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Standby Letters Of Credit

They are superior to guarantees and the possible and imaginative ways they can be used are endless
By PAUL S. TURNER

Paul Turner What is a standby letter of credit? How is it different from a guarantee? Is it better than a guarantee from the point of view of the creditor? This article will provide answers to these questions.

There are two kinds of letters of credit: commercial credits and standby credits. A commercial letter of credit supports the purchaser's obligation to pay for goods, typically imported or exported goods. A standby letter of credit normally supports a financial or a performance obligation, in much the same way as does a guarantee.

This article discusses only standby credits.

Letter of credit transaction

A letter of credit is an engagement by the issuer, normally a bank, to pay the beneficiary upon the presentation by the beneficiary of the document or documents specified in the letter of credit. The engagement is a supporting obligation. The issuer of a standby credit agrees to "stand by" in support of the debt or duty of the applicant to the beneficiary in another transaction. The other, supported, transaction is called the "underlying transaction."

Suppose, for example, that the parties to a $500,000 Loan Agreement agree that the borrower's obligation to repay the loan will be supported by a letter of credit. To obtain the letter of credit, the borrower will apply to a bank to issue a letter of credit to the lender.

The three parties in the letter of credit transaction in this example are (i) the borrower, (ii) the lender and (iii) the bank. In letter of credit parlance, the borrower is the "applicant," the bank is the "issuer" or "issuing bank," and the lender is the "beneficiary." It is traditionally said that the letter of credit structure consists of three contracts.

  • Contract I is the underlying transaction, the $500,000 Loan Agreement in our example.
  • Contract II is the agreement between the applicant and the issuer, in our example, the agreement between the borrower and the bank. Contract II is commonly called the "reimbursement agreement" because in it, the applicant agrees to reimburse the bank if the bank pays the beneficiary.
  • Contract III is the letter of credit. In our example, let us suppose that the bank engages to pay the beneficiary $500,000 upon the presentation to the bank of a Default Certificate, signed by two officers of the beneficiary, stating:
  • Borrower is in default under the Loan Agreement between Borrower and Lender dated Jan. 5, 2002. The sum of $500,000 is due and owing thereunder. Demand is hereby made for the sum of $500,000.

    The bank engages in the standby credit to pay the beneficiary upon the presentation by the beneficiary of the certificate worded as described above. The presentation of documents for payment is sometimes called a "draw." The letter of credit specifies an expiration date, which practitioners call the "expiry." The bank will not honor an attempt to draw after the expiry. The issuing bank is typically the applicant's bank. Many letter of credit transactions include another bank located in the same location as the beneficiary. Suppose that in our example, the applicant and issuing bank are located in Prague and the beneficiary is located in Chicago. For convenience, they might agree that a bank in Chicago will act as an "advising bank."

    The Chicago bank could notify the beneficiary that the bank in Prague has issued the credit, advise the beneficiary of the terms of the credit, and accept the Default Certificate in Chicago on behalf of the issuer in Prague.

    The advising bank in Chicago may also be authorized to pay the beneficiary if the Default Certificate presented to it conforms to the requirements of the letter of credit. A bank that is authorized to honor a complying presentation is called a "nominated bank." A nominated bank may also "confirm" the credit.

    A confirming bank makes the same engagement to the beneficiary as the issuer and is obligated to honor a complying presentation. The issuing bank must reimburse a nominated bank that honors a complying presentation.

    The independence principle

    The independence principle in letter of credit law decrees that the obligation of the issuing bank to pay the beneficiary is independent of the rights and obligations of the parties in the underlying transaction. If the documents presented comply with the credit, the bank must pay even though the applicant would not have to pay the beneficiary in the underlying transaction.

    In our example, suppose the purpose of the loan is to finance the construction by the borrower of a building for the lender under a Construction Agreement. There is a dispute under the Construction Agreement. The borrower claims that a default by the lender under the Construction Agreement excuses the borrower's obligation to pay under the Loan Agreement, but the lender claims that it has not defaulted under the Construction Agreement.

    The lender, as the beneficiary under the credit, presents the Default Certificate described above, reciting that "the sum of $500,000 is due and owing." The statement is arguably not true, but neither is it fraudulent from the lender's viewpoint. In the absence of fraud, the issuer must pay the beneficiary even though the statement may not be true. The independence principle forbids the issuer from inquiring into facts in the underlying transaction.

