United States: Part I: Using Letters Of Credit As A Credit Enhancement Tool

Raymond Patella and Michael Viscount write:

This is the first of a three-part series on letters of credit by attorneys in Fox Rothschild's Financial Restructuring & Bankruptcy Practice. In Part I, we focus on the advantages of letters of credit as a credit enhancement tool.

A letter of credit is a useful tool in commercial transactions in which a bank guarantees that one of the parties will meet its obligations — either that a buyer's payment to a seller will be received on time and for the correct amount or that a seller will deliver the goods or services according to the agreed-upon terms. Essentially, it is a method of shifting the credit risk from the customer to the financial institution issuing the letter of credit.

There are two types of letters of credit — "direct pay" and "stand-by."

Direct pay letters of credit, which are also commonly called commercial or documentary letters of credit, are used mostly in international sales. To illustrate, assume a buyer in New York wants to buy furniture from a seller in Germany. Because the German seller does not want to sell on open credit and the New York buyer does not want to pay the seller in advance, the seller (the beneficiary) would insist that the buyer (the applicant) produce a commercial letter of credit (LC) issued by a bank (the issuer) showing the seller as the beneficiary with the right to draw upon money (or the draft) on the issuing bank directly, rather than the New York buyer.

How does this work?

The New York buyer applies for an LC which commits a bank to pay money to the German seller upon the seller's presentation of certain documents that are outlined in the LC. These documents generally describe the goods in accordance with the LC or include an invoice, policy of insurance and/or certificate of inspection. Once the seller's documents comply with the LC, the bank would pay the seller.

The direct pay LC compels the bank to pay money to the seller, even if the buyer thinks the furniture is inferior and otherwise instructs the bank not to pay. After the bank pays the seller, the LC would force the New York buyer to pay the bank, even if the buyer might not be satisfied with the seller's goods. If the buyer is not satisfied with the furniture, then it would have to take legal action directly against the now fully paid seller.

By contrast, in a stand-by letter of credit, the beneficiary uses the LC to secure the performance of its customer rather than to obtain a direct payment for the customer's obligation. This is the type of LC that credit professionals typically use for domestic business. Stand-by LCs function somewhat like collateral because it is the applicant's default on its obligations that prompts the beneficiary to draw on the LC.

To illustrate, assume a customer agrees to pay for goods or services that the vendor provides. If the customer fails to pay, an event of default occurs under the customer/vendor contract. This event of default should entitle the vendor to draw on the stand-by LC. According to the stand-by LC, the issuer-bank would pay the vendor/beneficiary when the bank receives a written statement certifying that the applicant-customer failed to pay the vendor.

Basic Principles of Letters of Credit

An LC transaction is a three-party arrangement between the issuer (generally a bank), the applicant (a customer) and the beneficiary (the vendor). First is the relationship between the applicant and the issuer. This usually entails a reimbursement obligation between the issuer and the applicant requiring that the applicant reimburse the issuer for payments made on the LC to the beneficiary. Second is the relationship between the applicant and the beneficiary, and finally is the relationship between the issuer and the beneficiary. This third relationship is reflected in the LC itself, which is the undertaking between the issuer and the beneficiary.

The uniqueness of an LC arrangement is the independence principle — a rule of credit law that is central to understanding the importance of LCs. The principle states that the issuer's obligation to the beneficiary is independent of the beneficiary's performance on the underlying contract. In other words, the issuer should pay on a proper demand from the beneficiary even though the beneficiary might have breached the underlying contract with the applicant.

The issuer's obligation to pay the beneficiary is independent of the applicant's obligation to its issuer. For example, if the applicant goes into bankruptcy after the bank issues the LC, but before the beneficiary draws upon the LC, the issuer should pay even though the applicant may not be able to pay or reimburse the issuer.

The LC beneficiary is obligated to present conforming drafts or documents. Once the beneficiary does that, the issuer must honor the draft or demand for payment. However, the issuer should deny payment if the beneficiary does not present the proper documents/drafts to the issuer. Determining whether the documents the beneficiary submitted comply with the LC, however, is not always clear. The drafters of the Uniform Commercial Code (UCC) deliberately left this matter for the courts and industry to sort out in practice.

Two standards of compliance exist. One is the strict compliance standard, which holds that the beneficiary should comply strictly with the terms of the credit and that any failure to conform excuses the issuer from its duty to honor the beneficiary's payment demand. The other standard is substantial compliance, which requires the issuer to pay if the beneficiary's documents substantially or reasonably comply with the LC.

The majority of court rulings have favored the strict compliance standard. To avoid a problem situation with the issuing bank, the LC should be simple and clear on its face and the draft should track the language of the LC.

In Part II, we will explore LCs' use as collateral in bankruptcy proceedings. Part III concludes the series with an outline of important fraud exceptions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.