Chapter 8 Letters of Credit

• Jurisdiction: United States

Chapter 8 Letters of Credit

Aletter of credit is a formal legal document used by a bank customer to provide assurance of prompt payment of an obligation. Payment is assured to the recipient from a credit-worthy payment source (a bank) and offers a straightforward means of immediate collection. There are many types of letters of credit and ways to use them. Letter of credit uses that frequently appear in bankruptcy cases include letters of credit used to purchase goods and services, letters of credit given as lease security deposits, letters of credit supporting surety bond facilities, letters of credit supporting insurance obligations and letters of credit issued as a part of larger credit facilities.

A. Letter of Credit Basics

A letter of credit is a three-party arrangement. A bank customer (the "account party") requests that the bank (the "issuer") issue a letter of credit naming a third-party recipient (the "beneficiary") as the beneficiary. The beneficiary presents the issuer with a written statement (sometimes called a "draft") and potentially other papers required by the terms of the letter of credit, which the issuer reviews. If the draft strictly complies with the requirements of the letter of credit, the issuer makes a payment (a "draw") to the beneficiary. The issuer's administration of the letter of credit is purely ministerial: The issuer is not concerned about any disputes that may exist between the account party and the beneficiary. If the beneficiary has strictly complied with the conditions of the letter of credit, the beneficiary receives payment.⁹² The issuer charges the account party a fee for the letter of credit and receives reimbursement of the draw from the account party.

An illustration of a letter of credit arrangement for a sale of widgets follows:

In this example, the beneficiary (the seller of the widgets) does not want to take the credit risk that the account party (the seller's customer), who is overseas, will not pay for the widgets, and the seller only wants to be able to collect in the U.S. The issuer (the bank) issues a letter of credit on behalf of its customer, the buyer of widgets (the account party), for the benefit of the seller (the beneficiary). The goods are shipped upon the seller's receipt of the letter of credit, which requires a signed delivery receipt from the buyer along with a draft for payment. Upon delivery of the goods, the seller gets the signed delivery receipt and draws on the letter of credit by presenting the receipt and a draft on the issuing bank. Assuming that the papers strictly conform to the requirements of the letter of credit, the issuing bank pays the seller. In this situation, the letter of credit itself may be the vehicle used to pay the seller, in which case it is referred to as a "merchandise" letter of credit.

B. Letter of Credit Documentation

A letter of credit document itself is a short, standard form that identifies the account party and the beneficiary, states the amount and the letter of credit's expiration date (sometimes called the...