§ 7.1General Considerations for Letters of Credit in Real Estate Transactions
Developers, investors, buyers, sellers, lenders, landlords, and tenants may have need for letters of credit in real estate transactions. For instance, a tenant may furnish a letter of credit to its landlord as a portion of its security deposit; a letter of credit may be used to provide assurances that agreed-to joint venture investments will be funded; a letter of credit may be used to fund obligations for the purchase price for the acquisition of large tracts; a seller or landlord may use a letter of credit to secure construction or development obligations to a buyer or tenant; a letter of credit may be used to provide security for payment of bonds issued by tax-exempt entities for construction of low-cost housing or university or hospital facilities; a contractor may provide a letter of credit as security for completion of construction, performance of warranty obligations, and payment of subcontractors and suppliers; several builders party to a joint development agreement may provide letters of credit to an escrow agent to ensure payment of costs of roads, drainage, and other infrastructure; a letter of credit may provide security for the payment of indemnification obligations under a purchase and sale agreement; or the holder of a letter of credit may grant a security interest in the letter’s proceeds to secure the holder’s own loans for development of real estate projects.
A letter of credit, whether documentary or standby, is an irrevocable (unless specifically provided otherwise—see section 7.9:1 below), independent, and binding undertaking of a bank to make a payment to the beneficiary upon the presentation of certain documentation. It is not a guaranty or a surety bond, although in many cases it may serve the same function.
There are two primary types of letters of credit: the documentary credit and the standby credit.
Documentary letters of credit facilitate commerce within and among countries. For instance, a U.S. seller may be unwilling to ship goods to a buyer in another country based solely on the foreign buyer’s agreement to pay. Not only would the seller bear the risk of nonpayment, but it also might be required to enforce its rights in the foreign country. The delivery to the seller of a letter of credit as a condition to shipment relieves the seller of those risks. On the other hand, a U.S. buyer of foreign goods may want assurance that goods nominally fulfilling requirements of a purchase order are shipped before it is obligated to pay for the goods. Typically, the documentary letter of credit is payable only on submission of documentation such as shipping receipts, bills of lading, invoices, freight receipts, evidence of insurance, and inspection certificates evidencing that the seller has complied with the sales contract. The parties expect the letter of credit to be the actual source of payment of the sales transaction. The parties expect to draw upon the letter of credit because it is the method by which the seller is to receive payment for the goods. No default or other action by the buyer is required as a condition for the draw.
Standby letters of credit provide a source of payment for underlying contractual payment or performance obligations, such as a loan, a lease, or an acquisition agreement. It is typical, although not required, that a standby letter of credit is drawn only if there is a problem with the transaction or the account party has in some way breached an obligation. For instance, a letter of credit issued to a regulatory agency to ensure environmental remediation may be called upon if the account party defaults in the payment of its obligations. If a letter of credit backs a bond, the letter of credit may be drawn upon only if the bond is called and the bonding agency is required to pay the obligee.
§ 7.4Parties to a Letter-of-Credit Transaction
Letters of credit use specific terms to identify the various parties to a transaction.
Issuer: The issuer is the bank that issues the letter of credit and agrees to make the payment upon presentation of specified documents. This is the party upon whose creditworthiness the transaction depends. The issuer’s obligation is a simple, unsecured, corporate undertaking and is not insured by the FDIC. In fact, if the issuer is taken over by the FDIC, the FDIC may repudiate the obligations of the letter of credit. See Lexon Insurance Co. v. FDIC, 7 F.4th 315 (5th Cir. 2021).
Account Party, Applicant, or Customer:The account party, applicant, or customer is the party who requests the issuance of the letter of credit. In a standby transaction, this is the borrower or other obligor who obtains credit or induces another to enter into a transaction or to take or refrain from taking action based on the letter of credit. The applicant is responsible for reimbursing the issuer if the letter of credit is drawn.
Beneficiary: The beneficiary is the party entitled to receive the benefits of the letter of credit. In a standby transaction, this may be the lender who requires the letter of credit as a condition to making a loan or the landlord who requires a security deposit.
Confirmer: The confirmer is a bank or other person that confirms the obligations of the issuer. This person, which may be known to the beneficiary or located in the beneficiary’s jurisdiction, or which may have a stronger credit rating than the issuer, supplies additional credit or security to the beneficiary. The confirmer is independently responsible for honoring presentations under the issuer’s letter of credit. The beneficiary essentially has two obligors: the issuer and the confirmer.
