How secure are letters of credit?

• Author: Metzger, Paul

Among the various kinds of security that local governments require of developers to guarantee the completion of public improvements, letters of credit have enjoyed a number of advantages--until recently, when financial institutions have failed and the Resolution Trust Corporation has become the receiver.

Besides the recession's often discussed local government problems of revenue declines and budget shortfalls, the economic downturn has aggravated a less noticed problem. What should be done about the increasing volume of public improvements left uncompleted by developers who either have been forced out of business or are close to bankruptcy?

When their subdivisions were platted, citizens were promised roads, water, sewers, stormwater systems and more. Local governments have had to search for ways to ensure that, should it become necessary, nontax funds will be readily available for the governments themselves to complete these promised public improvements.

Typically, local jurisdictions require that developers provide security to guarantee that these public improvements will not become a further burden on local resources. A variety of security methods have been used, including: 1) cash escrows deposited with the local government; 2) surety bonds, provided by insurance companies or other corporations; 3) collateralized escrow accounts in financial institutions; and 4) letters of credit (LOCs) issued to local governments by financial institutions on behalf of developers. When economic conditions deteriorate, and developers come under increasing financial pressure, it becomes even more important that the funds to complete public improvements be fully secured.

But hard economic times lead to the increasing likelihood of legal contests with developers, their sureties or their creditors over a local government's right to these funds. Under these conditions, what types of security are best? If a local jurisdiction already has the security in cash form, of course, it is one step closer to being able to utilize these funds.

Pros and Cons of LOCs

Apart from cash deposited directly with a local government, are some forms of security less likely to lead to disputes than others? Surety bonds leave localities open to arguments with insurance companies over interpretation, and may prompt valid concerns about the soundness of particular insurers. Collateral in a financial institution may be subject to setoff by the institution or lawsuits by creditors.

Until recently, an LOC has appeared to many local governments to be perhaps the least vulnerable to obstructive tactics and outright legal assault.

An LOC has advantages because:

1) a presumably neutral and disinterested party provides the security;

2) the issuing institution is much more financially sound than a developer;

3) the security is granted in irrevocable and unconditional terms;

4) when a developer defaults (however the local government may define default in its agreement with the developer), the LOC may be drawn on immediately, up to its face value;

5) under Article 5 of the Uniform Commercial Code, a local government's sight draft must be honored by the issuing institution within three business days; and

6) failure to honor a draft against an LOC could result in a losing lawsuit and damage to the institution's reputation.

A number of difficulties, however, can offset any or all of these advantages.

Neutrality and Bankruptcy. The financial institution that issues an LOC may, in fact, be neither neutral nor disinterested. On the contrary, it may be very involved in the financial affairs of a developer...