Letters of Credit - Module 6 of 6

Module 6: Letters of Credit

Risk in Financial Management

Risks are inherent in the world of financial transactions.[1]  Financial intermediaries, along with their customers and transactional beneficiaries can benefit from the creation of financial instruments to minimize or eliminate risk.  There are several types of financial risk.[2]  Default risk is when someone might not meet her obligations, such as a borrower defaulting on a loan, which would represent a loss for the lender.  A default risk subset is dishonesty risk,[3] where one party willfully fails to honor its obligations. Another default situation is where the parties suspend performance over a disagreement, which is called an honest-dispute risk.[4] 

Liquidity risk is when the holder of an asset may not be able to readily convert the asset into cash, such as a manufacturer saddled with ownership of an aging and non-productive facility. Foreign exchange rate risk is when a holder of foreign funds of an asset denominated in foreign funds loses value because of an adverse exchange rate change.  Political risk refers to a situation in which ownership of someone’s assets are compromised because of the fall of a government or a change in leadership, such as when a bank branch is seized during a coup.  Maturity mismatch risk is when the obligations on some liabilities become due before the maturity of the assets needed to pay the maturing liabilities.  Maturity mismatch risk is of particular concern to financial institutions that need to match asset income streams with periodic liability payments.

The Letter of Credit: Basic Mechanics

The letter of credit is a financial instrument designed to avoid some of these risks.  It has been around since the twelfth century.[5]  Rather than providing open credit to a customer, a seller can use financial intermediaries to establish a reliable means of payment.

For example, assume BuyMart Corporation in Arkansas wants to import toys manufactured by ToyCo, in Hong Kong, into the United States, but is concerned about the mechanics of paying ToyCo and the quality of the anticipated shipment.  ToyCo is similarly concerned about receiving proper payment from Buy-Mart.  They could enter into a simple contract for the toy shipment, but if either party wants to make a claim for a breach then it may be forced to litigate in a foreign court.  BuyMart might need to seek a remedy overseas in Hong Kong and ToyCo may need to litigate in Arkansas.  Seeking judicial remedies such as injunctions and damages, along with the expense of transporting witnesses and securing local counsel could be complicated and costly.  A letter of credit is designed to address concerns each party may have about its counterparty’s possible default on the transaction, possible insolvency, unanticipated foreign exchange rate changes and other transactional risks.         

The mechanics are relatively straightforward.  A customer, also called the “applicant,” seeks a letter of credit from an issuing bank, called the “issuer.”  The application is typically made to pay a third party called a “beneficiary.”[6] 

In our example, assume BuyMart contacts First Bank to obtain a letter of credit to pay for its toy shipment from ToyCo.  BuyMart is the applicant, First Bank is the issuer and ToyCo is the beneficiary.  The parties agree to designate TransPacific Shipping Company to inspect the toys upon their arrival in Arkansas to ensure that  the toys meet the requisite standard of quality.  A bill of lading which passes title of the goods from ToyCo to BuyMart is another document used in the transaction.  Finally, a draft (or check) from First Bank, who is crediting the purchase on behalf of BuyMart, also constitutes a necessary document for the transaction. 

ToyCo will then make a demand for payment on the letter of credit.  Presentation of the correct documents is all that is required in order for ToyCo to be paid.  Since ToyCo may not want to depend on First Bank in Arkansas, it may use its own bank in Hong Kong and so may enlist Victoria Bank in Hong Kong.  Victoria Bank is the therefore the beneficiary’s bank, and in this role, Victoria merely obtains and transfers First Bank’s draft to ToyCo.

Commercial Letters of Credit and Standby Letters of Credit

There are two essential types of letters of credit.[7]  The commercial letter is used to facilitate transactions, such as the Buy-Mart-ToyCo transaction.  Upon entering into a contract with a seller for the purchase of goods, the applicant may apply for the letter of credit from an issuing bank that then transfers the letter to the beneficiary’s bank.  The beneficiary bank will then inform the seller of the letter’s issuer, who is the beneficiary, and it will, in turn, ship the goods to the buyer. 

