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Letter of credit or performance bond: which to choose in risk mitigation?

Risk and compliance professionals are often asked to consider risk mitigation measures in the form of recourse to a reliable third party, typically a financial institution such as a bank or an insurance company under a guarantee or other recourse arrangement. This can be because of the general requirement to manage risk, especially counterparty risk, or in relation to a specific regulatory requirement.

The Prudential Sourcebook for Banks, Building Societies and Investment Firms (BIPRU) section of the Financial Services Authority Handbook contains example of such a regulatory requirement. BIPRU 5.7.5 sets out the minimum requirements for guarantees for unfunded credit protection relating to credit risk mitigation.

Available products

Banks and insurance companies provide a wide variety of products and it would not be safe to assume that these all have the same quality or value from the beneficiaries' point of view. These products do, however, generally fall into two broad camps: letters of credit or documentary credits (credits), typically issued by banks; and a second group of products variously described as "performance bonds", "demand bonds", "demand guarantees" and "performance guarantees" (performance bonds or guarantees) which are often, but not always, issued by insurance companies.

The need for legal analysis

However these products may be described, it can be hard to tell whether or not they are actually fit for purpose and actually "do what it says on the tin". Establishing validity will generally involve legal analysis of the documents on offer. Assuming that the documents contain a valid English governing law clause, it may also be necessary to consider English case law and any one of a series of model form contract terms published by the International Chamber of Commerce (UCP600, ISP98, URDG758) which are typically incorporated by reference into product documentation.

These documents may contain two basic types of risk: first, that a party will not pay for whatever reason; and secondly, that a party cannot pay because it has gone into a legal insolvency process such as bankruptcy, administration or liquidation and actions by creditors are stayed or frozen by that judicial process.

The nature of credits

Credits are rooted in international trade transactions, where they are used to ensure payment of the purchase price by the buyer once the seller has shipped. In this context, the bank which issues a credit agrees to pay the buyer beneficiary of the credit against presentation of stipulated documents which provide evidence that the goods have been shipped. This will typically be a bill of lading or other transport document. Used outside the trade context the document specified in the credit is often a simple demand to pay.

The main characteristic of a credit is that the bank's obligation to pay is abstract and autonomous from the underlying transaction and arises on presentation of the document(s) specified in the credit. Whatever the documents specified in the credit, the bank undertakes this obligation because it has a counter-indemnity from its customer (on whose behalf it has issued the credit ) and holds security from the customer or otherwise is prepared to accept the credit risk in relation to the customer.

In very limited circumstances (generally those involving fraud) a bank can refuse or be compelled by a court not to pay under a credit. For this reason a credit offers a wide range of risk mitigation in relation to a party, although credit documentation is highly technical and even the most minor defect can render the credit ineffective and destroy its value.

Performance bonds or securities

Although the form and terminology relating to performance bonds is different, their basic function is to enable one party to a contract to obtain money from a reliable source, e.g., a bank or insurance company, where the other party has failed to comply with a contract or some aspect of it.

A distinction must be drawn, however, between credits on the one hand and performance bonds or guarantees on the other, as there are fundamental differences between the legal natures of the two. As noted, a credit is the autonomous and abstract obligation of an issuer. By contrast, the performance bond or guarantee will, typically but not always, require proof of primary liability in relation to the underlying transaction and the party issuing the undertaking will be afforded the especially favoured position accorded to a surety or guarantor under English law.

As an example, a party who has entered a properly-drawn credit into an insolvency process would, from the point of view of the beneficiary, cover the risk of non-payment up to and including insolvency, whereas the performance bond or guarantee may only really come into its own on an insolvency. This assumes, of course, that the beneficiary can establish liability under the performance bond or guarantee, but again the need for expert drafting comes to the fore in these circumstances. There is, or should be, therefore, a difference in risk pricing between performance bonds and guarantees and credits, and a credit may not always be an available option.

BIPRU 5.7.5

The requirements for a guarantee under BIPRU 5.7.5 are that the credit protection, when provided in the form of a guarantee must (among other things) be "direct", "clearly defined and incontrovertible" and "not contain any clause ,,, which could prevent the protection provider (the guarantor) from being obliged to pay out in a timely manner in the event that the original obligor fails to make any payment due".

Measured against these stringent requirements, a typical performance bond or guarantee may have shortcomings in that the beneficiary may have to establish proof of primary liability against the original obligor and/or to exhaust its remedies against the original obligor up to and including insolvency.

A better candidate for the required credit protection is a properly-drawn credit containing obligations which are closer to the stringent requirements of BIPRU 5.7.5, even the requirement that the obligations be "incontrovertible", although that term remains to be judicially defined. Whatever the risk mitigation context, it is important that the third-party document is properly drafted and analysed to ensure that it gives rise to the intended legal relationship and obligations, and does not itself give rise to legal risks.

This article was written by Ian Benson and published by Compliance Complete on 2 December 2011.

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