Elegant & Effective … Letters of Credit in Commercial Loans and Bankruptcy (Part 2 of 3)
For many years, letters of credit have been used to facilitate sales of goods and to provide credit enhancement for all kinds of contractual obligations. Despite the widespread use of letters of credit over the years, many view letters of credit as complicated and esoteric instruments. Part II of this series addresses security interests in letters of credit and the role of letters of credit in syndicated transactions. Part III of this article, which will appear in the October edition of ABF Journal, explores the treatment of letters of credit in bankruptcy.
Interplay Between Letters of Credit and Secured Transactions
Transfer of Letter of Credit Versus Assignment of Letter of Credit Proceeds — A secured party seeking to encumber a beneficiary’s rights in a letter of credit may either capture the beneficiary’s right to demand payment under the letter of credit or merely the beneficiary’s right to receive payment under the letter of credit if and when the beneficiary demands payment under the letter of credit. Both Article 5 of the UCC, which normally is the governing law for letters of credit issued in the United States, and Article 9 of the UCC, which is the governing law for secured transactions in the United States, distinguish between the “transfer” of a letter of credit and the “assignment of proceeds” of a letter of credit.
Under a transfer of a letter of credit, the transferee essentially becomes a substitute beneficiary, with the right to make draws directly under the letter of credit and to submit documents in its own name. Under §5-112(a) of the UCC, unless a letter of credit states that it is transferable, it may not be transferred. With an assignment of letter of credit proceeds, the assignee obtains just the right to receive proceeds of a draw on the letter of credit if and when the beneficiary makes a complying draw. The assignee is not entitled to make a draw directly or to submit documents in its own name. (See §5114 of the UCC).
Letter of Credit Rights — To help structure the general framework for dealing with security interests in letters of credit, Article 9 of the UCC uses the term “letter of credit right.” This term is defined as “a right to payment and performance under a letter of credit, whether or not the beneficiary has demanded or is at the time entitled to demand payment or performance.” (UCC §9-102(a)(51)). The definition specifically states that, “[t]he term does not include the right of a beneficiary to demand payment or performance under a letter of credit.” (UCC §9-102(a)(51)). Accordingly, a letter of credit right includes the right to receive payment from the issuer, confirmer or other nominated person only if and when the beneficiary makes a complying draw. The term does not include the right to draw under the letter of credit.
Supporting Obligations — Article 9 of the UCC utilizes the concept of a “supporting obligation,” which is defined as a “letter of credit right or secondary obligation that supports the payment or performance of an account, chattel paper, a document, a general intangible, an instrument or investment property.” (UCC §9-102(a)(77)). The general principle under Article 9 is that a security interest in items such as an account, chattel paper or a document automatically attaches to any related “supporting obligation.” (UCC §9-203(f)). Similarly, if the security interest in the underlying obligation is perfected, the security interest in the supporting obligation is automatically perfected. (UCC §9-308(d)).
Control — Article 9 also allows the attachment and perfection of a security interest in letter of credit rights by “control.” (UCC §9-203(b)(3)(D) and §9-314(a)). “Control” of letter of credit rights is defined under Article 9 as meaning that “the issuer or nominated person has consented to an assignment of proceeds of the letter of credit under §5-114(c) or otherwise applicable law or practice.” (UCC §9-107).
The concept of “control” is limited to the specific person giving the consent to the assignment. (UCC §9-102, comment 2). To be sure it has control in all circumstances, a secured party should obtain the consent of each of the issuer, any confirmer and any other nominated person. An issuer or nominated person need not recognize an assignment of proceeds of a letter of credit until it consents to the assignment (UCC §5-114(b)).
Priority — Section 9-329 of the UCC governs the priority of conflicting security interests in letter of credit rights by “control.” Section 9-329 provides that a secured party with “control” over letter of credit rights has priority over a secured party with a perfected security interest in letter of credit rights solely as a supporting obligation. An important exception to the priority of the security interest in letter of credit rights perfected by “control” is that the interest of a transferee beneficiary will trump the security interest of the beneficiary’s secured creditors in the proceeds of a letter of credit. (UCC §5-118). Accordingly, secured parties may seek to become transferee beneficiaries, particularly with regard to large dollar letters of credit.
Enforcement Rights — An additional benefit to achieving perfection of a security interest in letter of credit rights by “control” is the right to enforce direct payment against the issuer. To enforce direct payment against the issuer, the secured party must obtain the consent of the issuer to the assignment. (UCC §5-114(c), §9-107 and §9-409). Consent of the issuer does not need to be obtained if the secured party merely perfects its security interest in letter of credit rights as a supporting obligation.
