Informality as a bilateral assurance mechanism.

• Author: Katz, Avery Wiener
• Position: Response to article by Ronald J. Mann in this issue, p. 2494

Comments on Ronald Mann's `The Role of Letters of Credit in Payment Transactions'

Ronald Mann's study of documentary defects in the presentation of commercial letters of credit(1) is a valuable contribution to the commercial law literature in at least three respects. First, it offers a detailed and thorough empirical survey of an important though specialized aspect of commercial practice. Mann collected and coded a data sample of 500 randomly selected letter-of-credit transactions, personally evaluating each transaction to determine whether the documentary presentation by the beneficiary of the letter of credit (i.e., the seller) complied with the letter's formal terms. Then, for each case in which he found one or more documentary defects, Mann went on to classify the defects and to evaluate their commercial and practical significance. He also measured how quickly and readily the issuing bank and the applicant (i.e., the buyer) responded to -- and ultimately waived -- the defects, in addition to collecting various other information about the transaction and the parties involved. The creation of this data set required significant time, effort, and both professional and scholarly judgment; and the result is a level and quality of information that goes substantially beyond the qualitative information gleaned from his interviews with bank officers, not to mention the anecdotal information that motivated the study in the first place.

Second, Mann has not just produced a dry collection of business facts. Rather, in showing that the beneficiaries of letters of credit routinely fail to present documents that comply with the terms of the underlying letter and that the applicants and issuing banks just as routinely waive the resulting defects, he has convincingly documented an important and counterintuitive empirical regularity about commercial letters of credit -- one that substantially undercuts the conventional teaching in the area that the purpose of the letter of credit is to provide the beneficiary with a guaranty of payment that is legally enforceable against the issuing bank. His findings are striking, provocative, and persuasive enough to demand explanation and, thus, to force a revision of the conventional scholarly wisdom in this area.

Third, Mann has put forward a theoretical account of letters of credit, grounded in the modern economics of information and based on his prior work in other areas of commercial law, that is both more nuanced and conceptually more sophisticated than is the conventional scholarly view. His explanation is that the value of letters of credit in assuring beneficiaries of payment does not lie primarily in their legal significance, but rather in their practical significance. More specifically, the willingness of a bank to issue a letter of credit serves as a credible signal, enforced by an implicit reputational bond, of the issuer's private information that the applicant is a reliable creditor; and this signal is more important to the beneficiary in practical terms than is any right to collect directly from the bank. To use Mann's own terminology, the letter of credit is primarily a verification institution, not a guaranty institution.(2) This explanation is creative, interesting, and as far as I know, original. It may be that Mann's explanation, as he suggests at various points, will be regarded as old news by practicing commercial specialists in the letter-of-credit area. Even if this is so, however, and even if his explanation is incomplete or incorrect, he has significantly advanced the state of the scholarly literature on this topic.

In these comments, I argue that the theoretical account of letters of credit that Mann offers, while instructive and suggestive, is indeed incomplete. In particular, Mann's theory does not explain why parties contracting at a distance would want to use a commercial letter of credit as their mechanism for verifying information relevant to the extension of credit, as opposed to some other device. Similarly, his account does not explain why, given that the parties have chosen to use a letter of credit to signal the buyer's reliability, they would avoid the presumably stronger signal of making the letter legally binding. Indeed, as Mann himself tells us, if the parties' main purpose is to provide the seller with assurance that the buyer will pay, there are easier and cheaper means through which to provide such assurance. Thus, his information-verification theory fails to explain all of the facts he uncovers in his empirical research, and to the extent it is consistent with his findings, it would be equally consistent with other findings if not more so.

The reason why Mann's explanation is incomplete, I also argue, is that he focuses on only half of the incentive problem inherent in the stereotypical commercial letter-of-credit transaction. When parties deal at a distance, there is risk on both sides. The seller faces the risk that she will ship goods for which the buyer will not pay, leaving her with the relatively ineffective remedy of a lawsuit in a distant and unfamiliar jurisdiction; this is the problem on which Mann focuses. But the buyer faces the corresponding risk that he will pay for goods that are defective or that the seller does not even ship.(3) Either party could reduce or even eliminate this risk by insisting that the other party perform first; for instance, the seller could insist that the buyer prepay, or the buyer could insist that the seller ship on open account and that payment be due only after the buyer is satisfied that the goods conform to the underlying contract. Intermediate arrangements will give less protection to one party and more to the other. But there is no arrangement that will provide complete assurance to both; the difficulty lies in the very fact that the parties deal at a distance, which both makes it impossible for them to perform simultaneously, and renders the usual legal remedy for breach of contract -- a lawsuit for damages or specific performance -- ineffective in practical terms.

What Mann omits, in his focus on the seller's need to verify the reliability of her buyer, is that the commercial letter of credit is a bilateral assurance mechanism -- one that, more or less, splits the difference between prepayment and shipment on open account. When the bilateral nature of the risk inherent in long-distance transactions is taken into account, the use of letters of credit, as well as the fact that in most instances they are honored despite technical noncompliance with their documentary conditions, becomes substantially more understandable.

1. WHY USE A LETTER OF CREDIT AT ALL?

   As a vast theoretical and empirical literature in law and in economics makes plain, imperfect information is a primary institutional consideration in credit markets. According to the standard economic theory of risk bearing, creditors who lack individualized information about their debtors' risk profiles or post-credit behavior will be unable to price credit terms correctly or provide incentives for optimal precaution and risk taking by debtors over the life of the loan. As a result, the price of credit will generally include a premium for anticipated suboptimal behavior by the debtor (moral hazard) as well as a cross-subsidy from low-risk to high-risk debtors that inefficiently discourages the former from applying for credit in the first place (adverse selection). These informational transaction costs arise not just in explicit credit markets, but in any contractual relationship that includes an implicit credit element -- that is, in any contract where performance is not completely simultaneous.(4) Reducing such costs to manageable proportions, accordingly, will in many instances be crucial to the success of the overall contract.

   The problems of adverse selection and moral hazard are likely to be especially significant when parties contract at a distance. The difficulty of verifying information about a far-off and unfamiliar location, organized according to local conventions and possibly in a different language; the problems of collecting at a distance and navigating a foreign legal system; and the relative infrequency of such transactions, making it difficult to cover the overhead costs of investigation and enforcement or to establish a credible business reputation, all combine to make reliance on ex post legal enforcement an especially cumbersome tool to ensure compliance with contractual obligations. Thus Mann's observation that long-distance sellers would have special concerns about the reliability and creditworthiness of their buyers, and would accordingly have special need for devices that address these concerns, is both intuitive and empirically plausible.

   As both the practice of and the literature on commercial transactions attests, however, and as Mann himself has documented more fully in another context, a host of legal and commercial institutions are available to serve this accreditation function.(5) One such institution is secured credit, under which the debtor offers specific property as collateral for his loan, thus providing a source of funds out of which the creditor may satisfy her debt in the event of default, as well as, under most systems of secured credit, a relatively expedited process for collection.(6) Another such institution is the contractual guaranty, under which a third party undertakes a secondary obligation to pay the debt if the primary debtor does not.(7) A third device is the posting of a bond, to be forfeited to the creditor, to a third party, or even destroyed in the event of breach or other debtor misbehavior.(8) A fourth is the use of contractual intermediaries who have some link to the unknown debtor, whether through past transactional experience, common ethnic identity, or membership in a trade association, and who themselves are known or who have an established commercial reputation.(9)...