March 2007 Issue No. 63

Welcome to the March 2007 edition of
Business Leasing and Finance News

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FOUNDER'S NOTE
By David G. Mayer

The U.S. economy is sending mixed signals, but the finance world has never been more intriguing. This year BLFN has covered or will cover emerging financial products and emerging markets. For example, in January, BLFN focused on managed services in technology and other industries. It seems likely that managed services and related financial products could supplement or even supplant leasing as the service model grows and off-balance sheet leasing fades. In the next month or two, look for a lead article on doing business in India. Although India seems far away, it has influence everywhere around us because of its dynamic economy,

enormous consumer base and its value as a business partner. Remember to use BLFN’s Home Page to find all 63 issues (60 of them under our old name: Business Leasing News). You can find many topics in BLFN with imbedded resource links to help you make money or stay out of harm’s way.

Our readership keeps growing, which is a thrill for me. We now have readers in over 33 countries who receive BLFN each month. Your diversity and intelligence enable us to write on a variety of interesting topics. We thank you for reading BLFN. Feel free to contact me by telephone at (214) 758-1545 or e-mail at dmayer@pattonboggs.com to discuss BLFN’s topics or other issues affecting your business.

1. International Registry Poised to Implement Fractional Share Registrations

The Cape Town Convention and the related Aircraft Protocol, a controversial treaty affecting “aircraft objects” worldwide, quietly passed its first birthday of entering into force in the United States on March 1, 2006. But the quiet may be deceiving for the interests of current and future owners of fractional shares and partial interests in aircraft.

*Terms to Know: The Cape Town Convention and the Protocol together create an international “Treaty.” The term “aircraft objects” refers to aircraft certificated for at least eight seats (including crew), helicopters certificated for at least five seats (including crew) and engines rated with at least 1,750 pounds of thrust or 550 horsepower. The Treaty relates to “international interests” in aircraft objects, which refers to rights that may arise under a security agreement (an agreement that grants rights in collateral), lease agreement or title retention agreement (such as a conditional sale). The Protocol extends the Cape Town Convention to contracts of sale of aircraft objects.

Progress and Development

The drafters designed the Treaty to facilitate and increase buying, selling, leasing and financing airframes, helicopters and aircraft engines. The first year of operation for the U.S. shows a different picture.

According to Aviareto, the organization that established and operates the International Registry (IR) in Ireland, the first year represented a period of accomplishment, frustration and change. Aviareto registered 33,000 interests against 15,000 aircraft objects in 2006. It found that assumptions it made varied significantly from reality in some cases. As one good illustration, Aviareto discovered that one model of aircraft object used 20,000 serial numbers rather than the expected 40 serial numbers. The aviation community worldwide besieged Aviareto with calls and complaints about system questions and problems during 2006 but has begun to adjust to the IR and the Treaty.

Despite these difficulties, Aviareto met the challenge in 2006 of addressing over 1,000 design changes, assumptions and errors. It has improved performance, updated its software and maintained the integrity of the IR, which is its highest priority, according to Rob Cowan, Head of Operations. In the United States, the IR functions have now become a more predictable and routine part of closings of aircraft purchases and financings of whole aircraft even though the business aviation community, to a lesser extent than the commercial aviation industry, still complains that the Treaty does little, if any, good to facilitate corporate or general aviation transactions.

In 2007, Aviareto plans 26 software changes in four batches to address infrastructure, multiple asset and fractional transactions. The changes cannot occur soon enough as 15 countries, called Contracting States, have ratified the Protocol. By June 1, 2007, all of the newer ratifying countries will be able to register interests at the IR. The greater number of Contracting States should increase the volume of registrations at the IR. Several other significant countries are expected to ratify the Treaty this year, which should account for even more activity at the IR.

The Fractional Challenge

Perhaps the real test lies ahead in April when the IR has announced that it expects to begin registrations of fractional or partial ownership interests in aircraft objects. In other words, every “contract of sale” and financing or leasing of a fractional share or partial interest will become registrable.

