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Letters of Credit in Commercial Transactions Leveraging the Use of Letters of Credit and Drafting Tips to Comply with UCC Article 5
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THURSDAY, JANUARY 17, 2013
Presenting a live 90-minute webinar with interactive Q&A
Carter H. Klein, Partner, Jenner & Block, Chicago
Buddy Baker, Managing Director, Global Trade Risk Management Strategies, Chicago
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Letters of Credit in Commercial
Transactions
Presented by
Live Phone Web Seminar
Strafford Publications
Thursday January 17, 2013
1:00 PM – 2:30 PM EST
5
Carter Klein
Jenner & Block LLP
312-923-2950
Buddy Baker
Global Trade Risk Mgmt
Strategies
312-830-3038
Speaker Bios Carter H. Klein
Carter Klein is a partner at Jenner & Block LLP where he has practiced for the past 38 years in the
areas of financial services, Uniform Commercial Code, credit enhancements and commercial law. He
is co-author of West’s Uniform Laws Annotated – Uniform Commercial Code Forms and Materials;
West’s Illinois Practice – Uniform Commercial Code Forms Annotated; and West/Thompson Illinois
Code Comments. He is current Chair of the ABA’s UCC Payments Subcommittee and past Chair of
the ABA’s UCC Letter of Credit Subcommittee; he is past chair or co-chair of Chicago Bar
Association’s Commercial and Financial Transactions Committee; International Law Committee and
Consumer Credit Committee. He is an editorial advisor for Documentary Credit World; is a member of
the American College of Commercial Finance Lawyers; is the liaison for the UCC Committee of the
Business Law Section of the American Bar Association to the Permanent Editorial Board of the
Uniform Commercial Code; and is a member of the Banking Committee for the U.S. Council on
International Business. He participated in the drafting of the International Standby Practices (1998)
and Revised Article 5 of the Uniform Commercial Code and has authored numerous articles and
lectured frequently on Uniform Commercial Code topics. He is recognized as an Illinois Super Lawyer
and as a Best Lawyer in America. He can be reached at 312-923-2950 or [email protected].
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Walter Buddy Baker
Walter (Buddy) Baker has over 30 years of experience in international trade finance. In May 2009 he joined Fifth Third Bank as the head of their Global Trade Services Sales team. Fifth Third is one of the 20 largest banks in the US and provides a full range of risk mitigation and financing products for exporters and importers. Prior to Fifth Third, Buddy worked for Atradius Trade Credit Insurance, ABN AMRO Bank, Bank of America, Wachovia Bank, and The First National Bank of Chicago.
Buddy is a recognized expert in trade finance and author of numerous magazine articles and the books Users’ Handbook to Documentary Credits under UCP600, Documentary Payments & Short-Term Trade Finance, and The Regulatory Environment of Letters of Credit and Trade Finance. He owns the consulting firm Global Trade Risk Management Strategies, which specializes in educational training, and makes frequent presentations for national associations of exporters, importers, bankers and lawyers. Mr. Baker serves as a member-at-large of the National Letter of Credit Committee of the International Financial Services Association and is actively involved in establishing national and worldwide standard practices for LCs, such as the recent revision of the Uniform Customs and Practice for Documentary Credits (referred to as UCP600), the official ICC guide for examining letter of credit documents, called the International Standard Banking Practices for the Examination of Documents under Documentary Credits, the eUCP supplement to the UCP dealing with electronic documents, the International Standby Practices, and Article 5 of the Uniform Commercial Code. He acts as an advisor to the Wolfsberg Group, an international group that includes most of the largest banks in the world whose purpose is to set standards for combating money laundering, and to the Institute for International Banking Law and Practice. Buddy also serves on the Board of Directors of the Association of International Credit and Trade Finance Professionals (ICTF), a multinational association of export credit managers.
Buddy earned his undergraduate degree at Yale University and his MBA at Northwestern. He can be reached at (847) 830-3038 or [email protected].
7
Who Is the Audience?
Talk assumes that the audience (you) consists primarily of lawyers that occasionally practice in the LC area, that you represent applicants, beneficiaries and/or issuers (banks), and that you are more likely interested and involved with standby letters of credit rather than commercial letters of credit.
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Goal of the Program The goal of this presentation is to assist the lawyer in spotting and addressing LC issues — knowing when there is an issue, what to look for, where to go for help in solving it and some tips on how to handle it. Specifically, we will cover:
• Letter of credit facts
• Who issues LCs?
• What are LCs used for?
• What are LCs?
• What are the types of LCs?
• What are the advantages to using LCs?
• What are the disadvantages to using LCs?
• What are the alternatives to LCs?
• How can LCs avoid bankruptcy issues?
• How are LCs priced?
• What legal regimes govern LCs? 9
Program Topics
• Which set of rules is better for standbys – the ISP or the UCP?
• Where to find good sources of LC law and practice
• Role of consultants and where to find them
• Where to look for good forms
• How to pick a creditworthy issuer
• How to review LC reimbursement agreements
• What makes LCs unique?
• What is a bank guarantee vs. a letter of credit?
• What is a negotiable letter of credit?
• What is an advice of an LC?
• What is a confirmation of an LC?
• How and why is an LC transferred?
• How and why are proceeds of an LC assigned? 10
Program Topics
• How is an LC issued?
• What is a SWIFT format LC?
• How is an LC amended?
• How is an LC extended?
• How is an LC cancelled?
• How to draft an LC
• What problems are encountered in drafting LCs?
• How to prepare a presentation (draw) on an LC
• How to enjoin a draw on an LC and when not to
• Letter of credit scams to watch out for
• How can the ISP Model Forms be helpful?
• What are supersedeas LCs and how are they used?
11
Who Issues LCs? (Letter of Credit Facts)
• Over $600 billion of standbys issued by U.S. banks and U.S. branches of foreign banks were outstanding as of end of the first quarter of 2012.
• Over $1 trillion of international trade is paid for annually through commercial letters of credit. This is actually part of a steady downtrend as there is $10-$12 trillion in annual world trade.
• Letter of credit business is fairly concentrated: nearly 80% of the dollar volume of standbys that are issued by U.S. banks are issued by 10 banks, with Chase the leader at over $100 billion; Commercial LCs in the U.S. are even more concentrated with 80% issued by 5 U.S. banks. Of course, banks all over the world issue commercial LCs, including U.S. branches of foreign banks.
• Standby letters of credit are regularly used and accepted in the United States, Canada, Japan and a few other countries; they are accepted in much of the rest of the world, but in most foreign jurisdictions bank guarantees are more common.
12
Insurance Industry Has the Largest Use of LCs by Dollar Amount
Largest Dollar Amount Use -- Although there are dozens of different uses for letters of credit, the greatest use by dollar volume for standby letters of credit is standbys posted as security for the following types of obligations:
• Municipal bond issues;
• Obligations of nonadmitted reinsurers to insurance companies;
• Indemnities by private business to insurance companies fronting for workmen’s compensation and other types of state mandated insurance; and
• Payment assurance for obtaining surety and performance bonds
13
Largest LCs Ever Issued
The largest letters of credit issued were supersedeas LCs:
• $1.9 billion letter of credit posted by AT&T to act as supersedeas for the judgment obtained against it by MCI in an anti-trust case filed and tried in the Northern District of Illinois in the 1980’s; and
• $5 billion letter of credit posted by Exxon to secure payment of the judgment entered against it while its appeal was pending arising out of the Exxon-Valdez oil spill case.
• Each of these letters of credit was severally issued by a consortium of banks.
14
What Are LCs Used For?
Commercial letters of credit are used to pay for goods sold and delivered in international trade. Standby letters of credit can be used to support or pay almost any type of underlying obligation. Standby letters of credit have been used to secure obligations in connection with the following types of transactions: • Workmen’s compensation insurance fronting arrangements • Surety bonds • Commercial paper • Municipal or industrial revenue bonds • Commercial lease rent security in lieu of cash security deposits • Construction contracts • Open account indebtedness
15
Uses of LCs
• Government permits • Government contracts • Cable installation obligations • Purchase price holdbacks • Advance payment guarantees • Bank guarantees • Environmental clean-up • Executive compensation • Reinsurance obligations of nonadmitted reinsurers • Financial contracts such as SWAPs • Forward Contracts (e.g. power purchase agreements) • Clearing obligations (e.g. Chicago Mercantile Exchange) • Road and subdivision improvements • Obligations to consumers or the public
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Uses of LCs
• Supersedeas in lieu of appeal bond • Pre-judgment attachment security • Injunction security • Preliminary arbitration awards • Power plant construction • Equipment lease security • Securitizations • Oil for food and medicine (Iraq) • Exchange of prisoners (Cuba)
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What Is an LC?
