Letters of credit provide a valuable function in commercial contracting, serving to secure a party’s performance under the terms of the contract. For example, in the leasing context, a landlord may require a tenant to provide a letter of credit to secure the payment of rent. The tenant will arrange for a letter of credit to be issued, typically by a bank. Under the terms of the letter of credit, the landlord may request payment under the letter directly from the issuer, and subject to narrow exceptions, the issuer must honor the request. The funds are provided by the issuer — not the tenant. Thus, the risk of insolvency of the tenant (or other financial hardships) is transferred from the landlord to the issuer. However, what happens to the letter of credit proceeds when the issuer is reimbursed by the proceeds of a company that is under receivership pursuant to Chapter 128 of Wisconsin Statutes? Does the receiver have a claim on the proceeds paid to the landlord?

In Admanco, Inc. v. 700 Stanton Drive, LLC, et al.[1], the Wisconsin Supreme Court decided this issue, holding that the proceeds of a letter of credit are not part of debtor’s estate, and therefore, are beyond the reach of the receiver. In the case at hand, Admanco and 700 Stanton Drive, LLC (“Stanton”) were parties to a sale-leaseback transaction. Under the agreement, Stanton purchased Admanco’s facility, and Admanco leased back the facility under a long-term lease. To secure Admanco’s performance under the lease, Admanco arranged for its lender to provide Stanton with two standby letters of credit totaling $750,000. If Admanco defaulted under the lease, Stanton was permitted to draw upon the letters. In December of 2004, a receiver was appointed for Admanco for the benefit of its creditors under Chapter 128 of the Wisconsin Statutes. In January of 2005, Admanco failed to pay rent, and Stanton drew down the two letters of credit.

The receiver for Admanco sued Stanton, seeking a return of the majority of the proceeds drawn under the letters of credit. The receiver claimed that because the issuer of the letters of credit was ultimately reimbursed for a portion of the draw out of the estate of Admanco, the proceeds — to the extent reimbursed by Admanco — were part of the debtor’s estate. As a part of the debtor’s estate, the receiver argued that Stanton’s claim was subject to the cap on a landlord’s claim as provided in Chapter 128, and Stanton must return any proceeds received in excess of that cap. The trial court ruled in Admanco’s favor. And in a published opinion, the Court of Appeals upheld the trial court’s decision affirming that the proceeds paid to Stanton were part of the debtor’s estate to the extent the issuer was reimbursed out of the debtor’s estate, and therefore, Stanton’s claim was subject to the statutory cap on recovery by a landlord.

The Wisconsin Supreme Court accepted Stanton’s petition to hear the case. In a 3-2 decision[2], the Supreme Court held that the proceeds of the letter of credit were not the property of Admanco, even though property of Admanco was used to reimburse the payment made by the issuer to Stanton. In reaching this conclusion, the Court relied on the “independence principle,” holding that the issuer’s obligation to pay under the letters of credit was separate and distinct from any agreements between the issuer and Admanco, refusing to equate the proceeds received by Stanton with the issuer’s security interest in debtor’s collateral. As the proceeds from the letters of credit were not part of the debtor’s estate, the cap imposed on claims of a landlord under Chapter 128 were not applicable.

The Supreme Court’s Admanco decision makes it clear that proceeds from a letter of credit, regardless of the interest an issuer of the letter might have in a debtor’s property, are not part of the debtor’s estate, and therefore, are outside of the purview of Chapter 128. This result reinforces the important role letters of credit play in commercial transactions in Wisconsin, allowing parties to secure contractual obligations without being concerned that a receiver of the company can recover the proceeds. While the independence principle has been vindicated under Wisconsin law, its applicability under the Federal Bankruptcy Code is the subject of disagreement between the Federal Circuit courts.