July/August 2010

Elegant & Effective…Letters of Credit in Commercial Loans and Bankruptcy (Part 1 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.

This three-part article seeks to demystify letters of credit by examining their roles in commercial loans and bankruptcy. Part I of this article provides an introductory, “nuts and bolts” discussion of letters of credit. Part II of this article, which will appear in the next edition of ABF Journal, addresses security interests in letters of credit and the role of letters of credit in syndicated loans. Part III of this article, which will appear in the October/November edition of ABF Journal, explores the treatment of letters of credit in bankruptcy.

Letters of Credit: What They Are and How They Work

A letter of credit is a written undertaking, usually by a commercial bank (referred to as the issuer), at the request of the bank’s customer (referred to as the applicant), for the benefit of another person (referred to as the beneficiary), to honor a documentary presentation by payment or delivery of an item of value. (See UCC §5102 (a)(10))

Letters of credit have a long history. They developed hundreds of years ago to facilitate the sale of goods between distant parties. The buyer would be reluctant to part with its money until it knew the goods were safely en route; the seller was unwilling to ship the goods until it knew the money was ready at hand. This impasse was resolved by the bank issuing a letter of credit pursuant to which the bank undertook to pay the seller upon the seller’s presentation of various specified documents such as bills of lading evidencing the shipment of the goods, packing lists, invoices and the like. The seller felt comfortable relying on the bank’s credit, rather than depending solely on the buyer’s credit and willingness to pay. The buyer felt comfortable having the bank, an independent, trusted intermediary, holding the documents of title and knowing that the bank would not disburse the funds until it had the required documents in hand.

The use of letters of credit has evolved significantly from this early scenario. In addition to being used to facilitate sales of goods, letters of credit are now used in numerous other types of transactions to support all kinds of payment and performance obligations and to substitute the credit of the issuing bank for that of the applicant.

Structure — As the basic sale of goods transaction described above suggests, there are three independent relationships that comprise a letter of credit transaction. First is the relationship between the applicant and the beneficiary in their roles as the parties to an underlying transaction. The underlying transaction between the applicant and the beneficiary can be a sale of goods, a loan, an equipment lease, a public debt offering or any other kind of transaction.

The second relationship is between the applicant and its bank, the letter of credit issuer. The issuer issues the letter of credit at the request and for the account of its customer, the applicant.

The third relationship is between the letter of credit issuer and the beneficiary. The letter of credit issuer issues the letter of credit for the benefit of the beneficiary and thus adds its own credit to the applicant’s and induces the beneficiary to enter into the underlying transaction with the applicant.

Confirmations — In some cases, the credit of the issuing bank is not satisfactory to the beneficiary. In those situations, a second bank will add its credit to the transaction by “confirming” the letter of credit. The confirming bank will take on all the responsibilities of the issuer vis‑à-vis the beneficiary. The confirming bank’s customer is the issuing bank and it has reimbursement rights against the issuer.

Documentary Nature — A letter of credit basically provides that if the beneficiary presents the documents required by the letter of credit to the issuer, the issuer will promptly pay the beneficiary. The key to this arrangement is that the letter of credit is documentary. This means that the issuer pays only against the presentation of documents. If the documents comply with the requirements of the letter of credit, the beneficiary gets paid. If the documents do not comply, the beneficiary does not get paid — at least not through the letter of credit. Governing law and custom, discussed later, require that all the conditions to payment in the credit must be documentary rather than factual. If any condition is non-documentary, it must be ignored.

Commercial and Standby Letters of Credit — Letters of credit can be divided into two broad categories. First, the traditional letter of credit involving the sale of goods is often called a commercial letter of credit. The parties anticipate that, if the transaction goes well, the beneficiary/seller will be paid and the applicant/buyer will obtain title to the goods through the commercial letter of credit.

The second type of letter of credit is the standby letter of credit, which is a more recent development. Standbys are normally used in situations where the parties anticipate that the letter of credit will not be drawn upon unless something goes wrong in the underlying transaction. The standby credit is documentary, so the condition for payment is not that there is a default in the underlying transaction, but that the beneficiary submits a certificate stating that there is a default in the underlying transaction.

Drafts — One of the documents normally required under a commercial letter of credit relating to the sale of goods is a “sight draft” or a “time draft.” A draft is a negotiable instrument similar to a check in which the beneficiary instructs the issuer to pay a fixed amount to the beneficiary. A sight draft is one which is payable upon receipt (at sight) by the issuer. A time draft is one that is payable at a specified number of days after receipt by the issuer. Drafts that have been “accepted” by the issuing or confirming bank can become “bankers acceptances.” The Uniform Commercial Code (UCC) and International Standby Practices (ISP) (discussed later) permit substitution of a “demand for payment” for a draft. Often, in standby credits, since the draft is not a negotiable instrument, in order to simplify the drawing process, the parties will frequently decide that the beneficiary’s certification should be the only document the issuer requires for payment.