• A Letter of credit is an independent undertaking of an issuer, usually a bank or other financial institution, issued at the request of an applicant to pay the beneficiary up to a stated amount against the beneficiary’s timely presentation of documents that conform to the terms of the letter of credit. (See UCC §5-102.)
• A letter of credit must be issued in record form and authenticated (signed) by the issuer. (UCC §5-104.)
• The two most important qualities of a letter of credit are that it is an “independent” undertaking of the issuer, and that the issuer’s obligation to pay, with the exception of instances of material fraud, is based on documents presented conforming to the terms of the LC, not the underlying actual performance or default of a contract or obligation which the LC supports.
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Unique Qualities of LCs
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Letters of credit are sui generis and counterintuitive in a number of respects. An LC:
• Is independent of the underlying transaction • Deals in documents only; nondocumentary conditions are disregarded. • Requires documents presented to strictly comply with the terms of the LC • Relies on conventions – the ISP and UCP -- to supplement and interpret its
terms • Needs no consideration • Usually, but not always, is issued by a financial institution; cannot be
issued by a consumer • Frequently calls for the original of the letter of credit to be presented to
effect a draw • Cannot be cancelled without the beneficiary’s consent once it leaves the
issuer’s hands • Has a time limit – expiration date
Unique Qualities of LCs
• Issuer must give timely notice of dishonor with all the reasons it is dishonoring. (UCC §5-108(b); UCP600, Art. 16c; ISP98, Rules 5.01 & 5.02.)
• If the issuer fails to timely give notice of dishonor, it must honor even if the documents are discrepant. (UCC §5-108(c); UCP 16f; ISP Rule 5. 03.)
• Force majeure events do not extend time to draw on UCP LCs. (UCP600, Art. 36.) • Amendments can be accepted by the way the beneficiary draws on the LC.
(UCP600, Art. 10; ISP98, Rule 2.06(c).) • Statute of limitations is short – 1 year after later of expiry or cause of action arises.
(UCC §5-115.)
• Letters of credit have restrictions on transfer. (UCC §5-112; UCP600, Art. 38; ISP98, Rules 6.02 & 6.03.)
• Letters of credit have restrictions on assignment of proceeds. (UCC §5-114; ISP98, Rules 6.07-6.09.)
• Letter of credit litigation carries with it loser paying attorneys fees. (UCC §5-111(e).)
• The issuer is not normally subject to jurisdiction in the beneficiary’s out-of-state location if the issuer does not otherwise do business in that state.
• Law governing an LC is the law of the place of its issue, unless otherwise stated in the LC. (UCC §5-116(b).)
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Types of LCs
Two main types: Commercial and Standby LCs • They are all irrevocable unless they state they are revocable. UCC §5-106(a);
UCP600, Art. 7b; ISP98, Rule 1.06a.
Commercial LCs are two general types: • Freely negotiable with any bank • Negotiable with a single, nominated bank • Straight credits are rare in commercial LCs • Merchant LCs deserve special mention
Standbys can be divided into several subtypes: • True Standby LCs (to be drawn on only if default) • Direct Pay Standby LCs (drawn on as payment due) • Clean or suicide LCs (insurance industry) • Two-party standby LCs (merchant LCs)
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Commercial LCs
• Commercial LCs are used to pay for goods shipped in international trade. • They require presentation of “live” documents – such as bills of lading or
other shipping documents, insurance certificates, invoices, packing lists, inspection certificates, custom’s invoices, etc.
• These LCs are characterized by low cost (say 1/8th of 1%), low risk (risk rated at 20% of face value for capital adequacy purposes), high discrepancy rates (50-70%), short duration, and that they give control of goods to whoever pays for the documents.
• Lawyers are not usually involved in their use. • They are almost universally governed by the UCP – currently the ICC’s
UCP600. The UCP rules and practice are exacting, applied differently by different banks or countries, and require expertise and many years of experience to interpret and apply.
• Most lawyers reviewing commercial LCs should get help from an experienced LC banker, freight forwarder, employee of the export department of a large corporation or an LC consultant.
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Commercial LCs
• Most commercial LCs are issued through SWIFT (Society for Worldwide Interbank Financial Telecommunications), a secure bank-to-bank messaging system which has its own coding for fields and message types. (See last four slides for SWIFT LC message types and fields.)
• Commercial LCs work through a network of issuing, advising, confirming and negotiating banks. Frequently the advising bank is also the negotiating bank and the seller’s bank. The negotiating bank must be nominated in the LC to act as such. The LC can do so through naming a specific bank as negotiating bank or stating that the LC is freely negotiable or negotiable at any bank. A negotiating bank can pay the beneficiary, present the documents it honors to the issuer and, if they conform, be entitled to payment from the issuer. If the issuer dishonors because the documents do not comply, the negotiating bank has recourse against the beneficiary. True negotiation by banks in this country is rare.
• Letters of credit are not negotiable; drafts accompanied by documents presented under commercial LCs are negotiated (endorsed and delivered), like a negotiable instrument, giving the negotiating bank superior rights to payment. (See UCC §5-109 (1)(a)(holder in due course and similar rights); UCP600, Art. 12b; Fortis Bank (Nederland) N.V. v. Abu Dhabi Islamic Bank, 2010 WL 7326295 (N.Y.Sup.Ct. Aug. 26, 2010).)
• Negotiating and confirming banks do their own document review and facilitate the forwarding of documents to the issuer.
23
Merchant LCs
• Merchant LCs have the look and feel of commercial LCs because they are advised and processed by reputable major banks, but they are issued by a large merchant such as a Sears, Target or JC Penny. The applicant and the issuer are the same.
• In addition, these types of LCs sometimes require presentation of documents that must be signed by the applicant merchant, such as a receipt or inspection report or other administrative document. They are also frequently laden with extra fees the beneficiary must pay for various types of documentary procedures required by the merchant issuer for a draw on the LC to be honored.
• Merchant LCs work because the Chinese manufacturers with whom the orders for goods are placed obtain local bank credit to finance the costs of manufacture based on their receipt and strength of these “letters of credit.”
• Should there be a major merchant bankruptcy, that result may change.
24
Standby LCs
• Standby LCs are used to secure payment or performance of an obligation. They are used in transactions where lawyers are more likely to be involved – larger dollar amounts, structured deals that have a number of issues associated with them, and documents that require legal review.
• Standby LCs are relatively more expensive – 1 – 1.5% per annum. Can be lower or higher depending on the strength of the applicant, volume of business with the issuer and other considerations.
• Standby LCs are usually not negotiable, although sometimes confirmed and advised.
• Standbys are usually governed either by the UCP or the ISP.
• They are risk assessed for credit and capital adequacy concerns as a loan – usually at 100% of face value of the LC.
• They cannot be bought like insurance policies; you must have an established relationship with the issuer, a line of credit and in many cases collateral to secure them, and the risks of issuance must be acceptable to the issuing bank.
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Types of Standby LCs
• Direct Pay Standbys. Direct pay standbys are treated as standbys for almost all purposes, including pricing, risk assessment and capital adequacy standards.
• The major difference is that direct pay letters of credit are meant to be drawn on by the beneficiary, frequently a trustee for bondholders under an IRB issue supported by the LC. Direct pay avoids preference issues.
• Many direct pay letters of credit automatically reload after a draw to be ready for the next periodic payment, unless the issuer gives notice it will not reload the LC, in which event, the Trustee will declare a default.
• Direct pay LCs can be used in other contexts as well to avoid preference issues.
26
Clean LCs
• Clean LCs are sometimes referred to as “suicide LCs” because they only call for a draft to be presented to effect a draw. They are thus harder to enjoin, since there is no statement that accompanies the draw that the applicant can claim is materially fraudulent.
