1.01  From very early times, mercantile custom and practice common to all legal systems evolved alternative methods of payment of the purchase price of goods in foreign sales transactions. In settling the provisions of a sales transaction contemplating, for example, large-scale, long-haul shipments, the seller can stipulate for an advance payment, due from the buyer upon closing the negotiations; or may content himself with selling the goods to the buyer on open account terms; or agree to employ a bill of exchange; or request the buyer to furnish a letter of credit to cover the price. Each of these options involves different levels of risks; whichever alternative the parties’ agreement eventually selects is often the result of their individual bargaining strengths, an expression of a willingness on the part of one person to run a certain risk in order to reap the benefit of a potentially lucrative deal, rather than allow the business to pass him by and not take a chance at all. What are the possible risks associated with opting to pay or to receive payment by a particular mode?

1.02  It is possible for a seller, in proposing a sale transaction, to demand an advance payment of the price, and promise to deliver the goods by a stated date. Other than the occasional cases where, for instance, the sum will facilitate the production or procurement of the intended goods, the buyer usually eschews a contract requiring payment upfront. In the first place, he often lacks the wherewithal to make the advance, and taking out a bank loan attracts prohibitively high interest rates, including complex conditionalities. Second, even if the money is readily obtainable and remitted, the remittance to the seller effectively renders the capital unavailable for a significant period. Third, the buyer constantly faces the prospect of the goods failing to materialize, and the amount he had paid irrecoverable: the seller’s insolvency or financial difficulties may supervene. Notably, though, in the few transactions in which the parties agree the proposed stipulation, prudent buyers are wont to safeguard their interests against the likelihood of such untoward events occurring by requesting the seller to furnish an advance payment bond or on-demand guarantee.

1.03  Under a foreign sale on open account, the buyer receives the merchandise at the destination named in the contract and effects payment immediately or at some future time. Ordinarily, however, sellers loathe such arrangements. Goods can take several months to reach the point (p. 6) of delivery, and as much length of time to clear customs. Those periods effectively shut the seller out of the capital invested in procuring the cargo from some third-party suppliers, diminishing the funds he needs to satisfy his commitments to them. A sale on credit also means that the seller relies on the creditworthiness and personal integrity of the buyer. By such reliance, he runs the risk of losing a huge investment of time, effort, and money in the event of the buyer’s insolvency. Where the market for the goods has fallen considerably, this stands to influence the buyer to demand a substantial cut in the initially agreed price. A refusal to oblige the buyer can translate to the seller having to scout around for a new customer in a possibly unfamiliar market, or force the seller to commence an action for damages for breach of contract against him. Regrettably, pursuing such a claim could become a protracted legal battle, spanning a couple of years in a number of countries. The experience would be financially devastating for the seller, not least because the damages which the court or arbitrator might ultimately award in his favour are, in the nature of things,¹ unlikely to adequately compensate him for the disruption caused to his business by the litigation. Quite understandably, therefore, significant volumes of international sales seldom occur on open account terms.

1.04  With an advance payment unforthcoming from the buyer, and transacting on open account basis being generally unacceptable to the seller, both parties will stipulate that the seller shall draw on a named noticeably solvent financial institution (traditionally the buyer’s bankers as opposed to the relatively unreliable credit reputation of its customer, the importer) a bill of exchange² for the agreed price of the goods. The stipulation normally obligates the buyer to secure the drawee’s acceptance of the bill against presentation to the drawee of the documents required in the sales contract.³ The documents commonly include a bill of lading⁴ representing the merchandise, invoice, insurance policy,⁵ and a certificate of quality⁶ or an inspection report.⁷ A bill of exchange of the kind indicated, on occasion referred to as a (p. 7) time or usance draft to distinguish it from a bill drawn payable at sight, is customarily made out payable to the seller’s order. Compared with sight drafts, a usance bill has long been the most frequently and widely employed means of payment in mainstream international sales arrangements. The explanation for its predominant use lies in its ability to enable buyers to purchase goods, and defer actual payment of the price until a stated period (in many cases 180 days after its date⁸ ) has elapsed, while simultaneously ensuring that the seller, upon dispatching the cargo to the contractual destination, gets paid his money when he pleases.