The original development of the IR did not include a method to register fractional or partial ownership of aircraft objects. As a result of this omission, the fractional industry, led by NetJets, Flexjet and Citation-Shares, as program sponsors, have not registered any sales of fractional ownership interests since March 1, 2006, when the Treaty entered into force in the U.S. Lenders and lessors have required registration during that time, but the industry created a “Subordination and Disclaimer Agreement” to rig the IR system to protect and affect only the financiers’ interests in the financed fractional share. The fractional share industry already has its own challenges of meeting the demands of its 5,000 individual and business owners, up from 730 in 1997. See One Jet, 16 Owners, Big Problems, BusinessWeek online (Jan. 29, 2007). The imposition of filing requirements at the IR will add administrative headaches and require active planning on the part of fractional sponsors. Since the inception of the Treaty, sponsors have usually agreed to allow fractional owners to register existing shares at the IR once the IR begins to register fractional interests. The share owner may do so under prescribed terms, such as paying the IR fees of the registration.

*Warning: In the U.S., a sponsor must obtain a unique code from the Federal Aviation Administration (FAA) on submission of Form 8050-135 in order to register an existing fractional or partial interest when the registration systems begins at the IR. The FAA is the only point of entry to the IR under Article 18(5) of the Cape Town Convention and without the code, entry to the IR remains at best uncertain and, in any event, invalid.

In addition, sponsors will permit, if not require, owners to register sales and financing after the IR initiates the registration for fractional ownership. The magnitude of the volume of registration will be significant. Sponsors generally divide one aircraft into 16 shares; in some cases 32 shares. The multiplier effect on the IR’s volume will be significant.

How Fractional Ownership Will Be Registered on the IR

Although the registration system for fractional ownership remains completely untested, Aviareto has designed an approach that is relatively simple.

Each fractional share (or partial interest) owned by any person will be identifiable and identified on the IR by name and assigned percentages (up to six decimal places). To illustrate, say the purchaser of a fractional interest is “TopJet.” If TopJet purchases a one-half fractional share of the whole aircraft object, TopJet’s interest will be shown on the IR as “50.000000%” of the whole aircraft. The fractional share will be registered in the name of TopJet, as owner of the share. The IR will denote the original purchase of the share or partial interest as a “contract of sale.” Any financing will be denoted as an “international interest.”

A Priority Search Certificate issued by the IR will identify TopJet as the “debtor,” which is the usual designation of a borrower or lessee. The “creditor,” which typically is a lender or lessor to the fractional or partial owner/debtor, will be identified in the same certificate. The “Contact Details” for the debtor and creditor will also be available on Priority Search Certificates.

The percentages of interest on the IR will decline as all or any portion of an interest is discharged on the IR. For example, if TopJet transfers and discharges 30 percent of its interest, the IR will show that TopJet owns “20.000000%.” If TopJet sells the balance of its interest, the IR will show TopJet as having “0.000000%” interest. TopJet will remain in the IR’s system even if it has no interest.

Each transaction or registration will have and keep the same file number. For example, TopJet’s original purchase may be assigned “File number 001” and any transaction or registration in respect of the purchase will refer to File number 001. Each other transaction or registration will have its own transaction number, which may create some tracking challenges. However, the IR system promises to keep the percentages of interest in any aircraft object at 100 percent – not more and not less. The IR also expects to create a title/transaction history that is as complete as the owners and financiers choose. The IR will not review or require registrations. Those decisions will always remain with the sponsors, lenders, lessors, owners, borrowers, lessees and other transaction parties.

*Tip: Keep a spreadsheet of all interests relating to an aircraft object on Excel or other spreadsheet program so you can sort the transaction history, interests, contracts of sale and discharges, together with the assigned “file numbers.” This process will provide a back-up system of quickly identifying the completeness or gaps in the IR filings affecting an aircraft object.

Keeping Aircraft Objects on Track

The new registration system and the IR may still encounter growth pains ahead. However, the IR has made significant strides to track the interests of all parties in fractional (and other) aircraft transactions.

*Tip: Share owners should receive communications from their sponsors of what to expect as the IR continues its rollout of the registration of fractional interests. Questions about tracking will arise but the IR has pledged to openly interact with users of the IR to make the system work well for all parties. Contact the IR. Be patient with the staff. They can and will assist you, but also greatly appreciate your courtesy and patience.

Fractional share or partial interest owners and their financiers will soon have a fix to registrations on the IR. Although the IR fees will add relatively nominal costs, the IR system will enable all interested persons to visit the IR website and identify interests in aircraft objects easily and clearly 24 hours a day. If the transaction world shows some understanding and patience for these changes, the IR functions should become every bit as normal and routine in the United States as filing leases and security agreements at the FAA.