• Clean LCs are frequently required by insurance companies and their regulators to support reinsurance commitments of nonadmitted insurers, to support insurance fronting arrangements for workmen’s compensation, and to obtain issuance of a performance or surety bond. (See NY Insurance Department Regulation 133.)
• Practice Pointer: When representing an applicant that is required to have issued a clean LC in favor of a beneficiary, make sure that the underlying agreement is clear as to when and for what reasons and indebtedness the beneficiary can draw.
27
Clean LCs
• The run-off of major insurance companies such as Kemper in Illinois raised concerns over whether the clean LCs posted with them by corporations not in default would be drawn down.
• $225 million in LCs that should have been but were not clean LCs, posted by Koch Oil and Conoco Phillips, have given rise to litigation in the MF Global Bankruptcy. These LCs posted with MF Global as margin collateral required presentation of a default certificate. By CFTC regulation, they were to be treated and used as customer property in the event of the FCM’s insolvency. These LCs expired without a drawing after MF Global was declared insolvent because the customer-applicants were not in default. Conoco and Koch settled, paid and closed out their accounts within a short time after MF Global’s bankruptcy. As a result, the LCs posted with MF Global by these applicants could not be drawn upon and their proceeds shared along with other customer property on a pro rata basis with MF Global’s other 27,000 customers who had a shortage in their customer property accounts. (See trial briefs filed in ConocoPhillips Co. v. Giddens, Case No. 12 CV 6014 (KBF) (S.D.N.Y.).)
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Using Standby LCs in Trade Transactions
• Credit line back-up
• Bid bonds
• Performance bonds
• Warranty/retention money
• Advance payment guarantees
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Credit Line Back-Up
• Seller wants payment insurance when selling on terms such as open account, collection, etc.
• May be less expensive in the long run than commercial letters of credit for repetitive shipments, sales
• Amount may be equal to the maximum outstanding receivable, with automatic reduction schedule
• Will be drawn upon if buyer fails to effect payment within terms allowed
• Often issued in “evergreen” form
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Two-Party LCs
• Two-Party LCs are LCs issued by a financial institution for its own account.
• Under UCC §5-102(10) only financial institutions can issue two-party letters of credit.
• Trustees for bondholders are sometimes also the issuers of letters of credit supporting the bonds. These two “hats” worn by the bank can usually be justified because one of the hats is in a trust capacity and therefore arguably a different legal person.
• Beneficiaries will normally accept two-party LCs if the issuer is a well-regarded major financial institution that regularly issues LCs and cares about its reputation as a reliable LC issuer.
• If that is not the case, the beneficiary may want to be concerned about the independence of the issuer when it comes time for it to honor a draw.
31
Non-Bank LCs
• As mentioned in a previous slide and in discussing merchant LCs, there are nonbanks that regularly issue LCs.
• Some institutions, like factors, major insurance companies and GECC, regularly issue LCs for their customers. GECC has billions of dollars outstanding in LCs and is a AA credit, rated higher than most banks.
• Taking an LC from a corporate parent to guarantee the obligations of its subsidiary has been mentioned as a superior way to assure payment, but is not recommended.
• The problem is that if the “LC” is held not be a true LC, you will need suretyship waivers which an LC does not contain.
32
Advantages of LCs
• Instant liquidity -- The terms of a letter of credit can specify that fax presentments are allowed and that the draw must be honored (or notice of dishonor given) within a few days or less.
In some cases for special, large customers, such as trustees for bondholders, to secure commercial paper or to secure clearing obligations owed to commodities or security exchanges, the letter of credit will be payable on the same day presentation is made.
Payment is by cash, usually via wire transfer by the issuer to the beneficiary’s account.
33
Advantages of LCs
• Solvency of issuer -- By use of a letter of credit, the beneficiary is assured that the payment obligation is backed by credit of a bank, which is substituted for or added to credit of a corporate or individual applicant.
The creditworthiness of the bank can be determined or specified in the selection process and/or set forth in the letter of credit or the underlying agreement that provides for use of a letter of credit. If the credit of the issuing bank deteriorates below identified credit categories or designated ratings levels, the beneficiary of the letter of credit should be able to draw on the letter of credit if the applicant does not replace the letter of credit with one issued by a bank with an acceptable credit rating within a time certain – say 30 days after the downgrade of the issuing bank.
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Advantages of LCs
• Independence of issuer -- Except for material fraud, the issuer’s obligation to honor is independent of the obligations of the parties (applicant and beneficiary) and their disputes over the underlying contract which the letter of credit supports. The issuer only looks to see if the documents presented are timely and conform to the documentary conditions specified in the letter of credit. The issuer looks to standard banking practice for that determination, as supplemented by the UCP and ISBP if the UCP is applicable to the credit, or the ISP, if the ISP is applicable. (See UCC §5-108(a), (e); UCP500, Art. 13(a); UCP600, Art. 2 (definition of “Complying Presentation”); ISP Rules 1.03(b) and 4.01(b).) The issuer does not and should not involve itself in issues or investigations of whether the underlying contract has been properly performed.
35
Advantages of LCs – Bankruptcy Avoidance
• Automatic stay -- Unlike attempting to realize on collateral, because a draw on a letter of credit is treated as a draw on the funds of the issuing bank and not the funds of the bankrupt applicant-debtor, courts should not enjoin otherwise proper draws or treat the automatic stay under Sec. 365 of the Bankruptcy Code as applicable.
• Ipso facto clause -- Sec. 365(e)(1) of the Bankruptcy Code prevents a counterparty from declaring a default and terminating a contract with a debtor simply because the debtor is insolvent or bankrupt. However, that provision does not necessarily stop a beneficiary from drawing on a letter of credit to repay itself for municipal bond indebtedness secured by the letter of credit, because the issuer is in name a municipality and not the applicant. (See In re Prime Motor Inns, 130 B.R. 610 (S.D. Fla. 1991).) Some caution should be exercised here.
36
Advantages of LCs – Bankruptcy Avoidance
• Preferences -- As noted above, a draw on a letter of credit to pay for an obligation of a bankrupt applicant is not normally regarded as transfer of the bankrupt’s estate; rather the proceeds transferred are regarded as funds of the issuing bank. As a result, courts will not normally set aside as preferential a paydown of a debt from a draw on a letter of credit.
The exception is if the letter of credit is posted to secure the debt within 90 days of the applicant’s bankruptcy, the debt was antecedent, and the letter of credit reimbursement obligation is secured. That can be an indirect preference. (See In re Compton, 831 F.2d 586 (5th Cir. 1987); In re Air Conditioning, 845 F.2d 293 (11th Cr. 1988).)
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Advantages of LCs
• Pay now, litigate later -- Courts have taken the view that if there is a problem with the underlying contract or its performance while a draw is being made or about to be made on a letter of credit, the beneficiary should be entitled to draw and hold or use the proceeds until the dispute or litigation is resolved.
In the absence of egregious fraud, courts will treat the rights of a beneficiary under a letter of credit similar to those of a party already holding the cash, usually without restriction.
Courts have used the phrase “pay now, litigate later” to describe the beneficiary’s rights against the obligation of the issuer and applicant to allow the beneficiary to draw on the letter of credit. (See Eakin v. Continental Illinois Nat. Bank & Trust Co., 875 F.2d 114 (7th Cir. 1989); In re Sabratek, Corp., 257 B.R. 732 (Bankr. Del. 2000).)
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Advantages of LCs
• Difficult to enjoin draws -- The standard to enjoin a draw on a letter of credit is material fraud. (UCC §5-109.) Official Comment 1 to that section states that “material fraud by the beneficiary occurs only when the beneficiary has no colorable right to expect honor and where there is no basis in fact to support such a right to honor.”
The comment goes on to endorse cases such as Intraworld Indus. v. Girard Trust Bank, 336 A.2d 316 (Pa. 1975) and Ground Air Transfer, Inc. v. Westates Airlines, Inc., 899 F. 2d 1269 (1st Cir. 1990) where the standard for injunction is very high -- the fraud must be “so serious as to make it obviously pointless and unjust to permit the beneficiary to obtain the money.”
In addition, UCC §5-109 puts the burden on the applicant to show all the other requirements for equitable relief have been met, including irreparable harm, no adequate remedy at law, the public interest is served and the requirement of posting a bond.