1.05  Following completion of shipment, the seller draws up the bill of exchange in accordance with the terms of the sales contract, attaches the proper documents, and then tenders the documents, normally to his bank in the locality, with a request for a discounted payment of the amount of the draft. In practice, the tenderee will expect the presentation where it had acted as the financier of the shipment covered by the documents.

1.06  Prior to financing the deal, or deciding to grant the seller’s request for a discounted payment, the bank will have meticulously evaluated certain business risk factors and considered the overall picture of the transaction positive. Among the factors are the current status of the seller’s bank account; the invoice value; the nature and destination of the goods involved; the international financial standing of the bank on whom the bill is to be drawn; the relative stability of the currency in which the bill of exchange is denominated; the political situation existing in the country to which the currency belongs, along with the likelihood that the government there might impose or increase restrictions on foreign exchange dealings; the relations between the country and the other members of the global community, including the UN; and the substantive character of the country’s law, as well as the quality of its administration of justice.

1.07  The tenderee bank effects the desired payment in one of two ways. It may send the documents through its correspondent or branch operating in the buyer’s location with instructions to present them to the drawee for acceptance, a process known as collection.⁹ The drawee accepts the draft at the instance of the buyer, returns it via the banking channels or directly by courier to the seller’s bank. By this acceptance, the drawee acceptor promises¹⁰ to pay the sum on the draft at the maturity date, namely, on the 180th day from the date of the instrument. The bank then credits the seller’s account with a discounted amount of the accepted bill, the sum credited depending on the applicable discount rates, which largely depend on the weight of the risks earlier adverted to and the length of time the acceptance will take to mature. At all events, the discounting creates an avenue for the seller to circumvent having to wait 180 days for the draft to reach maturity before encashing it, thereby assisting him with solving certain of his immediate cash flow needs.

1.08  The alternative course which the bank may adopt to meet the seller’s request is to pay the discounted sum at the time of the seller’s demand, have the seller endorse the bill of exchange and the attached bill of lading in its favour, and afterwards transmit the documents to the (p. 8) drawee for acceptance. The payment so made gives rise to certain legal consequences.¹¹ It suffices here to point out that the bank’s purchase (negotiation) of the presentation prima facie goes to constitute the bank, a holder of the draft for value and in due course, with a security interest in the goods represented by the accompanying bill of lading to the extent of the sum advanced by way of the discount. On the other hand, by reason of the purchase, the seller’s ownership of the merchandise passes to the buyer by virtue of the contract of sale.¹² Upon the drawee taking up the documents and sending back the accepted bill, it acquires a limited proprietary interest in the cargo, and that of the bank ceases.¹³

1.09  After the acceptance and the dispatch of the bill to the seller’s bank, the drawee delivers the shipping documents to its customer, the buyer, to take delivery of the goods at the port of discharge and, if appropriate, arrange resale to sub-buyers. For its services, the drawee charges an acceptance commission. As the maturity date of the bill is the 180th day from the date of the draft, the obligation of the buyer to put the drawee in funds to meet its liability arising out of the acceptance to the discounter or eventual bona fide holder of the draft for value, only matures or crystallizes on that 180th day; thenceforward the sum due, if unpaid, metamorphoses into a loan and would naturally be subject to the prevailing interest rates, both of which the drawee may recover through the comparatively easy self-help remedy of realizing the asset pledged as security for the obligation.¹⁴

1.10  A distinguishing characteristic of the sales transaction affords the buyer two successive rights against the seller, namely, the right to conforming documents and the right to the goods that form the subject matter of the sale agreement.¹⁵ However, payment or acceptance of a draft by the drawee on behalf of the buyer against an unimpeachable set of documents is to occur earlier in time than when the goods reach the port of discharge. But the payment does not preclude his right to reject or to claim damages in respect of the goods if, upon discharge and reasonable inspection, he discovers that they do not correspond with the specifications in the contract as to description, quality, or quantity.¹⁶ On the other hand, rejection of the documents constitutes a repudiatory breach of the contract, entitling the seller to consider himself relieved of any further obligation owed to the buyer and to recover the loss he sustained because of the rejection. Prosecuting a lawsuit to vindicate that entitlement carries with it serious financial hardship for the seller.

