Vedder Price

Vedder Thinking | Articles Letters of Credit: A Refresher

Article

Reader View

Letters of credit are often issued in aircraft leasing transactions as an alternative to the provision of a cash security deposit and, less frequently, the obligation to pay maintenance reserves in cash. In an airline bankruptcy scenario, it is important to understand the differences that exist between different forms of letters of credit, and some of the challenges that may arise for an enforcing lessor or financier.

Letters of credit are widely accepted in aviation finance transactions, particularly where issued by a bank or other financial institution that may have a significantly better credit rating than the underlying applicant airline. There is a risk, with cash security deposits and payments of cash maintenance reserves, that local insolvency rules may recharacterize such payments as part of an airline’s insolvency estate (though leases are drafted to avoid this).1 As the proceeds of a letter of credit are paid by the issuing institution pursuant to an independent contract between the issuing bank and the beneficiary lessor or financier, the risk of recharacterization of such proceeds as being part of the airline’s insolvency estate is accordingly reduced.

Letters of credit generally

Fundamentally, a letter of credit is a written obligation issued by a bank or other financial institution to a specified beneficiary, on an applicant’s behalf, pursuant to which the issuing bank is obliged to make a payment, in immediately available funds, to the beneficiary against the presentation of specified documents or a written demand.

A letter of credit forms a separate, stand-alone contract between the issuing bank and the beneficiary, and broadly there are two main categories of letters of credit: commercial and standby.

A commercial letter of credit acts as a payment mechanism, which is put in place to safeguard payment of the purchase price by a buyer of goods or services to a seller of goods or services, whereas a standby letter of credit operates in much the same way as a security deposit, performance bond or demand guarantee – it provides collateral support for particular financial obligations owed by one party to another under an underlying contract, such as an airline’s obligation to make maintenance payments under an aircraft lease agreement. In any event, both categories of letter of credit are triggered by a contingent event (e.g., a default in the underlying obligation), create a primary obligation on the issuing bank and are a form of documentary credit.

Trade rules: UCP 600 v ISP98

Most letters of credit are issued subject to the International Chamber of Commerce’s (the ICC) Uniform Customs and Practice for Documentary Credits (currently in its sixth edition) (the UCP 600) or the ICC’s International Standby Practices (the ISP98). As a matter of law, the applicant and the beneficiary have the freedom to decide which set of rules to incorporate and it is important that the incorporation is expressly stated in the letter of credit, including which particular parts of the selected body of rules should be modified or excluded from application.

There are many similarities between UCP 600 and ISP98, including the inclusion of rules relating to presentation and examination of credits. While the UCP 600 does not distinguish between standby and commercial letters of credit, the ISP98 was introduced to provide more detail and clarification around the rules relating to standby letters of credit. For example, while article 36 of UCP 600 addresses force majeure events, it allows the issuing bank to disregard any letters of credit that expired during the interruption of the issuing bank’s business due to a force majeure event. This clearly puts the beneficiary in an unfavorable position through no fault of its own. ISP98 Rule 3.14, on the other hand, provides for an automatic extension of thirty calendar days in the same situation, thereby protecting the beneficiary’s right to access the collateral support provided by a standby letter of credit during a force majeure event.

It should be noted that both sets of rules are not all-encompassing. Parties will often have to refer to standard banking practices of the issuing institution and the governing law of the letter of credit to fully understand the requirements of the letter of credit.

Time for enforcement

Generally, a letter of credit will contain detailed steps to be taken by the beneficiary upon enforcement. Beneficiaries are oftentimes required to present the original letter of credit, together with a demand for payment under the letter of credit (often in the form of a drawing certificate) at the issuing bank, and may be required to provide evidence of the beneficiary’s corporate authority to issue the demand.2

Typically, the issuing bank then has a maximum of five banking days in which to determine whether the presentation of documents complies with the terms of the letter of credit. If the issuing bank decides the presentation is compliant with the letter of credit, the issuing bank must immediately pay the sum due to avoid being in breach of its obligation to pay the beneficiary (it is not entitled to wait until the end of the fifth banking day). Should a beneficiary be able to prove the issuing bank caused undue delay in providing the sum due, the issuing bank would be liable for damages including interest on the sum due.

