The recent ruling by the U.S. Court of Appeals for the 7th Circuit in Hoosier Energy Rural Elec. Coop. Inc. v. Hancock Life Ins. Co., 582 F.3d 721 (7th Cir. 2009), affirmed a decision by the Southern District of Indiana, applying New York law, to enjoin payment under a credit-default swap. The district court’s injunction protected a plaintiff that was not party to the swap agreement but allegedly would have been harmed by the payment. If extended, the Hoosier Energy precedent may become a tool for nonparties to stay payment under credit-default swaps or letters of credit until related contract disputes are resolved.

A traditional standby letter of credit (L.C.) involves three parties: the bank, the bank’s customer and the beneficiary. The bank contracts with the beneficiary on one side, providing that the bank will pay the beneficiary if the beneficiary makes a conforming request for payment. On the other side, the bank contracts with the customer to pay the bank in the event that the beneficiary draws on the letter of credit. The bank’s agreements with the beneficiary and the customer are independent. Kellogg v. Blue Quail Energy Inc. (In re Compton Corp.), 831 F.2d 586, 590 (5th Cir. 1987), reh’g granted, 835 F.2d 584 (5th Cir. 1988).

In the event of a conforming draw, the bank is obligated to pay the beneficiary, and if the beneficiary’s draw is inconsistent with the underlying agreement, the customer may recover the payment from the beneficiary. See, e.g., N.Y. U.C.C. § 5-109 cmt. n.1 (Consol. 2010). Conversely, if the bank’s customer goes bankrupt, the bank’s obligation to the beneficiary remains. In re Compton Corp., 831 F.2d at 590.

A credit-default swap (CDS) is another mechanism to assure payment as a means to hedge against contractually specified contingencies. Typically, counterparties to a CDS trade the risk of a third party’s credit default or decline in value in exchange for periodic payments. Like an L.C., a CDS conveys risk from one party to another. (In its Hoosier Energy pleadings, Hancock described its CDS as “essentially a letter of credit.” Hancock’s Memorandum of Law In Opposition to Hoosier’s Motion for a Preliminary Injunction [Docket No. 16] at 16, n.11 Hoosier Energy, No. 08-CV-0156 (S.D. Ind.; Hamilton, J.).


Hoosier Energy involved three parties: Hoosier Energy, John Hancock Life Insur­ance Co. and AMBAC Assurance Corp. Hoosier, a power company, agreed to sell a power plant to Hancock and lease the property back. To avoid the risk of Hoosier filing for bankruptcy and rejecting the lease agreement, Hancock negotiated for security in the form of a CDS (an International Swaps and Derivatives Association master agreement between Hancock and AMBAC) as well as a surety bond with AMBAC. Under both the CDS and the surety, AMBAC would make payment of $120 million to Hancock under certain specified conditions. Through a separate agreement, Hoosier pledged substantial assets to AMBAC to secure its obligation to AMBAC in the event that AMBAC became liable under the CDS. The assets posted by Hoosier covered most but not all of AMBAC’s potential liability to Hancock.

Under the swap agreement, one of the contingencies that triggered AMBAC’s obligation to pay was the downgrade of AMBAC’s credit rating below a specified threshold level if Hoosier could not find a qualified replacement within 60 days.

During the 2008 credit crisis, AMBAC’s rating fell below the threshold. Hancock demanded that Hoosier find a qualified replacement for AMBAC. Hoosier could not find a replacement within 60 days and received a 60-day extension. After Hoosier failed to replace AMBAC within 120 days, Hancock demanded payment from AMBAC on the CDS. AMBAC recognized its obligation under the CDS and indicated that it was ready, willing and able to make the payment to Hancock. To prevent AMBAC from paying Hancock, Hoosier filed a lawsuit seeking an injunction.

Hoosier sought to enjoin AMBAC from paying Hancock because, due to economic circumstances, Hoosier could not find a party willing to replace AMBAC. Hoosier asserted that the doctrine of “temporary commercial impracticability” provided a legal basis for the court to issue an injunction, thereby allowing Hoosier to defer finding a replacement CDS provider until economic circumstances made it practical to do so. Hoosier also argued that the credit-default swap was, in effect, an abusive tax shelter and could not be enforced. After the case was removed from state court, the district court found both arguments persuasive enough to justify a preliminary injunction. Hoosier Energy, 588 F. Supp 2d 919 (S.D. Ind. 2008), aff’d, 582 F.3d 721 (7th Cir. 2009).

