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I found an error in your book. In your "Accountants' Handbook, Special Industries and Special Topics, Volume 2" you claim:
"Standby Letters of Credit are typically recorded as contingent liabilities."
However, nothing could be further from the truth. You confuse letters of credit and standby letters of credit. A letter of credit should be accounted for as a contingent liability and the fair value of a guarantee is to be recognized as a liability.
The fact that you do not distinguish between guarantee, surety, and international bank guarantee or standby LC gives casts further doubts on the veracity of your statements and the value of your publication. I suggest to reread FASB Accounting Standards Codification Topic 460, Guarantees and ponder the difference between dependent and independent payment obligations (LC, international bank guarantee independent; guarantee, surety dependent) as well as documentary payment undertakings (LC, standby) and non-documentary payment obligations (European style bank guarantee).
I would have preferred to not publicly shame you, but your website is a mess and you treat me like a spammer when asking 20 pieces of personal information from me when I want to help you improve your product. Much easier to publicly point out your errors.
Counting on your goodwill,
The California Court of Appeals has spoken in California Bank & Trust V. Piedmont Operating Partnership and the result should be compared to the treatment of LC's in bankruptcy. A little background.
The law we are dealing with is the FIRREA, the 1989 enacted Financial Institutions Reform, Recovery, and Enforcement Act which allows the FDIC to “alter contractual rights `in order to stem the disruption of banking services within communities”. Similar to a bankruptcy proceeding FIRREA gives the FDIC broad powers in resolving the affairs of a failed bank. This includes the express power to repudiate, or "disaffirm," contracts to which the failed bank is a party.
In the case at bar the failed bank/applicant (Alliance Bank) leased premises from the defendant who, as is typical in commercial leases, secured the rent by a letter of credit issued by Union Bank of California. In 2009 the FDIC closed Alliance, took over the bank, disaffirmed the lease, and sold the assets “as is” to California Bank. The landlord/defendant calculated that the damages due to the disaffirmation amounted to 1 million dollars in lost future rents and filed a claim to recover. In addition it presented a draft amounting to $ 500,000 to the issuer of the letter of credit.
California Bank as the bank which acquired certain assets of the applicant, had received among others, an account holding $ 500,000 that was formerly used as collateral for the letter of credit. When the landlord demanded payment from the issuer (Union Bank), the issuer paid and debited California bank accordingly.
The court discusses in particular
a) Effect of the disaffirmation under FIRREA
b) Independence of letters of credit.
To the uninitiated the FIRREA proceedings look at lot like bankruptcy, and after some discussions, the court agrees. (“ a failed bank receivership is akin to a bankruptcy proceeding and the receiver functions much like a trustee in bankruptcy. (Unisys Finance Corp. v. Resolution Trust Corp., supra, 979 F.2d at p. 611.)”).
Under a bankruptcy proceeding a lessor cannot claim damages if the bankruptcy trustee disaffirms executory (i.e. still unperformed) contracts; the same applies in FIRREA cases.
The beneficiary vigorously argued that letters of credit are independent of the underlying transaction, the court however did follow this argument. The court simply asked: “Is the beneficiary entitled to keep the $ 500,000 if effectively seized already.” and subsequently negated it. One of the cornerstones of this case is that the beneficiary landlord breached its lease when demanding payment based on the disaffirmance of the lease. Citing Resolution Trust Corp. v. United Trust Fund, Inc., 57 F.3d 1025, the court finds that the disaffirmance of the Alliance Bank lease did not constitute a breach of the lease and did not give rise to a claim of damages for future rent, and that the beneficiary Piedmont did not have a claim to the proceeds of the letter of credit.
Later, when deciding that beneficiary has to pay plaintiff's attorney fees, the court finds that beneficiary breached the lease when asking for money after the disaffirmance.
Even though I do not agree with the reasoning, the result is correct. The landlord exceeds the bounds of chutzpah and enters a fraud zone when demanding damages for a trustee's repudiation of an executory contract. When presenting the drafts to the issuing bank the landlord/beneficiary knew that it was not entitled to damages. Furthermore, the letter of credit in this case seems to be akin to a standby letter of credit, since the only document presented was a draft. Under principles developed for SBLCs, fraud exists if the demand for payment is not covered by the objective of the SBLC. In this case the SBLC was supposed to secure the tenant's performance; at the time of the demand for payment, the tenant however did not have any obligation to perform since the lease had been repudiated.
