LOC Substitution
In the event of an LOC substitution, Standard &
Poor’s must again review the transaction in order to
maintain the rating. The review looks to conclude
that the terms of the substitute LOC, along with
the terms of the bonds, support the transaction, as
did the then-current LOC.
For U.S. transactions, Standard & Poor’s will
also inquire if any new or additional collateral is
being granted to the new LOC bank. In two cases,
courts held that under certain circumstances a pay-
ment under an LOC may be recaptured as a prefer-
ence by a bankrupt account party (the debtor). The
two rulings concerned are In re Compton Corp.,
No. 87-1135 Slip Op (5th Cir. Nov. 12, 1987) and
In re Air Conditioning Inc. of Stuart, 72 BR 657
(S.D. Fla. 1987). In both cases:
■The LOC was issued to secure a preexisting obli-
gation of the debtor;
■The debtor collateralized its obligation to reim-
burse the bank for payments under the LOC;
■The debtor became subject to a bankruptcy pro-
ceeding within 90 days after its obligation to
reimburse the bank for payments under the LOC;
and
■After the bankruptcy, the bank was permitted to
pay a draw under the LOC.
The courts held that:
■The pledge of collateral was a transfer by the
debtor of its property on account of an
antecedent indebtedness;
■The pledge occurred within 90 days prior to the
debtor’s bankruptcy; and
■Although the pledge was made directly to the
bank, it induced the bank to issue the LOC.
Therefore, the pledge was for the benefit of the
LOC’s beneficiary.
As a result, the courts ruled that elements of a
preference existed and, therefore, the debtor could
recapture the LOC payment from the beneficiary to
the extent of the pledged collateral.
These two cases affected Standard & Poor’s crite-
ria regarding the substitution of an LOC during the
life of a transaction and the provision of an LOC
subsequent to the issuance of the debt. If a substi-
tute LOC is provided or an LOC is brought in sub-
sequent to the closing of the transaction,
Standard & Poor’s will rate the issue if there is any
new collateral offered to the bank issuing the new
LOC, only if Standard & Poor’s has received a pref-
erence opinion of counsel that specifically addresses
the Air Conditioning and Compton cases.
Standard & Poor’s concerns can be addressed by
providing a written statement that no new collateral
is being offered to the bank issuing the new LOC.
Confirmation LOC Rating Criteria
A confirmation transaction is structured to provide
full credit enhancement of debt service with an
LOC from a lower-rated or unrated financial insti-
tution (the facing LOC) and a confirmation in the
form of a second LOC from a higher-rated institu-
tion. This second LOC (the confirmation LOC) also
provides full credit enhancement of debt service fol-
lowing the wrongful dishonor, default, or insolven-
cy of the fronting bank.
In its analysis, Standard & Poor’s seeks to
ensure that the likelihood of payment is equal to
the likelihood of the confirming bank’s honoring
draws on its confirmation LOC. Bondholders
must be insulated from any bankruptcy, default,
or lack of performance not only by the underlying
obligor, but also by the facing LOC bank.
Standard & Poor’s, therefore, seeks to ensure that
sufficient funds will be available from the confir-
mation LOC to make full and timely payment of
all amounts due to bondholders if the fronting
bank wrongfully dishonors a draw request or if,
upon the insolvency of the fronting bank, its fac-
ing LOC has been repudiated by a conservator or
receiver. As a result, the rating that Standard &
Poor’s assigns to a confirmation transaction is at
least the confirming bank’s issuer credit rating. If
applicable, the transaction could be rated in accor-
dance with the joint support criteria.
LOC repudiation
The concern of LOC repudiation developed as a
legislative effect of FIRREA, the 1989 U.S. savings
and loan bailout legislation. FIRREA includes pro-
visions describing the FDIC’s rights and responsi-
bilities when acting as conservator or receiver of
an insolvent institution. Under the provisions of
FIRREA, if an LOC issuer becomes insolvent, the
FDIC, as receiver of the insolvent institution, is
able to repudiate the LOC if it is perceived to be a
burdensome contract. Since an LOC can be repudi-
ated before it is drawn on, the confirmation LOC
must be available and be drawn on if the facing
LOC is repudiated.
Confirmation credit cliff issues
The same credit cliff concerns regarding expiration,
substitution, nonreinstatement, conversion, and pur-
chase price reinstatement also exist and will be ana-
lyzed in the context of the confirming LOC structure.
Confirmation LOC expiration
A confirmation LOC can expire without prior
redemption or tender of the bonds if there is prior
written evidence from Standard & Poor’s of rating
maintenance. This could occur if rating changes
equalize the ratings of the fronting bank and the
confirmation bank. At that point, the confirmationIntroduction To Structured Financehttp://www.standardandpoors.com 215