39
Advantages of LCs
• Adaptability -- As is shown from the variety of uses for letters of credit enumerated above, a letter of credit can be tailored to secure almost any type of obligation. The draw conditions can require elaborate or simple certifications identifying the obligation secured and the events justifying the draw.
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Advantages of LCs
• Documentary safeguards -- An applicant that is concerned about uncontrolled draws by a beneficiary can draft documentary conditions to guard or protect against untoward or unjustified draws. These safeguards could include such documents as third-party inspection certificates, copies of judgments or arbitration awards, copies or originals of bills of lading and other shipping documents, or even opinions of counsel as well as detailed statements, which if false, could give rise to a cause of action against the beneficiary after the draw is effected or if fraudulent, to enjoin the draw.
Caution: Issuers will balk at being required to interpret the meaning of an order or opinion; keep everything simple and straightforward.
Beneficiaries and issuers both will resist applicant-signed documents.
41
Advantages of LCs
• Payment against right to receive goods -- Commercial LCs used in international trade provide that the beneficiary must present to the issuer shipping documents, including bills of lading, to receive payment. These documents are passed along to the applicant to enable it to receive the goods shipped which are being paid from a draw on the letter of credit.
UCC §5-118 gives issuing, negotiating and confirming banks an automatic perfected and in most cases prior security interest in documents presented when they honor a draw on a letter of credit until they are reimbursed.
42
Advantages of LCs
• Cost is relatively modest -- The cost of a letter of credit can vary with the creditworthiness of the applicant or if cash or liquid collateral is posted to secure it. One rule of thumb that larger banks sometimes use is to charge for letters of credit based on the spread between the bank’s cost of funds and the borrowing on the loan facility offered to the applicant. This pricing in theory reflects extra cost for extra risk.
• On letters of credit issued by a bank secured by a brokerage account of an affiliate containing liquid securities, the fee could be as low as 80 basis points or lower. So the normal range for the annual fee, usually paid quarterly, is between 75 and 150 basis points.
• There are other fees as well, such as issuance and payment fees, amendment fees, document preparation fees, fees for advising or confirming a credit, and discrepancy fees.
• While bond premiums are normally less than letter of credit fees, a letter of credit usually has to be posted with the bonding company to induce it to issue the bond – resulting in two fees being paid.
43
Advantages of LCs
• Expiration date can be extended -- Although issuing banks insert an expiration date on their letters of credit, which is usually one year or less from the date of issue, through the use of an automatic extension clause, the letter of credit can be extended over a multi-year period or even indefinitely. These clauses work automatically, so that unless the issuer sends out notice in advance of expiration alerting the beneficiary that it will not extend the letter of credit, the letter of credit will be extended. If the notice is sent and the letter of credit and/or underlying agreement is properly worded, the beneficiary can then draw on the letter of credit to hold the cash proceeds as cash collateral unless the applicant procures a suitable replacement letter of credit within a stated time, say 30 days, before the current letter of credit expires.
44
Disadvantages of LCs
1. LCs are treated by issuers like loans – the applicant must be credit-approved, set aside credit lines and frequently have to set aside collateral.
2. Other forms of credit support may be less costly, such as a bond, export credit insurance, documentary collection, a security interest in collateral, or a corporate guaranty.
3. For commercial letters of credit, discrepancy rates are very high – over 50%, although in 99% of the cases the discrepancies are waived or corrected.
4. LCs have expiration dates to which attention must be paid.
5. LCs sometimes require presentation of the original LC and all amendments.
6. LCs must be amended each time there is a change in amount or terms.
7. Rules and practice governing LCs, especially commercial LCs, can be complex.
8. LCs can be misused to take advantage of applicants. E.g., Lloyds cases.
9. LCs are only as good as the banks that issue them.
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Alternatives to LCs
1. Surety or performance bond -- Bonds are issued by insurance companies. Most do not have expiration dates, although their coverage period for claims can be specified in the bond. Their payment of a claim goes through a claims review process and, unlike letters of credit, the surety can raise the defenses of the primary obligor against payment on the bond and in some cases its own suretyship defenses. This can lead to litigation that must be completed or settled before payment is effected.
• The pricing of a bond is usually lower than that for a letter of credit, but frequently the bonding company will require that a letter of credit be issued to it by a major, rated bank that can easily be drawn on and will be extended indefinitely until the insurer chooses to draw on it or release it. Thus the primary obligor ends up paying two fees – a premium for the issuance of the bond, and the annual and other fees for issuance of the letter of credit.
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Alternatives to LCs
2. Financial guaranty insurance -- Financial guarantee insurance is issued by a handful of what are known as “monoline” insurance companies that until recently had AAA ratings. The large monoline insurers include American Bond Assurance Corporation (Ambac), Municipal Bond Insurance Association (MBIA), ACA Financial Guarantee Group, Assured Guaranty Corporation, Financial Guaranty Insurance Company (FGIC), Financial Security Assurance (FSA), and XL Capital Assurance.
• The cost of financial guaranty insurance is generally very low, but these monoline insurers usually only insure obligations of state or local governmental bodies that have taxing power to repay the insured debt, or they insure debt of issuers of bonds that already have a credit rating of A or would have such a rating if rated.
• In the event of a default, financial guaranty insurers only pay the installments as they come due in the absence of a default.
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Alternatives to LCs
• The purpose of the use of this type of insurance is to move the rating of the insured debt from say “A” to “AAA” to enable it, with the higher rating, to command a lower interest rate in the financial marketplace for rated bonded debt. This means that only very large debt issues are insured, because the debt has to be rated, underwriting analysis performed, and then the say 50 basis points savings involved has to justify the cost of the insurance, obtaining and maintaining a debt rating and other costs of the underwriting. Monoline insurers would thus insure specific debt issues only of state or municipal governmental bodies, large corporations with good credit ratings or with debt that could structured with the use of a special purpose vehicle as having a separate good rating.
• Until 2007, no monoline had ever defaulted on making a payment of insured debt and in fact none were ever even downgraded. Monolines captured almost 50% of the municipal debt market by that time.
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Alternatives to LCs
• Monolines got into trouble when they insured credit default swaps and debt securities of subprime mortgage pools which were underwritten with assumptions that did not contemplate the default rates, foreclosures and decline in real estate values of the subprime mortgage crisis. The result of their insuring mortgage-backed securities is that five of the seven major monoline insurers suffered a decline in their AAA ratings. Some were even downgraded below investment grade because they had to pay out huge losses in derivatives market transactions that they insured.
• Unless they possessed sufficient capital to shore up these losses, their ratings suffered and they became unable to compete in the markets from which they generate the bulk of their business – raising a rating of a debt issue from A to AAA. One result of the decline of the ratings of the monolines has been a reported uptick in letter of credit-backed industrial revenue and governmental agency bonds that previously were insured by the monolines.
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Alternatives to LCs
3. Export insurance -- Export insurance is a strong competitor with commercial letters of credit for international trade payment assurance. The three major export insurers are Euler, Coface, and Atradius.
• Export insurance, with a number of exceptions, insures loss from a credit default by the buyer in an international sale of goods or services.
• To qualify for the insurance, both the exporter and the foreign buyer must be on approved lists of the export insurers, the trade credit extended must be within aggregate limits, within limits specified by the insurer for the particular buyer, and the terms of the sale otherwise must conform to the terms of export insurance policy.
• The export insurer insures against nonpayment due to insolvency and political or country risks, but does not insure or pay if nonpayment is due to fraud or disputes over the quality of the goods shipped, their conformity to contract terms, or the timeliness of their delivery.
• Export insurance is usually less expensive than the cost of letters of credit, but obtaining export insurance involves pre-approval and documentation processes that are burdensome.
• Unlike letters of credit, export insurance does not tie up lines of credit of the buyer or require collateral.
• State and federal government export insurance programs are also available to encourage U.S. exporters to sell on credit into specified international markets subject to the conditions and criteria specified in the respective government export insurance program.
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Alternatives to LCs
4. Documentary Collection -- Documentary collections are simply the payment for goods shipped in international trade in exchange for specified shipping documents, again through the banking system. If the buyer does not pay, the bill of lading and, thereby, control over the goods remains with the seller and the seller’s bank.
