Fundamentals of Commercial and Standby Letters of Credit
Sellers of goods that want assurance of payment, purchasers of services from contractors that want financial assurance of their contractors’ performance, lenders that want assurance that their loans will be repaid, borrowers that want to obtain loans at more favorable rates of interest all often use letters of credit to achieve their goals.
A letter of credit is an undertaking, usually on the part of a bank (the “issuer”) at the request of one of its customers, to pay a named beneficiary a specified amount of money if the beneficiary presents documents in accordance with the conditions specified in the letter of credit. Fundamental to a letter of credit transaction is that the undertaking of the issuer is independent of the obligations between its customer (the “account party”) and the beneficiary of the letter of credit, typically the account party’s vendor or lender.
There are two basic types of letters of credit. Commercial letters of credit are typically issued for the account of a purchaser and are intended to be drawn upon as the means of payment for the goods sold. Standby letters of credit are typically intended as security for the account party’s performance or payment obligations under its contract with the beneficiary, such as a performance bond, security deposit or security for a warranty or indemnification. Standby letters of credit are not expected to be drawn upon except in the case of a default or breach by the account party under its contract with beneficiary.
A third type of letter of credit is a hybrid: it is security and also intended to be drawn upon by the beneficiary. These direct pay standby letters of credit provide credit enhancement for debt obligations and are issued for the account of the borrower for the benefit of the lender or, in the case of a bond issue, the trustee for the bondholders. They provide the primary source of payment of the principal and interest on the debt and, in the case of bonds having a put option, a source of payment of the purchase price on the bonds which are put. Because the credit of the bank issuing the direct pay letter of credit is better than that of the borrower, the borrower is able to obtain a significantly lower interest rate.
All letters of credit set forth (a) the specific or maximum amount that may be drawn upon by the beneficiary and that the issuer will be obligated to honor upon a compliant presentation (the “stated amount”); (b) the date by which compliant documents must be presented (the “expiry date”), which may be automatically renewed for stated periods of time; and (c) a description of the documents and their contents to be presented (such as the seller/beneficiary’s invoice; transport bill of lading; insurance certificate; certificate of origin; and, in the case of direct pay letters of credit, the forms of the beneficiary’s certificates). The letter of credit will also state whether partial draws are permitted and whether amounts drawn permanently reduce the stated amount or may be reinstated. Letters of credit are irrevocable and are nontransferable unless the terms of the letter of credit otherwise provide. Nondocumentary conditions to a draw on a letter of credit are ignored. However, the letter of credit must be honored by the issuer according to its terms upon presentation of compliant documents prior to the expiry date.
There are three basic contracts involved in a letter of credit transaction: the contract between the account party (e.g., the purchaser of goods) and the beneficiary (e.g., the seller); the application and letter of credit agreement (the “LOC agreement”) between the issuer of the letter of credit and the account party; and the letter of credit itself between the issuer and the beneficiary. The contract between the account party and the beneficiary creates the payment or performance obligation, the payment of which or the security for the performance of which is provided by the letter of credit.
The LOC agreement obligates the issuer to issue the letter of credit on specified conditions and obligates the account party to reimburse the issuer for draws honored and interest on amounts not immediately reimbursed. It may also require the account party to secure its reimbursement obligation by a mortgage or security interest on its assets. The commercial LOC agreement is often a standardized form prepared by the bank’s letter of credit department and may have financial covenants that differ from the parties’ other more carefully negotiated loan documents. Therefore, it is very important that the account party carefully review the bank’s standardized form LOC agreement prior to its execution and determine which of the LOC agreement or the other negotiated loan documents control.
Last, there is the letter of credit itself, which obligates the issuer to honor draws on the letter of credit according to its terms upon presentation of compliant documents prior to the expiry date. The issuer’s obligation to honor draws is not dependent upon the beneficiary’s performance of its obligations under its contract with the account party. The independence principle requires that the issuer honor presentations that strictly comply with the requirements of the letter of credit prior to the expiry date. The account party may have a cause of action against the beneficiary for breach of the underlying contract, but that breach is not a basis for the issuer’s refusal to honor an otherwise compliant presentation.
In the United States, letters of credit are governed by Article 5 of the Uniform Commercial Code, which has been adopted in every state. Banks also incorporate the terms of one of two sets of standards of practice: UCP 600 (Uniform Customs and Practice for Documentary Credits published by the International Chamber of Commerce) or ISP98 (International Standby Practices published by the Institute of International Banking Law & Practice). UCP 600 is more appropriately used for commercial letters of credit and ISP98 for standby letters of credit, although some banks use UCP 600 for both types of letters of credit.
One of the significant differences between the two relates to the rules on transferability. These differences are of special importance to direct pay letters of credit provided as credit enhancement for bond issues because the beneficiaries of these types of letters of credit are corporate trustees that may change from time to time prior to the expiry date.
There are, of course, occasions when a letter of credit drawing is not paid: the letter of credit expired; the documents presented were not compliant; material fraud by the beneficiary upon the account party or the issuer; the letter of credit was issued during the preference period for an antecedent debt of the account party; or the insolvency of the issuer.
Presentation to the issuer of all documents that strictly comply with the requirements of the letter of credit must be made prior to the expiry date. The issuer has a reasonable time after presentation to honor or give notice of discrepancies. The limitations upon what is a “reasonable time” differ among UCC, UCP 600 and ISP98, ranging from seven calendar days to seven business days with a safe harbor of three business days under ISP98.
Strict compliance is required. If the documents are discrepant (e.g., if any of the documents are missing or if the letter of credit requires that the bill of lading refer to 15 red widgets and the bill of lading presented to the issuer states 14 red widgets or 15 blue widgets), the issuer will not honor the presentation. In that event, the issuer will notify the beneficiary of the dishonor and the beneficiary will have an opportunity to correct the discrepancies. However, presentation of compliant documents must be made prior to the expiry date. Since the issuer has a reasonable time to examine the presentation, it is recommended that the beneficiary present its draw and documents at least two weeks prior to the expiry date so that there is time to correct any discrepancies.
Studies have shown that more than 70 percent of initial document presentations are discrepant. Nevertheless, fewer than one percent of letters of credit fail to pay, either because the beneficiary cures the discrepancies or the account party waives the discrepancies.
A cardinal rule of bankruptcy law in the letter of credit context is that the proceeds of a letter of credit are not part of the estate of an insolvent account party. However, courts have held that the issuance of a letter of credit to secure or pay an antecedent debt of an insolvent account party during the preference period is a preference and the proceeds are recoverable from the beneficiary.
Letters of credit are usually the general, unsecured obligations of the issuing bank. They are not insured by the FDIC or other governmental agencies. If the bank becomes insolvent and its obligations are not assumed by another institution or governmental agency, then the beneficiary is a general, unsecured creditor of the failed institution.
Letters of credit are widely used. Beneficiaries and account parties who are not familiar with their terms and the customs surrounding their usage are advised to study the various agreements, including the letter of credit itself, before committing to apply for or accept one.