1.11  Bills of exchange as a mode of payment tend to work to the seller’s disadvantage. When the documents from the seller’s bank come forward for acceptance (or payment in the case of a sight draft), the drawee does not normally accept the bill until it has given the buyer a chance to examine them and confirm they are in every respect what the sales contract entitles him to. It often happens that an intervening change in economic conditions renders the contract an entirely unprofitable business for the buyer. Almost entirely on this basis, he no longer wants the goods he engaged to buy, so that well ahead of the documents’ arrival he will have made up his mind to get rid of the bargain. An invitation to call at the drawee’s premises to check the regularity of the tender would therefore merely provide him with an opportunity to assert a deficiency in comparatively faultless and adequate documents, and press the bank to decline acceptance of the presented draft. Perhaps anxious to avert a threatened or potential lawsuit and foster a mutually beneficial future relationship with the customer-buyer, some drawees would yield to the pressure exerted on them and accordingly refuse to accept the tendered draft. In the absence of exceptional circumstances,¹⁷ the drawee will not be liable to the seller qua drawer, nor to his bank qua endorsee of the instrument for withholding its acceptance.¹⁸ Instead, the dishonour by non-acceptance triggers the seller’s liability¹⁹ to his bank, the endorsee holder of the unaccepted draft and documents, in that the seller, being drawer of the bill, engages that on due presentation to the drawee, it shall be accepted and paid according to its tenor, and that if it be dishonoured, he will compensate the holder of the bill.²⁰

1.12  Even if the acceptance had been given and subsequently discounted, the drawee acceptor may decline to honour the bill at the maturity date, claiming certain defences, some urged on it by the buyer, others of its own initiative. Very often, the grounds for complaint are wholly centred on the quality of the goods and doomed to defeat as a matter of negotiable instrument law. In the first place, the dishonour by non-payment ex hypothesi runs afoul of section 54 (1) of the Bills of Exchange Act 1882 or, in the US, UCC Article 3–413. Second, an acceptance creates a separate contract from the sales agreement between the merchants; the contract admits of limited defences such as fraud on the part of the seller seeking to enforce it, and no defence at all to a bona fide holder of the draft for value.²¹ Nevertheless, when the drawee dishonours the bill by non-payment, an immediate right of recourse against the seller as the drawer accrues to his bank, the holder. Under the statute, therefore, the bank can recover the payable amount on the accepted but dishonoured draft plus interest from the drawee in an action or by way of set-off of the sum against the funds that it holds in an account of the dishonouring acceptor. In the ordinary case, however, set-off is inapplicable (p. 10) because no such funds are at hand; and it would, as a matter of prudence, choose to save itself the trouble of litigating the dishonour by simply debiting the seller’s account with the discounted sum paid previously,²² leaving the seller to sue the drawee on the acceptance or the buyer under the sale contract.

1.13  A sales contract, which stipulates for payment by means of a sight or usance draft, involves the contracting parties’ agreement that the drawee will accept the seller’s bill drawn in accordance with the provisions of the contract against complying delivery of the specified documents. The working out of the agreement usually exposes the seller and the potential discounter of his draft to major risks. There is no cast-iron guarantee that the drawee will perform the expected act upon receipt of the documents; a refusal to carry out the task ordinarily founds no cause of action at the suit of the presenting party. Nevertheless, the non-acceptance practically leaves the drawee on a par with the seller whose hopes are disappointed in a sale on open account transaction: it might eventually compel him to sue the buyer for the price in respect of goods discharged long ago and accumulating substantial warehouse charges. In the case where the drawee accepts a presentation, but subsequently dishonours the acceptance, the discounting bank normally exercises its right of recourse against the seller. In that event, the seller suffers the misfortune of proceeding against the drawee acceptor, typically abroad, to seek enforcement of the acceptance. Overall, then, the seller constantly runs two types of risk under a sale transaction which entails the use of a bill as the contractual method of payment: he faces the likelihood of the drawee refusing an otherwise apparently regular tender of documents without incurring liability for the refusal. The drawee’s failure to honour an accepted draft at maturity obligates him to repay the advance he received from the discounting banker; moreover, the repayment may well plunge him into liquidation or bring his business to the brink of collapse.

