Letters of Credit: Advantages and Disadvantages

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April 08, 2015

Advantages of Letters of Credit

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 where letters of credit secure bonds, commercial paper or 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 usually via wire transfer of funds by the issuer to the beneficiary’s account.

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Credit of a the Issuer Is Added

– 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 the credit of a corporate or individual applicant.

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 does not and should not involve itself in issues or investigations of whether the underlying contract has been properly performed.

Automatic Stay and Preferences

– 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 assets; rather the proceeds transferred are regarded as funds of the issuing bank. – As a result, courts will not normally enjoin a draw on a letter of credit even though the applicant has filed for bankruptcy.

– Because the draw on the letter of credit is of funds of the issuing bank, a court will not normally set aside as preferential a paydown of a debt from a draw on a letter of credit. Exception: Indirect preferences when a collateralized LC is issued for an already existing debt.

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.

– 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).

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.

Statute of Limitations
Some courts have held that even though an underlying obligation which a letter of credit supports is no longer enforceable under a statute of limitations, the LC can still be drawn upon by the beneficiary to pay the debt owed. See Williams Service Group v. National Union Fire Ins. Co., 2012 WL 5233558 (11th Cir. Oct. 23, 2012).

Payment against right to receive goods
– Documentary credits 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.

Disadvantages of Letters of Credit:

- Standby LC's are treated by issuers like loans – the applicant  must be credit approved, set aside credit lines and frequently has to set aside collateral to secure its duty to reimburse the issuer if there is a draw on the LC.
- Other forms of credit support may be less costly, such as a bond, export credit insurance, documentary collection, open account sales, a security interest in collateral, or a corporate guaranty.
- For commercial letters of credit, the rules are complex, the documentary requirements exacting and subject to differing applications at the issuing bank level and as a result, discrepancy rates are very high – over 50% of all presentments are nonconforming (discrepant), although in 99% of the cases the discrepancies are waived or corrected.
- LC's have expiration dates to which attention must be paid.
- LC's sometimes require presentation of the original LC and all amendments.
- LC's must be amended each time there is a change in amount or terms.
- Rules and practice governing LC's, especially commercial LC's, can be complex.
- LC's can be misused to take advantage of applicants. E.g.,Lloyds cases.
- LC's are only as good as the banks that issue them.
- LC's are sometimes difficult to terminate or cancel.

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