I disagree with the judges insofar they mix and match the parties. German law would more closely follow the contractual relationships of the parties. This means that a German court would most likely confirm the independence principle and seek restitution via the various relationships applicant/successor ? issuing bank ? beneficiary. The typical construct in these cases is to find fiduciary duties between applicant and issuing bank which were breached when the issuing bank honored a fraudulent demand for payment.
Despite my qualms, this is a well-reasoned decision that is worth reading.
Letters of credit in bankruptcy proceedings are only a topic of discussion in the United States. Other countries typically regard the payment of the bank INDEPENDENT (I capitalize in the futile hope to reach the ears of some US judges) of the bankruptcy estate of the applicant. In other words: Bene to Trustee: Move on, there is nothing to see here.
Not so in the US.
Many courts have repeatedly found that a beneficiary -who receives funds under an LC from the bank- has in fact received a preferential treatment from the applicant, voidable by the trustee. This long-standing misconception of letters of credit has been perpetuated In re ESA Environmental Specialists, Inc., 709 F. 3d 388 - Court of Appeals, 4th Circuit 2013. Even though the lucky beneficiary escaped liability, the escape was narrow and unpredictable. The beneficiary had provided bid bonds to the federal government for the construction to be performed by the applicant. Upon insolvency of the applicant, the beneficiary undertook to perform the contracts himself.
Was the payment to the beneficiary by the third party bank a preference under bankruptcy law that the trustee of the applicant could void ? The court said no and based its decision on the "new value" defense which is an explicit statutory defense to a § 547(b) preference action.
The trustee may not avoid under this section a transfer —
(1) to the extent that such transfer was —
(A) intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and
(B) in fact a substantially contemporaneous exchange.
In this case the beneficiary brought new value to the applicant, since the contracts the applicant was able to obtain from the federal government exceeded the value of the LC. Overall a disappointing decision since the new value statute might not protect normal beneficiaries who simply sell goods to the applicant. The court lengthily discusses the calculation of new value (how and when) but focusing on these formalities misses the point that the LC is independent.
The Economist reminded its readers that 50 years ago Eurobonds were created.
As befits the topic of international finance, the first Eurobond was complex and cross border in an elaborate attempt to avoid taxes. An Italian company, which could pay interest without deducting italian tax, issued its bonds
in Schiphol airport/Amsterdan to avoid British stamp duty with coupons payable in
Luxembourg to avoid British income tax.
This scheme reeks of the shenanigans that politicians and the publid have tired of. However, as the Economist titles it little stroll down memory lane "Money will find a way".
Liquidity will follow the path of least resistance and the Euro savers might discover that they saved the Euro and destroyed European finance through a maze of regulations intent on saving banks and investors from themselves. It seems that creeks of liquidity already pour into Asia, not only financial centres like HongKong and Singapore, but also the mainland where a strengthening Yuan offers comfortable returns and an economy that grows 3 to 5 times as fast as their Western competitors.
Politicians like generals fight the last war; that is however not always good enough to stem the tide of cash going out to less rocky shores.
Last week it was widely reported in the media that the Chinese interbank lending rates rose to levels reminiscent of post Lehman thus indicating a similar fate for the Chinese economy.
I am no expert on interbank lending in China and I do not anyone who claims to be. China is big, the various powerholders are often obscure and the decision processes out of grasp of outsiders (and often insiders). That being said, I doubt the interbank lending rate jump would lead to anything like Lehman.
This jump in interest rates probably signals the new leadership's desire to push forward reforms by starting to correct some of the inefficiencies in the Chinese economy. The Central bank under the veteran Zhou can always inject liquidity to lower the rates. This time around it chose not to do so , thus warning commercial banks that they can't alway look to PBOC for liquidity. Rather banks are urged to reallocate their own liquidity away from reckless investments.
Whether this subtle hint is sufficient remains to be seen, since China suffers from lower than hoped for growth rates; missing the 8 % growth rate mark is nibbling away at the Communist Party's nimbus of bringing wealth to everyone.