The Prime Motor Inns landmark letter-of-credit case last month was decided in favor of bondholders, clearing the way for draws on six letters of credit and for investors to recover their principal.
The tax-exempt bonds last year became the object of a turf battle between bankruptcy law and bond law. After Prime Motor Inns filed for bankruptcy in Florida, the judge held that letter-of-credit draws violated the Bankruptcy Code, which upset the bond law presumption that letters of credit were safe from Chapter 11 proceedings.
But thanks to a July 30, 1991, U.S. District Court decision, the stay of funds distribution was reversed and bondholders can expect to recover their principal investments.
"it's a real vindication," said Dennis O'Grady, counsel for trustee First Fidelity Bank and a lawyer with Riker, Danzig, Scherer, Hyland & Perretti. "For anyone who continues to structure their deals this way, then the court will ultimately uphold the reliability of the structure."
The only factor standing in the way of successful acceleration is an appeal of the decision by Prime Motor's attorneys, who were not available for comment on Friday. Prime Motor has until this Friday to file an appeal, but Mr. O'Grady thought such a move unlikely.
"We have no reason to believe that such an appeal will be filed," he said. "They have not given me any indication of such a move."
Municipal market participants, particularly letter-of-credit providers and purchasers of short-term debt, held their breath over the Prime Motor Inns case. Suddenly, a case involving $18 million of debt issued seven to nine years ago was jeopardizing a $13 billion-a-year marketplace.
The letter-of-credit industry was aghast. If the Bankruptcy Code had precedent over letter-of-credit draws, then letters of credit were essentially worthless in a bankruptcy situation. The credit quality of the transactions, furthermore, would be only that the borrower's ability to stay solvent. It would not matter which bank provided the "enhancement."
Portfolio managers of tax-exempt money market funds, which hold enormous quantities of letter-of-credit backed securities, refused to believe the ruling would stand. The fund managers were especially concerned that the affected bonds could be deened "long-term" and thus ineligible investments according to money market prospectuses.
Prime Motor's attorneys last October claimed victory and expected to prevail on appeal. One of the points swaying Bankruptcy Judge A. Jay Cristol was that, since Prime Motor was continuing to make interest payments, no actual -- or monetary -- default had occurred. The bondholders were not injured, the lawyers argued, so other creditors should not suffer due to their claims.
The trustee banks -- First Fidelity and Manufacturers Hanover Trust Co. -- filed appeals based on the argument that the tax-exempt letters of credit were not transactions between Prime Motor Inns and any other parties. The letters of credit were contracts between the municipal issuers and the trustees, the bank's lawyers submitted. Judge Kenneth L. Ryskamp of the U.S. District Court agreed.
In the July 30 ruling, Judge Ryskamp wrote: "A letter of credit is a separate contract, independent of the underlying obligations or transactions that give rise to its issuance ... Strict adherence to this principle is necessary to protect the integrity of letters of credit as a valuable commercial tool."
Lawyers for Prime Motor, according to court documents, countered that determining the issuing authorities to be the actual bond obligors "would exalt form over substance," since the hotel chain would actually be paying off the bonds. Also, the draws and subsequent claims on the hotel chain by the trustees still would materially drain Prime Motor's assets, the counsel pointed out.
The observation of "form over substance" actually lends rare insight into the heart of certain municipal financing practices. Thousands of issuing agencies nationwide are little more than conduits of tax-exempt financing, and presiding officials wash their hands of a borrowing even before the last bond is sold.
But Judge Ryskamp, to the relief of the entire tax-exempt market, stuck to the narrow interpretation of the bond sale itself. Prime Motor was a beneficiary of the enhanced transaction, not a party to it. The judge pulled the matter out of the bankruptcy court's consideration, finding that the contractual obligation to draw on the letters of credit occurred before, and outside of, the Bankruptcy Code's purview.
"The Bankruptcy Court," he wrote, "is not empowered to interfere with a contract between nondebtors because it perceives that carrying out the contract could adversely affect the estate."
In the end, the Prime Motor case boiled down to a matter of jurisdictions, with bankruptcy law going head-to-head with commercial law. Commercial law and the viability of letters of credit won a clear victory.
Mr. O'Grady of Riker Danzig said the decision should provide a much-needed precedent in a previously fuzzy area. "Prior to this, lawyers in the community were relying on their own analysis. Now there's case law," he said.
The funds will not be distributed until after the 30-day appeal period expires this Friday, Mr. O'Grady added.
Richard Klein, the counsel at Wilkie Farr & Gallagher who would file an appeal on behalf of Prime Motor, is on vacation this week, according to colleagues at the law firm.