A letter of credit (“LC”) is a legal commitment from a buyer’s bank to pay a seller for goods or services in accordance with the terms of the LC. Essentially, the bank guarantees payment for the underlying transaction between the buyer and seller (a.k.a. the applicant and the beneficiary). The LC operates autonomously from the underlying contract between the parties.

The buyer usually pays for the LC on a fee-basis or a percentage of the deal. The buyer’s/issuing bank sends the LC to the seller’s/advising bank. The seller receives payment from their own bank when they provide documentation proving shipment and/or adherence to any other terms of the LC.

LCs benefit both parties. Since the issuing bank guarantees the buyer’s payment, the seller can borrow against the LC to fund the sale. Sellers tend to prefer buyers who have the creditworthiness to obtain an LC from their bank, which can also be used as a bargaining chip by the buyer. That is why LCs are the financing tool of choice in international trade.

There are six main types of LCs. Commerical LCs are used in international trade. Standby LCs are a form of payment insurance and are irrevocable. Revocable LCs can be cancelled or amended, giving the issuing bank leverage. Irrevocable LCs cannot be altered or cancelled without the consent of both parties. Revolving LCs guarantee a series of payments, and Red Clause LCs contain an unsecured loan. Standby LCs are the most common.

In the case of 7636156 Canada Inc. (Re), (2020) 153 O.R. 3(d) 271, the Ontario Court of Appeal considered whether the terms of the underlying contract or bankruptcy of the applicant reduced the amount of the LC that the beneficiary could draw. On both points, the court concluded they could not. While this case turned on the specific language in a commercial lease, the legal analysis illuminates important principles of Canadian law. Firstly, the court confirmed that an LC creates an obligation between the issuing bank and the beneficiary that is autonomous from the underlying contract between the applicant and beneficiary. If the beneficiary complies with the terms of the LC, the bank must honour the demand to pay, subject to the fraud exception. There was no evidence of fraud by the beneficiary in this case. Further, the trustee in bankruptcy could not limit the beneficiary’s draw because the lease itself stated that the letter of credit would continue to operate as security in case of bankruptcy. And finally, the principles of insolvency law do not override the principle of autonomy of letters of credit. The Supreme Court of Canada dismissed this case on appeal.

The takeaways from this case are that the language in the underlying contract, including clauses related to breach, indemnities and termination, should be reviewed to ensure that it supports the intended use and function of the LC. And, the autonomy of the LC is not impacted by insolvency law principles.