Letters of Credit in General
April 26, 2022
Nature, Purpose and History of Letters of Credit
Our topic in this post is about Letters of Credit in general. But first, a little side note. There was recently a fire alarm in our 19 story office building (false alarm by the way) and the alarm sound and recorded announcement that goes with it was blaring right outside my office door. The announcement advised to wait for further instructions. But the same alarm kept repeating – continuously. I tried some headphones to no avail. I tried the bathroom, but turns out there is a speaker in there too. I tried wadding up toilet paper in my ears, to no avail. All of this was to avoid the walk down 18 flights of stairs, because once the alarm sounds the elevators stop working. Still more non-stop blaring, I had no choice but to take the stairs or risk insanity. Of course, there was a speaker on every landing in the stair well all the way down. It took three days for my legs to stop hurting. Now on to our topic.
A letter of credit is typically defined as an engagement by an issuer made at the request of a customer for a fee to honor a beneficiary’s draft or other demands for payment to the satisfaction of the conditions set forth in the letter of credit. Some of the basic nomenclature of letters of credit in the context of suretyship are that the “customer” or the “applicant” would be the principal under the bond; the “issuer” of the letter of credit would be the bank; the “beneficiary” under the letter of credit in the suretyship context would be, of course, the surety.
The primary purpose of a letter of credit historically was to facilitate commercial transactions by assuring the beneficiary of a letter of credit that they would get payment. Letters of credit were initially used in international transactions when the seller was not sure of the credit worthiness of the buyer. Accordingly, to satisfy the seller, the buyer would get a letter of credit from a bank and the seller deliver the goods and get payment from the bank under the letter of credit. More recently, the use of the letter of credit has changed to what is known as a “standby letter of credit.” The purpose of that form of letter of credit is really to act as a type of a guaranty. It serves to shift the risk of loss from the beneficiary under the letter of credit (the surety in our case) to the issuer – the bank, in the event that the principal cannot pay.
The Independence Principle
A letter of credit is the product of three separate transactions, and it’s helpful to look at it that way. As one court described it – the three legs of a tripod. The first transaction is that the principal request bonds from the surety and the surety demands as a part of its underwriting that a letter of credit be provided along with the indemnity agreement, etc. The second transaction is that the principal then requests the issuance of a letter of credit from the bank. The bank will issue a letter of credit after it obtains a fee for doing so and usually some collateral or security from the principal. The third transaction is the bank issuing the letter of credit to the surety with the surety as the beneficiary of the letter of credit. The linchpin or unique feature of a letter of credit that makes it a preferred form of collateral is something referred to as the “independence principle.”
The independence principle holds that each of those three underlying transactions that I just noted are actually independent and separate from each other. The issuance of a letter of credit is completely separate and independent from the underlying transaction between the principal and the surety. The bank, the issuer of the letter of credit, is pledging its own credit and its own assets in the letter of credit to the beneficiary, regardless of what transpires in the underlying transaction between the principal and the surety. The bank is paying out its own money, regardless of whether the principal can reimburse it, or if any of the security or collateral that the bank got from the principal in exchange for issuing the letter of credit turns out to be worthless. If the bank can’t recover from its security or collateral, that’s too bad because the bank still has to pay on the letter of credit. The bank’s obligation under the letter of credit transaction is independent and separate from the underlying transactions of the others.
The Benefits of Letters of Credit as Collateral
Because of the independence principle and its universally accepted and enforced application to letters of credit, it is almost uniformly held that a letter of credit is not property of the bankruptcy estate, should the principal go into bankruptcy. This makes a letter of credit a very unique and desirable form of collateral. Any other type or form of collateral would likely become property of the estate in the event of a bankruptcy. (We will do a subsequent blog post about letters of credit in bankruptcy.) Some other factors that make letters of credit the most desirable form of collateral include:
- Letters of credit are essentially a liquid form of collateral. In other words, you go to the bank that issued the letter of credit and make your demand, you get your money. That’s about as liquid as you can be short of cash.
- Letters of credit have a fixed value, so there’s no variation with the market. Real estate, stocks, bonds, those kinds of assets are constantly fluctuating in value. Letters of credits have are issued in fixed amounts and that amount is what you get.
- Letters of credit are easy to perfect a security interest in; you simply have to be the holder of the letter of credit and be the beneficiary of the letter of credit. If you are, then you “control” the letter of credit and you have perfected your security interest.
- There are no transaction fees or costs with letters of credit. There is an initial fee that is paid by the principal, but if you want to draw on the letter of credit, there is no fee to get paid.
Clearly, letters of credit have a lot of advantages as a form of collateral. Letters of credit are also unique under the law. They are considered to be a “commercial specialty” and are governed by their own unique terms. Letters of credit have similarities with guarantees, they have similarities with negotiable instruments and contracts, but they are not fully any of those things. They are separate entities unto themselves. Indeed, letters of credit have their own rules. Article 5 of the Uniform Commercial Code (“UCC”), governs letters of credits, assuming that that’s been adopted in your jurisdiction. There are also generally accepted customs and practices that have been set forth in a document called the UCP 600. That is a document created by the International Chamber of Commerce, which, while not having the effect of law, the UCP 600 is often incorporated into letters of credit and therefore, would have the force of contract. The UCP 600 can also be referred to as evidence for the custom and usage of letters of credit. Finally, letters of credit have, over the years, generated their own form of common law known as the “law merchant,” which has established a lot of the underlying rules and principles relating to letters of credit, as well. These well established rules and long history of case law give letters of credit more certainty and predictability.
Pay Attention to the Terms
When one is dealing with a letter of credit, you need to be careful in reviewing the terms, in particular paying close attention to two main issues. The first is the draw requirements on the letter of credit and the second is the termination or expiration provisions of the letter of credit. On the draw requirements, in order to draw on a letter of credit, the beneficiary must “strictly conform” to the requirements stated in the letter of credit. So, if you have to make your draw at a particular location during a particular time; if you have to have particular documents or make a specific representation, you have to be sure that you strictly comply with whatever the requirements are for making a draw on the letter of credit. The surety must be careful that it doesn’t have requirements in the letter of credit that cannot be met. Ideally, the surety should be able to draw on a letter of credit at any time, for any reason. The issuer’s role under the letter of credit is simply ministerial. It is to pay a draw on demand and to make sure that the demand conforms, and if it does, then it has the obligation to pay.
Of course, on the termination, you have to be careful about when that termination is and make sure that you either get the letter of credit renewed, if it’s not on an automatic renewal, or you get replacement collateral. Ideally, the letter of credit should be irrevocable and evergreen. If the issuer can elect not to renew the letter of credit, there must be a notice provision that will give a surety enough time to pursue alternatives.
The draw and termination terms can have drastic consequences. Consider this commone example: the letter of credit says that the surety can make a draw if it has incurred losses and the issuer can elect not to renew the letter of credit with thirty days notice. The principal goes into bankruptcy and shortly thereafter the issuer of the letter of credit provides notice that it will not be renewed. At this point the surety has not incurred any losses, but losses are on the horizon. The surety cannot draw down on the letter of credit without losses and cannot force the principal to provide a new letter of credit or other collateral because of the bankruptcy. The surety is then stripped of its collateral just as the losses start to pour in. The terms of the letter of credit do matter.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (email@example.com) or any member of the Surety and Fidelity Practice Group.
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