Unraveling Letters of Credit1
November 2004
Many sureties take letters of credit, either
in underwriting or to secure against potential loss once the surety has received
a claim. This commentary attempts to unravel the various different titles placed
on letters of credit.
by Marilyn
Klinger
Sedgwick,
Detert, Moran & Arnold LLP
There are two main types of letters of credit (LOC), conventional/commercial
and standby letters of credit. A conventional/commercial LOC operates as a transaction's primary payment mechanism—the beneficiary
looks directly to the bank for payment and not to the party providing the letter
of credit. In contrast, a standby letter of credit serves as a secondary payment mechanism—the beneficiary
looks to the bank only upon default.
The Code of Federal Regulations permits national banks to issue standby LOCs,
defined, in part, as follows:
- (a) Definition. As used in this section, the term standby letter of
credit means any letter of credit, or similar arrangement … which represents
an obligation to the beneficiary on the part of the issuer … (3) to make
payment on account of any default (including any statement of default) by
the account party in the performance of an obligation. … [12 C.F.R. §337.2(a).]
Section 337.2(a) distinguishes standby letters of credit from commercial
letters of credit:
- As defined in this paragraph (a), the term standby letter of credit
would not include commercial letters of credit and similar instruments where
the issuing bank expects the beneficiary to draw upon the issuer, which
do not "guaranty" payment of a money obligation of the account party and
which do not provide that payment is occasioned by default on the part of
the account party.
Standby letters of credit constitute a notable exception to the general rule
that national banks may not issue guaranties. Federal
Deposit Ins. Corp. v Philadelphia Gear Corp., 476 U.S. 426, 428, 106
S Ct 1931, 1933 (1986).
The Distinction between Standby LOCs and Guaranties
Given that payment under a standby letter of credit takes place upon a default,
standby LOCs appear similar to surety bonds and/or guaranties, but they are
distinguishable:
- Unlike the true contract of guaranty … the guaranty [standby] letter
of credit will oblige its issuer to pay on the presentation of specified
documents showing a default, rather than upon proof of the fact of default.
[Bank of North Carolina v Rock Island Bank,
570 F2d 202 (7th Cir 1978).]2
Thus, under a standby LOC, the issuer may not require proof of the default.3
Draws Against LOCs
Typically, an LOC includes specifications regarding language or documents
required to draw on it. For example, in Avery Dennison
Corp. v Home Trust & Savings Bank, 2003 WL 22697175 (ND Iowa), the court
noted that:
- [t]he letter of credit provided that a demand for payment thereunder
must contain a statement signed by an authorized official of the beneficiary
certifying that "AN EVENT HAS OCCURRED UNDER THE CREDIT AGREEMENT BY AND
AMONG FASSON/AVERY DENNISON CORPORATION AND VERITEC, INC., WHICH ALLOWS
THE BENEFICIARY TO DRAW ON LETTER OF CREDIT NUMBER 104." The letter of credit
further provided that "ALL DRAFTS MUST BE MARKED 'DRAWN UNDER MATTHEWS GROUP,
LLC STANDBY LETTER OF CREDIT NUMBER 104, DATED MAY 12, 2000."
In In re Enron Corp., 292 B.R. 752, 758, fn.
4 (Bkrtcy SD NY 2003), the subject LOC included a requirement that a draft must
include:
- A certificate purportedly signed by a corporate officer of Green Country
Energy, LLC stating that, "The Contractor has failed to perform in accordance
with [insert relevant sections of the EPC Contract] dated _____, 1999, between
Green Country Energy, LLC and National Energy Production Corporation and
NEPCO Procurement Company and we hereby demand payment in the amount of
[Written Amount and Figure] (USD) under your Standby Letter of Credit Number
SB 103855."
Does a Standby LOC Require Documentation Regarding Default?
Courts, almost without exception, strictly construe the requirements in a
letter of credit.4 Thus, a standby LOC typically
does not require a statement or documentation regarding default when its terms
do not specify such. The strict construction rule benefits both the bank, which
can dishonor draws that fail to strictly comply with the LOC's terms, but also
the beneficiary, whose obligations on a draft cannot exceed those contained
in the letter of credit.
Surplusage in a Draft upon a LOC
In Axxess, Inc. v Rhode Island Hospital Trust National
Bank, 1991 WL 146869, 15 UCC Rep Serv 2d 1011 (D Mass), the party who
provided the LOC sued the bank for paying on a draft, alleging that the draft
included superfluous words not required in the LOC. The court held that the
bank was justified in honoring the draft because none of the superfluous information
created an inconsistency.
In contrast, in American Coleman Co. v Intrawest
Bank of Southglenn, N.A., 887 F2d 1382 (10th Cir 1989), the LOC required
that the beneficiary present a "signed written statement that Jim Gammon and
Associates is in default on [the] Note and Security Agreement dated November
21, 1984…." Id. at 1383. The beneficiary
presented a statement that: "[J]im Gannon and Associates is in default on the
Note and Security Agreement dated November 21, 1984, and the Promissory Note dated November 16, 1984 …" which statement more accurately reflected the dates of the instruments. Id. at 1384 (emphasis added). The court
did not agree that the reference to the second note was "surplusage." Id. at 1386.
The 1998 International Standby Practices (ISP 98), Rule 4.09(c), requires
that, when an LOC calls for language that is "exact" or "identical" to the LOC,
a beneficiary must present a document with all words, numbers, and other symbols,
including typographical errors, spelling, punctuation, spacing, blank lines,
and the like exactly as they appear in the LOC.5
"Clean" and "Documentary" LOCs
The common term "clean" in a LOC means the beneficiary need present only
a draft or demand for payment and no other documents.6 "Documentary" LOCs require the beneficiary to present both a draft and specified
documents.7
- "The standby letter is often clean," because it may require merely a
demand for payment supported by a conclusional statement that the primary
obligor has failed to pay. Torco Oil Co. v Innovative
Thermal Corp., 763 F Supp 1445, 1449 (ND Ill 1991).
"Revocable" and "Irrevocable" LOCs
The Uniform Commercial Code (UCC), discussed more fully below, notes the
following with respect to an "irrevocable" LOC:
- Unless otherwise agreed, once an irrevocable credit is established,
as regards the customer it can be modified or revoked only with the consent
of the customer and once it is established, as regards the beneficiary,
it can be modified or revoked only with his consent. [UCC § 5-106(2); Beathard v Chicago Football Club, Inc., 419
F Supp 1133 (DC Ill 1976).]
In contrast, "a revocable credit … may be modified or cancelled at any moment
without notice to the beneficiary." [Beathard,
at 1137.]
Conclusion
Notwithstanding what appears to be a rather complicated scheme governing
letters of credit, the crucial message is that the language of the LOC is the
crux of any LOC.
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