“The letter of credit (LC) is an obligation that banks have to your company if certain conditions set forth in the LC are met,” said Robert Mercer, Esq. of law firm Powell Goldstein, LLP. “This is an attempt to isolate your company from the customer.”
Mercer, a partner at Powell Goldstein’s Atlanta office who practices in its Bankruptcy & Financial Restructuring Group, discussed LCs and the best ways to structure them at a recent CMA webinar entitled “Structuring Letters of Credit That Won’t Leave You Stranded in a Customer Bankruptcy.” Over the course of his presentation, Mercer outlined common stipulations that creditors should include as well as some that they should avoid when drafting their LCs.
Most importantly, Mercer noted, a vendor using an LC should be sure to include a Bankruptcy trigger in the LC, rather than just in the supply contract. Since the revisions made to the bankruptcy Code in the 1970s, provisions in contracts that attempt to construe a customer bankruptcy as a form of default have been unenforceable, meaning that when a customer files, the vendor is left open to preferences and placed in the running with the rest of the customer’s unsecured creditors. Still, these provisions are used very frequently. “You see them in many commercial documents,” said Mercer. “Put in the LC that, if the customer files bankruptcy, it’s a basis under which your company can draw on the LC.” In this way, when a customer files bankruptcy, under the terms of the LC, the bank is still obligated to pay your company.
“This is a really simple fix,” he added. “That’s a provision you want in the LC.”
Mercer also discussed the importance of removing as many conditions as possible from the LC, including provisions that require a vendor to give a bank or the customer a few days notice before drawing on the LC or provisions that
require the vendor to seek consent before drawing.