Expiration Date — Letters of credit must have an expiration date. The letter of credit terminates on the expiration date and no documents may be presented thereafter. Some letters of credit have an evergreen clause. Under such a clause, a letter of credit may be extended for additional time periods (usually one year) unless the issuer sends notice to the beneficiary that the expiration date will not be extended. To put teeth in the evergreen clause, the evergreen clause normally provides that, if a notice of non-extension is sent, the beneficiary may draw under the letter of credit with only a draft or demand for payment without the other documents that would normally be required. Evergreen (or auto-renewal) clauses are in a state of constant evolution as litigation over their mechanics motivates more detailed clauses.

Reimbursement Agreement — The issuing bank will enter into a reimbursement agreement with the applicant. The reimbursement agreement includes the applicant’s promise to pay fees to the bank and to reimburse the bank for any payments the bank makes under the letter of credit. It also contains a number of credit provisions similar to what one might find in a loan or credit agreement, including representations, warranties, covenants and the like. The reimbursement agreement can be secured just like any other credit agreement so that, if the issuer has to pay on the letter of credit, the issuer will have recourse against the security posted by the applicant. Cash collateral is a very common form of security for letter of credit reimbursement obligations.

Minimal Defenses — The appeal of the letter of credit to the beneficiary is at least twofold. First, the issuer’s credit is on the line in addition to that of the applicant. Second, if properly handled, the letter of credit is often deemed to be “as good as cash.” There are very few defenses to payment on a letter of credit. These include:

1.    The documents presented by the beneficiary do not comply with the letter of credit;

2.    The letter of credit has expired; and

3.    There is fraud in the transaction.

The prudent beneficiary normally has control over each of these possible defenses.

Independence Principle — A key principle under letter of credit law is that the letter of credit is independent of the underlying transaction. This is called the “independence principle.” Thus, absent fraud by the beneficiary, a dispute in the underlying transaction is irrelevant to whether the issuer must pay on the letter of credit, so long as the beneficiary submits complying documents. Another consequence of the independence principle is that, even if there is no dispute in the underlying transaction as to the right of the beneficiary to be paid, the beneficiary will not be paid under the letter of credit unless he submits complying documents.

Difference from Guarantees — Letters of credit differ from guarantees in several important respects. Guarantees are often referred to as “secondary” obligations. This means that the liability of the guarantor is derivative of that of the debtor in the underlying transaction. With a few exceptions, guarantors may raise the same defenses that a debtor may raise. Guarantors also have a number of suretyship defenses. Although these defenses may be and often are waived in a properly drafted guaranty, there is frequent litigation concerning the application of suretyship defenses and their waivers in particular transactions. In the vast majority of cases, guarantors do not pay without a fight. It has been said that the receipt of a guaranty is nothing more than an invitation to sue.

A letter of credit on the other hand is considered a “primary” obligation of the issuer, meaning that it is independent of the underlying transaction. The issuer may not rely on defenses that the applicant might have in the underlying transaction. If the beneficiary submits complying documents on time, the issuer must pay.

Most banks that are in the business of issuing letters of credit have a reputation to maintain in the banking community. If they dishonor complying presentations, they might as well get out of the letter of credit business. As a result, banks typically will resist any pressure from the applicant to dishonor a complying presentation. Thus the likelihood of prompt payment is much greater with a letter of credit than with a guaranty.

Applicable Laws, Rules and Trade Codes

Letters of credit are constructed according to custom and applicable law, which can include the following:

Uniform Commercial Code Article 5 — Article 5 of the UCC) generally governs letters of credit issued in the United States. Article 5 was last revised in 1995 in an effort to coordinate the UCC with the Uniform Customs and Practice (UCP) (discussed below). Accordingly, the Article 5 and UCP provisions, which cover the same areas, generally are substantially the same. Article 5 also covers certain areas, such as when the issuer is not obligated to honor its credit, which the UCP does not address.

Uniform Customs and Practice — The UCP for Documentary Credits is a set of industry rules prepared by the International Chamber of Commerce. There have been several editions, the most recent being UCP 600, which became effective on July 1, 2007. The UCP is not law. It is merely a set of rules that become binding upon the parties by incorporation by reference into a letter of credit. This is usually done by a sentence such as: “This letter of credit is subject to the Uniform Customs and Practice for Documentary Credits, ICC Publication No. 600.” It is possible to incorporate less than all of the UCP. There are some articles of the UCP that are often excluded or modified, such as Article 17 dealing with the issuer’s suspension of business because of force majeure.

