Outsourcing and Letters of Credit: Making Sense Out of Contract Security


Canadian businesses and governments are looking for outsiders to take over many functions such as printing, mail rooms, fleet management, and data or computing services. But how do contract managers get the right results from these outsourcing contracts? What type of contract security will give you quick financial relief without a costly court battle with a contractor or supplier?

In many of these situations, a letter of credit offers a reliable and quick method of security.

Can letters of credit be used to pre-qualify bidders?

Yes, in the sense that a potential contractor or supplier must meet the credit tests of the issuing bank. The issuing bank will only issue a letter of credit if the bank is confident that it will be repaid. Requiring a letter of credit offers an effective way to pre-screen tenders or RFP proposals. Anyone who is experiencing financial difficulties will have problems in arranging a letter of credit.

When would you use a letter of credit instead of a performance bond?

Bonding is a traditional approach for construction contracts, and most players in this industry are used to bonding requirements. However, outsourcing contracts tend to be unique situations that are crafted to meet the needs of the organizations involved. Therefore, letters of credit offer more flexibility for the custom situation. Moreover, a properly crafted letter of credit can achieve more immediate recourse – “cash to be paid“, if the supplier is in default, whereas with bonding there is a greater likelihood that you would be tied up in litigation with your contractor or supplier and the bonding company. Check the article in last month’s Legal Edge regarding bonding.

What are letters of credit?

Letters of credit are used widely throughout the business world. They afford an effective and immediate form of security for performance. They are especially useful in international transactions, to overcome difficulties in trying to enforce performance or recover damages in a foreign jurisdiction. But their usefulness is not limited to international transactions.

Where you specify a letter of credit, basically you are saying to your prospective contractor or supplier: “We need you to get your bank to promise to us that, if we comply with the terms of the letter of credit, then they will pay out on the letter of credit regardless of whether you are then in good standing with the bank, and even if at the time we make demand under the letter of credit you claim that nothing is owed to us“.

If the letter of credit is appropriately crafted, payment by the bank to you happens when you say default has occurred, regardless of whether the contractor or supplier disputes it. This effectively shifts the onus of initiating enforcement to the other party.

Uniform Custom and Practice for Documentary Credits:

The International Chamber of Commerce publishes what they call the “Uniform Custom and Practice for Documentary Credits“, which, when incorporated by reference in the letter of credit, governs the terms and rules applicable for the letter of credit. The latest version of this publication is referred to as “UCP 500“.

One of the principles embodied in the UCP regime is the “principle of autonomy“. That is, the issuing bank must pay out on the letter of credit so long as the terms of the letter of credit are satisfied, regardless of any claims or arguments between the beneficiary and the issuing bank’s customer. Actually, there is one exception – where the issuing bank becomes aware that fraud was committed by the beneficiary.

Another principle is that the bank must only pay out if there has been strict compliance with the stipulations of the letter of credit. Otherwise, the issuing bank will not be able to recover from its customer. Therefore, if the letter of credit requires presentation of documents, you need to have unambiguous stipulations as to exactly what must be presented.

Are letters of credit enforced by Canadian courts?

Yes. Letters of credit and their regulation by the UCP have been recognized by our courts. Notable cases are the Supreme Court of Canada decision in Angelica-Whitewear Ltd. v. Bank of Nova Scotia [1987] 1 S.C.R. 59 and a recent Ontario case called Robinson v. Ontario New Home Warranty Program (1994) 15 C.L.R. (2d) 115.

You need a letter of credit appropriate for your purposes.

Some letters of credit require that the issuing bank must pay out on presentation of the original of the letter of credit, and nothing else. This would be a “clean letter of credit payable at sight”. A documentary letter of credit might also require presentation of, for example, a bill of lading evidencing the delivery of goods. A “standby” letter of credit might require documentary evidence of default by the contractor or supplier. As beneficiary of the letter of credit, you obviously want the letter of credit to be in a form so that you are entitled to draw on it when you need to.

When would you use a Letter of Credit?

How do you ensure on-time printing of three publications with a print run of over two million? How do you then ensure that the publications get on-time distribution to over 3,900 locations? Last year the Ministry of Natural Resources in Ontario faced this problem. It had contracted with an outside company, The Cohen Group. The publications to be printed and distributed by The Cohen Group were the Ontario Provincial Parks Guide, the Sport Fishing Regulations, and the Ontario Hunting Regulations.

The Ministry wanted some immediate security if the publications were not printed or distributed on time. The Ministry would face immediate costs if the government had to take over the project. The solution — The Cohen Group provided an irrevocable letter of credit for $100,000.

TWO QUALIFIERS: FIRSTLY, the letter of credit does not, obviously, get the publications physically delivered to the 3,900 locations. The letter of credit will give a right to recover monies, but if there isn’t time to get the job done by an alternate method, then the letter of credit won’t turn back time. SECONDLY, if payment under the letter of credit is seen by the court to be an unreasonable penalty, then the court might allow the contractor or supplier to recover the monies. The issuing bank will have to pay out the monies per the letter of credit, but if the underlying obligation is held by a court to be unenforceable (because it is regarded as an unreasonable penalty) then the contractor or supplier may be entitled to get the monies back. In The Cohen Group example, if MNR engaged an alternate supplier to do a rush run in order to meet the deadline, then clearly their damages would be recoverable. But if the publications just did not get delivered on time, what damages, in monetary terms, did MNR suffer? To deal with this, the RFP might have to stipulate that the letter of credit represents “liquidated damages“.

Roy Nieuwenburg is a lawyer at Clark Wilson LLP in Vancouver, tel. (604) 687-5700. His practice areas include construction, RFP’s and tendering.