two recognized policies of Chapter 11, namely "preserving going concerns" and "maximizing property available to satisfy creditors." Ultimately, the Court did not decide between these two interpretations, instead ruling that the reorganization plan at issue failed to satisfy both. In other words, the Court viewed the "exclusive" opportunity to infuse new capital and retain the security as a property right that the junior equity holders possessed only "on account of" their status and thus are required to share with senior creditors.

What does this mean for senior lenders? The concurrence among legal commentators is that the decision is likely to result in a shift in bargaining leverage between borrowers and lenders. In particular, a borrower's threat of a bankruptcy filing may not carry nearly the same weight now that confirmation of a plan "cramming down" a secured lender's claim is unlikely unless creditors are given an opportunity to fairly compete for ownership of the reorganized debtor.

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