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2. Export and Import Rules Carry Risk in Aircraft Transactions

As cross-border transactions continue to expand in aviation and other related industries, aircraft owners, parts dealers and their personnel may have a rude awaking of the risks stemming from importing and exporting aircraft and aircraft parts. This article focuses upon export licensing requirements on the export side and requirements of the Bureau of Customs and Border Protection (Customs) on the import side. It does not address requirements relating to aircraft registration, certificates of airworthiness, operational certificates and other filing issues at the Federal Aviation Administration (FAA).

*Technical Point: Exporting a U.S.-owned aircraft refers to transferring ownership of the aircraft to a foreign person outside of the U.S. Importing a foreign-owned aircraft refers to transferring an aircraft asset by a foreign person to a U.S. person.

Exports: Military or Civilian?

When exporting aircraft or aircraft parts, a critical threshold determination is whether the aircraft or parts are civilian/commercial or military. In theory, the distinction between military and commercial items should be simple. An item is considered military if it has been designed, manufactured and modified for a unique military application. If a product is used in a civilian application, or the same product is used in both military and civilian applications, it is supposed to be treated as a “dual-use” civilian item. In practice, however, the distinction is sometimes hard to make.

Perhaps more troubling is the notice published in the Federal Register on May 23, 2006, which indicated that the office responsible for licensing military exports, the State Department’s Directorate of Defense Trade Controls (DDTC), was asserting jurisdiction over the common air frame parts. This published decision muddied the water considerably with respect to regulatory jurisdiction and increases risks to exporters of potentially significant penalties.

*Tip: Determine at the inception of a transaction or export whether the aircraft or parts you propose to export are, for export control purposes, military or civilian. The distinction makes a difference.

Commercial Exports

On the commercial or civilian side, the Department of Commerce Bureau of Industry and Security (BIS) regulates exports under the Export Administration Regulations (EAR). The bad news is that the analysis required to determine whether an export license is necessary can be quite complicated. The EAR include the Commerce Control List, which identifies the categories of products and technology and specifies for each such category whether an export license is required for a given destination country. In some cases, an exporter’s knowledge of the intended end use of the product it exports may also trigger an export licensing requirement. If an export license is required, an exporter can then refer to a list of “license exceptions.” If a “license exception” applies, an exporter can export under the “license exception” without having to apply for and obtain an export license. The good news is that, for many destination countries, an export license will not be required.

As a general rule, civil aircraft can be exported to almost all countries without first obtaining an individual export license. For those few countries where an export license is required (e.g., Cuba, Iran, Sudan, North Korea), if you apply for a license, your application will be denied. Basically, these countries are off limits to U.S. businesses. Many aircraft parts and components are likewise subject to only the lowest level of export controls. However, this general point is not true of avionics equipment or of certain aero gas turbine engines.

BIS also regulates the export of technology, including the disclosure of “controlled” technology to foreign nationals (even in the U.S.), and the provision outside the U.S. of services such as maintenance or repair. A careful classification and analysis under the EAR may be required in order to determine whether an export license is required. Significant penalties can be assessed for unlicensed exports of both products and technology. Pratt & Whitney agreed to pay $150,000 to settle charges that it made unlicensed exports in the late 1990s of hardware to customers in Japan, Singapore and China and of technology to Europe.

*Warning: You can export technology in a meeting held at your U.S. offices. If you are going to be sharing technical details about aircraft with non-U.S. customers, or with non-U.S. employees of your customers, consider the possible need to obtain an export license. Foreign maintenance and repair facilities must not service or maintain U.S.-origin aircraft owned by embargoed countries such as Iran or Sudan. BIS would hold that any such service involves an unlicensed export of U.S.-origin technology to the country of ownership of the airplane.

There is an interesting dynamic with respect to the licensing of parts needed for maintenance of U.S.-origin aircraft destined to countries with which the U.S. has little or no diplomatic status, such as Iran and Syria. These countries are subject to a general policy of denying all exports. Because parts are needed to maintain the safety of aircraft, exceptions to the general policy are sometimes made and these exports are sometimes allowed. Unlicensed or unauthorized exports of U.S.-origin products to these countries, however, have been severely punished. In 1998 for example, BE Aerospace paid $3 million to settle criminal and civil charges in connection with its export of seats to France for installation (in France) on board Iran Air aircraft.

