Letter of Credit and Guarantee Basics Flashcards
Letter of Credit
A legally binding undertaking by a Bank (referred to as the “Issuer”), for the benefit of another person entitled to payment under the letter of credit (referred to as the “Beneficiary”). LOC is issued at the request and for the account of a third person (referred to as the “account party” “applicant or “borrower” if the LOC is issued as a sub-facility to a revolving credit facility).
LOC provides that if the beneficiary presents the required documents required by the LOC to take a “drawing”, the Issuer will pay the beneficiary as provided in the LOC.
Two types of Letters of Credit
- Commercial Letters of Credit
2. Standby Letters of Credit
Commercial Letters of Credit
The LOCS may be the means of payment, even if the account party could pay directly. For instance, a seller of goods to a party in a different country it doesn’t know may want a LOC from a creditworthy bank located in its country before it’s willing to ship goods.
Standby Letter of Credit
The LOC serves more like a guaranty from the issuing bank, such that if the account party does not pay or perform an obligation owed to the beneficiary, and documents required under the standby LOC are presented in accordance with the LOC the beneficiary would be paid as provided under the LOC.
Defenses to Payment by the Issuer of a LOC
- The docs. presented by the beneficiary do not strictly comply with the requirements of the LOC
- The LOC has expired
- Fraud
Independence Principle
A LOC is independent of the underlying transaction. Absent fraud, a dispute in the underlying transaction is irrelevant to whether the Issuer has to pay on the LOC, provided the beneficiary submits complying drawing documents in accordance with the terms of the LOC.
LOCs are typically irrevocable
Guarantees
A guarantee by a third party such as a Parent or Affiliate of obligations of a borrower under a credit agreement is designed to provide, to the extent of its coverage and subject to its terms, additional credit support, for the borrower’s obligations.
“Primary Guarantee” vs. “Guarantee of Collection” only
Guarantees may be limited by narrowing language in the situations in which the Guarantee may be enforced against the Guarantor. Most Guarantees in corporate credit transactions are unconditional (e.g. the Guarantor has the obligation to pay when the guaranteed party makes a demand for payment whenever the debt is not paid when due.)
Primary Guarantees
The guarantor is liable under the terms of the guarantee regardless of whether the loan or any of the collateral has been or can be enforced against the guaranteed party (Borrower)
Guarantee of Collection
The guarantor is only liable for the collection of the debt, after the guaranteed party’s attempt to collect from the Borrower and/or collateral fails to satisfy the debt.
Guarantees Limitation on Liability
Guarantees may be limited or in accordance with their terms, such as by amount. Guarantees may (but more often do not) contain provisions that limit the Guarantor’s liability thereunder to avoid rendering the Guarantor “insolvent” under applicable bankruptcy or fraudulent conveyance law, (e.g. if the amount of the guaranty exceeds the ability of the Guarantor to pay based on its balance sheet/resources) which could adversely impact the enforceability of the Guarantee based on some relatively old case law.
Guarantee Waivers
Guarantees in certain jurisdictions expressly waive state statutory protections that provide the guarantor defenses that might otherwise be available, (e.g. customary waivers in CA law-governed guarantees of CA Civil Code provisions).
Subrogation
Lenders often require the Guarantor’s interests in the Borrower’s obligations to reimburse it for a payment under the guarantee to be subordinated in favor of the Lenders’ interests in payment from the borrower. This may be achieved through a Subordination Agreement or having the guarantor expressly waive its right of guarantor to subrogation in language in the Guarantee itself.
“If you pay off the debt of another you have the right to step in for the creditor that’s been paid in order to get reimbursed”
Lien Subordinations
Addresses how proceeds of any shred collateral are applied as between the debts owing to two or more creditors
For lien subordination, the security interest of the senior lienholder in the shared collateral has priority (but it might not be subordinated in right of collateral or share collateral and may have its own collateral) over the security interest of the subordinate or junior lienholder in the same collateral.
Debt Subordination
Addresses the ranking of the right to payment whether such payments come from the realization on particular assets or some other source.
With debt subordination, the debt owing to one creditor (“Senior debt”) is to be paid before the debt owing to the other creditor (“junior debt”).
