Letters of Credit in Limited Partnership Financing-a Legal Time Bomb?
| Publication year | 1984 |
| Pages | 1989 |
| Citation | Vol. 13 No. 9 Pg. 1989 |
1984, November, Pg. 1989. Letters of Credit in Limited Partnership Financing-A Legal Time Bomb?
Most lawyers have been subjected to the seductive financial hype for limited partnership investments. Frequently made just before year-end, these offerings are attractive, not only for potential long-term rewards, but because they offer immediate tax advantages to investors which often exceed their initial contributions to the partnership. The additional tax advantages are realized by putting investors "at risk" for a larger sum of money to be paid the partnership in the future, pursuant to a note executed by the investors before yearend. Typically, these notes are secured by letters of credit issued by a financial institution on each investor/limited partner's behalf. For this reason, letter of credit financing has become increasingly popular for limited partnership investments in real estate, mining and oil and gas development.
This article is intended to alert practitioners representing financial institutions to certain subtle risks inherent in issuing "irrevocable" letters of credit for limited partnership investments or in using such letters of credit to secure operating loans to the partnership. All letters of credit represent long-term loan commitments by the issuing bank with risks not all banks fully appreciate. The use of letters of credit in limited partnership transactions present some further unique dangers.
These additional risks stem from the interaction of federal and state security laws (with their broad concepts of "fraud") applicable to limited partnership disclosure statements with § 5-114(2) of the Uniform Commercial Code ("UCC"). This interaction permits an issuing bank to avoid its commitments under an "irrevocable" letter of credit, if there is "fraud in the transaction." Because defects or inadequacies can often be found in private placement disclosure statements (particularly where they involve complex technical matters such as geological information), it is possible for investors in a limited partnership to assert a technical claim of "fraud" in their investment purchases. This calls into question the enforceability of the letters of credit securing their obligations. This article analyzes the risks which issuing and lending banks assume, often unconsciously, in these transactions and suggests steps that might be taken to minimize those risks.
Limited partnership financing can be viewed as a two-step process. In the initial step a promoter (usually a general partner) sells the investor a limited partnership interest, obtaining a small down payment and a promissory note obligating the investor to complete his investment from three to five years later. Although the disclosure documents advise otherwise, the investor may expect that all or part of his future obligations will be met from his share of the partnership's cash flow.
The limited partnership interests are attractive because of the minimal down payment, the tax write-offs and the possible future returns from the venture. However, the sale of the partnership interests typically does not generate sufficient operating capital for the partnership. Thus, in the "second" step, the partnership approaches a bank (the "lending bank"), offering the collective long-term obligations of the investor/limited partners as collateral for an operating loan.
The lending bank issues a loan to the partnership and receives an assignment of the partnership's rights in the notes and letters of credit for the investors. On its face, each letter of credit appears to provide that the issuing bank will pay the lending bank if the investor does not meet his obligations on his note. This arrangement appears so secure
In the typical financing arrangement, the two discreet transactions---first selling the partnership interest, then collateralizing the investor's notes and letters of credit---often merge. General partners approach lenders to arrange loans tentatively prior to selling any partnership interests. Similarly, lenders intending to rely on letters of credit often become involved with the partnership and potential investors prior to extending the operating loan by advising the parties concerning the acceptability of proposed letters of credit or by directly negotiating letters of credit. This involvement, which is almost inevitable, is significant if the lender later asserts a holder in due course defense to an investor's request not to honor a draft presented on the credit.
To appreciate fully the risks involved for banks in financing limited partnerships with letters of credit, it is helpful to review how letters of credit operate, from where they originate, and the legal principles governing the rights of the beneficiary, the issuing bank and its customer.
Letter of credit transactions normally involve three separate "contracts."(fn1) First is the underlying contract---the contract between the issuing bank's customer and the beneficiary of the letter of credit. This contract may involve the purchase and sale of goods, investment in a venture such as a limited partnership or the performance of an executory obligation (e.g., the building of a highway). Second, the agreement between the issuing bank and its customer is a contract which authorizes the issuance of the credit to the beneficiary. This contract (implied by the UCC in the absence of a written document) contains the customer's agreement to reimburse the bank when the letter of credit is properly "drawn down." This obligation may be secured in the same manner as any other loan.(fn2) The "irrevocable" letter of credit represents the third "contract."(fn3)
While the "contract" analogy is helpful in understanding the relationships between customer, bank and beneficiary, it is highly doubtful that the letter of credit itself is a true legal contract. This article is limited to the problems inherent in a typical customer-bank-beneficiary triparty transaction. It does not consider the legal nuances arising when additional parties, such as affirming or confirming banks or transferees of the letter of credit, are involved. A letter of credit can be issued by persons or entities other than a bank. However, since the primary reason for the issuance of such credit is to provide the beneficiary with greater financial security than the customers can provide, almost all letters of credit are issued by banks. Thus, "bank" and "issuer" have been used interchangeably in this article.
When an irrevocable letter of credit or notice of its issuance has been received by the beneficiary, the issuing bank becomes bound to the terms of its credit. When the documents called for in the credit are presented to the issuing bank, the bank normally must pay.(fn4) Since the bank cannot withdraw from its obligation to honor the letter of credit without the beneficiary's consent, the credit is said to be "irrevocable."(fn5) Nevertheless, in certain circumstances, discussed below, the issuing bank may refuse to honor its obligation on this credit. It is important to remember that these circumstances are normally beyond the control of both the issuing and the lending banks.
Letters of credit evolved hundreds of years ago to provide sellers of goods in international transactions with assurance that payment would be made upon the proper delivery of specified goods. Without the letter of credit, sellers risked shipping goods long distances to customers whose financial, if not moral, integrity was unknown. The letter of credit assured the seller that he would receive payment directly from a reputable financial institution when presented with the specified commercial documents evidencing delivery of the goods.(fn6) The letter of credit represented the unconditional promise of the issuing bank that it would pay---the problem of collecting from the buyer, the issuer's customer, was the issuing bank's problem.
The letter of credit also provided the buyer/customer with some protection, because the seller did not receive payment until the buyer transferred documents indicating the seller's performance on the underlying contract. Use of the credit therefore protected both parties by ensuring that neither the buyer nor the seller controlled both the goods and money simultaneously.(fn7)
Because the letter of credit was issued for the benefit and at the insistence of the seller, a fundamental principle developed that the issuer must pay when presented with the appropriate documents, regardless of whether the buyer/customer believed there were problems with the underlying transaction (e.g., the goods did not conform to contractual requirements). As stated in a leading case: "It is well established that a letter of credit is independent of the primary contract of sale between the buyer and seller."(fn8) It is the contemporary erosion of this principle which has caused increasing concern by beneficiaries such as lenders regarding their right to payment even under "irrevocable" letters of credit.(fn9)
Although letters of credit are still used to ensure payment in sales...
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