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Nov 01 2013
Letters of Credit v. Security Deposits
Dana T. Farmer, Smith Knowles, PC

Some creditors find that maintaining security deposits for marginal customers is a convenient method to protect against default. However, security deposits are still considered to be the property of your customer and if the customer files bankruptcy the bankruptcy trustee has the authority to take the security deposit. Therefore, as an alternative to the security deposit, you can use a letter of credit. If your customer has enough money to give you to hold as a security deposit, then they could also deposit that money with the bank in exchange for a letter of credit. 

Once the bank has the money, it can issue a letter of credit which you would be able to use to apply to any deficit. Since the money is then deposited with the bank, the bank bears the risk of losing the money to a bankruptcy trustee. Yet, since the letter of credit is between you and the bank, your customer's bankruptcy would not impact your ability to make a claim on the letter of credit. Therefore, if a bankruptcy is filed and you are owed money, you would be able to enforce the letter of credit against the bank and the bank would be in the position of losing property to the bankruptcy court. 

The key is to structure the letter of credit so that it is not subject to revocation upon the filing of a bankruptcy, and furthermore, that the letter of credit clearly specifies the nature and amount of the obligation, along with the specific documents you are required to produce at the time you demand payment.