- Letter of Credit is an Effective Tool for Securing a Loan
- July 22, 2013 | Author: Nicole Necklas Soraruf
- Law Firm: Lerch, Early & Brewer, Chartered - Bethesda Office
A letter of credit (LC) is a financial instrument a creditor requires of a debtor to secure repayment of a loan (or payment for the purchase of goods). For a bank, a letter of credit, unlike a deed of trust or guaranty, is an effective way to recover losses on a defaulting loan in an efficient and less costly manner. There is no need for a foreclosure or a lawsuits against a guarantor if the lender has an LC. In fact, to draw down on an LC, the bank often is required merely to present documentation to the financial institution issuing the LC showing that the loan is in default and that the amount available under the LC is not greater than the amount due under the loan.
There are very few instances where a defaulting borrower or guarantor can prohibit its lender from drawing on the letter of credit. Aside from forged documents, the other instance where a bank has been prohibited from drawing on an LC is when a court finds that the loan or transaction that is secured by the LC is in fact fraudulent.
A recent case from South Carolina indicated just how narrow that fraudulent transaction exception is and how high the burden a defaulting debtor must meet if it seeks to prohibit its lender from drawing on an LC. In Hook Point, LLC v. Branch Banking and Trust Company et al., the borrower, Hook Point, defaulted on a $5.1 million loan from BB&T. Part of the security for the loan was a $1.5 million standby letter of credit issued by First Reliance Bank in favor of BB&T.
After BB&T sent notice of default to Hook Point and accelerated the indebtedness under the loan, it sought to draw on the full amount of the LC. Hook Point filed a suit for a preliminary injunction against BB&T, seeking to prohibit BB&T from asserting its rights under the LC. Hook Point’s claim was based in part on the fact that the commitment letter for the loan stated that the LC was to be “used as last resort for interest carry” and that BB&T’s action against the LC for more than the outstanding interest amounted to fraud.
The court held that to prove its claim of material fraud Hook Point would need to establish that “the alleged fraud vitiates the entire transaction, that is, it deprives Hook Point of any benefit from the transaction” and that BB&T “would have no colorable claim or basis in fact for asserting its rights under the letter of credit.” The court, looking at terms of the letter of credit, noted that BB&T was permitted to use the letter of credit if “Hook Point defaulted under any obligation of the loan agreement and note.” Additionally, the court found that none of the terms in the loan agreement or promissory note limited BB&T’s use of the letter of credit to the interest due. The court held that “it is incontrovertible that BB&T had some basis in fact for the representations it made when it drew on the letter of credit;” therefore, “there is no evidence Hook Point is more likely than not to succeed on a claim of material fraud so egregious as to vitiate the entire transaction.”
This case is cited as Hook Point, LLC v. Branch Banking & Trust Co., 397 S.C. 507 (SC S.C. 2012).