1.14  Since the mid-nineteenth century, or thereabouts, down to the present day, only one instrument has emerged to make it possible for the seller to contract in terms that tap the bill of exchange method of payment and nevertheless free him from becoming entangled in the risks attendant on the use of the bill. The mechanism is widely known in the mercantile and international banking world as a letter of credit. It extracts the drawee’s engagement to take up the conforming documents and, on the other hand, often eliminates the possibility of the seller being required, after obtaining payment, to refund money already ploughed back into his business. In defined contexts,²³ the obligation also runs to the seller’s banker or some other discount house: by its nature, in such an event, it authorizes either party to purchase (i.e. negotiate) the seller’s draft with the accompanying documents covering the merchandise involved in the sale contract; upon effecting the envisaged negotiation, the purchasing party becomes possessed of the right²⁴ to demand the drawee’s acceptance of the draft to recoup its cash advances to the seller. As will appear in the next section, a letter of credit provides (p. 11) a range of additional benefits for the parties and can assume different forms. But whatever its shape in any particular transaction, current banking practice and usages understand a letter of credit²⁵ to mean an irrevocable promise by a bank (‘the issuing bank’ or ‘issuer’²⁶) at the request of a party (‘the applicant’²⁷) in favour of another party (‘the beneficiary’²⁸) to honour²⁹ a presentation of documents which complies with the terms of the promise. The fact of issuance of the undertaking together with its requirements is usually notified to the beneficiary in the form of a letter, hence the expression ‘letter of credit’. Considering the condition for acceptance of documents, whether the seller gets paid or not, principally lies within his power—an ability which the bill of exchange lacks the means to confer on him. If his presentation adheres to the stipulations of the credit, ‘nothing will’ ordinarily prevent him from receiving the amount of the instrument, the price of the goods articulated in the sales contract.³⁰ If not, the bank is entitled to reject the tender unless it omits to follow a stipulated contractual course in communicating the rejection.³¹ What the beneficiary’s or other presenting party’s right to payment and the presentee bank’s right of rejection covers, runs through subsequent chapters of this book.

1.15  Unlike the bill of exchange, which the law of negotiable instruments controls, the letter of credit enjoys the protection of that law, and has an entire article devoted to it in the American Uniform Commercial Code (Revised Article 5–Letters of Credit).³² Furthermore, it forms the subject of constant regulation of the Uniform Customs and Practice for Documentary Credits (the UCP) to ensure its provisions keep abreast of the latest developments in associated business transactions. The device also occupies the careful attention of International Standby Practices (ISP98) and a United Nations convention.³³

1.16  Drafted by the American Institute of International Banking Law & Practice Inc (IIBP), adopted and published in 1998 by the International Chamber of Commerce as ICC Publication No. 590 with 1 January 1999 as the effective date, the International Standby Practice (ISP98) codifies certain banking practices relating to standby letters of credit thought to be generally accepted. Unlike the UCP, ISP98 has yet to gain popularity among non-American banks. Standby credits issued outside the US occasionally express themselves subject to it. This is, however, hardly surprising. Its development and eventual adoption faced fierce opposition from the vast majority of the national committees and direct members of the ICC’s Commission on Banking Technique and Practice. The principal grouse was that (p. 12) standby credit, whatever its peculiarities might be, did not require a fresh, separate regime. The dissentient considered the UCP adequate for the instrument.³⁴

