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Letters of credit: the magic wand for minimizing international credit risks?

Do you ever wish you had a "magic wand" to make a credit risk go away? For many trade creditors and lenders, that magic wand is the letter of credit. Letters of credit have increasingly become the first and last resort for many credit executives attempting to eliminate transaction risks, and they are essential to both domestic and international trade. Letters of credit are particularly important to international commerce. When a letter of credit is issued to a beneficiary, the issuer promises to honor the beneficiary's demand for payment and thereby substitutes its own creditworthiness for that of the customer. Letters of credit assure prompt payment and provide goods to those who might not otherwise qualify for credit, shift litigation risks to the buyer instead of the seller, protect against currency fluctuations and insulate the seller from many bankruptcy problems. Creditors should be careful to note that there are a few bankruptcy limitations with a letter of credit and they should be careful to avoid these pitfalls.

What Is a Letter of Credit?

A letter of credit is a commercial device involving three parties: the issuer (usually a bank), the customer and.the beneficiary. The customer, in essence, buys the letter of credit from the issuer. That is, the customer pays a fee for the issuance of the letter of credit and agrees to be responsible to the issuer for reimbursement of any funds which the issuer pays to the beneficiary. The issuer is then bound to honor the demand of the beneficiary for payment of the letter of credit, as long as the demand is in compliance with the conditions of the letter of credit, including presentation of appropriate documents.

How Does a Letter of Credit Work?

The letter of credit is enforced by the beneficiary submitting a draft. Essentially, the draft is a document that looks similar to a check but is signed by the beneficiary, made payable to the beneficiary and addressed to the issuer. Upon submission of the draft, and any other documents required by the letter of credit, the issuer will pay the beneficiary the face amount of the letter of credit.

The two types of letters of credit are standby letters of credit and direct pay letters of credit. Most letters of credit fall under the direct pay category. In a transaction secured by a direct pay letter of credit, the beneficiary and account party expect the issuer to honor the letter of credit upon submission of the draft and the documents of title covering the shipped merchandise. Upon payment, the issuer charges the account of the buyer/account party, or resorts to security held by the issuer. With a standby letter of credit, the beneficiary and account party expect that the account party will honor the invoice of the beneficiary when the buyer/account party refuses to pay the invoice is a demand made upon the issuer.

What Are the Main Principles of Letter of Credit Law?

Letter of credit law comprises five basic principles. The first is the independence principle. The independence principle holds that a letter of credit is an independent engagement on the part of the bank/issuer to honor its promise to pay. The letter of credit is independent because it is to be construed only by its own terms, without reference to any other agreement or transaction. Most jurisdictions hold that the bank/issuer is not required or allowed to withhold payment on evidence other than the terms contained in the four corners of the letter of credit. California has departed from the independence principle by allowing a reviewing court to consider not only the letter of credit, but the underlying transaction documents as well. However, the majority of jurisdictions throughout the country have upheld the independence principle and have refused to consider other documents outside the letter of credit no matter how tempting they may be.

Obligation To Perform Conditioned on Submission of Documents, Not Extrinsic Facts

Letters of credit always are conditioned upon the submission of documents, not extrinsic facts. The leading case in this area, and probably the single most important case in letter of credit law, is the Ninth Circuit's Wichita Eagle & Beacon Publishing Co. vs. Pacific National Bank. The court held that a document styled as a letter of credit was in fact a guaranty because the document required the bank/issuer to determine extrinsic facts, such as whether a tenant failed to obtain a building permit or failed to build a garage. Because the determination of these facts required an analysis outside the parameters of the letter of credit, the document was held to be a guaranty.

If a document is construed as a guaranty, the result may be unpredictable. While the bank/issuer may have the benefit of suretyship defenses, the amount of damages the bank/issuer may be forced to pay could actually be increased. The bank/issuer also risks exposure to a lawsuit from its customer/account party if the terms of the document were honored by the bank. While most letters of credit are conditioned upon the submission of documents, Wichita does not forbid all nondocumentary conditions. Indeed, the International Uniform Customs and Practices for Documentary Credits (UCP) allows nondocumentary letters of credit but construes them so that the bank/issuer may disregard any nondocumentary condition and pay the beneficiary without regard to documentary conditions.

The Strict Compliance Doctrine

The strict compliance doctrine requires the seller/beneficiary to present documents that conform to a strict reading of the letter of credit. If the beneficiary submits the precise documents required by the letter of credit, the issuer must honor the letter of credit. The majority of the cases enforce strict compliance on the part of both the beneficiary and the bank/issuer. Problems in this area develop chiefly when the seller/beneficiary fails to describe the goods exactly as indicated in the letter of credit, places an amount on an invoice that does not match the letter of credit, places the wrong name on the invoice or submits an improper draft.

Problems frequently arise when beneficiaries make errors of omission, such as failing to submit the exact bill of lading and/or the accompanying certificate - both required by the letter of credit - or misstating the proper quantity of merchandise. While the strict compliance rule may seem harsh to beneficiaries, its enforcement fosters predictability and certainty in letter of credit transactions.

The Fraud/Injunction Doctrine

The fraud/injunction doctrine is an exception to the strict compliance doctrine. An issuer may dishonor a letter of credit if the documents are fraudulent or if there is fraud in the transaction. Typically, buyer/account parties attempt to obtain injunctions against the bank/issuer honoring the letter of credit on the grounds that the seller/beneficiary has committed fraud. The fraud must be connected with the documents used to draw on the letter of credit, such as an invoice, misdated bill of lading or false certificates. It must be material. Courts are reluctant to delve into the underlying agreement to find fraud to support an injunction.

