Limitation of Banks' Liabilities in Letters of Credit Agreements
| Publication year | 1986 |
| Pages | 1019 |
| Citation | Vol. 15 No. 6 Pg. 1019 |
1986, June, Pg. 1019. Limitation of Banks' Liabilities in Letters of Credit Agreements
Letters of credit traditionally have been used in connection with the sale of goods. The issuer of the letter is obligated to pay upon receipt of conforming documents of title covering the delivered goods. Recently, letters of credit increasingly have been used in non-commercial transactions to guarantee a party's performance of financial obligations under an underlying contract.(fn1)
The credit of the contracting party is enhanced by the creditworthiness of the issuer of the letter of credit, usually a bank. For example, letters of credit are often used in bond financings for borrowers with a low credit rating or none at all. The credit rating on the bonds can be enhanced by having the payment of the bonds guaranteed by a higher-rated bank which issues the letter of credit. The higher rating on the bonds presumably lowers their interest rate, thereby offsetting the cost of the letter of credit.
In the context of financing transactions, letters of credit are structured either as standby or direct pay letters. Standby letters are honored only if the party whose performance it guarantees defaults with respect to a payment required under the underlying contract. Direct pay letters require the issuer of the letter to pay the addressee-beneficiary of such letter the amounts due on the scheduled payment dates and, thereafter, to seek reimbursement for the payments from the customer on whose behalf the letter was issued. However, the essential purpose and nature of letters of credit and the parties' obligations thereunder remain the same whether the letter is used in a commercial or in a financing context.
With the increased use of letters of credit in financing transactions, there has been a trend by the banks issuing the letters to include exculpatory provisions in the reimbursement agreements disclaiming any liability except for gross negligence or willful misconduct in two factual situations. A typical exculpatory provision provides:
This provision appears to limit the bank's liability to the two cited instances of gross negligence and willful misconduct. It thereby purports to relieve the bank of any liability for other acts related to the letter of credit such as the calculation of the interest due on draws under the letter of credit or the improper declaration by a bank of a default. Under limited circumstances, default permits the bank to terminate the letter of creditThe customer shall have a claim against the bank and the bank shall be liable to the customer to the extent, but only to the extent, of any direct, as opposed to consequential, damages suffered by the customer which the customer proves were caused by (i) the bank's willful misconduct or gross negligence in determining whether documents presented under the letter of credit comply with the terms of the letter of credit or (ii) the bank's willful failure to pay under the letter of credit after the presentation to it of a certificate strictly complying with the terms and conditions of the letter of credit.
This article discusses various standards under the Uniform Customs and Practice for Commercial and Documentary Credits and the Uniform Commercial Code, which govern the obligations and liabilities of issuers of letters of credit. Another issue addressed is how the choice of a particular standard may affect the enforceability of provisions which attempt to limit the issuer's liability. This article does not examine the enforceability of such provisions under general, non-code case law which invalidates contractual disclaimers that are contrary to public policy.(fn2)
Only the state law of New York and Colorado is examined here, since most letters of credit issued in the United States are by banks licensed under the laws of New York state or the New York City branches of foreign banks, and the agreements relating to letters of credit often provide that New York state law will govern the interpretation and enforcement of the agreement.
The basic purpose of letters of credit is to provide assurance of payment to those unwilling to rely solely on the creditworthiness of the party to whom goods, services or financing is being provided.(fn3) A letter of credit resembles an ordinary letter. It is issued at the request of a customer who agrees to reimburse the issuer if a draw is made under the letter; that is, if payment is made in accordance with the terms of the credit.
The customer usually pays the issuer an annual fee (ranging from approximately 1
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