Letters of Credit As Credit Enhancements Explained

Letters of credit may be a good credit enhancement for credit professionals to consider in their sales—especially those involving buyers in foreign countries. For those wanting to learn more about letters of credit (LCs), NACM provided a timely audio teleconference on the topic entitled, “Letters of Credit as a Credit Enhancement.” Presenting the May 23, 2007 event was Mark Berman, Esq. of Nixon Peabody LLP. Berman is a partner at Nixon Peabody LLP, resident in its Boston office. His practice concentrates on business restructurings, creditors’ remedies, securitizations and the negotiation and documentation of certain aspects of financing transactions and is a renowned legal expert in his fields of expertise, which includes bankruptcy law.

One aspect of note about LCs pointed out by Berman is, “(They’re) putting a bank’s credit at risk as opposed to the purchaser of goods.” However, he issued some cautionary advices when agreeing to a sale backed by an LC: “Care has to be taken that you precisely follow the rules of the LC.”

Berman pointed to the two types of LCs. There are Documentary LCs, which are mainly used in international transactions, and Standby LCs, which prompt a payment to the seller when the buyer doesn’t make a payment. In such a cases of nonpayment, the seller must present documents required by the LC that, among other things, establishes that the buyer has not made timely payments. The governing rules for commercial LCs are the UCP500, which stands for Uniform Customs and Practices for Documentary Credit. These rules are published by the International Chamber of Commerce (ICC) and are generally followed by banks and applicants for LCs. The UCP500 will be emerge in a revised form as the UCP600 on July 1, 2007. The ISP98 or International Standards and Practices are rules that apply to standby LCs. Berman also mentioned that Article 5 of the Uniform Commercial Code (UCC), which exists in state laws, applies to LCs used in domestic transactions. He also explained the difference between irrevocable and revocable LCs as well as confirmed and unconfirmed LCs and how the banks process each of them.

The courts view a sales contract as being between the seller and buyer but an LC is treated as a contract between the bank and seller, independently from the sales contract. Therefore, Berman said that any financial difficulties of the buyer do not affect the LC’s relationship between the seller and bank. “No matter what happens to the buyer, the beneficiary (seller) is going to get paid.” He added that the proper documents must be submitted in good order before a bank will pay on an LC.

If an LC was issued at the beginning of the transaction, and not at the end, usually the seller will get paid even if the buyer enters Chapter 11 Bankruptcy. Berman pointed out that as long as the LC is issued more than 90 days prior to the bankruptcy—or one year if the beneficiary is an insider of the debtor—then the payment made by the issuing bank pursuant to the LC cannot be recovered by the trustee in bankruptcy. In other words, the LC payment cannot be recovered or taken back by a bankruptcy trustee in a preference action.

In answer to questions from teleconference attendees, Berman said that fees for LCs can be negotiated. Generally, the amount of the fee is related to the size of the issuing bank and the creditworthiness of the applicant. On the question of whether a payment pursuant to a standby LC can be claimed as a preference payment, Berman said, “You should have no fear. It was used to secure a future debt that the buyer is going to make. The payment from the bank to you cannot be a preference.” On the question of what to do if payment terms are changed, Berman advised getting the LC amended to reflect those changed payment terms. Audio teleconference attendees also received a PowerPoint presentation with detailed information on what Berman covered.

NACM teleconferences are an inexpensive way to learn more about topics important to credit executives. For information on future NACM teleconference subjects, go to NACM’s website at www.nacm.org and click “teleconferences” or just point your browser to: http://www.nacm.org/education/teleconfs/schedule.shtml.
Source: Tom Diana, NACM staff writer

Leave a Reply

Your email address will not be published. Required fields are marked *