Enforcement issues

As mentioned above, a beneficiary oftentimes needs to present the original letter of credit to the issuing bank in an enforcement scenario. Although a beneficiary will usually require the applicant to deliver the original letter of credit to it for safekeeping during the relevant period, the beneficiary would be prudent to also consider the location in which the original is held to circumvent any avoidable delay in an enforcement scenario when arranging for the original letter of credit to be presented to the required branch or office of the issuing bank for drawings under that letter of credit.

Issuing banks often require beneficiaries to follow the exact instructions contained in the letter of credit, to avoid liability for any fraud that may come to light after a drawing under the letter of credit is made. This can pose problems if the instructions are not clear from the outset or impose conditions that are difficult for a beneficiary to comply with. For example, letters of credit that require signatures to be authenticated with a “banker’s confirmation of signature” leave open the question as to who a “banker” is for confirmation purposes and what degree of authentication that bank is required to undertake.

Issues may also occur in relation to the practicality of attending the issuing bank’s offices to demand the payment in the letter of credit. Many issuing banks do not have counter services and often the documents are presented to a member of the trade finance team that may not be familiar with the UCP 600 or ISP98 rules governing the demand for payment. In some scenarios, particularly if the presentation requirements of a letter of credit are unclear, multiple visits may be required by the beneficiary’s representative before the issuing bank accepts the presentation of documents and its window of consideration of the documents begins.

A standby letter of credit will typically be issued by the issuing bank for a term no longer than one calendar year, after which time the letter of credit will need to be renewed (though many auto-renew prior to the otherwise scheduled expiry). Care should be taken with letters of credit that expire on a specific date or at a specific time to ensure that coverage by the next letter of credit commences immediately at or prior to expiration of the existing letter of credit.3 It should be noted that this may be a point of contention, as the applicant airline will be obligated to finance the issuing bank for that extra day/hour and bear the risk that during such time the beneficiary may submit demands to the issuing bank under both letters of credit.

Finally, it is significant to note that the relationship between the issuing bank and the applicant is usually stronger than the relationship between the issuing bank and the beneficiary. Absent a direct relationship between the issuing bank and the beneficiary, undue friction may occur in the enforcement process if the applicant disagrees with the beneficiary’s demand for payment. It is also possible, in cases of the applicant’s insolvency, that the issuing bank may concurrently be in the process of managing its exposure to the applicant’s insolvency at the same time a beneficiary makes a payment demand under a letter of credit. It is important to note a letter of credit is an independent contract between the issuing bank and the beneficiary and these matters should not influence the issuing bank’s decision to delay or deny payment under a letter of credit.

For further information or advice on enforcing letters of credit, please contact your Vedder Price attorney.


1 An example provision: The Security Deposit and any interest accrued on it shall be Lessor's absolute and unconditional property. Lessor shall not have to keep the Security Deposit in any particular fund or bank account, and Lessor may commingle such amounts with Lessor's general and other funds, and may use such amounts in any way that Lessor chooses, including by creating a Security Interest over such funds in favour of a Financier. Lessor shall not hold the Security Deposit as agent of or on trust for Lessee or in any similar fiduciary capacity.

2 This demand is not typically stated in the letter of credit itself but may be required pursuant to the practice and/or banking requirements of the issuing institution.

3 To avoid such untenable situations, the beneficiary should ensure the underlying contract is carefully drafted to provide for an event of default or to allow the beneficiary to make a payment demand under the existing letter of credit if such letter of credit is not renewed by 30 days prior to its expiry.



Professionals



John Pearson

Solicitor



Esha Nath

Solicitor