• While cheaper than letters of credit, documentary collection does not assure the seller that it will receive payment when it ships the goods. No bank stands behind the obligation of the buyer to pay for the goods shipped. The seller therefore may be stuck with unsold goods overseas in a declining market or without ready means to dispose of the goods without incurring substantial losses, in either case, if the buyer chooses not to or is unable to pay for them.
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Alternatives to LCs 5. Demand guarantee -- demand guarantees are sometimes called simple
demand guarantees, first demand guarantees, independent bank guarantees or unconditional guarantees. A demand guarantee is in some respects the European equivalent of a standby letter of credit.
• The ICC has a regime for demand guarantees called the Uniform Rules for Demand Guarantees, ICC Publication No. 758, which unlike its predecessor, URDG 458, is gaining usage. The URDG will only apply if the guarantee specifies it applies.
• Like letters of credit, the payment undertaking under a demand guarantee is regarded as independent of performance of the underlying obligation the guarantee supports. The guarantee is usually issued by a bank and payment is made after the beneficiary makes a written demand on the guarantee accompanied by a statement of default (whether or not the bank guarantee so specifies). (See URDG 758, Art. 15a.)
• True demand guarantees are considered independent obligations of the issuer and thus are not normally subject to injunction in the absence of a showing of fraud.
• Demand guarantees are quite different from contract guarantees or accessory guarantees, like what a parent company might issue for a subsidiary.
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Demand Guarantees -- URDG
• Statement of default required even if not indicated in the guarantee
• May include an expiry event instead of or as well as an expiry date; an expiry event is actually a document stating the event has occurred, presented by the applicant and the bank is not responsible for veracity
• No such concept as a nominated bank; documents must be presented to the issuing bank by the expiry date even if presented through the beneficiary’s bank
• No rules for confirmation; counter-guarantees are considered the norm
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Standby L/C Demand Guarantee
Accessory/Contract
Guarantee, Surety Bond
Surety Bond
Independent & payable
against documents
Independent & payable
against documents
Specified amount
Specified amount
Payable upon occurrence
of specified event
Amount of damages
(usually with a maximum)
Specified expiry
Usually has a specified expiry
Expiry event
Rules: UCP or ISP
(and UCC5 in the U.S.)
Rules: URDG, ISP,
or local law
Rules: Local law
Standby LCs vs. Guarantees & Bonds
Other Alternatives to LCs
• Cash or other collateral or security
• Corporate guarantees
• Open account or unsecured credit
• Payment in advance
• Escrows
• Netting in some cases
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Bankruptcy Avoidance
Planning is required to make proper use of LCs to avoid bankruptcy issues:
• Neither the LC nor the underlying agreement should require notice to the applicant of the default as a condition of effecting a draw; notice may be prohibited by the automatic stay, although some courts regard it as informational.
• It is preferable that there be some default other than bankruptcy or insolvency of the applicant before a draw is made.
• If the LC secures a payment obligation in default, because of the danger of a preference, it is better to draw on the LC to pay it than to receive a late payment from the debtor-applicant. (See In Re Powerine, 59 F.3d 969 (9th Cir. 1995).)
• If payment of a debt secured by an LC is received directly from the debtor, a defense to a preference claim may exist where the payment has the effect of releasing collateral securing the LC. (In re Fuel Oil Supply & Terminaling, Inc. , 837 F.2d 224 (5th Cir. 1988).)
• If the LC is issued after the debt is already incurred, the reimbursement obligation is secured, and the debtor files for bankruptcy within 90 days thereafter, the proceeds of the draw can be recovered as an indirect preference. (In re Compton, 831 F.2d 586 (5th Cir. 1987); In re Air Conditioning, Inc., 845 F.2d 293 (11th Cir. 1988).)
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Bankruptcy Avoidance
• The issuer also has to be concerned about preference issues. If it receives collateral or perfects a security interest to secure the reimbursement obligation of the applicant within the preference period, the value of that collateral taken by the lender to reimburse itself is subject to recovery as a preference. (See, e.g., In re P.A. Bergner & Co., 140 F.3d 1111 (7th Cir. 1998).)
• When the issuer issues or extends a letter of credit for the account of a financially shaky applicant, the issuer should make sure that it has a perfected security interest in sufficient collateral to cover the applicant’s reimbursement obligation; waiting to obtain collateral and/or perfect a security interest until the draw occurs or is threatened, while better than not getting the collateral, can result in receipt of a preference.
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LC Legal Regimes
• Letters of credit issued in the U.S. are governed by Article 5 of the UCC – the shortest article in the UCC, consisting of 18 sections.
• However, almost all commercial LCs are governed by the UCP600 – that has 39 articles that are fairly detailed, and that are interpreted by the ISBP or International Standard Banking Practices promulgated by the ICC which consists of 185 articles.
• Standby LCs may be governed by either the UCP600 or the ISP98 (International Standby Practices), which can be found as ICC Publication No. 590.
• Neither the ISP or the UCP is available on-line. They are not free publications. You have to order them from the ICC or find them in an LC handbook that pays a royalty to the ICC for their publication.
• Article 5 of the UCC specifically allows for the use of the ISP and UCP in letters of credit and defers to those regimes. (UCC §5-116(c).)
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Highlights of UCC Article 5
• Adopted almost uniformly by all 50 states; variances exist only in a few states in a few provisions. Contrary to the Official Text of Article 5 of the UCC, the award of attorneys fees to the prevailing party is discretionary rather than mandatory in Ala., Ct, NY, NJ and Tx (UCC §5-111(e)); and a jury can determine standard banking practice for LCs in Ala., NY and Pa. (UCC §5-108(e))
• Only article to limit good faith definition to honesty in fact. (UCC §5-102(a)(7))
• Clarifies fraud standard for enjoining draws on LCs (UCC §5-109)
• Clarifies warranties of presenter that documents presented do not violate any agreement which the LC supports (UCC §5-110)
• Provides subrogation rights after the draw is honored. (UCC §5-117)
• Defers to regimes like the ISP and UCP (UCC §5-116(c))
• Allows most provisions of Article 5 to be varied by agreement. (UCC §5-103(c))
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Highlights of UCC Article 5
• Allows the parties to choose the law and forum governing their LC. In the absence of a choice, the law of the place of the issuer governs the LC. (UCC §5-116)
• Adopts standard banking practice as the proper interpretative rule for determining compliance of documents with the terms of the letter of credit (UCC §5-108(e))
• Statutorily adopts the independence principal. (UCC §5-103(d))
• Contains clear rules on the conditions for assignments and transfers. (UCC §§5-112 – 5-114)
• Contains a relatively short, one-year statute of limitations. (UCC §5-115)
• Makes clear the preclusion rule. (UCC §5-108(b)-(d))
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Applicability of the UCP to Standby Credits
All Credits – Expiry – Time allowed for document examination – Procedure for refusal – Confirmation – Force majeure
Commercial Only – Transport docs – Acceptance and negotiation of drafts – Insurance – Partial shipments – Installment shipments – Late presentation – Partial transfers – Assignment of proceeds
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ISP vs. UCP in Standby LCs
The ISP is clearly the preferable regime for standbys for the following reasons:
1. ISP rules were written specifically for standbys; the UCP were written for commercial LCs; UCP rules apply to a standby to the extent applicable, but the UCP doesn’t provide guidance when its rules should and should not be applicable to standbys.
2. ISP rules are clear, understandable, readable and transparent. Official comments and interpretations are not usually required to apply them, unlike the UCP.
3. The ISP does not deal with specialized treatment of documents used in international trade, greatly simplifying the compliance process.
4. The ISP does not adopt the UCP’s consistency rule – that documents presented must be internally consistent, consistent with each other and consistent with the terms of the LC; under the ISP they need only comply with the terms of the LC.
