Training Session: Letters Of Credit
By Denis Petkovic
Chadbourne runs internal training sessions for lawyers in the project finance group and interested clients. The following is an edited transcript of a session on letters of credit that took place by videoconference in mid-August among the Chadbourne offices in New York, Washington and London. The speaker is Denis Petkovic in London. Copies of the handouts — including slides used for the presentation and a detailed outline of the law in this area — can be obtained by sending an email to email@example.com.
The starting point for this topic is to look at the “Uniform Customs and Practice for Documentary Credits,” or “UCP 500.” This is a set of rules published by the International Chamber of Commerce that nearly all international banks follow when issuing international letters of credit. The rules have been revised five times since they were first issued in 1983. The most recent revision took effect in January 1994.
UCP 500 is a set of conditions that is routinely incorporated into letter-of-credit transactions by the parties. It pays to be familiar with the conditions because they are not usually spelled out — merely incorporated in letters of credit by reference.
These conditions govern all international letters of credit that expressly incorporate them. The United States has its own version of UCP 500. It is article 5 of the “Uniform Commercial Code.” This is meant to be consistent with UCP but it is not identical and UCC article 5 is really only suitable for purely domestic letters of credit in the United States.
If a bank does not expressly incorporate UCP 500, can one argue the letter of credit should still be considered governed by these conditions on grounds of existing custom or usage? There is a school of thought headed by a leading English academic named Professor Goode that says these rules are now so widely used that they do constitute existing custom and usage, but I am not sure this is correct. The fact that one has a different set of conditions in the UCC in the United States calls into question whether Professor Goode is right and when dealing with issuers in civil law countries like France and Italy, local civil codes will invariably influence the legal position.
In cases where the set of standard conditions is incorporated by reference in a contract, it becomes part of the contract. However, the conditions can be varied as the parties see fit. English case law holds that the express terms of the letter of credit govern. If they are inconsistent with the UCP, the set of conditions in the UCP yields to the more express terms.
US practice is that only banks tend to issue letters of credit — possibly because of concerns about triggering breaches of banking laws. This is not the practice outside the US where non-banks frequently issue standby and other “non-trade finance” LCs.
On page 24 is a diagram of a fairly typical letter of credit transaction. The most important point to take away from the diagram is that a letter of credit transaction is not just one transaction. It is a series of transactions.
The diagram shows a buyer in China who wants to purchase goods from a US seller. The first contract in the transaction is a contract to sell the goods. Obviously, the seller in the United States wants to be paid and the buyer is a long way away.
Therefore, we come to the second contract. The buyer approaches its local branch or local bank to arrange for the issuance of a letter of credit. The bank in the diagram is in Hong Kong. The letter of credit is nearly as good as cash to the US seller.
The issuance contract — contract two in the diagram — can be described as mandate or a reimbursement agreement or a counter-indemnity. In that contract, the buyer will be obliged to put the bank in funds when the bank makes a payment under the letter of credit or when the bank’s obligation matures to make such a payment because the US beneficiary of the letter of credit has presented the documents required to draw on the LC. The bank will allow the draw, but it then looks to its customer under an indemnity reimbursement or other obligation for payment.
Contract three: the bank is in Hong Kong but the beneficiary of the letter of credit is in the United States. In contract three, the Hong Kong bank enters into an agency contract with a US bank that says — in effect — please tell the beneficiary what the nature of our obligation is under our letter of credit. This is called the “advising” of credit.
This still doesn’t get the US seller where it wants. It will want someone whom it can sue locally if there is non-payment or non-performance of the Hong Kong bank’s obligations. That gets us to contract five. Contract five occurs when a US bank — usually the advising bank — confirms the LC in favor of the US seller. This confirmation constitutes a separate and independent legal obligation of the confirming bank to the US seller. The wording typically goes something like, “We confirm the credit issued by Hong Kong bank in the following terms . . .” The magic words “we confirm” create a separate and independent obligation by the US bank so that the US seller now has what it needs: someone in the United States who is prepared to pay. The US seller has a choice of suing the Hong Bank directly or going against the US bank.