ISP98 — Recognizing that the UCP focused primarily on commercial letters of credit and in some instances did not properly address issues of particular concern for standby letters of credit, the U.S. banking industry drafted and promulgated the International Standby Practices 1998 (ISP98) to adopt a parallel set of rules for standby letters of credit. ISP98 was ultimately adopted by the International Chamber of Commerce (ICC). There are some significant differences between UCP 600 and ISP98 that are unrelated to the differences between standby and commercial letters of credit, such as the provisions dealing with the impact of the issuer’s suspension of business because of force majeure. There are many other differences derived from the differences between standby and commercial letters of credit. As with the UCP, ISP98 is applicable to a letter of credit only if it is incorporated by reference into the letter of credit.

United Nations Convention on Independent Guarantees and Standby Letters of Credit — The United Nations Commission on International Trade Law drafted the Convention to provide rules for credits issued in countries without well-developed trade law. While the United States has an elaborate body of statutory law on letters of credit, in the form of Article 5, and many market participants incorporate trade codes, such as UCP or ISP, into their credits, the Convention is the first international codification of letter of credit law. The Convention was adopted by the United Nations General Assembly in 1995, became effective in 2000, has been ratified by a number of countries, and was signed by the United States in 1997. U.S. Senate ratification is pending. The Convention provides an alternative for market participants operating in countries where there is resistance to using Article 5, UCP or ISP to govern transactions.

eUCP — In recognition of growing electronic commerce, the ICC has promulgated an addendum to the UCP called the eUCP. This is a relatively short set of rules concerning issues with electronic documents and presentations. As with the UCP, the eUCP is applicable only if it is specifically referenced in the letter of credit. A mere reference to the UCP in the letter of credit does not automatically include the eUCP.

URDG 758 — In many countries, banks issue so-called “demand guarantees,” which are very similar in function to letters of credit. The laws applicable to demand guarantees vary from country to country. On November 24, 2009, the ICC Commission on Bank Technique and Practices updated the Uniform Rules for Demand Guarantees by adopting URDG 758, which are effective as of July 1, 2010. URDG 758 aims to bring greater uniformity to the laws applicable to demand guarantees.

Drafting Suggestions

Each of the beneficiary, the applicant and the issuer will have a different perspective on the drafting of a letter of credit. A key issue is the form of the documents required to be presented under the letter of credit.

Beneficiary — From the beneficiary’s perspective, the ideal letter of credit is a “clean” letter of credit, that is, one that requires the submission of only a sight draft or demand for payment. Clean letters of credit have been compared to blank checks and are usually resisted by applicants. If the beneficiary is unable to obtain a “clean” letter of credit, the beneficiary should strive to keep the required documents short and simple. For instance, if a certificate of default is required, a mere statement that the applicant is in default is preferable. A beneficiary should avoid letters of credit that require documents produced or signed by the applicant or parties within the applicant’s control. Such a requirement puts the beneficiary at the mercy of the applicant.

Applicant — The applicant’s perspective is normally just the opposite of the beneficiary’s. The applicant will want documentation to include detailed certificates about certain facts and perhaps even documentation from independent third parties. The theory is that the more documentation a beneficiary must submit under a letter of credit, the more likely it is that the beneficiary will not be able to obtain the documents or that the documents will not be able to comply with the letter of credit.

Issuer — The issuer is normally amenable to accepting the applicant’s and the beneficiary’s joint decision regarding the substance of the documents needed to be delivered under a letter of credit. However, the issuer is very concerned about the format. All conditions to draw need to be clearly documentary —“a certificate stating that the applicant is in default” versus “the applicant is in default.” Issuers do not investigate the facts underlying documents submitted with a draw. When faced with language requiring a “certificate signed by the president of the beneficiary,” the issuer will re-word it to require “a certificate purportedly signed by the president of the beneficiary.” The issuer is not in a position to verify whether the person named on the certificate is in fact the president of the beneficiary or, even if the named person is the president, whether the signature is genuine. The issuer wants its role in the letter of credit process to be as ministerial as possible and to minimize any difficulty by its letter of credit clerks in making a decision as to whether a draw complies with the letter of credit.

Letters of credit are unique instruments. However, they have several advantages over guarantees. And when properly structured, they can elegantly and effectively accomplish the goals of and balance the risks to all the relevant parties to a transaction.

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.

Continue to Elegant & Effective…Letters of Credit in Commercial Loans and Bankruptcy (Part 2 of 3)