Standby Letters of Credit in Bankruptcy

Abstract

When a bank issues a letter of credit, it makes a binding promise to the party to whom it sends the letter to honor that party's drafts' on it, when those drafts are accompanied by specified documents. Letters of credit traditionally have been used as a method of paying for goods in international sales. For example, if geographical distance or some other factor makes a seller of a piece of equipment uncertain of its buyer's payment, the seller may insist that the buyer's bank issue a letter of credit naming the seller as beneficiary. After it ships the goods, the seller can draw on the letter by presenting the bank with its draft and the documents specified in the letter, which usually include a negotiable document of title such as a bill of lading. The bank is obligated to honor the draft regardless of any defenses to payment the buyer may have.2 In recent years, however, letters of credit have been used primarily in a different way. Known as guarantee or letters of credit, they are drawn upon if the principal means of payment fails.3 For example, a seller might agree to defer payment until the buyer receives the goods, but insist that the buyer provide a standby letter of credit from the bank, in which the bank promises to honor drafts when accompanied by the seller's signed statement that the buyer has received the goods and has failed to