Bankruptcy Issues

Although a number of letter of credit law issues have been decided favorably in bankruptcy courts, there are problem areas. On the positive side, it appears to be well settled that a beneficiary may draw on a letter of credit without violating the automatic stay. The rationale is that the bank's funds, not the debtor's, are being disbursed. However, it remains unclear whether a trustee may acquire a previously agreed to letter of credit or draw against one as a successor to either the account party or the beneficiary.

Preference Problems with Letters of Credit

Although most letter of credit situations have been held clear of the preference laws, two areas have created problems. The first arises where the letter of credit is issued to insure payment of a pre-existing debt, rather than as part of the original sales arrangement. The second area arises only with standby letters of credit when the issuing bank is undersecured against the debtor's assets.

Securing Payment of a Preexisting Debt

Letter of credit arrangements have been challenged as a preference where the letter of credit is issued to secure payment of an antecedent debt and the debtor filed for bankruptcy within 90 days of issuance. In American Bank vs. Leasing Services Corp. (In re Air Conditioning, Inc.), the debtor was under siege by a creditor who had sued, obtained a judgment and was threatening to exercise replevin of the debtor's property. To obtain the creditor's forbearance, the debtor induced a bank to issue a letter of credit in favor of the creditor. The bank took security for the debtor's reimbursement obligation and the creditor agreed not to enforce the judgment.

However, the debtor failed to rebound and filed a Chapter 11 petition a month after entering into the letter of credit arrangements. Shortly thereafter, the case was converted to a Chapter 7 case. Subsequently, the creditor/beneficiary demanded payment of the letter of credit from the bank. The bank responded by filing a complaint in the bankruptcy court against the creditor which alleged a violation of the automatic stay. The trustee intervened, arguing that to pay the letter of credit to the creditor would be an avoidable preference under section 547(b) of the Code. The creditor stated that there was no transfer of the debtor's property "to or for the benefit of a creditor" and that, as a secured creditor, it would receive no more than it would upon liquidation of the debtor's estate. The bankruptcy court ruled for the trustee and the district court affirmed in part.

On further appeal, the Eleventh Circuit found that, although the proceeds of an letter of credit were not property of the debtor's estate, that did not answer how to deal with the bank's security and the benefit to the creditor for its antecedent debt. When the debtor pledged collateral to secure the issuing bank's reimbursement rights, that collateral was property of the estate. Moreover, a previously unsecured creditor became secured by virtue of the issuance of the letter of credit, and thus received "a benefit under section 547(b)."

The beneficiary did not qualify for the preference defense for transfers for a "contemporaneous exchange for new value". The court declined to recognize the debtor's forbearance from exercising its judgment as new value.

In considering the trustee's right to recover from the bank or the vendor as the initial transferee of such transfer or "the entity for whose benefit such transfer was made. . .", respectively, the Air Conditioning court upheld the trustee's right to recover the proceeds of the letter of credit from the creditor as the ultimate beneficiary of the transfer. The court was clearly reluctant to permit the former because that would, in the court's view, have violated the terms of "vital instruments of commerce."

The Air Conditioning court based its decision in large measure on the Fifth Circuit decision of Kellogg vs. Blue Quail Energy, Inc. [hereinafter Compton], where the facts were almost identical to Air Conditioning. A creditor received a letter of credit from a bank to secure its previously unsecured obligation and the bank took collateral from the debtor. When other creditors filed an involuntary bankruptcy petition against the debtor, the trustee filed a preference complaint against the creditor and sought recovery of the letter of credit proceeds pursuant to section 550(a) of the Code.

Compton affirmed the principle that proceeds of a letter of credit are not property of a debtor's estate and upheld the denial of an injunction sought to prevent the payment of proceeds to the beneficiary. The court found instead that the beneficiary received an indirect transfer of the debtor's property. The court said it was not necessary for the creditor/beneficiary to receive the debtor's property directly. If the effect of the transfer is to enable a creditor to obtain a "greater percentage of his debt than another creditor of the same class. . .", then an indirect transfer can be avoided. Therefore, the creditor received a beneficial payment which could be avoided under 11 U.S.C. section 547(b) as a preference.

Standby Letters of Credit with Undersecured Lender/Issuer

The other situation in which preference problems arise is when a standby letter of credit is issued with an unsecured lender/issuer. In In re Powerine Oil Company, a vendor of crude oil received a standby letter of credit to back the debtor's obligation to pay for the oil. The debtor paid the vendor within the preference period and after the letter of credit had expired, the vendor was sued for a preferential transfer. The vendor claimed that it would 'have received no less in a Chapter 7 liquidation because it could have drawn on the letter of credit had the debtor not paid. The majority opinion held that in determining whether a creditor received more than it would have in a Chapter 7 liquidation, the law only covered whether the vendor would have been paid out of the debtor's estate, not from a third party source. The dissenting justice rejected this view. Moreover, the court held that there was only a "contemporaneous exchange of new value" defense to the extent that the issuing bank was secured by the debtor's assets. This provided little solace to the vendor where that issuing bank was grossly undersecured. Although the Powerine opinion has been criticized, vendors should keep it in mind when drafting the terms of letters of credit within the Ninth Circuit - the U.S. west coast.

Daren R. Brinkman is a partner with Blakeley & Brinkman located in Los Angeles. He specializes in creditors' rights law, including commercial law and bankruptcy.
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Author:Brinkman, Daren R.
Publication:Business Credit
Date:Nov 1, 1997
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