CPI Reference in Counter LC Text: What’s the Ultimate Obligation?

In a recent group discussion, LC professionals took up the matter of guarantee text referencing a consumer price index (CPI) which periodically fluctuates. Banks in certain jurisdictions (particularly Israel and France) have been known to link the amount of the guarantee to a specific index which is set and periodically updated by the governmental bureau of that jurisdiction. As the index fluctuates, the amount of the guarantee increases or decreases accordingly.

For the banks who issue their counter LCs to support issuances of the guarantees linked to such indices, it has become a challenge to assess and underwrite the ultimate true obligation under the counter LC. The Issuer of the guarantee expects to be reimbursed for its total undertaking under the guarantee which includes the indexation, while the Issuing bank of the counter LC and the Applicant of the LC expect to have a clear understanding of their obligation and true exposure under the LC and the ultimate guarantee.

The issuer of the guarantee may demand a clause similar to what is shown below to make certain that all future increases resulting from the fluctuation of the index will be reimbursed by the Issuing bank of the counter LC. In fact, the Issuing bank of the guarantee expects the Issuing bank of the counter LC to increase their counter LC upon demand or commit to periodic automatic future increases.

An example of the wording that an Issuing bank of a guarantee may request to be added to the text of a counter LC:

OUR LIABILITY UNDER THIS COUNTER LETTER OF CREDIT SHALL BE RESTRICTED TO XXX (AMOUNT IN WORDS) WHICH REPRESENTS THE PRINCIPAL AMOUNT PLUS A 10% BUFFER COVERING THE [COUNTRY specified] CONSUMER PRICE INDEX (“CPI”) OR CONSUMER BUILDING INDEX (“CBI”) EXPOSURE UNTIL THE EXPIRY DATE.

THE AMOUNT OF OUR COUNTER LC, WILL INCREASE BY 10 PER CENT PER ANNUM, CALCULATED ON A DAILY BASIS, STARTING FROM YOUR ISSUANCE OF THE ABOVE MENTIONED GUARANTEE, UNTIL THE EARLIER OF THE EXPIRY DATE OR THE DATE OF PAYMENT BY US (IF REQUESTED). ON EACH ANNIVERSARY DATE OF THE DATE OF ISSUANCE, YOU WILL ISSUE TO US, BY AUTHENTICATED SWIFT, A CONFIRMATION OF THE UPDATED AMOUNT OF THE GUARANTEED SUM AS OF THAT DATE. ANY DEMAND UNDER OUR COUNTER LC MAY BE MADE FOR ANY AMOUNT UP TO THE GUARANTEED SUM UPDATED EACH YEAR, PLUS 10 PER CENT PER ANNUM FOR THE PERIOD FROM THE DATE OF ISSUANCE (IF A DEMAND IS MADE PRIOR TO THE FIRST ANNIVERSARY DATE) OR FROM THE ANNIVERSARY DATE IMMEDIATELY PRIOR TO THE DEMAND, UNTIL THE DATE OF PAYMENT BY US.

The above clause raises concerns due to its lack of clarity. In addition, the Applicant would likely refuse to agree to the 10 percent increase on an annual basis for a multi-year LC since it will require them to deposit a significant amount of a collateral (to capture all future increases) upfront at the time of issuance.

As a viable alternative to consider, it is proposed that the Applicant negotiate with the beneficiary for a shorter-term guarantee (ideally with one-year expiration) and provide a cushion (additional coverage) to the Issuing bank to cover any possible index fluctuation during the initial year. Later, closer to the expiration date, the Applicant will request, and the Issuing bank of the counter LC will underwrite and process, an amendment to adjust the amount of the counter LC based on the new indexation which will be provided by the Issuing bank of the guarantee.

Unfortunately, it is unlikely there is any acceptable solution if the beneficiary refuses the short- term expiration and insists on a multi-year guarantee.