1.17  This code is a product of the International Chamber of Commerce (ICC).³⁵ ICC’s membership includes banks and trading companies in over 120 countries and territories; but periodic revision of the UCP falls to the organization’s Banking Commission.³⁶ The code is easily the most effective in the annals of privatively drafted international rules for trade, presumably because its formulation usually undergoes extensive consultation with the ICC’s national committees and member companies. The UCP comprises a unique set of precepts and requirements aiming to harmonize, clarify, and standardize the almost endless variety of municipal banking and related commercial practices touching on letter of credit operations around the world. Originally launched in 1933,³⁷ following the conclusion earlier in that year of the Seventh Congress of the ICC in Vienna, Austria, the code has thus far seen six revisions.³⁸ The prevailing edition is the Uniform Customs and Practice for Documentary Credits, ICC Publication No. 600 (often referred to as ‘the UCP 600’).

1.18  At present, banks customarily incorporate by express reference the UCP 600 into their letters of credit and the applicant’s application for the issuance of the credit in virtually every part of the world. We shall have occasion in Chapter 2 to look in depth at the legal nature and effect of such incorporation on certain disclaimer clauses. In the meantime, it is worthwhile to note (p. 13) that arbitrators, judges, as well as legislature are generally sensitive to the aims and objectives of the UCP; they largely treat its clauses as articulating universally accepted international banking practice. In the United States, the UCP applies under the Uniform Commercial Code Revised Article 5 as ‘rules of custom or practice’³⁹ to letters of credit issued, advised, or confirmed in the US, or issued in a foreign country but determined by the rules of private international law of that country to be subject to the laws of an American state. In case of a conflict between a provision of the UCP and that of the Revised Article, the former takes precedence.⁴⁰ Revised Article 5, developed and promulgated in 1995 by the Uniform Law Commission (ULC)⁴¹ and the American Law (ALI), has now finally gained statutory footing in each of the fifty states of the US and in the District of Columbia, the last adoption having been made in the state of Wisconsin on 27 March 2006. We turn now to the general legal status of the UCP in credits.

1.19  The designation ‘uniform customs and practice’ used in the title Uniform Customs and Practice for Documentary Credits offers a suitable starting point for consideration of the general status of the UCP in a credit expressly incorporating it. The appellation seems to fit in with what Professor Thouless⁴² humorously classifies as the trick of claiming prestige by parading false credentials. Sir Christopher Staughton once observed that the UCP label is very much like Voltaire’s book entitled Holy Roman Empire: they ‘do not precisely match their name’.⁴³ Thus far, no one has disproved the judge’s view; we agree with him. The UCP does not represent a statement of ‘customary banking practices’. Some of its provisions occasionally conflict with commercial common sense, banking practice and decisional law on letters of credit in a number of countries. By way of illustration, Article 10 (a), UCP 600⁴⁴ appears to contemplate that a letter of credit may only be amended or cancelled with the agreement of the issuing bank, the confirming bank (if any), and the beneficiary. The code fails to include the applicant who induced the issuance of the credit, and with whose consent the issuing bank must amend the credit or risk a lawsuit disputing the authorization to effect the amendment.

1.20  Regarding decisional law, it has long been settled in American,⁴⁵ English,⁴⁶ Singapore,⁴⁷ and Hong Kong⁴⁸ courts that non-requirements in credits are effective and binding on the parties (p. 14) to a credit. However, Article 14 (h), UCP 600 deems such requirements as ‘not stated’ in the credit and purports to instruct the examining bank to ‘disregard’ them in deciding whether a presentation answers to the terms of the credit. But at present, an examining bank which adheres to the sub-article and honours a tender of documents that omits to comply with a non-documentary stipulation, stands to lose its claim for reimbursement in the courts of the indicated jurisdictions. We shall discuss the position further in a later chapter.⁴⁹ It need only be added, however, that, beginning with the promulgation of the maiden edition of the UCP, the stated goal of the code has been to offer, on letters of credit, practical rules capable of application worldwide. A provision such as sub-article 14 (h) hampers rather than enhances the accomplishment of the declared objectives. Universal acceptance of the rules would benefit greatly if the ICC’s Banking Commission would give due consideration to the relevant aspects of judicial pronouncements under national laws in updating the code.