Military Exports

Virtually without exception, every export from the United States of a military aircraft and every export of a part or assembly that is uniquely adapted or designed for a military aircraft must be individually licensed by DDTC. As noted above, the need to obtain an export license can extend even to the level of piece parts such as hose fittings and hoses. The clarity of the rule – everything requires a license – may make this seem like an easy body of regulation to deal with. In practice, however, it can take forever to obtain licenses, and license applications sometimes get lost.

Exports: Customs Inspection and Filings

In addition to export licensing considerations, exporters should be aware of certain formalities that Customs requires when exporting an aircraft. First, these aircraft are subject to Customs inspection.

*Tip: The pilot should be prepared to show his FAA pilot license, his medical certificate, aircraft registration and air worthiness certificate, and an approved FAA Form 337 if the aircraft has ferry tanks. Second, a Shipper’s Export Declaration (SED) must also be filed with Customs before departure.

Importing Civilian Aircraft

Aircraft and aircraft parts are generally eligible for importation into the United States free of Customs duties. However, various notifications must be made and certain documents must be filed. For aircraft that enter the United States only temporarily, Customs requirements vary depending on whether the aircraft is operating as a commercial or a private flight. All entries of aircraft for importation into the United States are considered to be operating commercially. All of the notifications to Customs that are required of an aircraft operating commercially will be required in the case of an aircraft being imported.

*Technical Point: These notifications include advanced notice of arrival and, unless the plane will land at an “international” airport, Customs’ granting of “landing rights” at a “designated” airport. Importers may request permission to land at airports other than international airports or “designated” airports, but must make these arrangements in advance with Customs. Special reporting procedures apply to aircraft arriving from areas south of the United States.

Upon arrival, the aircraft and its crew must report directly to Customs for inspection. During inspection, the pilot must produce for inspection a valid airman’s certificate or pilot’s certificate or license, a medical certificate and the aircraft registration certificate. The pilot must also provide Customs Form 178 (Private Aircraft Enforcement System Arrival Report) or the information necessary to complete the form. Failure to present the required documentation and information can result in the imposition of civil penalties. Imported aircraft must be formally entered and released by Customs. This action typically requires that a bond be posted.

*Tip: Make these arrangements in advance. A qualified customs broker can typically make these arrangements and prepare the required forms. Ask the customs broker for his experience in the type of aircraft or parts that you have. Use caution on importing and exporting of aircraft or parts: ask the right questions first and plan ahead for contingencies to deal with difficult government controls or procedures. Avoid an issue that one of our clients faced when Customs told the client that it could not obtain a certificate of airworthiness when it touched down in the U.S. because its aircraft had not been properly entered by Customs.

The export and import world for aircraft and parts carries a variety of risks. Terrorism and international trade have become increasingly complex and important policy issues worldwide. When confronted with cross-border transactions, due diligence should include a focus on importation and exportation issues. Otherwise, the place you land your aircraft may be the location from which you started your flight.

Thanks to Daniel E. Waltz of our International Trade and Transactions practice for contributing this article.

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3. BLFN Case & Comment: Chattel Paper Surprise in Netbank FSB v. Kipperman

In a case of first impression, a Ninth Circuit Bankruptcy Appellate Panel ruled on critical issues affecting securitizations and syndications of lease rental payments. In re Commercial Money Center, Inc. (Netbank FSB v. Kipperman), Bk. No. 02-09721 (Amended Opinion, Aug. 25, 2006) (Netbank), the Court focused on the characterization, perfection, sale and financing of lease rental payments stripped from leases (chattel paper) under the Nevada Uniform Commercial Code. See Nev. Rev. Stat. Chapters 104 and 104A (UCC). Deal makers and lawyers can gain clear direction on, among other points, how to identify and prevent identifiable errors in closing and making correct UCC filings in these transactions.

BACKGROUND: Commercial Money Center, Inc. (CMC) leased equipment to lessees with sub-prime credit. CMC then assigned to banks, such as Netbank, the rights to receive the rental payments from pools of the leases. In Netbank’s case, the pools amounted to an original asset cost of more than $47 million. To enhance the credit of the lessee and attract purchasers of the rental payment streams, CMC acquired surety bonds and assigned rights to the bonds to banks, including Netbank, as security for the receipt of the lease payments. CMC purported to sell the lease streams and continued to service the underlying lease transactions under an agreement called a “Sale and Servicing Agreement” (SSA).