The 7th Circuit upheld the district court’s preliminary injunction on interlocutory appeal. Although the circuit court dismissed Hoosier’s tax shelter argument, it found that Hoosier had established some prospect of prevailing on the merits of the claim of “temporary commercial impracticality,” justifying the district court’s issuance of a preliminary injunction.

Commercial impracticability is a contract law doctrine that excuses performance under a contract if supervening events dramatically upset the expectations of the parties. The doctrine developed to avert circumstances in which unpredictable events outside of the control of the parties made performance under the contract either impossible or unduly burdensome. However, commercial impracticability is not an excuse if performance would simply cause financial difficulty or insolvency. Moreover, failing to make a payment does not constitute commercial impracticability. Therefore, hardship caused to either AMBAC or Hoosier did not factor in the circuit court’s decision.

AMBAC’s payment to Hancock could be stayed only if it were impracticable for Hoosier to perform a duty to replace AMBAC. The circuit court affirmed the district court’s grant of an injunction, finding that Hoosier could make out a plausible claim of impossibility, the New York law doctrine related to commercial impracticability. The circuit court held that the determination rested on two key considerations. To make out its claim, Hoosier had to show, first, that its obligation to replace AMBAC was a duty rather than an option and, second, that fulfilling that obligation was actually rendered impossible. Due to the ambiguity in the contract and facts suggesting that no replacement was available, the circuit court determined that both elements of Hoosier’s impossibility defense were sufficiently plausible to justify a preliminary injunction. Nevertheless, the circuit court imposed a time limit on the injunction such that, if Hoosier did not replace AMBAC within approximately a year, Hancock would be allowed to realize on its security.


Payment on an L.C. generally is considered independent from the underlying arrangement secured for which the L.C. provides security. Even bankruptcy, in which the bankruptcy automatic stay prohibits any act to obtain possession of the debtor’s assets or property, does not prevent a draw on a letter of credit related to a transaction with the debtor. See 11 U.S.C. 362(a)(3) and In re Compton Corp., 831 F.2d at 586. In fact, there appears to be no published cases in which an L.C. draw has been stayed on the basis of a contract dispute involving the underlying transaction.

L.C.s facilitate commercial transactions by allowing the beneficiary to rely on the creditworthiness of the bank rather than its contract counterparty. The bank’s guarantee of payment is substituted for the contract counterparty’s guarantee, which is in turn owed to the bank. The L.C. is intended to provide its beneficiary with the independent payment source. Courts have therefore consistently upheld the “independence principle” with respect to L.C.s, recognizing that allowing parties to enjoin L.C. draws with respect to every breach of contract claim would largely eliminate the usefulness of L.C.s and therefore adversely affect commerce. Frey & Son Inc. v. E.R. Sherburne Co., 184 N.Y.S. 661, 664 (N.Y. App. Div. 1920).

In Hoosier Energy, the courts declined to extend the “independence principle” to CDS agreements. The CDS between Hancock and AMBAC was purportedly separate from the underlying lease transaction between Hancock and Hoosier. The CDS purported to create “separate and independent obligations.” Hancock’s Memorandum of Law In Opposition to Hoosier’s Motion for a Preliminary Injunction [Docket No. 16] at 16, Hoosier Energy, No. 08-CV-0156 (S.D. Ind.; Hamilton, J.). Nevertheless, the circuit court rejected Hancock’s argument that Hoosier was not party to the CDS and lacked standing to complain. The circuit court found that it would “press legal fiction beyond the breaking point to say that the independent enforceability of each party’s promises to the others meant that any of the three parties lacked standing to complain about the acts of others that will produce an immediate, concrete injury.” Hoosier Energy, 582 F.3d at 725-26. Thus, the circuit court treated the CDS as one element of a much larger “three-party” transaction, subject to the contractual vagaries of the transaction as a whole, including Hoosier’s commercial-impracticability arguments.

The 7th Circuit opinion strikes at the heart of the “independence principle” and therefore at the basis for separating L.C.s from the underlying obligations for which they provide security. L.C. draws are independent because they are obligations only as between a bank and the recipient. L.C.s are, however, almost always nominally a separate contract but practically interrelated with the underlying transaction. Should courts begin to evaluate L.C.s as the circuit court evaluated the CDS in Hoosier Energy, numerous L.C.s and CDSs may be vulnerable to injunctions because they are not sufficiently “independent” from the transactions for which they provide security.

Shmuel Vasser and Bret Harper are, respectively, a partner and an associate in Dechert’s bankruptcy, business restructuring and reorganization practice in the New York office.

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