1.22  The judge must be correct. The common law approach to construction of clauses incorporated by reference into a contractual document requires that so much of the incorporated terms as is not inconsistent with the substance of the incorporating document has to be enforced.⁵² Put another way, the whole terms of the incorporated clauses should be read into the document to the extent of their consistency with the substance of the contract gathered from its express terms. In this connection, Buckley L.J. in Modern Building Wales Ltd v Limmer & Trinidad Ltd⁵³ observes: ‘Where parties by an agreement import the terms of some other document as part of their agreement, those terms must be imported in their entirety ... but subject to this: that if any of the imported terms in any way [irreconcilably] conflict with the expressly agreed terms, the latter must prevail over what would otherwise be imported’. The reason underlying Buckley L.J.’s pronouncement is that the parties specifically negotiated the express terms, whereas one of the parties or both might be seeing the imported provisions of the standard form for the first time when matters get to a critical stage, a crisis point necessitating preparation for litigation.

(p. 15) 1.23  UCP clauses are thus subordinate to the express terms of a credit incorporating the code. Overall, however, in deciding the contractual rights and obligations of the parties in respect of a particular issue in dispute, the concern of the court would be to read both the provisions of the UCP and the express terms together to ascertain the reasonable common intention of the parties and uphold it.⁵⁴ If the judge finds some irreconcilable conflict between a provision in the code and a stipulation in the credit, the objectively discovered intention of the parties governs. Where the reciprocal rights and engagements as found are to the effect that a part or the whole of the incorporated provision ought not to be applied, the court will leave it out of account, even though the credit omits to expressly exclude the otherwise imported clause. It would be irrelevant that the provision in question is established to be a manifestation of the best thinking of bankers, for it is the objectively ascertained contractual intention of the parties, not the thinking of bankers, that carries preponderant significance on matters arising out of the credit.

1.24  Letters of credit abound with terminology, but it would be impossible or unnecessary to deal with all the key phrases at this point. Many will be explained when first mentioned in the analyses undertaken in subsequent chapters. An early appreciation of some of them may, however, assist the reader in coming to grips with particular facets of the discussions. A précis of the irrevocability of the promise embodied in the credit furnishes a suitable entrance to the subject in hand.

1.25  Until recently, a credit could have been revocable, in which case it merely authorized the seller to draw bills of exchange for the purchase price in compliance with the terms of the promise. The issuing bank could withdraw or modify the authority at any time without notice, even after a draft and the requisite documents were tendered to it for acceptance. A credit of that sort provided very little security of payment to the seller and, quite understandably, appears to have been last seen in practice just after the conclusion of the First World War.⁵⁵ Under modern banking practice, as reflected in the UCP 600,⁵⁶ a credit upon issuance⁵⁷ establishes an irrevocable undertaking of the issuing bank (where the credit is unconfirmed) and of both the issuer and the confirming bank (if the credit has been confirmed) to honour a set of conforming documents.

1.26  Under an unconfirmed credit, the issuer whose sole promise comprises the credit usually operates as the buyer’s bank and is based in the same jurisdiction as him, whereas the (p. 16) beneficiary of the instrument resides abroad. But in respect of a confirmed credit, the confirming bank and the beneficiary almost invariably share a common national government and are both susceptible to identical economic policies, including foreign exchange regulations. A confirmer’s confirmation of a credit traditionally attracts a commission⁵⁸ in proportion to the amount of the credit and, perhaps more importantly, to the outcome of the confirmer’s risk assessment of the transaction in question. In the majority of cases, a particular clause in the credit will require the confirming party to charge the confirmation service to the beneficiary. In the absence of such a provision, the issuer bears the cost of the confirmation and in turn passes it to its customer, the applicant, as stipulated in the credit opening agreement. Owing to the expenses indicated, confirmed credit is employed less frequently than unconfirmed credit. A potential beneficiary would, however, be well-advised to bargain for the procuring of the former if the result of a far-sighted assessment of the relevant risks (noted previously⁵⁹) substantially shrinks his business confidence in the prospective transaction.