Letters of Credit in Syndicated Credit Facilities
Multiple Loans But Single Letter of Credit — In syndicated credit facilities, the issuance of letters of credit is treated differently from the mechanics of making loans. Whereas all lenders in the syndicate normally are required to fund their pro rata share of a requested loan, having separate letters of credit issued on a pro rata basis is usually not feasible. The beneficiary normally is not interested in dealing with multiple letters of credit from several different lenders when one letter of credit will suffice. The beneficiary might also have requirements for the creditworthiness, expertise or location of the issuing lenders, and not all the lenders in the syndicate will necessarily meet these standards. Accordingly, there usually will be only one letter of credit and one issuer when the borrower requests the issuance of a letter of credit under a syndicated credit facility.
Communication With the Issuer — If the administrative agent is not the issuer of the letter of credit, the borrower normally is free to communicate directly with the issuer to arrange the details of the letter of credit. In this scenario, the issuer will need to notify the agent of the amount of the letter of credit and the proposed issuance date so that the agent may confirm that the issuance of the proposed letter of credit would not cause the borrower to exceed any of the applicable restrictions under the credit agreement (e.g., the borrowing base, the letter of credit sublimit, the overall commitment limit, the expiry date limit, etc.).
Purchase of Risk Participations — The issuer is liable to the beneficiary for the full amount of the letter of credit. Until the beneficiary makes a complying draw, this liability is contingent. The issuer also receives a contingent asset, in the form of the applicant’s reimbursement obligation. To spread the risk among the other syndicate members and to remove a portion of the asset and liability from the issuer’s calculation of lending limits, capital adequacy and other regulatory restrictions, the credit agreement normally provides that each syndicate member is deemed, upon the issuance of the letter of credit, to purchase a pro rata risk participation in the letter of credit. This risk participation also entitles the syndicate member to an offsetting pro rata right of reimbursement from the borrower.
Funding of Draws Under the Letter of Credit — When the issuer honors a draw under a letter of credit, there are several reimbursement alternatives. First, each lender can fund its pro rata share of the draw to the issuer and then seek reimbursement from the borrower. A more efficient alternative is for the issuer to seek reimbursement from the borrower and if the borrower fails to pay, each lender must fund its pro rata share of the draw. A third common alternative is for the credit agreement to provide that the issuer’s payment under a letter of credit triggers a loan from the lenders to the borrower. The last alternative is problematic if the borrower is in bankruptcy, as the Bankruptcy Code considers caution against the making of loans to the borrower. In the bankruptcy scenario, the credit agreement should provide that loans will not be made and that any draw not immediately reimbursed by the borrower will trigger the obligation of each lender to fund its pro rata share of the draw.
Sharing of Fees and Other Payments
- Interest on Reimbursement Obligations. If a draw is made and the borrower does not immediately reimburse the issuer, interest will accrue on the borrower’s reimbursement obligation. This interest is shared pro rata among the issuer and the other lenders (perhaps with some small skim in favor of the issuer).
- Letter of Credit Fees. Since commissions for the issuance of letters of credit are similar to commitment fees on loan commitments, letter of credit commissions normally are shared pro rata among the issuer and the other lenders. Negotiation, amendment, transfer and other processing fees, however, are not usually shared with the lenders as these reimburse the issuer for its staff time in preparing the letter of credit documentation.
- Litigation. If there is litigation over the letter of credit, the other lenders normally indemnify the issuer for the other lenders’ pro rata share. This indemnity normally will not apply in the event of the issuer’s gross negligence or willful misconduct.
- Defaulting Lender. If a lender fails to fund its portion of a draw (or any loan to the borrower to pay the draw), that lender should be charged interest by the issuer on the unfunded amount.
Documentation — Members of the lending syndicate are not active in the letter of credit issuance process. They do not approve the beneficiary, prepare the letter of credit, review the documents submitted by the beneficiary with drawings, or decide whether to pay under the letter of credit over discrepancies. Yet the lenders are obligated to reimburse the issuer in all cases other than gross negligence or willful misconduct by the issuer. Accordingly, it is important that the syndicate members have confidence in the issuer’s letter of credit department. In syndications, it is not uncommon for the borrower to be liable to the other lenders even if the issuer has acted in a grossly negligent manner, but the borrower in such situations frequently reserves the right to go back against the issuer for any damages suffered by the borrower as a result of the issuer’s gross negligence or willful misconduct.
Amendments — Letters of credit are frequently amended, and certain amendments involve changes that require internal credit approval by all the syndicate members or otherwise have a significant impact on the lenders. Examples are amendments, which would extend the existing date beyond the facility maturity date, or a decision to allow an evergreen credit to roll over for an additional period that extends beyond the facility maturity date. One general way to handle amendments is to provide that the issuer will not permit any amendment which, if put into effect, would cause the letter of credit to violate any of the limits placed on letters of credit in the credit agreement.
