Good afternoon Buddy!

 

I have a question related to accepting a standby letter of credit from a counterparty that we consider a high risk of claiming bankruptcy.

 

What guidance can you provide to us in accepting a standby from such a counterparty?  Pitfalls, risks, best approach, etc.

 

Can we structure an LC in a way that would mitigate our risks of payments made directly to us being recalled as preferential?

 

Thanks,

TD

TD,

I attach a format that I recommend you follow in order to protect yourself from preference claims.  It’s not entirely obvious how it works, so allow me to explain:

What you are worried about, at least when your customer is in the US, is being paid during the 90-day preference period.  If the preference period extends past the expiration date of the standby, you might have to return payments you received and yet not be able to draw on the standby.  One of the issues is that most standbys that cover past-due invoices make you certify that you have not received payment, but this might not be the case—the real trouble is when you have received payment directly from the customer and then, within 90 days, they go bankrupt.  Now you know you have probably received a payment that can be recalled as a preference, but it might not get recalled for months or even years as the trustee in bankruptcy works to settle the debts of the bankrupt party.

So the worst case is that the buyer goes bankrupt on the 90th day and the L/C is expiring that day.  You probably won’t even find out about the bankruptcy for a day or two and the L/C is gone.  My recommendation is that you not make any shipments during the last 120 days—that way you still have 30 days to draw on the L/C if the buyer goes bankrupt 90 days after the last payment you received.  The language attached allows you to draw EITHER by stating that you have not been paid OR by stating that you WERE paid, but the buyer went bankrupt thereafter.  In the latter case, you are drawing for the amount you have already been paid, so you agree to return the first payment.  You might go ahead and return it immediately, as it’s a duplicate payment anyway, but you agree that you will certainly return it once the bankruptcy estate is settled to the extent that you’ve been overpaid.  Note that the payment from the bank, under the letter of credit, is not subject to a preference claim as it’s the bank that is paying you, not the customer; the bank is the one that runs the risk that the reimbursement they receive from the customer will be recalled.

The format assumes that you intend to do sell to this customer on an ongoing basis, beyond just one year.  It therefore includes an automatic extension clause.  I’ve made the non-extension notification deadline 120 days before expiration to match the 120-day recommendation I explained above, that you stop shipping when there are only 120 days left in the LC.  I also put in language that allows you to draw for any unpaid invoices once you get a notice of non-extension; this avoids getting any payments directly from the buyer for these invoices.  Note that these invoices need not be past due or even due.  And the way I’ve worded it, you can even make additional shipments during the final 120 days, but you are expected to draw under the LC for payment of these invoices.  In other words, it starts to work like a commercial LC.

There is another approach that I sometimes recommend that accomplishes the same objective. That is to put in the contract with the buyer all of the conditions under which you are allowed to draw on the standby, including for past-due invoices, for invoices that were paid in the 90 days preceding bankruptcy, for invoices that are outstanding at the time the LC has reached 120 days before expiration, and for any orders placed in the final 120 days before expiration of the L/C.  Then, in the standby itself, say that the only document required is a statement that you are entitled to the amount drawn “in accordance with the terms of the contract.”  I mean this literally—you don’t state why you are drawing, only that you are entitled to.  Then be sure to pay attention to the 120-day point where you stop shipping and draw for any outstanding invoices.