Commercial Letters Of Credit

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Seller is assured payment in international sales transactions if documents are in order

Turner

By PAUL S.TURNER
© 2003

When goods are purchased under a commercial letter of credit, a bank pays the purchase price to the seller provided that the seller presents to the bank the documents specified in the letter of credit. The documents normally include the seller's invoice and a transport document showing that the seller has shipped the goods to the buyer.

A standby letter of credit typically supports the payment of a financial obligation other than payment to the seller for the purchase of goods. This article discusses commercial, but not standby, letters of credit.

International sale of goods

Suppose that Asian Importers in Los Angeles and Taiwan Chinese Dolls, a manufacturer in Taipei, agree that Asian Importers will buy 25,000 dolls from the manufacturer for $555,000. The manufacturer asks to be paid in advance, but the importer is reluctant to pay before the dolls arrive in Los Angeles. Neither party will risk the other's insolvency or failure to perform.

To resolve the payment impasse, Asian Importers applies to First Bank of Los Angeles for the issuance of a letter of credit to Taiwan Chinese Dolls. In the application, the importer asks the bank to authorize Taipei National Bank, in Taiwan, to advise Taiwan Chinese Dolls that the credit has been issued and to pay Taiwan Chinese Dolls pursuant to the credit. On the reverse side of the application is a form of contract in which Asian Importers agrees to reimburse First Los Angeles Bank if the bank honors the letter of credit.

First Bank of Los Angeles issues the credit. Taipei National Bank advises the manufacturer of the issuance and that to be paid for the dolls, the manufacturer must present the following documents, either to the Taipei advising bank or the Los Angeles issuing bank:

1. An invoice describing the following goods:

2. A packing list showing, as contents:

6,000 girl dolls in blue dresses
5,000 girl dolls in gold dresses
6,000 boy dolls in brown pants
8,000 boy dolls in warrior costumes

3. A negotiable bill of lading for the shipment of the goods from Taipei to the Port of Los Angeles, to be consigned to First Bank of Los Angeles, marked freight prepaid and "notify Asian Importers."

4. An insurance certificate showing coverage of at least $555,000

5. A draft drawn on First Los Angeles Bank by Taiwan Chinese Dolls, payable to Taiwan Chinese Dolls in the amount of $555,000.

Three contracts

Every letter of credit involves at least three contracts. There are four in our example.

Contract I: Contract I is the underlying agreement that is supported by the letter of credit. In a commercial credit, Contract I is an agreement for the sale of goods. The seller is the beneficiary of the credit, and the buyer is the applicant.

Contract II: Contract II is the agreement between the applicant and the bank, often called the "reimbursement agreement," in which the bank agrees to issue the credit, and the applicant agrees to reimburse the bank if the bank pays the beneficiary. The bank is called the issuer or issuing bank.

Contract III: Contract III is the letter of credit itself. The issuer engages with the beneficiary to honor the beneficiary's presentation of documents provided that they comply with the requirements of the credit. Practitioners often refer to a letter of credit as, simply, a "credit."

A commercial credit is either an acceptance credit or a sight credit. The issuer honors an acceptance credit by "accepting," that is, signing, the beneficiary's draft, thereby agreeing to pay the draft at a specified later date. The issuer honors a sight credit simply by paying the beneficiary.

Every credit specifies an expiry, the latest date on which the beneficiary may present the documents.

Contract IV: In addition to the issuing bank, commercial credits usually involve a second bank, often in the same location as the beneficiary. The second bank, as the adviser or advising bank, typically advises the beneficiary that the credit has been issued and that the documents may be presented locally to the advising bank rather than to the issuer abroad.

An advising bank may, or may not, also be nominated, that is, authorized, to pay the beneficiary. The bank may also confirm the credit by engaging directly with the beneficiary to honor a complying presentation of documents. A confirmer is not only a nominated bank; it is also obligated to pay the beneficiary to the same degree as the issuer.

Contract IV is the agreement of the issuer to reimburse a nominated bank.

In our example, First Bank of Los Angeles, the issuer, agrees in Contract IV to reimburse Taipei National Bank, the advising and nominated bank, if Taipei National Bank honors the presentation of complying documents by Taiwan Chinese Dolls, the beneficiary.

