Magazine article Business Credit

A Standby Letter of Credit Payment within the Preference Period Is Not a Preference

Magazine article Business Credit

A Standby Letter of Credit Payment within the Preference Period Is Not a Preference

Article excerpt

One of the most frequently asked questions from trade creditors is whether a drawing and a payment on a standby letter of credit during the 90-day preference period is recoverable as a preference. A letter of credit is a security device where a bank or other entity agrees to pay up to the amount of the letter of credit to a beneficiary that presents all of the documents required by the letter of credit. A standby letter of credit is intended to serve as a backstop to secure payment or performance of a separate independent transaction between the letter of credit beneficiary--and frequently--the person that arranged for the issuance of the letter of credit, the letter of credit applicant. For example, a seller of goods or provider of services could be a beneficiary under a standby letter of credit to secure the payment of the purchase price of goods sold or services provided to a buyer that arranged for the issuance of the letter of credit.

In ITXS, Inc., a Chapter 11 case pending in the United States Bankruptcy Court for the Western District of Pennsylvania, a Chapter 11 debtor had brought a preference action against a landlord that made a drawing under, and received payment of, a standby letter of credit within 90 days of ITXS's bankruptcy. The standby letter of credit was issued for ITXS's account in favor of ITXS's landlord as a partial security deposit to secure ITXS's obligation to pay rent and other sums due under ITXS's lease with the landlord. The Bankruptcy Court held the payment was not a preference. The court's analysis is equally applicable to trade creditors who are beneficiaries of standby letters of credit that secure payment of the purchase price of goods or services provided to a customer.

Overview Of Standby Letters Of Credit

A standby letter of credit is used in many transactions as a backstop that protects a letter of credit beneficiary from a default in its transaction with a third party, usually the letter of credit applicant. A letter of credit arrangement involves three parties and three independent contracts. First is the underlying contract between the letter of credit applicant and beneficiary, such as a sale of goods or provision of services. The bank's agreement, usually with the letter of credit applicant, is the second contract.

This contract provides for the issuance and the terms of the letter of credit, the applicant's obligation to reimburse the bank for payments made to the beneficiary upon the presentation of conforming documents under the letter of credit as well as the bank's charges and commissions earned from issuing the letter of credit, and the collateral security for the applicant's reimbursement obligation to the bank. The third contract is the standby letter of credit that the bank issues in favor of the beneficiary. When the beneficiary presents all of the documents required by the standby letter of credit, usually consisting of a draft and a statement or certification of default in the underlying transaction, with the letter of credit applicant (such as the buyer's/applicant's failure to timely pay for goods sold or services provided by the seller), the issuing bank must pay the amount of the draft to the beneficiary, or else breach the bank's payment obligation under the letter of credit.

One of the central tenets of letter of credit law is the principle of independence. Each of the contracts in a letter of credit transaction is independent of the other. And a letter of credit issuing bank deals only in documents. For example, if the beneficiary presents all documents required by the letter of credit, the issuing bank must pay the letter of credit. The existence of disputes between the beneficiary and the applicant, and/or the applicant's financial inability to reimburse the bank for letter of credit payments and charges, has no bearing on the bank's obligation to pay a beneficiary that presents all documents required by the letter of credit. …

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