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Seven things businesses need to know.

"Why don't we just get a Letter of Credit?" In today's global marketplace, businesses are increasingly relying on letters of credit to secure performance of future contract obligations. For example, an Alberta company placing an order for machinery being fabricated in Germany may be asked for a sizable deposit before work begins. As an alternative, the customer may offer the fabricator a Letter of Credit instead of the cash deposit. Typically a real estate developer is required to give the municipality a Letter of Credit to, in effect, guarantee construction of public utilities and roads required for the development. No development can proceed until the Letter of Credit is deposited with the municipality. Businesses today need to know the fundamentals of Letters of Credit.

What is a Letter of Credit?

A Letter of Credit is an undertaking by a bank or other financial institution to pay to a beneficiary, usually named in the Letter of Credit, an amount of money to secure the customer's contractual obligations to the beneficiary. These obligations may be payment under contract (e.g. by a purchaser of goods or services) or performance of services (e.g. a contractor's performance under a construction contract). Payment is usually subject to performance of the conditions stated in the Letter of Credit.

Letters of Credit have historically been used as a means of payment for goods in international trade. However, they are being used increasingly to guarantee the performance of obligations previously secured by a performance bond or guarantee.

The Letter of Credit can be clean -- meaning on documents other than the Letter of Credit are necessary for the beneficiary to receive payment from the issuing bank, or documentary -- meaning some additional documents must be presented along with a documentary Letter of Credit, typically bills of lading in international trade transactions.

Letters of Credit for domestic use are typically clean with a statement that the issuing bank is not required to inquire whether or not the beneficiary of the Letter of Credit has the right to the amount claimed as between it and the bank's customer. However, the unconditional nature of the clean Letter of Credit can been modified, especially where it secures future performance under a contract to require, as a condition of payment, that the beneficiary certify that the amount claimed is truly outstanding, (often as a result of a default under the underlying contract). This is referred to as a Stand By Letter of Credit or a Letter of Guarantee.

What about cost?

As with any credit facility, costs vary. Typically a bank charges a premium equal to one quarter percent to three percent or more, (depending on the credit worthiness of the bank's customer) calculated on the face amount of the Letter of Credit, payable in advance at the time of issue and every year thereafter. While it is more efficient than a cash bond, a letter of credit will reduce the line of credit otherwise available to the customer of the issuing bank by the amount payable under the Letter of Credit. Needless to say, banks in most cases will be secured by acceptable collateral from their customer for the full-face amount of the Letters of Credit outstanding at any time.

Is the issuing bank always

Once the bank issues a Letter of Credit that states it is irrevocable, then the bank is legally committed to pay the amount demanded subject to satisfaction of any conditions stated in the Letter of Credit. This is based on the reliance both parties have placed on the bank's promise to pay. For example, a seller of goods will enter into the sales contract on the assurance that nothing will prevent him from being paid on delivery of the specified goods. Courts have taken the position that freezing payment under a letter of credit where there is a dispute between the contracting parties would undermine the commercial system on which clean Letters of Credit are based. Further, the holder of the letter of credit may have assigned the proceeds of the Letter of Credit to his bank that may have extended credit relying on the unconditional promise to pay of the issuing bank.

What about the term of Letters of Credit?

The issuing bank's obligation to pay monies under a Letter of Credit is usually irrevocable for the term stated in the Letter of Credit. The bank typically seeks to restrict the term of the Letter of Credit to not longer than one year. However, commercial contracts are often performed over longer periods of time. Thus, a mechanism is usually placed in the underlying contract between the issuing bank's customer and the beneficiary of the Letter of Credit requiring the customer to renew or replace the Letter of Credit within 15 to 30 days prior to the stated expiry date. If not renewed, the beneficiary is then permitted to demand payment and hold the proceeds as a cash bond.

Some Letters of Credit expressly provide for automatic renewal, unless the issuing bank gives notice (again usually within 15 to 30 days of its stated expiry) that it will not renew. If not renewed, the beneficiary still has time to make demand under the Letter of Credit before its expiry date and keep the proceeds as a cash bond.

What about references in Letters of Credit to "Uniform Customs" and "Uniform Commercial Code (UCC) -- Article 5"?

The Uniform Customs are general rules governing Letters of Credit, drafted by the International Chamber of Commerce, an international non-governmental body whose membership includes Chambers in most countries. By referencing the Uniform Customs, they become part of the contract between the issuing bank and the beneficiary holding the Letter of Credit.

For the most part, the Uniform Customs deal with the relationship between the issuing bank and local agent banks typically used in international commerce, as well as the types of documents to be presented in import/export transactions. Generally speaking, nothing in the Uniform Customs takes away from the obligation of the issuing bank to pay in accordance with the wording of the Letter of Credit.

Letters of Credit issued by American banks often refer to the Uniform Commercial Code (UCC) -- Article 5, which has been adopted in most states in the USA. Generally speaking, like the Uniform Customs, nothing in the UCC undermines the fundamental obligation of the issuing bank to pay under the Letter of Credit with one crucial difference. While the Uniform Customs provides that in the absence of any clear indication to the contrary, the credit is deemed to be irrevocable in nature, such is not the case under the UCC. Therefore as a general rule, the beneficiary of a Letter of Credit should ensure that it is stated to be "irrevocable".

Protection Against Abuses?

There is always a risk that the beneficiary under a Letter of Credit will improperly demand payment under the Letter of Credit. As we have seen, as long as the stated conditions for payment have been met, the issuing bank is obliged to pay. This holds true even if the customer on whose behalf the bank is extending the Letter of Credit becomes insolvent or bankrupt.

In cases of abuse by a beneficiary, legal action for a judgment can be pursued. Fortunately, abuses are not wide spread.

Conclusion

Letters of Credit are a convenient way to secure payment obligations without having to expend precious cash resources. They are not without a cost, but parties are increasingly resorting to their use, especially in lieu of performance bonds. Letters of Credit have evolved over the years through international convention. They will remain an important part of commercial transactions in the future.
COPYRIGHT 2001 Legal Resource Centre of Alberta Ltd.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2001 Gale, Cengage Learning. All rights reserved.

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Author:Neeland, Don
Publication:LawNow
Date:Jun 1, 2001
Words:1276
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