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Covid-19 coronavirus update: 7 key points for making sure your standby letter of credit is still as good as cash

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17 April 2020

Standby letters of credit and similar financial instruments such as demand guarantees, refund guarantees or performance bonds are often considered as good as having a cash security deposit. They are used in a wide variety of commercial contexts in which one party, an obligor, needs to provide security to another, the beneficiary, for its obligations or potential liabilities. They are intended to be readily enforceable and reliable means of mitigating a counterparty's default.

In this note we outline some of the practical problems in claiming payment under a standby letter of credit or demand guarantee which the current Covid-19 outbreak has brought to the fore, and how to go about ensuring your letter of credit remains a viable form of security.

In the shipping industry, letters of credit and demand guarantees are often used as collateral to secure a shipyard's liability to refund a customer's down payments under a shipbuilding contract. In the aviation industry aircraft lessors often accept letters of credit in place of cash security deposits to secure an airline's obligations under a lease of an aircraft (such as to provide maintenance reserves or pay rent). The beneficiary of the letter of credit can replace the credit risk of its customer with one of a bank with a higher credit-rating. The shipyard or airline will typically access such credit support to avoid using their own cash as collateral, instead simply paying the bank a fee for issuing the letter of credit.

Their acceptability as good collateral arises from:

(a) standard sets of rules issued by the International Chamber of Commerce (ICC) (the ICC provides the URDG 758 for demand guarantees and the UCP 600 or the ISP 98 for letters of credit; the ISP 98 rules are preferable for standby letters of credit as the rules are drafted with this in mind whereas the UCP 600 rules are drafted primarily for trade finance); and

(b) English law's long established legal principles that allow almost no room for argument as to whether payment is due if the beneficiary serves a demand meeting the requirements of the letter of credit or refund guarantee.

To get paid, the beneficiary of a letter of credit or refund guarantee simply has to comply with its terms and present the demand or certificate at the bank in the manner required. Strict compliance with the terms is essential. Letters of credit and demand guarantees are often valid only for a year with provisions for their automatic renewal, unless the bank gives notice. Banks may not be willing to renew if they see that an imminent risk of a demand being served. Failure to renew should trigger the right of the beneficiary to make a demand under the letter of credit, even if there is no other default in the underlying transaction. However, there may be only a short window in which to serve the demand or get the counterparty to provide alternative collateral in the form of cash collateral or an acceptable replacement letter of credit,

The impact of the Covid-19 virus presents some challenges to the apparent simplicity and certainty of standby letters of credit and guarantees. Set out below is a series of pointers to ensure that they remain as cast-iron as they can be in these challenging times. Planning is important, and the following issues should be considered as priority in terms of being able to access the security.

1. Do you have the original letter of credit/guarantee and do you know where it is?

If the letter of credit is in paper form, rather than an electronic SWIFT message, the original usually must be presented alongside the demand for payment. If it is lost, there is no requirement for the issuing bank to provide a replacement unless this had been expressly included in the terms of the instrument. Don't wait until you need to make a demand to check the status and whereabouts of your letter of credit or refund guarantee.

2. Is the right signatory available to sign the demand?

Many key staff may be working in self-isolation. Getting the demand and any other documents required signed by the right person may be more challenging in terms of logistics than in normal times.

3. Is the letter of credit/guarantee and demand in the right place to serve?

Usually a letter of credit or demand guarantee will specify where the beneficiary has to present it for payment. This must be complied with strictly. International travel and courier services are being impacted by the lock-downs and by travel restrictions in many countries. Check the terms of the letter of credit/refund guarantee to see if it allows for service by SWIFT message, email/pdf or by fax.

If the letter of credit or refund guarantee is silent about where a demand must be served, each of the ICC rules has slightly different requirements.

Under the ISP 98 Rule 3.04, if no place is specified, presentation must be made at the place of business from where the standby was issued or confirmed. If a place is specified, but not a location within that place, the postal address, the location designated for incoming deliveries or a person authorised or apparently authorised to accept delivery will suffice. The UCP 600 is silent about the specific place for presentation, beyond the fact that presentation must be made at one of the issuing, advising and confirming banks' offices (the choice for the beneficiary is not without implications). Article 14 of the URDG 758 permits presentation at the place of issue or the place specified in the guarantee.

4. Is the bank branch where the demand must be served open for business?

If it is closed, why? The ICC rules may apply differently if the bank is closed because it has decided to suspend business or if it is closed because it cannot open due to factors beyond its control (force majeure).

5. If the bank is closed, what do the applicable ICC rules state?

Under the ISP 98, if a standby letter of credit is due to expire on a day which is not a business day at the relevant bank, presentation can be made the next business day (Rule 3.13) but if the bank is closed on a business day which is the last day available for presentation, and presentation is not made because of the closure, Rule 3.14 will give the beneficiary an extra 30 calendar days after the bank re-opens for presentation.

The UCP 600 rules are less helpful to beneficiaries. Under Article 36, the bank is not liable for "the consequences arising out of the interruption of its business by Acts of God, riots, civil commotions, insurrections, wars, acts of terrorism, or by any strikes or lockouts or any other causes beyond its control" and it has no obligation to honour a letter of credit which has expired during an interruption of its business for such reasons. Article 29 offers only a glimmer of hope: if the bank "is closed for reasons other than those referred to in article 36", the expiry date is extended until the first following banking day.
Article 26 of the URDG uses a slightly different definition of force majeure to the UCP 600, and provides for an automatic 30 day extension to the period for presentation.

6. Have the applicable ICC rules been amended or varied by letter of credit/guarantee?

The express terms of the letter of credit or guarantee are often used to vary the rigor of the ICC rules (for example Article 36 of the UCP 600 is regularly disapplied). The express provisions of the instrument should therefore be carefully examined.

7. If you cannot present the demand because the bank is closed, you may need to document your efforts to show you have complied with the terms of the letter of credit/guarantee if the bank later disputes matters.

 

Because letters of credit and demand guarantees are designed to be independent of the underlying transactions which they are intended to secure, an event of force majeure which affects the underlying contract should not render a valid demand under such an instrument ineffective under English law.

Allen & Overy is advising clients on a range of coronavirus-related issues. For more information on the potential impact of coronavirus on your business or transaction, please get in touch.

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