A letter of credit (LC) terms clause in a restrictive covenants context establishes a financial instrument that guarantees performance of obligations—typically compliance with non-compete, non-solicitation, or confidentiality restrictions. Rather than relying solely on the restricted party's promise or future damages claims, the LC creates a bank-backed guarantee: if the restricted party breaches (e.g., solicits customers in violation of a non-compete), the beneficiary can draw funds from the LC to compensate for losses. This clause should specify the LC amount, issuing bank, validity period, conditions for drawing, and whether the LC is "standby" (drawn only upon breach) or "demand" (drawn upon claim of breach). This mechanism is particularly valuable when the restricted party may lack sufficient assets to satisfy a damages judgment or when the parties want to avoid litigation.
The clause is unusual in restrictive covenant contexts because LCs are more common in commercial transactions, but sophisticated parties sometimes use them to secure compliance with post-employment or post-acquisition restrictions. The enforceability and practical utility depend heavily on precise drafting of draw conditions.
If you are the beneficiary (the party relying on the LC), insist that the LC be "standby" and require that draws be permitted upon a written statement of breach without requiring proof of actual damages—this preserves your leverage and avoids litigation over damage quantification. Specify that the LC must be issued by a creditworthy bank, remain in effect for the full restriction period plus 12 months, and be automatically renewed unless the issuing bank provides 60 days' notice. If you are the restricted party, negotiate for a "demand" LC that requires the beneficiary to prove breach before drawing, and cap the LC amount at a reasonable multiple of the restricted party's compensation or the transaction value. Require that any draw be credited against actual damages awarded in litigation to prevent double recovery.
Frequently Asked Questions
What does this clause mean in simple terms?
A letter of credit (LC) terms clause in a restrictive covenants context establishes a financial instrument that guarantees performance of obligations—typically compliance with non-compete, non-solicitation, or confidentiality restrictions.
Why should I care about this clause?
Rather than relying solely on the restricted party's promise or future damages claims, the LC creates a bank-backed guarantee: if the restricted party breaches (e.g., solicits customers in violation of a non-compete), the beneficiary can draw funds from the LC to compensate for losses.
What are my options?
This clause should specify the LC amount, issuing bank, validity period, conditions for drawing, and whether the LC is "standby" (drawn only upon breach) or "demand" (drawn upon claim of breach).
How does this affect small businesses?
This mechanism is particularly valuable when the restricted party may lack sufficient assets to satisfy a damages judgment or when the parties want to avoid litigation.