Fundamental principles

In the United States, letters of credit are governed by Article 5 of the Uniform Commercial Code. Com-mercial credits normally also incorporate by reference the Uniform Customs and Practice for Documen-tary Credits, commonly known as the "UCP." The UCP, which is published by the International Chamber of Commerce, contains detailed rules for the bank's examination of documents.

The following principles have evolved under the common law, UCC Article 5, and the UCP:

1. The doctrine of "payment against documents;"
2. The "independence principle," isolating the credit from the underlying sales contract;
3. The "strict compliance" doctrine to determine the compliance of documents;
4. The "preclusion rule," applicable when the issuer fails timely to assert discrepancies;
   and
5. The doctrine that despite the principles described above, relief may be available to the applicant in the event of fraud.

Payment Against Documents (UCP Article 4)

The UCP states that the parties "deal with documents." The issuer has no dealings with the goods to which the documents relate. If the documents comply with the requirements of the credit, the bank must honor the credit. If they do not comply, the bank is obliged to the applicant (subject to modification in the reimbursement agreement) to dishonor the credit.

The Independence Principle (UCP Article 5 — UCC §5103(d))

The principle of payment against documents is often formulated as the "independence principle." The independence principle provides that the obligation of the issuer to the beneficiary to honor the credit is independent of the rights and obligations of the parties in the underlying agreement and in the reimbursement agreement.

Walls are conceptually erected between Contracts I, II and III. Thus, any defense the buyer may have to payment of the seller in the sales contract is not available to the bank as grounds for dishonor under the letter of credit.

In our example, Asian Importers may have good reasons why it need not pay Taiwan Chinese Dolls. Perhaps the manufacturer has failed to ship the dolls by a date specified in the sales contract, or the buyer may have exercised a cancellation option. These circumstances, although grounds for Asian Importers not to pay the seller, would not be grounds for the bank not to honor the credit.

"Strict Compliance" and "Standard Banking Practice" (UCC §§5108(a) & (e) – UCP §13(a))

The documents presented by the beneficiary must strictly comply with the requirements of the credit. If the invoice in our example shows 5,000 girl dolls in blue dresses and 6,000 girl dolls in gold dresses, instead of 6,000 in blue and 5,000 in gold dresses, the bank must reject the documents and decline to pay the beneficiary.

"Strict compliance" is determined according to "standard banking practice" (UCP Article 13(a) and UCC §§5108(a) & (e)). The document examiner at the bank refers to "standard practice" to answer questions such as: Must a document be signed? By whom must it be signed? Must it be dated? May it be in a foreign language? Banks and national banking associations maintain checklists of standard practices. The International Chamber of Commerce has recently published the International Standard Banking Practice for the Examination of Documents that identifies more than 200 practices as "standard" for the examination of documents under the UCP.

The Issuer's Preclusion (UCP Article 14 (e) – UCC §5108(c))

The bank must give timely notice when it determines to dishonor the credit, specifying the discrepancy on which it bases the determination. The time allowed is a "reasonable" time, not exceeding seven banking days after the date the documents are presented.

If timely notice is not given, the issuer must honor the credit. If timely notice is given, and documents are subsequently re-presented prior to the expiry, the bank is precluded from asserting any documentary discrepancy that it had failed to assert in the previous presentation.

Fraud (UCC §5109)

Suppose that in our example, Asian Importers claims that instead of dolls, the Taipei manufacturer has shipped crates containing only sand and gravel. When there is convincing evidence of material fraud, the issuer may, in good faith, decline to honor the presentation. If the issuer determines to honor the presentation despite the applicant's claims, the applicant may apply to a court to enjoin the issuer's payment.

Conclusion

The letter of credit assures the seller of payment for the goods if the documents presented comply with the requirements of the credit. In the absence of fraud by the seller, the seller holds the purchase price while disputes in the sales contract are resolved, by litigation or otherwise.

Let us imagine three scenarios in connection with our example:

Scenario 1. The documents comply. Taipei National Bank pays Taiwan Chinese Dolls, First Los Angeles Bank reimburses the Taipei bank, and Asian Importers reimburses First Los Angeles Bank.

Scenario 2. The invoice shows 5,000 girl dolls in blue dresses and 6,000 in gold dresses, instead of 6,000 in blue and 5,000 in gold dresses. The Taipei bank rejects and dishonors the discrepant presentation. Taiwan Chinese Dolls must find another buyer.