Consequences of Issuer Exceeding Authority — If the issuer issues a letter of credit that does not conform to the credit agreement, what is the liability of the lenders? For example, what if the amount of the credit exceeds the limit under the credit agreement, or if the letter of credit has an expiry date beyond the facility maturity date? One alternative is that the lenders have no obligation to reimburse the issuer for these non-complying letters of credit. Another alternative is that the lenders are liable only to the extent the letter of credit complies with the credit agreement. These issues have not generally been explicitly addressed in most credit agreements.
Conditions to Issuance and Funding Draw — Normally the same conditions precedent apply to the issuance of a letter of credit as apply to the making of a loan under a credit agreement for a syndicated credit facility. However, once the letter of credit is issued, the issuer is irrevocably obligated to the beneficiary even if the borrower is in default under the credit agreement or is otherwise unable to meet the conditions precedent for loans under the credit agreement. Accordingly, the obligation of the lenders to fund their participation in the letter of credit (and to make loans to fund the borrower’s reimbursement) in case a draw is made by the beneficiary is not subject to the conditions precedent for the making of new loans. The lenders’ obligation to fund their participations must be as unconditional and irrevocable as the issuer’s obligation to pay the beneficiary. A lender without an active letter of credit business might not appreciate the possibility that it may be required to fund new money to cover a draw on a letter of credit even if the borrower is in bankruptcy.
Assignments by Syndicate Members — As noted, the issuer is relying on the creditworthiness of the other lenders to fund their pro rata share of a complying draw. Thus, the issuer is normally reluctant to permit the other lenders to assign their rights under the credit agreement without the issuer’s consent.
Defaulting Lenders — Given the increased uncertainty in the financial world concerning the solvency of financial institutions, letter of credit issuers in syndicated credit facilities need to pay close attention to the creditworthiness of the other lenders in the syndicate. Syndicated credit agreements attempt to address this issue through the concept of “defaulting lender.” A lender typically is considered to be a defaulting lender if it a.) has failed to fund its pro rata share of any loan or letter of credit obligation as and when required under the credit agreement or b.) has been deemed insolvent or become the subject of a bankruptcy or insolvency proceeding. In the letter of credit context, the major consequence of a lender’s being deemed to be a defaulting lender is the triggering of the right of the letter of credit issuer to refrain from issuing additional letters of credit unless the issuer has entered into satisfactory arrangements with the borrower or such lender to eliminate the issuer’s risk with respect to such lender.
Secured creditors have alternative means of encumbering the rights of a beneficiary under a letter of credit. They may encumber such rights as supporting obligations for other primary collateral provided by the beneficiary, such as accounts receivable, and may automatically perfect their security interest in such supporting obligations by perfecting their security interest in the primary collateral. Secured creditors may also encumber a beneficiary’s letter of credit rights as primary collateral. This encumbrance, which allows a secured creditor to receive payment if and when the beneficiary draws under the letter of credit, but does not allow a secured creditor to draw under the letter of credit, may be perfected only by control over the letter of credit rights. Such perfection by control allows priority to the secured creditor in relation to another secured creditor that automatically perfects his security interest in such letter of credit rights as supporting obligations. Nevertheless, a security interest in letter of credit proceeds, which is perfected by control will be subordinate in priority to the rights of a transferee beneficiary of a letter of credit.
Letters of credit issued under syndicated credit facilities at the request of a borrower present special issues for both the letter of credit issuer and the syndicate members. The letter of credit issuer is concerned about the risk that syndicate members will not be able to pay their respective pro-rata shares of any reimbursement obligation not satisfied by the applicant. This is a particular concern for issuers in the current economy. Syndicate members have little control over the issuance and administration of letters of credit and must rely upon the letter of credit issuer to issue and administer letters of credit in compliance with the restrictions contained in the credit agreement.
Anthony Callobre is a co-chair of Bingham McCutchen, LLP’s Banking and Leveraged Finance Group. Collobre practices in the areas of commercial lending and corporate finance. His clients include commercial banks, commercial finance companies, hedge funds, private equity groups, business development companies, small business investment companies, and other institutional investors and lenders. He practices across a broad spectrum of the commercial and industrial sector, and has considerable experience in asset-based lending, entertainment finance and letters of credit. In addition to representing credit providers, he represents the firm’s corporate clients as borrowers in debt financing transactions. He earned an Artis Baccalaureate from Brown University in 1982, a Juris Doctor and a Master of Laws, both from Boston University School of Law in 1985 and 1986, respectively.
This article incorporates portions of articles and outlines previously written by the author’s colleague, George A. Hisert, Esq. of Bingham McCutchen, LLP. This article also includes portions of an outline co-written by the author, Janis Penton, Esq. of Union Bank, N.A., Hisert and Lawrence Safran, Esq. of Latham & Watkins, LLP. The author gratefully acknowledges the permission of Penton, Hisert and Safran to include such materials in this article.