A letter from a bank or other financial institution guaranteeing payment on account of debts owed to a creditor, in exchange for a fee. In the event the relevant debtor fails to make payment timely and in full, the bank is required to cover the full amount of the debt.
Letters of credit may be used to protect vendors on account of important trade receivables, and are also commonly used by landlords to protect themselves in the event a tenant fails to pay rent.
In bankruptcy proceedings, letters of credit are subject to the “independence principle,” (i.e., letter of credit funds can be pursued by the relevant creditor without such actions being considered a violation of the automatic stay).
For more information about a letter of credit, read Dealing with Corporate Distress 13: The Unsecured Creditor’s Perspective About its Debtors.