The SSA contained inconsistent and confusing loan and sale language regarding the nature of the assignment of the lease rental streams to Netbank. For example, in Section 2.1(c), the SSA provided that “each assignment and transfer herein contemplated constitute a sale and assignment outright, and not for security” of the leased assets. In Section 2.10 the tax characterization, however, the SSA provided that the amounts payable to Netbank will “qualify [under tax law] as indebtedness [of CMC, as debtor] secured by Leases and other assets… .” Many other sections contained similar contradictory language. Further, the SSA indicated that CMC made the assignment on a non-recourse basis to Netbank. The SSA used terminology like a non-recourse secured loan. Finally, at the end of the period of payments of “principal” and “interest”, Netbank had to reassign whatever interest it had to CMC. “In other words, Netbank (1) [had] none of the potential benefits of ownership and (2) [was] contractually allocated none of the risk of loss,” according to the Court.

Under Section 2.1(b) of the SSA, Netbank required CMC to perfect CMC’s interest in the leased equipment, file financing statements under the UCC, assign the financing statements to Netbank under Section 10.2(a) of the SSA (as secured party), and affix a legend to the leases Section 10.2(e) of the SSA indicating Netbank’s interests. CMC also agreed to take other actions to assure the proper issuance of the surety bonds under Section 2.7(g) of the SSA. CMC did not complete these tasks necessary to perfect Netbank’s interests. As a result, Netbank did not have a perfected security interest in the lease rental streams.

The Bankruptcy Court initially reviewed the transaction in connection with a challenge by the trustee for CMC’s bankruptcy estate (Trustee) to the perfection of the interests of Netbank in the lease rental streams. The Bankruptcy Court ruled that the payment streams assigned to Netbank constituted “chattel paper.” In the alternative, it found that if the leases did not constitute chattel paper, Netbank did not achieve automatic perfection of its interests in the lease streams as payment intangibles under UCC §9-309(3) because the transactions were loans rather than sales.

*Technical Point: Automatic perfection can occur when the assignment constitutes a sale and not just a secured loan pursuant to UCC §104.9309(3).

ISSUES: Did the payment streams constitute “chattel paper” within the meaning of UCC Article 9? Were the assignment transactions loans or sales?

OUTCOME/DECISION: The Court overturned the Bankruptcy Court finding that the payment streams assigned to Netbank constituted chattel paper. Instead, it held that the payment streams assigned to Netbank were “payment intangibles” under UCC Article 9. The payment of funds by Netbank to CMC did not qualify as a sale, entitling Netbank to automatic perfection in the lease streams as collateral. Rather, the transactions were loans, secured by the lease streams, chattel paper and surety bonds. Perfection of these security interests did not occur by filing based on undisputed facts in the case.

LAW OF THE CASE: The perfection rules of Revised UCC Article 9 apply to security interests for loans and to sales of chattel paper and payment intangibles. UCC §104.9109(1)(c) states, with inapplicable exceptions, “this article applies to . . . (c) a sale of accounts, chattel paper, payment intangibles, or promissory notes.” A security interest includes the interest in chattel paper, payment intangibles and accounts under UCC §104.9309(3).

*Terms to Know: A “Debtor” means: (1) A person having an interest, other than a security interest or other lien, in the collateral, whether or not he is an obligor; (2) A seller of accounts, chattel paper, payment intangibles or promissory notes. ... UCC §104.102(bb). “Security interest” means an interest in personal property or fixtures which secures payment or performance of an obligation. “Security interest” includes any interest . . . a buyer of accounts, chattel paper, a payment intangible . . . in a transaction that is subject to Article 9. “Security interest” does not include the special property interest of a buyer of goods on identification of those goods to a contract for sale under UCC §104.2401, but a buyer may also acquire a “security interest” by complying with Article 9. . .. “Record” means information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form. See UCC §104.2401(ee) . (k) “Chattel paper” means a record or records that evidence both a monetary obligation and a security interest in or a lease of specific goods or of specific goods and software used in the goods, or a security interest in or a lease of specific goods and a license of software used in the goods. . ... UCC §104.102(k). A “general intangible” means any personal property other than account, chattel paper, and various payment intangibles. See UCC §104.9102(1)(pp). A “payment intangible” is a general intangible under which the account debtor’s principal obligation is a monetary obligation such as payments of rentals stripped from a lease. See UCC §104.9102(1)(hhh).