Following shipment of the goods, the seller will forward documents to its bank showing that it has shipped the goods.  Recall that the seller is the beneficiary and the bank is the beneficiary’s bank.  The beneficiary’ bank will then forward the shipping documents to the issuing bank, which will forward payment to the beneficiary’s bank.  The purchaser will then reimburse the issuing bank (the applicant’s bank).[8]

For example, ToyCo ships the toys from Hong Kong to Arkansas and obtains documentary evidence of having shipped the goods.  It then presents its shipping documents to Victoria Bank which then pays ToyCo.  Victoria Bank then forwards the shipping documents to First Bank in Arkansas and First Bank pays Victoria Bank for the shipped toys.  First Bank then obtains reimbursement for the amount it paid to Victoria Bank from the original applicant of the letter of credit, Buy-Mart in Arkansas.  Note that each bank collects a fee for the services it renders, which is typically a small percentage of the price of the goods shipped.

The other type of letter of credit is the standby letter.[9]  The standby letter is often used as a safety net when one party fails to honor its obligations.  They are used in construction projects and investment deals, among other environments. 

For example, assume Shady Acres Development hires BuildCo to construct a large commercial building.  BuildCo applies to First Bank to issue a letter of credit on behalf of Shady Acres, which is the beneficiary.  In this situation, First Bank will pay Shady Acres upon presentation of two documents.  The first is a written demand to be paid the stipulated amount and the second is written statement certifying BuildCo’s failure to perform the construction work as agreed.  

There are other variations of this arrangement which include naming  the builder as the beneficiary, who will draw on the letter of credit to be properly paid upon successful completion of the construction or some incremental part of the construction.[10] Another alternative approach makes a surety, which is an entity that contractually guarantees a loan, the letter of credit beneficiary.  The surety agrees to the contractual obligation to guarantee payment or performance in exchange for the letter of credit.  Surety arrangements are governed by contract law, as opposed to letters of credit, which are governed more mechanically by the UCC.[11]     

The standby letter of credit serves as a loan from the issuer to the customer and a guarantee that the issuer confers on the beneficiary.  Note that unlike a credit guarantee, where defenses available to the principal are available to the guarantor, in a standby letter of credit, the issuer cannot raise the defenses of its customer in order to avoid payment.  The issuer’s obligation to pay a letter of credit is independent of the underlying contract between the applicant and the beneficiary.  This is called the “independence principle,”[12] and it is a key feature that distinguishes between a contractual guarantee and a letter of credit.  The letter of credit and the underlying contract are independent of one another.

Consequently, if prior to the presentment the customer declares bankruptcy or repudiates the agreement, the issuer must pay the beneficiary even though the customer will not be reimbursing the issuer.[13]  The beneficiary is thus shielded from the dishonesty-risk and the honest-dispute risk.[14]

Governing Law

Letters of credit are governed by Article 5 of the Uniform Commercial Code.[15]  Under the Code, an arrangement that meets the Code’s definition of letter of credit may be treated as such even if it doesn’t call itself a letter of credit. While letters of credit typically feature standard clauses, the Code encourages the parties to innovate when using them, and many of the Code’s provisions state “unless otherwise agreed.”  The Code also provides that many of its provisions with respect to letters of credit are guidelines that can benefit from industry standards in their interpretation.[16] 

One such source to aid in judicial interpretation of disputes involving letters of credit is the Uniform Customs and Practices,[17] which typically is  referred to simply as the UCP.  The International Chamber of Commerce adopted the UCP and while, unlike the Uniform Commercial Code, it is not enacted as law, it nevertheless serves as evidence of trade usage and custom in the financial industry that the courts follow. The courts also refer to the international trade terms, which are called “Incoterms” and are sometimes incorporated in letters of credit provisions.[18]

When interpreting the letter of credit, a court may examine its terms and extrinsic evidence, including trade usage and custom.[19]  As in contracts, a court may construe any ambiguous terms in a letter of credit that are disputed by the parties against the issuer.  This interpretative principle is based on the rationale that the issuer drafted the letter of credit and is in the best position to avoid ambiguity. 

