“Underlying Transaction Doesn’t Violate Law” Exception in a Letter of Credit

As a lawyer representing leasing companies I hate letters of credit. Kinda harsh I know, but read on.

The LC most common in aircraft leasing is the standby LC. It is usually issued in lieu of the lessee paying the security deposit and sometimes in lieu of the lessee paying maintenance reserves, and it is usually drawable by the lessor upon the occurrence of an event of default by the lessee under the lease documentation.

Lessees sometimes prefer to provide LCs rather than a cash deposit or cash reserves because the lessee needs/wants the cash for itself and the LC costs imposed by the bank issuing the LC are (sometimes) low enough for the lessee to justify agreeing to those costs and providing the LC in lieu of cash.

Lessors of course prefer to receive and hold the cash, but the use of an LC by the lessee is often a negotiating point during the lease negotiations, and it is common for the lessor to agree to accept an LC in lieu of a security deposit (much less common is the lessor accepting an LC in lieu of maintenance reserves).

During these negotiations on the LC issue, I will hear from the lessee (and sometimes from the lessor’s own commercial people) “an LC is the equivalent of cash.” That is never true in a strict sense and, depending on the form of the LC and other factors , often not true in a meaningful sense.

An LC gives the beneficiary (the lessor) a right to payment from the issuing bank upon certain conditions and requirements being met. The primary job of counsel for the lessor is to make sure those LC conditions and requirements are minimal and are able to be easily satisfied by the lessor; that is, the primary job of counsel for the lessor is make sure the LC is as close as practical to the “equivalent of cash.”

The reason I hate letters of credit is because at the time the lessor wants to draw a letter of credit neither the issuing bank nor the lessee (as the LC account party) will want the lessor to get paid under the LC–the issuing bank will be worried about not being repaid by the lessee (and/or becoming involved in litigation/bankruptcy proceedings) and the lessee will be worried about the commercial consequences of an LC draw after default. Both will be looking for excuses allowing the issuing bank not to pay the lessor under the LC. On the other side, the commercial officers at the lessor will be expecting prompt payment under the LC–after all, “it is the “equivalent of cash, right Brad?”

With the forgoing as background, I’ll discuss one somewhat common LC provision that should be struck by the lessor’s counsel from any LC draft.

From time to time I will see a broad illegality exception in an LC providing that the issuing bank is not obligated to pay under the LC if the underlying transaction is illegal. When I see this exception it can usually be traced to a current political or regulatory event that is making banks more cautious at that time. For example, I saw the following language in a draft LC last year at the height of the crisis in Ukraine and when the US and EU were imposing sanctions against Russia (even though neither the LC nor the underlying transaction had any connection to Russia or Ukraine):

No party which is sanctioned by the United Nations, United States or the European Union, or United Kingdom, is to be involved in the transaction in any manner. We may not complete a transaction which involves such a party, or any party in the above countries.

Wow. Ignoring the really bad drafting (what countries are being referred to in “or any party in the above countries”?), that provision is way too broad. Let’s give the bank of the benefit of the doubt and assume what it was trying to say was something like:

We will not be obligated to make any payment hereunder if the transaction underlying this letter of credit is illegal.

When first reading that exception, a reasonable lawyer might think “hmm, that sounds right–the bank shouldn’t be obligated to be involved in an illegal transaction.” But the second time the lawyer reads the exception he should think the following:

1. Wait a minute, should the bank be excused for paying under the LC if the underlying transaction is illegal or only if the payment itself by the issuing bank is illegal?

2. Who bears the risk of illegality under the underlying transaction documents, and more importantly why is the LC addressing a risk normally allocated between the parties in the underlying transaction documents?

3. If the LC is supposed to be a cash equivalent, then shouldn’t the LC issuer be obligated to pay regardless of illegality of the underlying transaction–so that the lessor is put in the same position as if it had held cash? Isn’t this especially true if the illegality arose during the performance of the underlying transaction?

4. LCs are supposed to be separate and independent from the underlying transaction. Some LCs state this expressly, and even where they don’t the LC rules incorporated by reference do (see UCC 600 Article 4 (“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.”) and ISP98 Section 1.06(a) (“A standby is an irrevocable, independent, documentary, and binding undertaking when issued and need not so state.”)).

In conclusion, be very wary of any exception to the issuing banks obligation to pay under an LC. Your lessor client is going to be anxious during the draw process and very disappointed with a failed draw. As a general rule you should review a draft LC with the same intensity and care as you would read a final LC after your client has called and told you to draw the LC.