Letter Of Credit Basics

A version of this article originally appeared in Business Law Today, the ABA Business Law Section's digital magazine offering in-depth articles, quick summaries of the month's key developments by practice area, checklists and other practical tools, and more.

If you are accepting a letter of credit ("LC") as support for a payment or performance owed to you, what should you require?

LC Features and Types

Determining what to require depends on the underlying transaction supported by the LC and understanding two key features of an LC: it is documentary, and it is independent.

An LC is "documentary" in that it is an undertaking by an issuer to a beneficiary to honor a documentary presentation by payment (or, in rare cases, by delivery of an item of value).¹ In other words, the issuer promises to pay the beneficiary if the document or documents specified in the LC are presented in accordance with the LC. An LC is not a suretyship undertaking, where a surety promises to pay if a primary obligor breaches a payment or performance obligation; an LC issuer's payment obligation is triggered by the presentation of documents, not by the occurrence of a breach.

An LC is "independent" in that the issuer's obligation is "independent of the existence, performance, or nonperformance of a contract or arrangement out of which the [LC] arises or which underlies it. . . ."² A promise to pay if a primary obligor defaults is a suretyship undertaking; a promise to pay if a beneficiary presents a statement that a primary obligor has defaulted is an LC. An LC issuer's obligation to pay the beneficiary is independent of whether the issuer is reimbursed or paid a fee or whether the primary obligor actually defaulted.

These features make LCs desirable to beneficiaries, but a promise is only as good as the promisor. You want a creditworthy and reliable issuer, typically an issuing bank or confirming bank located in your jurisdiction and subject to your local law. If the issuer fails to honor the LC, you want to be able to sue it for wrongful dishonor in a convenient forum and not have to worry about cross-border issues like sanctions or currency controls blocking payment.

You also want assurance that the LC is not forged, so you may want your trusted bank to "advise" the LC to you, which means that it communicates the terms and conditions of the LC to you and checks the apparent authenticity of the issuer's request to communicate those terms and conditions.³

LCs are often classified as "commercial" or "standby" LCs. Commercial LCs (sometimes called documentary LCs) are intended to be drawn upon as payment for the sale or lease of goods or provision of services. Standby LCs (sometimes called independent guarantees) are generally intended to be drawn upon only if an underlying obligor defaults in payment or performance. There is a subset of standby LCs called "direct-draw" LCs, which are typically intended to be drawn upon to avoid the preference risk of the underlying obligor paying the beneficiary and thereafter becoming bankrupt during the preference period.

Choice of Law and Practice Rules

Most LCs state that they are subject to letter of credit practice rules. Beneficiaries would generally be well served to require the International Standby Practices 1998 ("ISP98") as the rules for a standby LC. The Uniform Customs and Practice for Documentary Credits No. 600 ("UCP 600") is almost always chosen as the rules for a commercial LC.

The beneficiary would typically want the governing law of the LC to be the law of its local jurisdiction (not, if different, the local law of the issuer or of the obligor that owes the underlying performance or payment).

Obtainment of Payment

The LC should describe each document that must be presented to obtain payment. It often helps to attach a form of each required document as an exhibit to the LC.

The beneficiary should ascertain that it will be able to timely obtain and present each required document in every scenario where it expects payment under the LC. For example, if the LC specifies that a document be signed by a third party, will the beneficiary be able to obtain the signed document?

Beneficiaries should resist any requirement in the LC that the "original" LC must be presented for payment lest they risk nonpayment if the original LC is lost, stolen, or destroyed. Alternatively, beneficiaries can insist on a provision for an LC to be replaced by the issuer if the beneficiary certifies that the original LC has been lost, stolen, or destroyed.

Beneficiaries should check the mechanics for how to present the required document(s). For example, the issuer may specify that the document(s) be presented in paper form at its office. The beneficiary should consider requiring the option to instead present by email or fax.

If the LC's purpose is to protect you both from the risk of nonpayment of the underlying obligation and the risk that payment will be made but must subsequently be disgorged as preferential in the payer's bankruptcy, consider using a "direct-pay" LC so that you are paid by the issuer rather than the underlying obligor.

Expiration Dates

An LC typically contains an expiration date (or other presentation deadlines). Make sure that each deadline is far enough in the future that you will have ample time to demand payment in every plausible scenario and that, if the issuer refuses to pay, the deadline allows time for one or two subsequent attempts to cure any discrepancies claimed by the issuer. For example, if the underlying performance is owed to you by December 31, 2025, you may want an expiration date not earlier than January 31, 2026.

If the LC contains an "evergreen" or "auto-extension" clause that automatically extends the expiration date from time to time unless the issuer sends you at least "XX" days' written notice that there will be no further extension, make sure that the LC permits you to demand payment by presenting a document stating that you received a nonextension notice rather than having to state some other basis for drawing. Also, consider requiring the LC to provide for any notice of nonextension to be sent to at least two people or addresses; this reduces the risks of nonreceipt of the notice and of failing to act timely on the notice.

Transferability

LCs are generally nontransferable unless they provide for transfer. There are circumstances where the beneficiary should require transferability. For example, if the LC is acting as a security deposit supporting a real estate lease, the beneficiary should want the ability to transfer the LC to a new owner if the building is sold. The transfer rules in ISP98 and UCP 600 are complicated and may not fit your transaction, but well-drafted provisions in an LC can override any ill-fitting transfer rules.

Final Thoughts

These are just basics to consider. Particular transactions may raise additional concerns. The structuring and drafting of each LC should be carefully coordinated with the structuring and drafting of the underlying contract or arrangement to be supported by the LC.

A well-drafted LC from a strong, reliable local issuer can provide you with valuable credit support. A poorly drafted LC or an undesirable issuer may leave you unpaid.

Footnotes

^{1. See U.C.C. § 5-102(a)(6) ("Document"), -102(a)(10) ("Letter of credit"), -102(a)(12) ("Presentation").}

^{2. Id. § 5-103(d).}

^{3. Id. § 5-107(c).}

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.