§ 7.5Sources of Letter-of-Credit Law and Practice
Chapter 5 of the Texas Business and Commerce Code governs documentary and standby letters of credit. While this is the law that governs letter-of-credit transactions, additional conventions and practices may also apply to letters of credit. The two most likely to be selected in domestic letter-of-credit transactions are the UCP and the ISP98. For a letter of credit to be governed by one of these conventions, it must specifically state that it is governed by UCP or ISP98.
The International Chamber of Commerce has adopted Uniform Customs and Practice for Documentary Credits (UCP). This was first published in 1933 and was subsequently revised many times. The current revision, ICC Publication No. 600, was adopted in 2006. The UCP memorializes customs and practices of issuers of documentary letters of credit. It was also widely used to govern standby letters of credit before the adoption of ISP98.
The International Chamber of Commerce adopted International Standby Practices (ISP98) in 1998 specifically to standardize practices for standby letters of credit. Even though ISP98 is more closely aligned with standby letter-of-credit practice, some issuers continue to use UCP for standby as well as for documentary letters of credit.
§ 7.6Differences between ISP98 and UCP
There are many differences between ISP98 and UCP, including the absence of detailed provisions for insurance, shipping documents, and other trade-related concerns that are important in UCP for documentary letters of credit. ISP98, dealing specifically with standby letters of credit, has no need for such provisions.
An important difference between UCP and ISP98 for a beneficiary is the effect on the letter of credit arising from an extended disruption in business because of weather and other force majeure events. ISP98 provides the following:
If on the last business day for presentation the place for presentation stated in a standby is for any reason closed and presentation is not timely made because of the closure, then the last day for presentation is automatically extended to the day occurring thirty calendar days after the place for presentation re-opens for business, unless the standby otherwise provides.
Int’l Standby Prac. R. 314(a).
UCP articles 29 and 36 address closure in different fashions. Under article 29, if a presentation is due on any day when the bank is closed for any reason other than those set forth in article 36 (which governs force majeure issues), the presentation is extended to the first following banking day. Article 36 provides the following:
A bank assumes no liability or responsibility 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. A bank will not, upon resumption of its business, honour or negotiate under a credit that expired during such interruption of its business.
Uniform Customs and Prac. for Documentary Credits art. 36. Although article 36 would relieve the bank of the obligation to honor a draft due to closure for a force majeure event, many issuers routinely modify this rule if requested. A beneficiary who is presented with a letter of credit governed by UCP should check to see if article 36 is waived; if it is not, the beneficiary may wish to request an amendment to the proposed form.
An additional difference between ISP98 and UCP, discussed in greater detail in section 7.9:4 below, is that in the event of death, bankruptcy, and other similar changes in the identity of the beneficiary, ISP98 specifically provides for rights to a successor to make a drawing, while UCP does not.
§ 7.7The Independence Principle
The essence of the letter-of-credit transaction is the independent undertaking of the issuing bank. This “independence” principle is one of the most cited aspects of letter-of-credit law.
ISP98 provides in rule 1.06(a) that a letter of credit is “an irrevocable, independent, documentary, and binding undertaking.” Int’l Standby Prac. R. 1.06(a). Rule 1.06(c) stipulates that enforcement does not depend upon, among other conditions, either the “beneficiary’s right to obtain payment from the applicant” or “the issuer’s knowledge of performance or breach of any reimbursement agreement or underlying transaction.” Int’l Standby Prac. R. 106(c)(ii), (iv). Thus, the existence of a dispute between applicant and beneficiary about whether conditions for payment have actually occurred will not authorize the issuer to refuse to honor a presentation that appears to comply with the requirements of the letter of credit.
UCP provides a similar provision in article 4 and provides the following:
A credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the credit. Consequently, the undertaking of a bank to honour, to negotiate, or to fulfil any other obligation under the credit is not subject to claims or defences by the applicant resulting from its relationships with the issuing bank or the beneficiary.
Uniform Customs and Prac. for Documentary Credits art. 4.
