Mergers & Acquisitions

How Letters of Credit Can Stall Mergers

Here are four ways to finesse M&A agreements stalled by impasses involving letters of credit.
Eirik E. Tellefsen and Jill E. BronsonJanuary 22, 2018

Congratulations! You are one of the winners in the current flurry of M&A activity. After long nights arguing over indemnity provisions and adjustments for diligence items, you have signed the purchase agreement and are heading to closing. Everything has been carefully considered, checklists are in place, and all should go smoothly. But will it?

Jill E. Bronson

Jill E. Bronson

Whether you are buying or selling a business, something that should not be overlooked, but often is, the target company’s outstanding letters of credit (LCs), which are often issued as one component of a company’s larger secured credit facility.

The liens securing that credit facility, which may include liens on all the assets of the company, will not be released unless the LCs are addressed. The buyer will not want to close on an acquisition if the underlying assets are subject to a third-party lien. Unfortunately, LCs also cannot be paid off in the same simple way that the company’s outstanding loans can.

To refresh your memory: an LC is issued by a bank (known as the issuing bank) for the benefit of a beneficiary (e.g., the landlord under a target company’s lease) and are for the account of the party requesting the LC (i.e., the target company).

Eirik E. Tellefsen

Eirik E. Tellefsen

There is an absolute obligation between the beneficiary and the issuing bank. It states that if the beneficiary comes to the issuing bank with the LC and any other papers that the LC requires, the issuing bank will pay the beneficiary the amount specified in the LC.

For example, if a landlord has an LC securing the target company’s obligations under the latter’s lease and the target company defaults on its rent payment under that lease, the landlord can go to the issuing bank with the LC and get paid by the issuing bank instead. Then the issuing bank will turn to the account party (i.e., the target company) and demand reimbursement of the amount that it paid to the beneficiary.

Let’s examine a common scenario. A purchase agreement says that the seller will sell a company free of all liens. The agent bank on the target company’s secured credit facility issues a payoff letter that says that all liens will be released when it gets paid the specified amount and the LCs have been terminated. The landlord, however, won’t return the LC because the lease will remain in effect after the company is sold. It would seem we are at an impasse.

Complicating things are the fact that the beneficiary only derives value from an LC if the original LC document is in its possession and the issuing bank will not consider that the obligations under the LC are terminated until the original LC document is returned to the issuing bank.

Buyers and sellers don’t need to panic, however. There are many ways to deal with this situation, depending on the circumstances. Below are a few examples.

Work with the Beneficiary

You can work with the beneficiary directly to get it to release the existing LC immediately upon the closing of the sale. It may do that if the buyer delivers a replacement LC or a cash deposit.

This approach requires the cooperation of the beneficiary, as well as a willingness by the seller to disclose (at least to the beneficiary) that a deal is in the works. You also need a replacement LC issuer or cash on hand and, more likely, an escrow with a trusted escrow agent so that there is a process in place to effect the transactions. This approach can be complicated, but it would result in acceptable new arrangements being in place at closing.

Provide a Back-to-Back LC

Another option is to work with the target company’s issuing bank to provide for a modified arrangement so the liens will be released in exchange for a back-to-back LC from the buyer’s bank. That requires that the buyer arrange for an LC to be issued at closing and that the buyer’s bank and the target company’s bank coordinate the terms of that new LC. One benefit of this arrangement is that it does not require any cooperation of the beneficiary, since the original LC will stay in place.

Deposit Cash with Target’s Bank on Closing Date

Similarly, you can deposit cash with the outgoing issuing bank on the closing date. The cash can be dealt with as an adjustment to the purchase price, if applicable. This option is available as long as the dollar amounts of the LCs are manageable relative to the purchase price of the transaction, and so long as the issuing bank is willing to replace the existing collateral with cash collateral, which it typically would be willing to do. Unlike the aforementioned back-to-back LC approach, going this route provides the added benefit of being easier to coordinate. However, the drawback is you’re using cash rather than an LC – and the incremental carrying cost that comes with it – so this is something to consider when weighing your options.

Induce Target Company’s Bank

Lastly, another option is having the target company’s LC issuing bank become an LC issuing bank under the buyer’s credit facility and (assuming the credit facility is secured) having the existing LC become a secured obligation under the buyer’s credit agreement on the closing date.

That requires the buyer to have an LC facility in its acquisition financing or other financing arrangements, as well as coordination between the buyer’s lender and the LC issuing bank. This also requires that the LC issuing bank desire to be part of, and a welcome addition to, the buyer’s new credit facility.

If that doesn’t work, you may be able to convince your beneficiary that the credit of the buyer is so good that it does not need an LC. Good luck with that.

Jill E. Bronson and Eirik E. Tellefsen are partners at Drinker Biddle & Reath and are both members of the law firm’s corporate and securities group.