An Updated Primer on Letters of Credit

• Publication year: 1999
• Pages: 5

28 Colo.Law. 5 Colorado Lawyer 1999.

1999, April, Pg. 5. An Updated Primer on Letters of Credit

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Vol. 28, No. 4, Pg. 5

The Colorado Lawyer
April 1999
Vol. 28, No. 4 [Page 5]

Articles
An Updated Primer on Letters of Credit
by Beat U. Steiner

This article updates an article written a dozen years ago1 to take into account the rewriting of the law applicable to letters of credit. In July 1996, the Colorado legislature adopted revised Article 5 of the Uniform Commercial Code ("UCC").2 Revised Article 5, a wholesale revision of the article, significantly updated and modernized the UCC as it applied to letters of credit, creating greater conformity between law and practice.3 The Uniform Customs and Practices for Documentary Credits ("U.C.P."),4 a convention used by bankers around the world for interpreting and dealing with letters of credit, also has been rewritten since the time of the original article, with some rather significant changes. In addition, on January 1, 1999, the International Standby Practices ("I.S.P.")5 became effective. The I.S.P. is a statement of generally accepted practice, custom, and usage of standby letters of credit that has been approved by the International Financial Services Association and the International Chamber of Commerce Banking Commission

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 in commercial transactions generally is a function of interest rates (which at times have made letters of credit financially more attractive than cash deposits) and increasing awareness of their enormous flexibility. Although shakiness in the banking industry during the 1980s and the legal assault on the assurance of payment under letters of credit have had an impact, they have not significantly weakened the correct perception that letters of credit offer one of the highest possible forms of security.6

There is a substantial body of literature on letters of credit generally,7 the enforceability of letters of credit when the underlying transaction goes awry,8 and the treatment of letters of credit in bankruptcy proceedings.9 This article is about drafting letters of credit. It is directed to the practitioner who does not specialize in letters of credit but is required in the course of commercial transactions to draft and review credits, particularly standby letters of credit

BACKGROUND

Definition

CRS § 4-5-102(a)(10) defines a letter of credit as a definite10 undertaking by an issuer, to a beneficiary, at the request or for the account of an applicant,11 to honor a documentary demand by payment or delivery of an item of value (usually money).12 As the name implies, the undertaking is customarily in the form of a letter from the issuer to the beneficiary. The essence of a letter of credit is the primary obligation of the issuer to the beneficiary to pay on behalf of the applicant—an obligation independent of the actual performance of the beneficiary's duties to the applicant and dependent solely on the beneficiary's presentation to the issuer of documents complying with the terms of the credit.13

Like a negotiable instrument (which a letter of credit is not),14 most of the terms and conditions of the instrument are implied by law and do not appear in the text of the credit.15 Applicable law for credits issued in the United States is Article 5 of the UCC, either the original 1954 version or the 1994 revision.16 Credits also may incorporate by express reference, custom, or usage of trade the provisions of the U.C.P. and of the I.S.P., as well as other banking practices.17 If the UCC applies to the letter of credit, unless disclaimed, the standard practice of financial institutions that regularly issue letters of credit must be observed by the issuer.18 In addition, if the issuer is a regulated banking institution, certain regulations will apply.19

Under CRS § 4-5-102(a)(9), an engagement by an individual for personal, family, or household purposes is not a letter of credit. This rule cannot be waived by agreement.20 Moreover, this rule does not preclude a financial institution from issuing a letter of credit on behalf of an individual for personal, family, or household purposes, since the individual is not the issuer of the credit. It is possible that, in the future, courts will set aside a circumvention of this rule as where, for example, an individual forms a single-member limited liability company to issue a letter of credit. Circumstances where individuals are issuers (as opposed to applicants) are rare enough that this rule would not appear to limit the utility of letters of credit to any significant degree. The existence of the rule suggests, however, that where an individual is the issuer of a letter of credit, the credit should expressly disclaim its use for "personal, family or household purposes."

Types, Features, and Parties

There are various types of letters of credit. A "clean credit" requires nothing for payment but a draft or other demand for payment under the credit.21 A "documentary credit," on the other hand, requires, in addition to the making of a demand, (commonly referred to as a "drawing"), the presentation of documents, usually title or shipping documents, against which payments are made. A "standby credit"22 falls into another category, distinguished by the fact that the issuer has a primary obligation to the beneficiary, but the credit may be drawn on only when the applicant 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" often used by lawyers in relation to letters of credit has no legal definition. Every credit has conditions—even a so-called "unconditional" letter of credit requires the presentation of a sight draft or other demand for payment on or before the expiration date.23 Thus, it is not useful for a contract to call for an unconditional letter of credit. The conditions should be specified.

Letters of credit can be drafted to include various features. For instance, they can be "revocable" or "irrevocable." If revocable, the obligation of the issuer can be revoked without notice to the beneficiary or the applicant at any time. A letter of credit can be a "straight credit," that is, for the benefit of the beneficiary only, or 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. Notation credits are no longer separately defined in the UCC, but credits on which multiple drawings are permitted may, as one of their conditions, provide that the letter of credit be delivered to the issuer so each drawing may be noted thereon. A credit can be "transferable," but it is nontransferable unless otherwise designated. These various features are discussed in greater detail below.

Parties to a letter of credit transaction may include more than the issuer, beneficiary, and applicant. For example, there may be a "nominated person," a party whom the issuer designates to pay, accept, negotiate, or otherwise give value under a letter of credit and who is reimbursed by the issuer.24 One common type of nominated person is a "confirmer,"25 a person (usually a larger bank or a bank nearer in location to the beneficiary) who undertakes to honor a letter of credit issued by another. Confirmation also is discussed below. Other functions of nominated persons, including the functions of an "adviser,"26 are less common in standby transactions and are not discussed in this article.

The Three Contracts

A transaction involving a letter of credit usually involves three contracts:27 (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"28 of the credit, and one of the parties to the business transaction who is its "beneficiary";29 and (3) the reimbursement agreement between the issuer and the party to the business transaction who causes the letter of credit to be issued and who the UCC refers to as the "applicant."30 To understand their respective rights and obligations, the parties must remember at all times that these three contracts are separate, distinct, and independent of each other. When properly applied, this "independence principle" answers many questions relating to the rights and obligations of the parties to a letter of credit transaction.31

The three parties in a letter of credit transaction have joint and conflicting interests with respect to the terms of the credit. In general terms, the beneficiary wants to get paid no matter what happens; the applicant 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 drafting, and the courts have developed legal principles to protect each party's main interest.

BASIC CONCEPTS

The Issuer's Main Interest and the

Rule of Strict Compliance

The issuer ordinarily should police 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...