    In Western Security Bank, N.A. v. Superior Court, 25 Cal. Rptr. 2d 908 (Cal. Ct. App. 1993), remanded 37 Cal. Rptr. 2d 840 (Cal. 1995), the beneficiary was a lender that had foreclosed under a trust deed securing the loan. The court enjoined the issuer from paying the beneficiary because payment would have yielded the beneficiary a deficiency contrary to California anti-deficiency law.

    In response to criticism from the financial community at this affront to the independence principle, the legislature reversed the decision (but not to allow the collection of a deficiency against a natural person). See Cal. Civ. Proc. Code §§580, 580.5 and 580.7(b) and Cal. Civ. Code §2787.

    Thus, in a commercial context, the independence principle under letter of credit law trumps California anti-deficiency real property law.

    The independence principle may be expressed in different ways. One common way is to say that in a letter of credit, the parties "deal only with documents," not with the goods or performance to which the documents relate.

    A second way to express the independence principle is to distinguish between primary obligations and secondary obligations. A guarantee is a secondary obligation because the guarantor is liable only if the obligor in the underlying transaction has defaulted in that transaction.

    By contrast, the issuer under a letter of credit is a primary obligor. Its liability is independent of the liability of the obligor in the underlying transaction. The bank must pay provided only that the documents conform to the documents specified in the credit.

    Fraud

    In our example, the default certificate is arguably false but not fraudulent, and the issuer must pay. It should be noted, however, that when documents are materially fraudulent, or payment would facilitate a material fraud, the issuer may ignore the independence principle and, in good faith, refuse to pay.

    If the issuer determines to pay despite the applicant's assertion of material fraud, a court may enjoin payment by the issuer. This exception to the independence principle, however, is construed very narrowly.

    Law and practice governing standby letters of credit
    UCC Article 5, the UCP and the ISP

    Letters of credit issued in the United States are governed by Article 5 of the Uniform Commercial Code (except for credits that choose the law of another country). In addition, standby letters of credit typically incorporate by reference either the Uniform Customs and Practice for Documentary Credits (UCP) or the International Standby Practices (ISP). The UCP and the ISP are rules for letters of credit published by the International Chamber of Commerce.

    The UCP was originally intended only for commercial credits, but the ICC subsequently approved its use for commercial credits as well. The ISP, which applies only to standby credits, became effective Jan. 1, 1999.

    Strict compliance doctrine

    UCC Article 4A adopts the "strict compliance doctrine," which states that the issuer shall honor a presentation only if it appears "strictly" to comply with the requirements of the credit. Article 4A also states that the bank, in its examination of the documents, must observe the "standard practice of financial institutions that regularly issue letters of credit." UCC §§5-108(a) and (e). The "standard practice" concept is also referenced in the UCP and the ISP and globalizes documentary examination practice.

    Strict compliance in accordance with standard banking practice in our example probably means that the wording of the Default Certificate as presented must track closely the wording in the credit. If the certificate states, "Borrower is going bankrupt and can't pay its debts," instead of "Borrower is in default under the Loan Agreement," the document would be rejected and the presentation dishonored by the issuer. Strict compliance, however, does not normally require the beneficiary to duplicate typographical errors in spelling, punctuation or the like.

    The preclusion rule

    The "preclusion rule" under the UCP, the ISP and UCC Article 5 requires the issuer to examine the documents presented under the credit within a reasonable period of time, which may not exceed seven banking days after the issuer has received the documents. The ISP allows the issuer a minimum of three, but no more than seven, days.

    If the issuer determines to reject the documents and dishonor the presentation, it must give notice within the prescribed period, and the notice must state specifically which document it asserts is discrepant and why. If the issuer fails to give timely notice as to a specific documentary discrepancy, the issuer is precluded from asserting that discrepancy thereafter.

    Uses of standby credits

    The possible uses of standby letters of credit are endless. They have been commonly used:

  • to enhance the credit rating of commercial paper;
  • as a lessee's security deposit in lieu of a deposit of cash;
  • to support the reclamation obligation of a mining company; and
  • to support the debt service obligation of developers in municipal bond financings.
  • An imaginative use of a letter of credit was to support the obligation of the United States to deliver $53 million worth of food and medical supplies to Cuba in exchange for the release of prisoners taken in the 1962 Bay of Pigs invasion. The American Red Cross applied for, and the Royal Bank of Canada issued, a standby credit to the Cuban government. The engagement of the bank was to pay $53 million upon presentation to the bank of a certificate stating that the United States had failed to deliver the food and supplies.

