A Primer to Drafting and Reviewing Letters of Credit-part I
| Publication year | 1986 |
| Pages | 1775 |
| Citation | Vol. 15 No. 10 Pg. 1775 |
1986, October, Pg. 1775. A Primer to Drafting and Reviewing Letters of Credit-Part I
In recent years, letters of credit have become increasingly common in commercial transactions far afield from their traditional domain---the international sale of goods transaction. Their increasing popularity is primarily a function of high interest rates, which have made letters of credit financially more attractive than cash deposits, and an awareness of their enormous flexibility. Bankers, appreciative of the fee income from letters of credit, also have been encouraging their use. Although the shakiness of some pockets of the banking industry and the legal assault on the assurance of payment under letters of credit have had an impact,1 they have not significantly weakened the perception that letters of credit offer one of the highest possible forms of security.
There is a substantial body of literature on letters of credit generally,(fn2) the enforceability of letters of credit when the underlying transaction goes awry,(fn3) and the treatment of letters of credit in bankruptcy proceedings.(fn4) The focus of this article is on the drafting of letters of credit. The article is directed to the practitioner who does not specialize in letters of credit, but is required in the course of transactions to draft and review credits, particularly standby letters of credit.
A letter of credit is a letter from the issuer to the beneficiary stating that the issuer undertakes to pay a certain amount upon specified conditions. The essence of a letter of credit is the primary obligation of the issuer to the beneficiary to pay on behalf of the account party. This is an obligation which is independent of the actual performance of the beneficiary's duties to the account party and dependent solely upon the beneficiary's presentation to the issuer of documents complying with the terms of the credit.(fn5)
Like a negotiable instrument (which a letter of credit is not),(fn6) most of the terms and conditions of the instrument are implied by law. They do not appear in the text of the credit. Applicable law is Article 5 of the Uniform Commercial Code ("UCC") with respect to credits issued in the United States.(fn7) In addition, credits may incorporate by express reference, by custom or by usage of trade the provisions of the Uniform Customs and Practice for Documentary Credits ("UCP"). The UCP is a convention prepared by the International Chamber of Commerce and agreed upon by bankers around the world as a uniform means of interpreting and dealing with letters of credit.(fn8) If the issuer is a regulated banking institution, certain regulations will also apply.(fn9)
There are a number of recognized types of letters of credit. A "clean credit" requires nothing for payment but a draft or other demand for payment under the credit. On the other hand, a "documentary credit" requires, in addition to the making of a demand, the presentation of documents against which payments are made, usually documents of title or shipping documents. A "standby credit" falls into another category, distinguished in that the issuer has a primary obligation to the beneficiary; however, the credit may be drawn upon only when the account party fails to perform its obligation to the beneficiary.
Despite the apparently straightforward distinction between clean credits and documentary credits, credits requiring drafts plus some statement of the beneficiary (the usual format for standby credits) are generally referred to as "clean credits."
The term "unconditional" in relation to a letter of credit has no legal definition.
Every credit has conditions. The closest thing available to an "unconditional" letter of credit is a credit requiring only the presentation of a sight draft on or before the expiration date.
Letters of credit may be drafted to include various features. A letter of credit can be "revocable" or "irrevocable." If revocable, the obligation of the issuer can be revoked without notice to the beneficiary or the account party at any time. A letter of credit can be a "straight credit," that is, for the benefit of the beneficiary only. It can also be a "negotiation credit," on which the issuer will pay drafts drawn by the beneficiary to third parties who negotiate (by endorsement) the drafts to the issuer. A credit can be "transferable," but it is nontransferable unless otherwise designated. Some credits are designated "notation" credits, meaning that the letter of credit must be presented with the drawing so that the amounts of successive drafts can be marked on the credit. These various features are discussed in greater detail in Part II of this article.
Parties to a letter of credit transaction may include more than the issuer, beneficiary and account party. Credits are often "confirmed," which is accomplished when another bank (usually a larger bank or a bank nearer in location to the beneficiary) undertakes the primary obligation for the credit and arranges for reimbursement from the issuing bank whose credit standing it accepts. Letters of credit may be "advised" by a party other than the issuer who undertakes to advise the beneficiary, without any obligation other than the correctness of its advice, of the opening of the credit in the beneficiary's favor.
A "paying bank" enters the picture if the issuer engages it to pay the beneficiary, without liability on the credit. This may be arranged as a matter of convenience when the issuer is at a geographical distance from the beneficiary. Finally, a "negotiating bank" may become involved by buying a draft drawn under the credit from the beneficiary and presenting it to the issuer for payment. Confirmation is discussed in Part II of this article. Paying, advising and negotiation functions are less common in standby transactions and are not discussed herein.
A transaction involving a letter of credit invariably involves three contracts: (1) the business transaction between two parties, represented by the contract between them; (2) the letter of credit itself, involving usually, but not necessarily, a bank as the "issuer"(fn10) of the credit and one of the parties to the business transaction who is its "beneficiary";(fn11) and (3) the reimbursement agreement between the issuer and the party to the business transaction who causes the letter of credit to be issued, referred to herein as the "account party."(fn12) To understand their rights and obligations properly, the parties must remember at all times that these three contracts are separate, distinct and independent of each other. Many questions relating to the rights and obligations of the parties to a letter of credit transaction can be answered simply by a proper application of this so-called "independence principle."(fn13)
The three parties in a letter of credit transaction have joint and conflicting interests with respect to the terms of the credit. In very general terms, the beneficiary wants to get paid no matter what; the account party wants to reimburse the issuer only if the beneficiary is entitled to the money; and the issuer, caught in the middle (or, more accurately, having placed itself in the middle for a fee), wants to pay if the demand for payment is proper. The interplay of these conflicting interests places a high premium on proper drafting.
The issuer in the ordinary transaction should be the policeman in a letter of credit transaction to assure that the credit meets all of the technical requirements. In addition, the issuer should be sure that the credit is clear, objective and simple.
Since credits will be strictly construed against the issuer,(fn14) and issuers are subject to a rule of strict compliance in letter of credit transactions,(fn15) clarity is of utmost importance. The obligation to pay should be stated in a way that permits the issuer to perform its function by a rote process. Moreover, the credit should be drafted to make the issuer an objective party with respect to the obligations between the beneficiary and the account party. The issuer should not be an interpreter or arbiter. As the UCP states, "In credit operations, all parties concerned deal in documents, and not in goods, services and/or other performances. . . ."(fn16) This is the UCP's way of expressing the first rule of the "independence principle"---the issuer should not get involved in the underlying business transaction.
Finally, the letter of credit should state, in the simplest terms possible, the requirements that fix the issuer's obligation to pay. The letter of credit should not contain extraneous material, "extraneous" meaning anything not strictly needed for the issuer to be able to evaluate whether a drawing is proper. Most important, the letter of credit should not incorporate by reference the agreement relating to the underlying transaction. Issuers should take primary responsibility to assure that the letters of credit they issue meet the highest standards of clarity, objectivity and simplicity.
From a beneficiary's point of view, the key to a letter of credit is that it can be drawn upon without interference from the account party. In a disputed transaction, the letter of credit often determines who gets the money at the outset, which, of course, often determines who gets the money at all. Accordingly, the credit should be drafted to assure that the beneficiary gets paid over the...
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