Few security interests can be perfected automatically. A sale of a payment intangible is one of them under UCC §309(3); it is perfected when the security interest in the payment intangible “attaches.”

*Technical Point: Under UCC §104.9203 “(1) A security interest attaches to collateral when it becomes enforceable against the debtor with respect to the collateral, unless an agreement expressly postpones the time of attachment. With exceptions, “(2) a security interest is enforceable against the debtor and third parties with respect to the collateral only if: (a) Value has been given; (b) The debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party; and (c) One of the following condition[s] is met: (1) The debtor has authenticated a security agreement that provides a description of the collateral . . ..” See also UCC §104.9308 and UCC §104.9310(1).

For automatic perfection by attachment, CMC, as debtor, had to sell the lease rental streams to Netbank, as secured party. However, the Court and the lower Bankruptcy Court both found that the assignment to Netbank did not result in a sale because the transaction possessed the dominant characteristics of a secured loan, including loan language and rights functionally typical of loans. Therefore, the Court held that Netbank did not perfect its interests in the lease rental stream automatically by attachment.

Netbank could also perfect its security interest in the lease receivables upon filing of a UCC financing statement or, in the case of the chattel paper, either by filing or by taking possession of the chattel paper. See UCC §104.9310(1). Netbank relied on CMC to take certain actions to file the UCC financing statements to perfect Netbank’s security interest but, according to the undisputed facts, CMC failed to make the UCC filings.

Netbank had only one last method to perfect its security interest in the chattel paper: take or have another authorized person take possession of the leases on its behalf in a manner legally sufficient to be an agent for Netbank for such purpose. In detailed discussion, the Court construed the definition of chattel paper as evidence or a record of monetary obligations. It then concluded that the payment streams once separated by CMC from the leases and assigned to Netbank did not evidence a payment stream or create a record. It concluded: “Payment streams stripped from the underlying leases are not records that evidence monetary obligations – they are monetary obligations.” Opinion at 15. It also classified the rental payment stream: “When stripped from the chattel paper they are payment intangibles.” Opinion at 20. In doing so, it distinguished a transfer of chattel paper which carries the rights and benefits of the underlying transaction. CMC separated the payment stream from the chattel paper in this case. Opinion 19-20.

Because of factual issues, the Court remanded the case on the issue of whether Netbank perfected by possession. (The potential for such perfection could occur by the surety bond company holding the chattel paper leases on behalf of Netbank.) The Court clearly stated that CMC, as debtor, could not hold the leases for Netbank as a basis of perfecting Netbank’s security interest.

*Comment: The decision of the Court is highly technical, but has important consequences for how parties structure and close securitization and syndication transactions. The secured party or purchaser in Netbank’s position can avoid these issues and fulfill the requirements articulated in the case if the secured party:

• Files UCC-1s itself or through its counsel to assure filings are done and tracked;

• Drafts service or similar agreements with consistent language of sales or financing language consistent with the true intent of the parties;

• Allows no debtor to act as an agent to hold chattel paper (such as the only “original” of a lease);

• Uses an agent in a three-party agreement to hold originals of leases or other chattel paper if good and valid reasons exist for the purchaser/financier not to hold them; and

• Handles small transactions (in dollar amount) as important enough to complete the steps for perfection or not do these transactions without the Netbank risk in mind.

Lessors must assume that a trustee in bankruptcy will use its strong-arm powers to set aside preferences and to find weaknesses in transactions, including unperfected security interests. Those involved in significant securitizations and syndications generally recognize this risk and understand the importance of complying with UCC rules. The key lesson of this case is that each financial institution that buys or finances lease rental streams should not neglect or agree to allow most lessees/debtors to file UCC financing statements or to comply with other obligations relating to perfecting security interests for the secured party, as apparently occurred in this case, regardless of the size of the lease transaction. As Netbank discovered, small transaction problems can lead to large legal fees, financial losses and unproductive management time.

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4. BLFN's Finance 101: For Letters of Credit, What Is “UCP 600”?