This independence principle is the primary difference between a letter of credit and a guaranty or surety bond. With a guaranty or surety bond, the guarantor or surety company has no obligation until there is a default, and it would expect to investigate whether the conditions of its obligations had accrued, including whether there had been an actual default or failure of performance under the underlying contract. The opposite is true in the case of the letter of credit. The issuer examines only whether the conditions for draws have been met. It does not investigate any provisions of the underlying contract.
The issuer pays drafts drawn under the letter of credit from its assets. An issuer that has honored a presentation is entitled to be reimbursed by the applicant in immediately available funds not later than the date of its payment of funds. Tex. Bus. & Com. Code § 5.108(i)(1). This reimbursement obligation may be evidenced by a reimbursement agreement or a letter-of-credit application, or the applicant may agree that any amounts paid under the letter of credit will be considered advances under an existing credit facility. The issuer may have required a guaranty and security in the property of the account party or guarantor. These requirements are typically made based on the issuer’s underwriting of the credit of the account party.
Form 7-2 in this chapter is an example of a simple standby letter of credit. Other examples of standby letters of credit may be found at the Institute of International Banking Law & Practice website, https://iiblp.org. Typically, the issuing bank will prepare the letter of credit based on its internal policies and procedures. However, the applicant and the beneficiary may be able to request changes to address specific concerns or deal points, such as requirements that a letter of credit be furnished substantially in a form attached to a lease or credit agreement. Several basic points are described in this section.
§ 7.9:1Revocable or Irrevocable
Texas law provides that a letter of credit is revocable only if it specifically states so. Tex. Bus. & Com. Code § 5.106(a). Under UCP, a letter of credit is deemed to be irrevocable unless it provides otherwise. ISP98 specifically provides in rule 1.06(a) that a standby letter of credit is irrevocable. Notwithstanding the strong support for irrevocable letters of credit in the law and banking conventions, letters of credit typically state specifically that they are irrevocable.
§ 7.9:2Documentary Submissions
A letter of credit is drawn upon the submission of documents and certificates specified in the letter. A standby letter of credit does not provide that the beneficiary may draw upon an event of default under a lease, a credit agreement, or another agreement between the beneficiary and the applicant. Rather, it might provide that a draw would be paid upon submission of documents to the issuing bank, such as a certificate of the beneficiary that the applicant is in default under other agreements. With such a provision, the issuing bank is removed from the underlying transaction and fulfills its obligation upon the receipt of the specified documents.
A letter of credit can be transferred only if it so states. Tex. Bus. & Com. Code § 5.112; Int’l Standby Prac. R. 6.02(a); Uniform Customs and Prac. for Documentary Credits art. 48(b). If the beneficiary is the collateral agent for lenders under a secured credit facility or the trustee for bondholders under bonds and the parties wish to provide for transfer to a successor agent, the letter of credit would provide for this right. If a letter of credit is provided as security for a lessee’s lease obligations, the lease may provide that if the lessor sells the property the lessee would consent to a transfer or would post a replacement letter of credit in favor of the new owner. If the parties wish to provide in the letter of credit itself for transfer to a subsequent owner, a clause to that effect could be included in the letter of credit.
The successor of the beneficiary may submit draws. Tex. Bus. & Com. Code § 5.113. “Successor of a beneficiary” is a person “who succeeds to substantially all of the rights of a beneficiary by operation of law, including a corporation with or into which the beneficiary has been merged or consolidated, an administrator, an executor, a personal representative, a trustee in bankruptcy, a debtor in possession, a liquidator, and a receiver.” Tex. Bus. & Com. Code § 5.102(a)(15). ISP98 rules 6.11 through 6.14 contain detailed provisions for presentations by “an heir, personal representative, liquidator, trustee, receiver, successor corporation, or similar person who claims to be designated by law to succeed to the interests of a beneficiary.” Int’l Standby Prac. R. 6.11; see Int’l Standby Prac. R. 6.12–6.14. UCP does not directly address this issue. The beneficiary may not assign a single contract and a letter of credit securing payment and performance under chapter 5 of the Texas Business and Commerce Code and ISP98. However, a successor to the beneficiary may submit a draw that otherwise would have to be submitted by the originally named beneficiary.
