Magazine article Business Credit

A Letter of Credit as Security for Pre-Judgment Remedy-Beware of the Expiration Date

Magazine article Business Credit

A Letter of Credit as Security for Pre-Judgment Remedy-Beware of the Expiration Date

Article excerpt

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Introduction

A letter of credit (LC) can be an effective device to secure payment of an obligation of a debtor to a creditor. An LC beneficiary obtains payment by presenting to the issuing bank all of the documents required by the LC. The beneficiary's presentation of documents to the issuing bank must be made prior to expiration of the LC. If an LC beneficiary is unable to present all of the required documents before the LC expires, the beneficiary may not be able to rely on the LC as a source of payment.

That is precisely what happened in the Chapter 11 case involving Dairy Mart Convenience Stores Inc. ("Dairy Mart"). An LC was supposed to secure a prejudgment remedy in favor of a creditor. Unfortunately for the creditor, the LC was set to expire before final judgment could be entered in the lawsuit. In the meantime, Dairy Mart had filed a Chapter 11 petition and the beneficiary was unable to obtain an order of the bankruptcy court extending the expiration date of the LC. Could the creditor have avoided this unfortunate state of affairs? Read on people and you will see.

What Is a Letter of Credit?

An LC is an undertaking, usually by a bank, to a named person, the beneficiary, to honor a presentation of documents that complies with the requirements of the LC. An LC can be used as a means of payment in international trade and other business transactions, such as in the export and import of goods and services. An LC could also be issued as security for a party's performance of its obligations. For example, an LC could be offered to secure a buyer's obligation to purchase goods from a seller. LCs have also been tendered in lieu of a security deposit on a lease, and have been issued to secure payment of various note and indenture obligations.

An LC transaction involves three parties and three independent contracts. The first contract is the agreement for which the LC is to be the means of payment or collateral security. This agreement could be a contract for the sale of goods. Where an LC is the method of payment of the purchase price of goods, the seller is the LC beneficiary, the buyer is the LC account party or applicant and the bank issuing the LC is the LC issuer.

The second contract is the agreement between the LC issuing bank and the applicant/account party, such as a buyer of goods. A bank agrees to issue an LC and the LC/applicant/account party/buyer agrees to reimburse the issuing bank for payments made to the beneficiary upon the presentation of all of the documents required by the LC. The LC/applicant/account party also agrees to pay all commissions and fees provided in the issuing bank/account party agreement. The agreement also sometimes provides for collateral security for payment of the account party's reimbursement obligation to the bank.

The third contract is the LC itself that a bank issues in favor of the beneficiary/seller. The beneficiary/seller must present all of the documents required under the LC prior to expiration of the LC as a condition to payment by the issuing bank. The documents may include a draft (demand for payment), invoices, delivery and insurance documents.

Each of these contracts is independent of the other. For example, if the seller presents the required documents, the issuing bank must pay on the LC regardless of disputes between the seller and the buyer in the sale transaction and/or the buyer's financial inability to reimburse the bank for payments and charges under the LC. The issuing banks payment to the beneficiary/seller based upon the seller's presentation of noncomplying documents extinguishes the buyer's obligation to reimburse the bank for that payment.

The issuing bank's primary concern is to determine whether the seller/beneficiary has presented documents that comply with the terms of the LC. The bank deals only in documents presented by the beneficiary when deciding whether to pay on the LC. …

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