Scenario 3. The documents are discrepant as described in Scenario 2, but Taiwan Chinese Dolls asks the Taipei bank to seek a waiver of the discrepancy from the issuer. First Los Angeles Bank and Asian Importers both agree to waive the discrepancy. As in Scenario 1, the Taipei bank pays Taiwan Chinese Dolls, First Los Angeles Bank reimburses the Taipei bank, and Asian Importers reimburses First Los Angeles Bank.

Scenarios 1 and 2 illustrate how letters of credit facilitate payment to sellers in international sales transactions. Scenario 2 illustrates how a credit can protect the buyer.

Paul S. Turner served as an official advisor to the uniform law commissioners who revised UCC Article 5, "Letters of Credit," in 1995 and is a co-author of Standby and Commercial Letters of Credit (Aspen Law and Business). He is an advisor to the executive committee of the State Bar's International Law Section and a retired assistant general counsel of Occidental Petroleum Corporation.

Certification

• This activity has been approved for Minimum Continuing Legal Education credit by the State Bar of California in the amount of one hour.
• The State Bar of California certifies that this activity conforms to the standards for approved education activities prescribed by the rules and regulations of the State Bar of California governing minimum continuing legal education.

SELF-ASSESSMENT TEST

Answer the following questions after reading the MCLE article on commercial letters of credit. Use the answer form provided to send the test, along with a $20 processing fee, to the State Bar. If you do not receive your certificate within four weeks, call 415-538-2504.

1. There are two kinds of letters of credit: "commercial" letters of credit and "documentary" letters of credit.



2. The three contracts that inhere in the structure of a letter-of-credit transaction are: (i) the underlying agreement that is supported by the letter of credit, (ii) the agreement between the applicant for the credit and the issuing bank, and (iii) the letter of credit itself.



3. In a commercial letter of credit, the underlying agreement that is supported by the letter of credit is an agreement for the sale of goods. The seller is the beneficiary of the credit, and the buyer is the applicant.



4. 4. The agreement between the applicant for the letter of credit and the issuing bank is often called the "reimbursement agreement."



5. The "expiry" is the date on which the issuer becomes obligated to pay the beneficiary.



6. A "nominated bank" must pay the beneficiary if the presented documents comply with the requirements of the credit.



7. An advising bank may also be nominated to pay the beneficiary under the credit.
   
8. In the United States, letters of credit are governed by Article 3 of the Uniform Commercial Code.



9. Commercial letters of credit typically incorporate by reference the Uniform Customs and Practice for Documentary Credits, which is published by the International Chamber of Commerce and known as the "UCP."



10. One of the fundamental principles of letter of credit law and practice is that the parties involved "deal with documents." The issuer does not deal with the goods to which the documents relate.



11. The "independence principle" provides that the obligation of the issuer to the beneficiary to honor the credit is independent of the rights and obligations of the parties in the underlying agreement and in the reimbursement agreement.



12. Under the independence principle, any defense the buyer may have to payment of the seller in the underlying sales contract is not available to the bank as grounds for dishonor under the letter of credit.
13. 
    
14. The issuer must honor the presentation of documents under the credit only if the documents substantially comply with the requirements of the credit.



15. In determining whether the documents "strictly" comply with the requirements of the credit, banks refer to "standard banking practices," which are listed in checklists maintained by banks and national banking associations.



16. The time allowed a bank to notify the beneficiary of a discrepancy in the documents is seven banking days after the date the documents are presented.



17. If timely notice of a discrepancy is not given by the bank, and documents are subsequently re-presented before the expiry date of the credit, the bank is precluded from asserting any documentary discrepancy that it had failed to assert in the previous presentation.



18. When there is convincing evidence of material fraud, the issuer may, in good faith, decline to honor the presentation.



19. When there is convincing evidence of material fraud, but the issuer determines to honor the presentation despite the applicant's assertion that the presentation is fraudulent, the applicant may apply to a court to enjoin the issuer's payment.



20. If a nominated bank honors a presentation of documents that strictly comply with the requirements of the credit, the nominated bank is then entitled to reimbursement by the issuing bank, and the issuing bank is then entitled to reimbursement by the applicant.



21. If the documents presented under a letter of credit do not strictly comply with the requirements of the credit, the beneficiary may nevertheless ask the bank to seek a waiver of the documentary discrepancies; and if the discrepancies are waived, the bank may pay the beneficiary.