Turning to the last contract, we have yet another bank called the negotiating bank. LCs may provide for payment in, say, 30 days after presentation of documents required for a draw. The negotiating bank will buy at a discount those documents from any party who is in possession of the documents and make a profit when the documents are finally presented to the Hong Kong bank because the negotiating bank has “negotiated,” or given value for the documents. The negotiating bank obtains by law under the UCP an indemnity obligation from the issuing Hong Kong bank whereby it will be reimbursed by virtue of having given value for the documents stipulated in the credit.
Which Country’s Law Governs?
These are five separate contracts. Because they are written in different countries, the question increasingly comes up whose law governs? The answer is that they may not all be governed by the same country’s law — even though they are related pieces of a trade finance LC.
Letters of credit in practice have not had a governing law clause inserted, and you may still find many trade finance LCs that lack such clauses. Be sure to insert such a clause. Left to its own devices, an English court — and I believe the approach is the same in the US — would look to the law of the country that has the closest and most real connection to the transaction. This is typically the place where the issuing bank — in the diagram, the bank of Hong Kong — has to perform its obligations under the letter of credit. When you have an advising or confirming bank involved, it will be where the beneficiary is located. The point is that where parties fail to specify what is the governing law, one gets into questions about which country has the closest and most real connection. This becomes important because countries have, in the past, invoked remittance blocking orders or passed laws to prevent payment. For example, if a foreign law governs the letter of credit obligation or any applicable obligations in the chain, a bank in the chain will rightfully be entitled to withhold payment by virtue of an applicable block order. This is why it is so important for letters of credit and other related contracts to contain governing law clauses.
There are other concepts that are fundamental to understanding how the letter-of-credit rules apply.
The main one is the “autonomy principle” in articles 3 and 4 of UCP 500. Article 3 says that LCs are separate transactions from the underlying sales contract. Banks are in no way concerned with or bound by the sales contract.
Article 4 says that parties to a letter of credit are concerned only to insure that documents presented to them conform on their face to the terms of the credit. The LC bank is not concerned with the correctness of statements in the documents. It will not examine the goods that are the subject of the contract of sale to see if they conform. Its business is only to deal in the documents. These are documentary credits.
There are strong policy reasons why courts observe these principles. The absolute nature of the payment obligation that one gets under a letter of credit would be threatened if banks looked beyond the documents presented to draw on the LC. There is, though, one major exception to this principle, and that is fraud. It is very hard to establish fraud. The bank must have had knowledge of the fraud before a court will issue an injunction to block payment.
Illegality is another exception to the autonomy principle. An example is where it is illegal under the applicable law for the Hong Kong bank in our scenario, to make payment.
What the Law Requires of Banks
What duties are imposed on banks in an LC transaction? The issuing bank — the Hong Kong bank in the diagram — has a duty first to issue a credit in accordance with its instructions, second to receive and examine documents under the credit, and third to pay against conforming documents. A important corollary is to refuse to pay against documents that do not conform.
UCP 500 is largely silent on the issuance duty, but the payment duty and the examination duty are covered and are probably the most significant articles in UCP. Article 13 of UCP 500 requires banks to examine all documents stipulated in the credit with reasonable care, to ascertain if they appear on their face to be in compliance with the terms and conditions of the credit. Documents that are inconsistent with one another do not appear on their face to be in accordance with the terms and conditions of the credit. In addition, if additional documents are presented that are not stipulated in the credit, the bank is not required to examine them. So UCP 500 provides guidance for banks when trying to figure out what they must do to comply with the examination function.
Advising banks have a fairly limited role. They are an agent of the issuing bank, and the normal contractual rules of agency apply. Not much is written in UCP 500 about advising banks. They simply inform the beneficiary of the terms of the credit.
The confirming bank has a very interesting role that is addressed in article 9 of the UCP. It is clear to me on various readings — and I have advised banks in the past — that the confirming bank’s obligation to make payment is a collateral obligation that is independent from that of the issuing bank. If the issuing bank goes bust, the beneficiary can look to the confirming bank for payment. The point about confirming banks is the same as for issuing banks: if they pay against nonconforming documents, they do so at their own peril and may not be entitled to recover the amount of their payment — even though they end up in fact with possession of the underlying transaction documents!