A letter of credit can be an effective tool for a business when it is required to provide additional payment security to a third party. The letter of credit is essentially a guarantee by a bank or other financial institution (called an “issuer”) to a third party (called a “beneficiary”) that it will be paid the funds owed to it by a business (called an “applicant”). What makes the letter of credit unique from other forms of credit is the protections it affords the beneficiary by virtue of the instrument’s independence from the applicant and the ease by which a beneficiary can draw funds without the consent or involvement of the applicant.
While letters of credit can come in a variety of forms, two prevalent types are the commercial letter of credit and the standby letter of credit. A commercial letter of credit may be used when an applicant is required by a supplier to provide a guarantee of payment for goods or services to be purchased by the applicant. In this case the supplier beneficiary would draw the purchase price payments directly from the issuer under the commercial letter of credit when due, thereby avoiding any non-payment risk by the applicant. An example of when a standby letter of credit might be used is when a landlord under a lease requires a guarantee of payment of rent and any other amounts owed by the applicant under the lease. Under these circumstances, the letter of credit is generally only drawn against upon an inability or other failure of the applicant to pay the beneficiary, unlike a commercial letter of credit which serves as a primary source of payment.
Unlike most other instruments that can be used to provide a beneficiary with a reliable means of payment, the issuer’s obligation to make a payment under a letter of credit is independent of any rights between the applicant and the beneficiary. Using the example of a landlord-tenant letter of credit, the landlord beneficiary would have the unilateral option to draw on a standby letter of credit for non-payment of rent or other lease damages notwithstanding any objection by the tenant applicant, and without needing to demonstrate the existence of the underlying payment obligation or otherwise justify its payment demand to the issuer. Moreover, an issuer cannot rely on any defenses that may be available to the applicant in attempting to avoid a payment under the letter of credit. This offers more security to the beneficiary than what is provided by guarantees and sureties, which are more susceptible to challenge by the applicant (or other obligor) or delays in payment, making letters of credit the preferred (and often required) instrument of third parties in certain types of commercial transactions.
The letter of credit essentially shifts the risk of non-payment from the beneficiary (e.g., a supplier or landlord) to the issuer. Then, once paid by the issuer, the risk then shifts to the applicant who must either repay the issuer for the draw down on the letter of credit, or dispute any draw down directly with the issuer. Importantly, the letter of credit is also irrevocable once issued, meaning that, no matter what occurs in the relationship between the applicant and the issuer, the beneficiary can have comfort that the letter of credit and attendant funds will remain available until the letter of credit’s stated expiration date. In many circumstances, this is true even after the applicant files for bankruptcy protection as the draw down right under a letter of credit often remains available to the beneficiary thereafter (unlike certain other security mechanisms, such as a tenant’s security deposit held by a landlord, which would likely be negatively affected by any the applicant’s bankruptcy filing).
As with any legal instrument, a letter of credit must be in writing and signed, and it should clearly specify the terms of the financial arrangement. For example, some letters of credit have hardwired expiration dates, while others are “evergreen” – meaning they will continuously renew unless and until withdrawn by the issuer in accordance with the terms of the letter of credit. Most letters of credit allow for partial draws of the guaranteed amount over the term of the letter of credit, thereby providing flexibility to the beneficiary to draw funds as needed rather than solely on an all-or-nothing basis. The letter of credit should also describe the mechanics of making a draw, including to whom the notice must be sent, how it must be sent, and what it must say. Strict compliance with these requirements will be necessary for the beneficiary to effectuate the intended draw as any deviation may allow an issuer to avoid, or at least attempt to avoid, paying the draw.
Despite being relatively short documents, the terms of a letter of credit are generally not limited to the four corners of the agreement. Relevant provisions of the Uniform Commercial Code and certain international trade conventions will typically supplement the express terms of a letter of credit. And as with the other terms of a letter of credit, the application of these provisions will largely turn on the facts and circumstances of the particular situation.