Texas law provides that, unless otherwise stated, a letter of credit will expire one year after its stated date of issuance, and a letter of credit which states that it is perpetual expires five years after its date of issuance. Tex. Bus. & Com. Code § 5.106. Under UCP article 42, all letters of credit must contain expiration dates. Under ISP98 rule 9.01, a standby must either contain an expiration date “or permit the issuer to terminate the standby upon reasonable prior notice or payment.” Int’l Standby Prac. R. 9.01. If the events that must be certified in connection with a draw have not occurred before the expiration date, the issuing bank is not obligated to extend the time for a draw.
To comply with their underwriting standards, including the ability to monitor the credit of the applicant, banks may issue letters of credit with a one-year expiration date with an “evergreen” renewal. Under these circumstances, the letter of credit typically provides that it will automatically renew for successive one-year periods unless the issuing bank advises the beneficiary within some period before expiration that the letter of credit will not be renewed for an additional year. In these cases, the letter of credit may provide that the beneficiary may draw down the full amount of the credit upon a certificate stating that the letter of credit is not being extended and that the beneficiary is entitled to draw the full amount. If so, the beneficiary and the applicant may address in the lease, credit agreement, or underlying document what will be done with the proceeds of that draw. The parties may intend that the proceeds be held in escrow, subject to a security interest to secure the obligations, or may be held only until the applicant is able to procure an acceptable alternate letter of credit.
Even in cases such as the evergreen, in which the issuing bank can decline to extend on any anniversary, many banks also prefer to include a final maturity date beyond which there will be no extensions. This allows the issuer to clear the expired letter of credit from its books without having to obtain evidence from the beneficiary that the letter of credit was cancelled or released.
§ 7.9:6Submission of Certificates; Sight Draft
The types of certificates that may be required in connection with a draw are subject to negotiation between the applicant and the beneficiary to conform to the provisions of the underlying contract. While older letters of credit typically required submission of a sight draft, together with certificates, these are seldomly required in more recent credits. A sight draft is a draft payable on presentation to the bank that issued the letter of credit. Form 7-3 in this chapter is a simple sight draft for use if required under the particular letter of credit.
§ 7.9:7Submission of Originals or Electronic Copies
The parties may consider whether the beneficiary must submit originally signed certificates or other documents for the draw or whether it would be authorized to submit electronic forms of certificates. Submission of originals can require more advance planning (and potential travel time if personal deliveries are made to reduce errors), particularly if the issuing bank is located in another state. Cases have generally provided that absent specific agreement to the contrary, original documents must be presented.
ISP98 rule 3.08 provides that a standby may be drawn in partial or successive draws unless it provides to the contrary. UCP article 31 allows partial drawings but does not stipulate whether this is the default rule or if it must be reflected in the terms of the letter of credit itself. Texas law is silent regarding partial draws. If the parties intend to allow the letter of credit to be drawn in successive draws, the letter should provide this right.
The parties may choose any jurisdiction’s law to control a letter of credit, regardless of whether the jurisdiction bears any relation to the transaction. If no other jurisdiction’s law is specified, a letter of credit issued by a Texas bank is governed by the Texas Business and Commerce Code and may also be governed by either ISP98 or UCP, if so stated in the letter of credit. Typically, the issuer will select the law of its main office or the law of a state in which it maintains a substantial commercial presence.
§ 7.10Pitfalls in Draw Process
As indicated at section 7.9 above, many details should be carefully considered in drafting a letter of credit. For example, when drawing on a letter of credit, the beneficiary must submit documents that comply exactly with the requirements of the letter. If the letter of credit calls for documentation the beneficiary cannot furnish, the issuer will not fund the draw. The applicant could agree to an amendment to the letter of credit or could agree that the issuer may pay a nonconforming draw, but that is unlikely if the draw is in connection with a default or other issue with the underlying contract between the beneficiary and the account party. Other potential defects could also result in a draw not being honored.
§ 7.10:1Draw after Expiration Date of Letter of Credit
If the draw is not submitted before the stated expiration date of the letter of credit, it will not be honored. For that reason, if the letter of credit does not permit electronic submissions, the beneficiary must plan the draw sufficiently in advance to ensure that original certificates or other documentation can be delivered to the issuer before the expiration date. If the expiration date is imminent, a beneficiary may consider sending an officer or agent to the city where the submission must be made rather than relying on couriers or other delivery services.