Letters of credit support business transactions in over 160 countries. Lessors may rely on them to enhance the creditworthiness of a lessee in a transaction. Lenders may issue or rely on them to enable companies to fund business worldwide. For more than 70 years, letters of credit have provided the basis for buying and selling goods and financing transactions around the globe in part under rules established by the International Chamber of Commerce (ICC).

In December 2006, the ICC adopted changes to its guidelines for letters of credit known as the Uniform Customs and Practices for Documentary Credits (UCP). The changes, set forth in ICC Publication No. 600, or “UCP 600,” become effective July 1, 2007. UCP 600 will modify its predecessor guidelines commonly known as “UCP 500.” UCP 600 is intended to clarify rules that affect both commercial and standby letters of credit primarily in the insurance, banking and transport industries.

*Terms to Know: A “commercial letter of credit” is a credit document used by a buyer to pay for goods. The buyer arranges with a bank to issue a letter for the benefit of a third party who can draw funds from the commercial letter of credit to pay for goods it sells in a domestic or international trade deal. A “standby letter of credit” is a financial accommodation independently issued by financial institutions to and for the benefit of third parties for the account of a debtor. The issuer agrees to allow a third party, which is the beneficiary, to draw funds under the standby letter of credit when some contingency occurs, such as a default under a lease or an insurance premium or deductible payment becomes due. See Leasing 101: What is a “Standby Letter of Credit”?, Business Leasing News (Oct. 2003)

If incorporated in a letter of credit, UCP 600 applies to both commercial and standby letters of credit. UCP 600 changes several aspects of UCP 500. UCP 600:

• Reduces the number of articles in UCP 500 from 49 to 39;

• Establishes a five-business-day period for banks to reject a letter of credit draw (rather than a “reasonable” time to determine if documents presented comply with the letter of credit);

• Improves definitions and uses more typical commercial terms pertaining to letters, such as “honour” or “negotiate” the letter of credit;

• Expands risk of liability of an issuer for delay, loss in transit, mutilation or other errors arising in the transmission of any messages or delivery of letters or documents; and

• Creates new rules of when an issuer (bank) can enforce amendments to letters of credit in contrast to Section 5-106(b) of the Uniform Commercial Code, which requires the consent of affected parties: beneficiary (creditor), issuer (bank), applicant (debtor) and confirming bank.

Although UCP 600 does not enter into force until July 1, 2007, it will provide more consistent and clear new guidance on use of standby and commercial letters of credit.

*Technical Point: It is important to remember that UCP 600 is not the only set of rules governing letters of credit. Article 5 of the Uniform Commercial Code, United Nations Convention on Independent Guarantees and Stand-by Letters of Credit (for contracting states), and International Chamber of Commerce Publication No. 590 (ISP98). ISP98 is a compilation of alternative rules developed by the Institute of International Banking Law and Practice with the endorsement of the ICC. See International Standby Practices (ISP98), Report of the Secretary-General, United Nations Commission on International Trade Law, Thirty-Third Session (New York, 12 June - 7 July 2000)

When UCP 600 becomes effective July 1, 2007, it should contribute more clarity to rules for use of letters of credit. However, ISP98 is being used more frequently and the impact of UCP 600 remains to be seen.

*Tip: If you use letters of credit, read and consider UCP 600. For banks that use UCP 600, adjust your procedures, forms and documentation to reflect the changes.

As the rules for letters of credit evolve, understanding UCP 600, ISP98, Article 5 of the UCC and UCP 500 will be essential for transactions supported by standby or commercial letters of credit. Issuing banks will have more choices on provisions to include in their letters of credit. It appears the time has come to prepare to make those choices.

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Thanks to BLFN’s Team

I would like to thank BLFN’s team at Patton Boggs LLP. The team includes J. Atwood Jeter, a senior associate in the firm’s business transactions, real estate, and wind energy groups; the Patton Boggs staff editors, Paul Dumansky and Adrian Nicole McCoy; our Project Manager, Melissa Green; Claire Campbell; and our designer, Winston Jackson. Thanks also to Douglas C. Boggs, a Business Group/Securities partner and web site reviewer for BLFN, and our Marketing Chief, Mary Kimber, for assisting BLFN through our firm’s editing, design, and posting process.All the best,

David

David G. Mayer
Founder: Business Leasing and Finance News
(formerly Business Leasing News)
Partner: Patton Boggs LLP
2001 Ross Avenue
Suite 3000
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© David G. Mayer 2007

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