    The United States delivered the food and supplies, and the government of Cuba did not draw under the letter of credit.

    Standby letters of credit versus guarantees

    The superiority of standby letters of credit to guarantees, from the point of view of the creditor, should now be obvious to the reader. Defenses of the applicant in the underlying transaction are not available to the issuer. So long as the document or documents presented strictly comply with the terms of the credit, the issuer must pay.

    The traditional defenses of guarantors (see, for example, Cal. UCC §3605) are not available to issuers. The beneficiary may draw under a letter of credit in a commercial context even when payment would result in the collection of a deficiency despite California anti-deficiency law.

    Finally, the issuer must specify its objections to the documents within seven days after receiving the documents or be precluded from asserting the objections thereafter.

    California lawyers representing creditors who may not be familiar with standby letters of credit are encouraged to consider their use.

  • Paul S. Turner was an official advisor to the uniform law commissioners who revised UCC Article 5, "Letters of Credit," in 1995 and is a co-author of Standby and Commercial Letters of Credit (Aspen Law and Business ). He is a retired assistant general counsel of Occidental Petroleum Corporation and currently consults on letter of credit and banking law matters in Los Angeles.
  • Answer the following questions after reading the MCLE article on standby letters of credit. Use the answer form provided to send the test, along with a $20 processing fee, to the State Bar. If you do not receive your certificate within four weeks, call Ibrahim Bah at 415/538-2028.

    SELF-ASSESSMENT TEST

    Answer the following questions after reading the MCLE article on standby letters of credit. Use the answer form provided to send the test, along with a $20 processing fee, to the State Bar. If you do not receive your certificate within four weeks, call Ibrahim Bah at 415/538-2028.

    1. The two kinds of letters of credit are "documentary" letters of credit and "standby" letters of credit.

    2. The principal parties in a letter of credit transaction are the applicant, the beneficiary and the issuing bank, which is typically the applicant's bank.

    3. A letter of credit is a "supporting obligation" in the sense that the obligation of the issuer under the letter of credit supports the obligation of the applicant to the beneficiary in an underlying transaction.

    4. The issuer will not honor a presentation of documents made after the "expiry" date.

    5. If the documents presented by the applicant comply with the terms of the letter of credit, the issuer must pay the applicant.

    6. An "advising bank," which advises the terms of the credit to the beneficiary, may also be a "nominated" bank, that is, a bank that is authorized to receive the documents on behalf of the issuer and to pay the beneficiary if the documents comply with the requirements of the credit.

    7. A "confirming" bank is a nominated bank that is obligated to pay the beneficiary if the documents comply with the requirements of the credit.

    8. The issuer must reimburse the nominated bank if the nominated bank honors a presentation of documents that comply with the terms of the credit.

    9. Under the independence principle, the bank must pay the beneficiary if the documents comply with the requirements of the letter of credit even though the applicant has a defense to payment of the applicant in the underlying transaction.

    10. Under the independence principle and letter of credit law, the beneficiary's right to payment under a letter of credit trumps the rights of a business organization that owned real property that was foreclosed upon under California real property anti-deficiency law.

    11. A way of expressing the independence principle is to say that the bank "deals in documents," not with the goods or the performance to which the documents relate.

    12. The guarantor is a primary obligor as contrasted with the issuer of a standby letter of credit, who is a secondary obligor.

    13. The fraud exception to the independence principle is construed broadly.

    14. Letters of credit issued in the United States are governed by UCC Article 5 even though the credit chooses the law of another country.

    15. The ISP and the UCP are rules governing letters of credit promulgated by the International Chamber of Commerce.

    16. The UCP may apply either to commercial letters of credit or standby letters of credit, but the ISP, which is relatively new, is intended to apply only to standby letters of credit.

    17. The "strict compliance" doctrine requires the beneficiary to present documents that are strictly in accord with the documents described in the letter of credit, so that the presented document must duplicate spelling errors in the letter of credit.

    18. The maximum time allowed an issuer to determine whether to honor a presentation of documents is seven banking days after the bank has received the documents to be presented under the letter of credit.

    19. Under the preclusion rule, if the issuer fails to assert that the presentation of documents did not comply with the terms of the letter of credit within the seven banking-day period, the issuer must pay the beneficiary.

    20. Standby letters of credit are commonly used as a lessee's security deposit in lieu of a deposit of cash.

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