Getting Paid – A Letter of Credit May be the Answer

Suppliers, contractors and service providers worry about the risk associated with advancing credit and nonpayment by the customer. Current economic conditions have heightened those concerns. The savvy creditor knows that obtaining security for the payment obligation may reduce the risk of nonpayment due to the customer’s financial distress. Perhaps the best protection available to creditors is the use of Letters of Credit. This is true for two very important reasons – the Independence Principle and the Documentary Compliance Principle.

A Letter of Credit, a promise by a third-party to pay the obligation, consists of three agreements:

(1) the underlying contract between the applicant (usually the buyer of the goods or services) and the beneficiary (usually the seller of goods or services);

(2) the agreement between the issuer and the beneficiary, which is the Letter of Credit itself; and

(3) the agreement between the issuer and the applicant, which includes the applicant’s obligation to reimburse the issuer for any draws made on the Letter of Credit.

The essence of a Letter of Credit is that the issuer must honor requests for payment that comply with the terms of the Letter of Credit irrespective of any disputes between the applicant and beneficiary regarding the underlying contract between them, or the ability of the applicant to pay the underlying obligation. The issuer of the Letter of Credit (usually a bank) deals in documents and not the facts of the underlying transaction that gave rise to the Letter of Credit. The most important legal rule governing Letters of Credit is the independence of all three of the agreements. This “Independence Principle” gives the Letter of Credit its commercial utility.

The Independence Principle is what distinguishes a Letter of Credit from a Guaranty. Because the obligation of the issuer to pay the beneficiary is also independent of any obligation of the applicant to reimburse the issuer, the issuer must pay on the Letter of Credit even if the applicant has filed bankruptcy and the prospects for reimbursement are grim. Under usual circumstances, the only defense to payment under the Letter of Credit is material fraud in the documents or the underlying transaction. Under such circumstances, the issuing bank may require the applicant to get an injunction from a local court prohibiting the bank from honoring a draw on the Letter of Credit. Because of the Independence Principle, courts use their discretion to grant injunctive relief only in very limited cases where fraud is apparent.

The second important principle governing Letters of Credit is that the issuer must honor a presentment that appears on its face to strictly to comply with terms and conditions of the Letter of Credit. Under this “Documentary Compliance Principle,” if the issuer of the Letter of Credit refuses to pay a draft accompanied by documents that are conforming in all respects, it will be guilty of wrongful dishonor, with sanctions. The sanction for wrongful dishonor is loss of the right of reimbursement.

The bottom line – a creditor with suspicions that its customer’s future obligation to pay may be at risk, is wise to consider obtaining a Letter of Credit to ensure payment. Other forms of security for payment, such as a Guaranty or a lien against the customer’s assets, are subject to the defenses of the customer and the guarantor.

Henry A. Efroymson is a partner at Ice Miller LLP and chair of the Bankruptcy and Debtor/Creditor Disputes Practice Group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.