For example, in one case,[20] a standby letter of credit stated the maximum drawing amount under the letter as credit “that shall be automatically reinstated from time to time for any sum or sums up to $145,000 upon presentation of described documents.”  This could mean sums up to $145,000 in total or sums up to $145,000 per presentation by the beneficiary (which is what the beneficiary wanted).  In that case the court used extrinsic evidence and construed the provision against the drafter, who was the beneficiary.  Thus, the beneficiary was limited to $145,000 in total draws.

Also, the beneficiary is subject to strict compliance of the letter’s terms and given that burden, the beneficiary should be given the best opportunity possible to comply with the terms of the letter.  This is called the strict compliance standard.[21]  Generally, the courts favor interpretative results that favor enforcement of a letter of credit over unenforcement.[22] 

Letter of Credit Provisions and Mechanics

A letter of credit can be modified or cancelled by the parties who must produce a record of the modification or cancellation with requisite signatures.[23]  Modifications and cancellations are binding on customers, issuers and beneficiaries only to the extent that they agree to be bound.  If a customer and issuer cancel a letter of credit prior to presentation,the beneficiary is unaffected and its consent is not required.  If the issuer and its customer modify the letter of credit before presentation, but do not obtain the consent of the beneficiary, then the beneficiary is not bound by the modification and may conduct its presentment according to the original terms of the letter of credit.

The letter of credit terminates on its date of expiration or the draw of its maximum amount.  The documents must be assembled and transmitted in timely fashion, and the drafter of the letter should account for the time constraints in performing these documentary tasks.  Expiration dates and delays in document processing can hurt beneficiaries in court cases.[24] 

Upon presentation of the requisite documents by the beneficiary, the issuer must make payment.  This is called a “documentary letter of credit.”[25] The documentary presentation must comply with the terms of the letter of credit.  Slight deviations may relieve the issuer from paying.  Therefore, the issuer has an incentive to find anomalies in the documents submitted by the beneficiary. 

For example, in one case, “Imported Acrylic Yarn” was held not to be the equivalent of “100 percent Acrylic Yarn.”[26]  This rule forces the drafter to draft carefully and relaxes the need for the bank examiner to be an expert in the trade that is the subject of the transaction. Instead, the bank examiner may be able to rely on the plain meaning of the term, secure in the knowledge that it will be not be interpreted more broadly than its plain meaning.

Note that if an issuer accepts documents that are not in compliance with the letter of credit or knowingly accepts fraudulent documents, then it has committed wrongful honor and breached its obligation to its customer.  The Code requires an issuer to dishonor demands based on fraudulent documents.[27]  A customer might object when an issuer makes a payment when  it should have not done so, because the documents the beneficiary presented were nonconforming.  However, the courts have not historically accepted this customer’s argument because the customer’s rights and responsibilities are governed by its arrangement with the issuer.  The courts do not want to give incentives to customers to make unreasonable documentary demands to act as a pretext  to avoid future reimbursement to the issuer.   

Nondocumentary conditions[28] may or may not eliminate a document’s status as a letter of credit.  If the conditions merely stipulate the time and place required for the beneficiary’s presentation, the document can still be considered a letter of credit.  However, if the condition affects the undertaking in a fundamental way, such as requiring payment on a contractual default between the customer and the beneficiary, then the letter of credit status is lost. 

For example, a letter of credit that states that goods must arrive before Christmas would not eliminate the letter’s eligibility as a letter of credit and so the issuer would be required to ignore the condition and honor the presentation of the beneficiary irrespective of the Christmas delivery condition.   

Thank you for participating in LawShelf’s video-course on UCC Banking Law. We hope you have found this course useful and we encourage you to take advantage of other available LawShelf course. Best of luck and please let us know if you have any questions or feedback.