5. The ISP is not concerned with stale documents, latest shipping date, or installment drawings; the UCP is.
6. The ISP has a built in force majeure provision; the UCP does not.
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More UCP vs. ISP
• UCP assumes applicants want to pay
• ISP assumes applicants don’t want to pay
• ISP is more liberal re document examination
• ISP is more liberal re time allowed to present
• UCP is more concerned about originality of documents
• ISP contains a few rules that are just missing from the UCP
• ISP contains standby-specific rules (that no one wanted to put in the UCP)
• Transfers work differently
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UCP600 ISP98
Force majeure
L/C expires nonetheless Expiry extended 30 days
after bank re-opens
Consistency of documents Data in documents must
not conflict
Documents need not be
consistent
Time allowed for dishonor 5 banking days <4 days = reasonable
>7 days = unreasonable
Original documents “In __ copies” means one
original of each document
“Copies” means copies
Transport documents Extensive, detailed
requirements
Treated like “other”
documents
Disposition of documents Strict requirements No requirements
Deemed acceptance of
amendments
If documents comply
w/ amended terms
If documents will not
comply w/o amendment
Transfer One time but multiple
partial transfers allowed
Multiple times but always
in entirety
UCP vs. ISP
Where to Find LC Laws, Rules & Practices
Note: Most countries do not have laws governing LCs or even demand guarantees, though they may have laws for accessory guarantees.
• UCC Article 5
• ISP98 (ICC Publication No. 590)
• UCP600 (ICC Publication No. 600)
• IIBLP, LC Rules & Laws – Critical Texts for Independent Undertakings (5th ed. 2012)
• John Dolan, The Law of Letters of Credit (A.S. Pratt)
• James Barnes, The ABC’s of the UCC, Article 5: Letters of Credit (ABA)
• IIBLP Annual Survey of Letter of Credit Law & Practice (1996-2012)
• IIBLP’s Documentary Credit World
• ICC’s Documentary Insight
• Carter Klein, Standby Letter of Credit Practices and Rules Little Understood or Misunderstood by Applicants and Beneficiaries, 40 U.C.C.L.J. 125 (2007)
• Klein and Murray, Uniform Laws Annotated – Uniform Commercial Code Forms, Vol. 4, Art. 5 (Thomson West)
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Where to Find LC Forms
• IIBLP’s Model ISP Forms and endnotes found at www.iiblp.org
(See Slide 83)
• Klein & Murray, Uniform Laws Annotated – UCC Forms (Thomson/West)
• Your bank
• Prior deals
• SEC filings (Edgar)
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LC Advisors
Consultants:
– Walter “Buddy” Baker at www.gtrisk.com
– Prof. James Byrne at www.IIBLP.org
– Donald Smith at www.globaltradeadvisors.com
– Europe – Gary Collyer at www.Collyerconsulting.com
– Your LC banker
– Your freight forwarder
Attorneys:
– Carter Klein, Jenner& Block LLP, Chicago
– James Barnes, Baker & McKenzie, Chicago
– Michael Avidon, Moses & Singer, New York
– George Hisert, Bingham McCutchen, San Francisco
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LC Reimbursement Agreements
• LC Reimbursement Agreements are one-sided in favor of the issuer and generally onerous.
• Most applicants can get no traction in requesting changes to these pre-printed forms of the bank issuer.
• Reason: for a small fee, issuer takes credit risk, document checking risk, a litigation risk, sometimes a political risk, and sometimes a currency exchange risk.
• If your client is important enough to have bargaining leverage with its bank over the terms of its LC reimbursement agreement, consider focusing on terms not dealing with reimbursement, but with the right to make sure the LC is issued the way you expect it to be worded, that your client will have time in the event of a fraudulent draw to proceed to court to enjoin the draw, and that the fees are properly charged, in arrears on an accrued basis.
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Choose a Creditworthy Issuer
• LCs are only as good as the issuer that issues them. If the issuer becomes insolvent, the FDIC will not allow, except in very limited circumstances, the beneficiary’s rights under the LC as a claim against the failed issuing bank’s assets that are not sold, even if the reimbursement obligation is fully secured and the receivership will suffer no loss. (See FDIC Policy Statement on Collateralized LCs. 60 Fed. Reg. 27976, May 26, 1995.)
• Criteria for selecting an issuing bank include bank credit ratings, asset size, capital size, capital ratios and whether the issuer is “well capitalized” within the meaning of FDIC Guidelines.
• During the credit crisis other measures were used including credit default swap rates charged on the issuer’s obligations and the rapidity with which deposits left the bank.
• Credit downgrade provisions should be contained in the underlying agreement, not the LC, and the applicant should be required to replace the issuer within a time certain or it is a default or draw event and the beneficiary can draw on the LC. The proceeds should be held as cash collateral or applied to the obligation.
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Capital Requirements for LCs
• Banks are subject to regulations (based on the Basel Accords) that require that they maintain specified minimum levels of capital to absorb losses on their loans and other assets, including contingent assets like letters of credit.
• Under existing US regulations, commercial LCs receive a 20% “credit conversion factor” based on the low risk of loss. Standby LCs receive a 50% credit conversion factor if they support performance obligations, but have the same capital requirement as loans if they support financial obligations.
• New regulations (“Basel III”) have been proposed that will raise the overall amount of capital banks are required to maintain. Generally, the new regulations require more capital for riskier customers and riskier types of transactions.
• “Large, internationally active banks” will be required to statistically validate the probability of loss for their various types of assets instead of using set credit conversion factors. Ironically, for lack of loss data, these banks may need to treat all letters of credit as if they were loans.
• Fees will need to be doubled or even quadrupled to maintain return-on-capital targets. Confirmation fees will have to increase even more drastically to reflect the risk ratings of foreign banks.
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Advising Bank (UCP600, Art. 9; ISP98, Rule 2.05; UCC §5-107(c), (d))
• The advising bank notifies the beneficiary of the terms of the LC and its authenticity. It is not liable on the LC and is not nominated to act as a negotiating bank unless the LC so states, but it must advise accurately.
• The advising bank is usually but need not be the beneficiary’s bank. As a matter of customer assistance, the advising bank will frequently assist its customer, the beneficiary, in presenting documents.
• The advising bank must be nominated in the LC to be the advising bank.
• There can be more than one advising bank – one chosen by the issuer and one requested by the beneficiary.
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Confirmation (UCP600, Art. 8; ISP98, Rule 2.01(d); UCC §5-107(a))
• A confirming bank in effect becomes an issuing bank and agrees to honor timely, conforming draws on the LC when presented to it.
• A confirming bank must be nominated as such in the LC by the issuer. • The ISP and the UCP require and confirming banks word their confirmations so that
they are not bound unless the documents are presented to them instead of directly to the issuing bank.
• Confirming banks are not bound by amendments unless they expressly agree to confirm the LC as amended.
• Confirming banks will be very exacting on document review because once they honor, unlike negotiating banks, they have no recourse against the beneficiary if the issuing bank dishonors because of discrepancies found in the documents.
• It is not always necessary to have a local confirming bank, if the issuing bank is reputable and is located in a politically well-developed jurisdiction whose court decisions show deference to letter of credit principles and the issuer consents to jurisdiction and venue in the United States.
• Some issuing banks will consent to jurisdiction in some well-known jurisdictions and venues such as New York, Chicago and Los Angeles.
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Confirmation Issues
• The confirming bank will want to control the terms and governing law of its confirmation and where it consents to jurisdiction.
• If the underlying letter of credit is automatically extended, the confirmer will want to word its confirmation so that it also has the right to give notice that its confirmation will not be extended.
• If the confirmer fails to give the notice or reserve in its confirmation the right to do so, it will be bound on its confirmation to automatic extensions.
• Non-automatic amendments are not binding on the confirmer unless it agrees to them.
• The beneficiary will want to make sure it has a right to draw on the letter of credit if the confirmation is not extended by amendment or automatic extension by the issuer.
• Who pays confirmation fees and how are they collected.
• How and when is the confirmer reimbursed.
• On which bank is the draft to be drawn.
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LC Transfers (UCP600, Art. 38; ISP98, Rules 6.01-6.05; UCC §5-112)
• Transferable LC – One that specifies it is transferable. A letter of credit is not transferable unless it so specifies. Transfer gives the transferee the right to draw on the letter of credit and refuse amendments or cancellation.
• A UCP LC is transferable only once, but may be partially transferred.
• An ISP LC is transferable without limit, but may not be partially transferred.
• The UCC and the ISP give the issuer control over the transfer process.
• Transfers by operation of law (trustee, receiver, merger, change of name, but not asset sales) are recognized whether or not the LC states that it is transferable. (UCC §5-113; ISP98, Rules 6.11 – 6.14.)
• Practice pointer: If transfer is expected, negotiate transfer fee upfront and attach form of transfer document to the LC.