§ 7.10:2Inability to Present Exact Documentation Required
If the letter of credit requires specific documents that cannot be supplied, for example, a certificate of a person who is no longer part of the beneficiary or an original letter of credit that cannot be located, the issuer will likely refuse to fund the letter of credit.
§ 7.10:3Injunction Filed by Account Party
Most issuers will not alert the account party when a draw is presented, and no issuers would ask permission to fund a draw that complies with the terms of the letter of credit. They cite their reputation as the reason: if they do not honor conforming draws, others would be unwilling to accept their letters of credit in the future. However, some letters of credit require as a part of the draw a certificate that the beneficiary has notified the account party of its intent to make the draw. If the account party disputes the draw (such as disputing that a default exists under the operating contract at the source of the letter-of-credit transaction), it may sue to enjoin the issuer from honoring the draw. While the ability of an account party to obtain such an injunction is limited, it remains a possibility. Generally, a draw will be paid unless a required document is forged or “materially fraudulent” or honoring the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant. See Tex. Bus. & Com. Code § 5.109.
As stated at section 7.6 above, whether a letter of credit can be extended due to force majeure or other extended disruptions of business depends on whether it is governed by UCP or by ISP98.
The COVID-19 pandemic raises the question whether any additional or special provisions might enable the beneficiary to obtain delays or extensions in the term of the letter of credit due to force majeure or similar theories. This is highly unlikely—the standard rules and obligations still apply—and the beneficiary should assume it is not available. A letter of credit governed by ISP98 will obtain a thirty-day extension if the issuer’s place of business is closed, as discussed at section 7.6 above. A letter of credit governed by UCP article 36 will obtain an extension to the next available banking day if a bank is closed for any reason other than those set forth in article 36, also discussed at section 7.6 above. However, if the issuer’s place of business is open but the beneficiary is subject to “stay home” orders or its operations are so impacted by the pandemic that it is delayed in compiling the documents necessary for the draw, it does not seem that either ISP98 or UCP will provide a specific remedy.
In March 2020, the International Chamber of Commerce (ICC) began issuing guidance, including limited emergency guidance regarding the flexibility of ICC rule interpretation for banks and, for issues beyond the ICC’s reach, recommended policy and other steps for governments (Int’l Chamber of Commerce, “ICC Memo to Governments and Central Banks on Essential Steps to Safeguard Trade Finance Operations” (Apr. 6, 2020), https://iccwbo.org/content/uploads/sites/3/2020/04/icc-memo-on-essential-steps-to-safeguard-trade-finance-operations.pdf), as well as a guidance paper generally addressing the impact of COVID-19 on financial transactions subject to its rules (Int’l Chamber of Commerce, “Guidance Paper on the Impact of COVID-19 on Trade Finance Transactions Issued Subject to ICC Rules” (July 4, 2020), https://iccwbo.org/content/uploads/sites/3/2020/04/2020-10-the-impact-of-covid-19.pdf).
§ 7.11Security Interests in Letters of Credit
Section 9.5:5 in this manual identifies the method by which a creditor may perfect a security interest in a letter of credit. Notwithstanding the ability to obtain a perfected security interest in the proceeds of the letter of credit, the secured creditor will be forced to rely on its debtor’s compliance with the terms of the credit, such as submission of drafts and documents, in order to obtain proceeds. As a result, a security interest in this sort of collateral may be less desirable than a security interest in a deposit account or some other collateral that would not be so dependent on the actions of the obligor to realize its value.
Bastian-Rodriguez, Allison A. “Letters of Credit: Don’t Forget the Real Estate Forms Manual!” In Advanced Real Estate Drafting Course, 2021. Austin: State Bar of Texas, 2021.
Byrne, James E. Standby & Demand Guarantee Practice: Understanding UCP600, ISP98 & URDG 758. Montgomery Village, MD: Institute of International Banking Law & Practice, Inc., 2014.
Institute of International Banking Law & Practice, Inc. International Standby Practices: ISP98. New York: ICC Publishing, Inc., 2012.
International Chamber of Commerce. ICC Uniform Customs and Practice for Documentary Credits: UCP 600. New York: ICC Publishing, Inc., 2007.
Maloney, Marilyn C. “Letters of Credit in Real Estate Transactions.” In Advanced Real Estate Law Course, 2015. Austin: State Bar of Texas, 2015.