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.
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).] 1
Thus, under a standby LOC, the issuer may not require proof of the default. 2
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. 3 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. 4
"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. 5 "Documentary" LOCs require the beneficiary to present both a draft and specified documents. 6
"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.
Credit must be given to Peter Cofield of Sedgwick, Detert, Moran & Arnold's Los Angeles Surety Practice for the thorough research and creative analysis in this article.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
Footnotes
