Reconsidering the Law of Credit Enhancement from Economic Perspectives: Guaranties, Letters of Credit, Insurance, and Credit Derivatives

Credit enhancement, in other words, means enhancing debtor’s credit. Describing it more precisely, credit enhancement is a procedure which creditor identifies, analyzes, and manages the credit risk through risk avoidance, prevention, reduction, isolation or transfer. These series of measures to mitigate credit risk are all comprised in the conception of credit enhancement mechanism. Focus on credit enhancement provided by external parties, it is triggered by the need of creditor, but it is feasible only when the debtor and credit enhancer both benefit from it. Therefore, through economic analysis, credit enhancer must help lower transaction cost, which is composed mainly by time value cost, marginal cost of liquidity, marginal cost of monitoring, and marginal cost of default, to benefit himself and the debtor. Thus, from the economic perspectives, credit enhancement is structured by the creditor who specializes in obtaining loanable funds, the credit enhancer who holds a sufficiently great comparative advantage in monitoring and collection, and the debtor who is willing to maintain this three-party credit transaction for profit inducement.

Guaranties, surety, letters of credit, insurances, and swaps are all credit enhancement mechanisms. Guaranty is conditional, subordinate, ancillary and guarantor is secondary obligator. Surety is jointly and severally liable. They are both governed by Civil Code in Taiwan, Restatement (Third) of the Law of Suretyship and Guaranty in the U.S., and URCG, URDG, ISP98 in global transactions. Commercial letter of credit which governed by UCP500 is independent, documentary and primary liable. Standby letter of credit is also independent and documentary, but its obligation is primary in form and secondary in intent. Parties could choose UCP500, URDG, or ISP98 as governing law. Bonding Insurance is governed by Insurance Act in Taiwan. Insurer’s obligation which arises from insurance contract and is independent of the underlying contract is to indemnify the insured for loss incurred through non-performance of obligations by its debtors. Credit default swap is one kind of credit derivatives and does not have an available body of law. The characteristic of credit default swap is that its positions are tradable.

Among theses different credit enhancement mechanisms, there are still some connections could be generalized. Based on the processes of credit enhancement ─creditor claims, credit enhancer performs and then seeks indemnity, three dimensions─”to whom and in what condition the creditor could claim,” “in what condition credit enhancer’s performance is legitimate,” and “who is ultimately responsible for the debt” are helpful not only in reconsidering the law of credit enhancement and comparing the advantages and disadvantages of these mechanisms, but also in clarifying the conception of “Primary Obligator,” and the misleading between “Joint-Debtors” and “Joint-Guarantors.”

Although distinctions can be draw among these mechanisms, complementary measures designed by the law, comment by the court, and the countermeasures by the market participants, blur the rigid borders. By taking joint-liability, guaranty is moving toward letter of credit in the dimension of ”to whom and in what condition the creditor could claim;” by waiver of defense in the U.S., the affirmation of “Bank Guaranty,” and using direct compulsory execution provided in article 13 of the Public Notarization Act in Taiwan, guaranty is also moving toward letter of credit in the dimension of “in what condition credit enhancer’s performance is legitimate;” by the recognition of fraud exception, using revocable letter of credit, and increasing document requirements, letter of credit is moving toward guaranty in this dimension too. Therefore, there are still some borderlands existing on the borders.

In conclusion, facing the interaction of these different mechanisms, reconsidering the law of credit enhancement, such as the legitimacy of article 739-1 of the Civil Code, by referring to what market participants need, and re-examining the true reasons distinguish these same-function mechanisms are necessary. Only by returning to the market mechanism, and thinking from the viewpoint of business practice can the law of credit enhancement conforms to the expectations of market participants