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Assignments of LC Proceeds (UCP600, Art. 39; ISP98, Rules 6.06-6.10; UCC §5-114)
• An assignment of proceeds of a letter of credit is an agreement by the issuer or nominated bank to pay proceeds of a draw to the assignee if and when a conforming and timely draw is made.
• An assignment of proceeds without more confers no right on the assignee to make a draw, refuse amendments or refuse cancellation of the LC.
• An assignee of proceeds is therefore subject to the beneficiary’s fulfilling the requirements of the LC to effect a draw, not amending or cancelling it adverse to the assignee, not transferring it and not having granted a prior assignment.
• A recognized assignment of proceeds under UCC §5-114 creates a perfected security interest in the proceeds if they are assigned as collateral security pursuant to a security agreement. (See UCC §9-107, 9-312 & 9-314.)
• Most security interests in LC proceeds are perfected as a supporting obligation in the underlying collateral such as an account or general intangible. (See UCC §§ 9-102(a)(77) & 9-308.)
• The issuer or nominated bank acknowledging the assignment controls the conditions of an assignment of proceeds.
• Practice pointer: The assignee will want certain minimum warranties from the issuer/nominated bank and the beneficiary that there are no prior assignments, that the LC will not be amended or cancelled without the assignee’s consent; and that the proceeds will be payable to the assignee’s designated account.
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Issuance of an LC (UCP600, Art. 7(b); ISP98, Rule 2.03; UCC §5-106(a);
• An LC is issued when it leaves the control of the issuer. This triggers booking the liability, charging the applicant LC fees, setting aside risk-weighted capital, and making the issuer liable on the LC if a draw is made.
• If possession of the LC is given to the applicant to take to a closing, the closing doesn’t occur, and the applicant returns the LC to the issuer, the issuer still needs to obtain the consent of the beneficiary to cancel it.
• If the LC is a presentation LC, the applicant’s retention of possession will prevent it from being drawn upon.
• Bringing an agent of the issuer to closing, escrows and covenants to cancel the LC are sometimes used to deal with this problem. Post-issuance limits on the effectiveness of an LC are disfavored but also sometimes used to deal with this problem.
• If the beneficiary’s bank must issue a performance bank guarantee (or counter-guarantee) as one of the documents when drawing on a commercial letter of credit, make it effective only if the draw on the commercial LC is honored.
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Amending an LC (UCP600, Art. 10; ISP Rule 2.06; UCC §5-106)
• LC amendments occur for many reasons: extending the expiry date; changing the amount after the underlying obligation is reduced or increased; correcting errors or deleting unagreed-upon documentary draw conditions are examples.
• An issuer should obtain the consent or request of the applicant in order to amend, but is bound if it issues the amendment without the applicant’s consent. Amendments are irrevocable once issued.
• The beneficiary must accept the amendment in order for it to be effective; time limits on their refusal do not work.
• An amendment can be accepted in writing, usually on a form provided by the issuing bank for that purpose, or by simply drawing on the LC in accordance with the terms of the LC as amended.
• Or the beneficiary can reject the amendment by so indicating, by attempting to accept only part of the amendment.
• The beneficiary may draw on the LC in accordance with its terms as unamended without accepting or rejecting the amendment at that time.
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Amendments – Extensions (Evergreen Letters of Credit)
• Amendments can be built into the LC – these are called automatic amendments.
• Examples include automatic extensions of the expiry date and automatic ratcheting down of the amount of the LC by the lapse of time.
Typical Automatic Extension Clause:
THIS LETTER OF CREDIT SHALL EXPIRE ON __________________, BUT SUCH EXPIRATION DATE SHALL BE AUTOMATICALLY EXTENDED WITHOUT NOTICE OR AMENDMENT FOR PERIODS OF ONE (1) YEAR ON EACH SUCCESSIVE EXPIRATION DATE, BUT IN NO EVENT LATER THAN ____________, UNLESS AT LEAST SIXTY (60) DAYS BEFORE ANY EXPIRATION DATE WE SEND YOU NOTICE BY REGISTERED MAIL OR OVERNIGHT COURIER SERVICE AT YOUR ADDRESS ABOVE THAT THIS LETTER OF CREDIT IS NOT EXTENDED BEYOND THE THEN-CURRENT EXPIRATION DATE.
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Evergreen Letters of Credit
• Contain language that says the expiration date automatically extends unless the bank sends notice of non-extension
• Commonly, extension is one year at a time
• Notice of non-extension must be sent a specified amount of time in advance, often 30 or 60 days
• Upon receipt of a notice of non-extension, the beneficiary is usually entitled to draw for the full balance of the L/C
• No notice is sent of extension; it occurs automatically, but good to check with the issuer
• If you are the beneficiary, be sure to let the issuer know when your address changes for notices of non-extension
• If you are the applicant, be sure to let the issuer know when you want extensions to stop.
• If you are the issuer, keep proof of the sending of notice of non-extension forever.
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Cancellation & Expiration (ISP98, Rules 7.01-7.02; UCC §5-106(b))
• A cancellation of an LC is a type of amendment and must follow the formalities of amending an LC.
• The UCC and the ISP give the issuer the right to demand a number of conditions be met before an LC will be cancelled by it; most issuers will cancel an LC if the beneficiary consents in writing and, if the LC is a presentation LC, the original is returned to the issuer.
• All letters of credit have and should have an expiration date. If a draw is submitted to the issuing, confirming or nominated bank before the LC expires, it must be reviewed and, if conforming, honored, even if the review and decision to honor is completed after expiration.
• If the LC does not have an expiry date, it expires in one year after date of issuance. (UCC §5-106(c).)
• A letter of credit that states it is perpetual expires in five years. (UCC §5-106(d).) Two cases have interpreted this provision literally.
• An automatic extension clause with a right of the issuer by notice not to extend is not a perpetual letter of credit. (UCC §5-106, Official Comment 4.)
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How to Draft or Review an LC Standby LC Terms Checklist
Have all essential terms checked for their presence in the LC:
• Designation of LC as irrevocable
• Name and address of Issuer
• Signature of Issuer
• LC date of issue
• LC number
• Language used (English)
• Name and address of Applicant
• Name and address, type of entity, and jurisdiction of formation of Beneficiary
• Nomination of Advising and/or Confirming Bank (if any)
• Amount
• Undertaking
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Standby LC Terms Checklist • Expiry date and, if applicable, automatic extension clause with outside
expiry
• Clear description of what documents need to be presented
• Language to be used in documents (English)
• Place of presentment
• Manner of presentment (originals, copies, fax)
• Time for issuer to review and honor or give notice of dishonor
• Regime governing the LC (ISP or UCP)
• Account to which wire transfers for payment should be made
• Transferability and form of transfer document
• Governing law
• Jurisdiction and venue (not always necessary or allowed)
• Direct pay or clawback provisions (if worried about preferences)
• Number and addresses for communications about the LC
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Standby LC Terms Checklist
• If standby is governed by the UCP instead of the ISP, modify the LC to provide:
– Stale documents permitted (i.e. documents may be presented more than 21 days after the date of shipment)
– Force majeure – ability to present documents after expiry for a 30-day period after re-opening if bank is closed within last 10 days of expiry for unplanned reasons (flood, hurricane, earthquake, acts of terrorists, etc.)
– Documents need only meet requirements of LC whether or not consistent with one another
– No latest date for shipment
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Superfluous Terms (ISP98, Rule 1.10)
Terms that often are but need not be in LCs: Partial drawings allowed
Multiple drawings allowed
Payable out of the Issuer’s own funds
Undertaking is independent
Undertaking is unconditional
Undertaking is absolute
Undertaking is primary
Payments made under LC reduce the amount available
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Practice Tips on Drafting Standby LCs
• Use the ISP if possible. Sometimes can’t be done – municipal bond and infrastructure deals – old forms die hard; insurance LCs are prescribed by regulators; and some applicants prefer the UCP in standbys because it is more exacting to comply with. Not necessarily a good idea – could be buying a lawsuit.
• Attach form of draw document so there is no misunderstanding of what it must contain or how it must appear.
• Avoid non-documentary conditions.
• Do not require presentation of original of LC.
• Do not require use of a draft; a simple demand should be sufficient.
• If representing the beneficiary, provide for fax presentation of documents.
• Incorporate an auto-extend clause if worried about expiry.
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Practice Tips on Drafting Standby LCs
• Consider adding a choice of law and forum provision for out-of-state issuers
• Designate a specific account to which payment must/may be made
• Avoid applicant-signed draw documents
• Don’t confuse a surety applicant with the counter-party on the underlying agreement that the LC supports
• Make sure beneficiary has a right to draw in the event the LC is within 30 or 45 days of its expiry and the applicant and issuer have not extended
• Make sure the beneficiary has a right to draw in the event the issuer’s credit becomes unsuitable and the issuer is not replaced within a time certain. This provision usually is inserted in the underlying agreement.
• Provide in the underlying agreement what is to be done with proceeds due to an expiry draw or issuer downgrade draw – escrow, segregated account, paid into court, etc.
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ISP Model Forms
• The ISP Model Forms are free for use if not commercially reproduced and are available on IIBLP’s website at www.iiblp.org.
• The forms are useful tutorials on how and why LCs are or should be drafted.
• In some cases, e.g., confirmation forms, they are not market, but rather what the IIBLP believes should be used.
• The forms include: – ISP98 Model Form 1 - Standby Incorporating Payment Demand
– ISP98 Model Form 2 - Standby Providing for Extension
– ISP98 Model Form 3 - Standby Providing for Reduction
– ISP98 Model Form 4 - Standby Providing for Transfer
– ISP98 Model Form 5 - Standby Simplified
– ISP98 Model Form 6 - Counter Standby
– ISP98 Model Form 7 - Standby to be Confirmed
– ISP98 Model Form 8 - Confirmation
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Drawing Tips
• Prepare ahead of time – line up what documents you need, where to get them from, who needs to sign them, and what they must contain; be particularly mindful of third party documents that must be presented.
• Don’t wait too long to effect a draw; allow yourself time to cure. Remember the issuing bank may have up to 5 or 7 business days to review the presentation and notify of discrepancies.
• Where draw conditions are ambiguous, consider submitting alternative draw documents.
• Don’t expect the issuer to honor when beneficiary walks the documents into the bank.
• Do not lose the originals (and all amendments) of presentation LCs.
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Common Types of LC Disputes
• Remember that in LC disputes, loser must pay attorneys’ fees in almost all states. (UCC §5-111(e).) Courts have increasingly enforced this provision.
• Wrongful Dishonor
• Wrongful Honor
• Injunction against draw for fraud – Tough standard to meet
– Must be egregious, clear and material
– Little time to prepare
– Must show no adequate remedy at law, irreparable harm, public interest, clean hands, and post a bond
– Contract disputes are not enough to warrant injunction against draw
– Not necessary to show documents are forged, but it helps
– Must be material fraud – if the draw is based on certification that 10,000 bales were delivered, when only 9,950 were, materiality is lacking
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Supersedeas LCs
• Many times a defendant with a judgment entered against it will prefer to post a letter of credit in lieu of a bond to stay enforcement of the judgment pending appeal.
• Reasons include saving premiums because a supersedeas bond will normally require an LC to back it thus accruing two fees, and because the defendant may have an LC facility readily available to use and there is usually little time to obtain and post the bond.
• Some Courts by rule allow LCs to be posted in lieu of bond to stay execution of a judgment pending appeal. E.g., IL Sup. Crt. Rule 305; Northern District of Illinois Local Rule 65.1(b)(4). Others by case law, such as most federal courts. Almost all courts will allow supersedeas LCs to be posted by agreement of the parties.
• LCs can benefit the plaintiff as well because they can be drawn outside of the court proceedings and sometimes will avoid bankruptcy issues.
• Several issues have to be thought through and negotiated: (i) draw trigger; (ii) whether a trial court order is necessary to effect the draw; (iii) what constitutes a final and nonappealable order; (iv) expiry date and what happens if the LC is not extended or the issuer is downgraded and not replaced.
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LC Scams
• Prime Bank Fraud – LCs are not traded like bearer notes
• Advance Fee scams
• Unheard-of Issuers
• Throwing around LC terms like SWIFT Message Types (e.g. MT760) that make sense to those who don’t know much about LCs but don’t make sense to those who do
• Charging high fees to procure a letter of credit without a firm promise from a bank issuer to issue one
• Outright fraudulent documents
• Others
General Rule – If it sounds too good to be true, it isn’t.
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Buyer Seller
Contract
Buyer’s Bank
Letter of Credit Application
How Letters of Credit Work: Theory
Buyer Seller
Contract
Buyer’s Bank
Letter of Credit Application
How Letters of Credit Work: Theory
Letter of Credit
Buyer
Buyer’s Bank
Seller
Contract
Letter of Credit Application Letter of Credit
3 parties
3 independent contracts
How Letters of Credit Work: Theory
Buyer
Buyer’s Bank
Seller
Contract
Goods
Letter of Credit Application
Documents
Letter of Credit
How Letters of Credit Work: Theory
Principles of Letters of Credit:
Independent and
Documentary
Buyer
Buyer’s Bank
Seller
Contract
Goods
Letter of Credit Application
Documents
Payment
Letter of Credit
How Letters of Credit Work: Theory
Buyer
Buyer’s Bank
Seller
Contract
Goods
Letter of Credit Application
Documents Documents
Payment Debit
Letter of Credit
How Letters of Credit Work: Theory
Nominated Bank
Docu- ments
Goods
Debit
Documents
Payment
Pay- ment
Buyer’s Bank
L/C Appli- cation
L/C
Advising Bank
L/C
Docu- ments
How International Letters of Credit Work
Buyer Seller
Contract
L/C
Docu- ments
Pay- ment
Buyer Seller Goods
Contract
Confirming Bank
L/C
Debit
Documents
Payment
Buyer’s Bank
L/C Appli- cation
Docu- ments
How Confirmed Letters of Credit Work
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SWIFT Format LCs – Message Types
MT700 Issue of a Documentary Credit MT701 Continuation of MT700 MT705 Pre-Advice of a Documentary Credit MT707 Amendment to a Documentary Credit
MT710 Advice of a Third Bank's Documentary Credit MT711 Continuation of MT710 MT720 Transfer of a Documentary Credit MT721 Continuation of MT720
SWIFT Format LCs – Message Types
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MT730 Acknowledgement of the receipt of a Documentary Credit MT732 Advice of Discharge stating that documents with discrepancies have been taken up MT734 Advice of Refusal of documents under a Documentary Credit MT740 Authorization to Reimburse
MT742 Reimbursement Claim MT747 Amendment to an Authorization to Reimburse MT750 Advice of Discrepancy MT752 Authorization to Pay Accept or Negotiate MT754 Advice of Payment, Acceptance or Negotiation
MT756 Advice of Reimbursement or Payment MT760 Issue of a Guarantee or Standby LC MT767 Guarantee or Standby Amendment MT768 Acknowledgement of a Guarantee or Standby Message MT769 Advice of reduction or Release of a Guarantee or Standby
SWIFT Format LCs
Letters of credit in favor of international exporters are usually sent by SWIFT and in a prescribed format. A SWIFT format indicates the issuing bank at the top (“received from”) and has numbers (field tags) at the left for specific information such as:
20: doc credit number
31C: date credit issued
31D: expiration date
32: currency/amount
40A: form of doc credit (irrevocable and/or transferable)
41D: available “by payment” or “by negotiation”
42C: tenor of drafts
42D: bank on which drafts are drawn
44A: shipping dispatch point: place of export
44B: shipping destination point: place of import
44C: latest shipping date (year/month/day)
45A: goods being shipped and terms of trade (FOB, CIF, etc.)
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SWIFT Format LCs
46A: documents required to draw under the letter of credit
47A: additional conditions: this is often where it mentions if TT reimbursement is acceptable (“TT” means tested teletransmission)
48: period for presentation of documents (if silent, 21 day maximum after shipping date on bill of lading, but within expiry date)
49: confirmation instructions: requests advising bank to confirm; usually states “without”, i.e. no confirmation.
50: applicant (account party)
53A: issuing bank’s U.S. correspondent who will act as reimbursing bank
53D: reimbursement instructions between paying and issuing bank
59: beneficiary (the exporter - usually customer of the
71B: who pays for banking charges outside the issuing bank’s country
72: bank to bank information
78: instructions to advising bank: includes information on where drafts and documents are to be sent and from which bank to claim reimbursement
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