1.27  The confirming bank’s undertaking being additional to the engagement of the issuing bank means that any serious financial difficulty undermining the solvency of either bank before the expiry date of the credit will not impinge on the availability of the facility to the beneficiary. The banks can, of course, simultaneously go under during the period, considering the contemporary global meltdown in the banking community; nevertheless, it is a highly unlikely contingency. A confirmed credit thus offers greater security of payment. It performs the function mainly by localizing the liability for the payment in the beneficiary’s place of business,⁶⁰ beyond the reach of the issuer’s country’s law, including a court order made thereunder purporting to prohibit honour of the credit or to attach the proceeds of the instrument.⁶¹

1.28  As the expression sometimes goes in the nomenclature of an intermediary bank, an issuer designates to receive and forward the beneficiary’s documents to the issuing bank, who then examines the set; and if acceptable, honours it. In its role, the intermediary bank merely serves as the issuer’s vehicle for ensuring the safety of the transmission, a function which might as well be assigned to any established courier operator at the beneficiary’s location.

1.29  More often, a ‘nominated bank’ signifies a bank authorized, but unobligated under the terms of a credit, or considered authorized because of the issuer’s conduct,⁶² to honour the beneficiary’s complying tender of documents. Performance of its mandate entitles it to claim reimbursement from the nominating party (the issuer in respect of an unconfirmed credit, and the confirmer in the (p. 17) case of a confirmed one) or through another party⁶³ identified in the credit at the maturity date of the credit.⁶⁴

1.30  Notably under Article 2 of the UCP 600, ‘a nominated bank means the bank with which the credit is available’. This wording seems to convey the impression that the issuer at whose counters a credit is available also constitutes a nominated bank. It may be observed, however, that an issuer could not be so treated, for the notion of nomination imports the entrusting of a specified task by one party to another. Section 5–102 (11) of the UCC Revised Article 5, in contrast to Article 2, defines the term as ‘a person⁶⁵ whom the issuer ... authorises to pay, accept or negotiate [a presentation] under a letter of credit’. The definition appears satisfactory, but it deserves pointing out that where a bank confirms the credit,⁶⁶ the confirmer and issuer are jointly and severally the giver of the authority, while the confirmer would be an obligated nominated bank.

1.31  Finally, a nominated bank may denote a bank that has an obligation to honour a complying presentation under an unconfirmed credit. The obligation arises when a credit (or the issuer by conduct) invites the nominated bank to discharge the issuer’s undertaking pursuant to the credit and the bank expressly agrees to the invitation and communicates the agreement to the beneficiary.⁶⁷ Parties frequently use a credit of the stated variety when they do not wish to have the bank’s confirmation of the facility.

1.32  While the central promise of the issuing bank under a letter of credit is to ‘honour a complying presentation’,⁶⁸ the means of honouring the obligation depends on the ‘mode of availability’ of the credit. With effect from the 1983 edition of the UCP,⁶⁹ a credit can only be issued available (realizable) to the beneficiary in one of four ways: (i) by sight payment; (ii) by deferred payment; (iii) by acceptance of a bill of exchange drawn in accordance with the stipulated terms; and (iv) by negotiation.⁷⁰ The credits are respectively known as sight credit, deferred payment credit, acceptance credit, and negotiation credit. According to Article 2 of the UCP 600,⁷¹ under each of the first three credits, ‘honour’ correspondingly means that the issuer, upon determining that the documents are conforming, a) pays cash forthwith; b) incurs a deferred payment undertaking and pays at the maturity date; c) accepts a draft drawn by the beneficiary and pays it at maturity. Although the clause says nothing about the mode by which an issuer honours its payment undertaking to the beneficiary in a negotiation credit, the issuer performs the promise by taking up the complying presentation without recourse to the beneficiary-drawer at a discount tied to the ruling discount rate.⁷²

1.33  Crucially, a properly drafted credit conventionally expresses the mode of its availability to the beneficiary in a clause articulating the issuer’s (and confirmer’s) undertaking to honour a complying delivery of documents. To a degree, the stipulation provides valuable clues about the legal effect a credit should receive. In the ensuing subsections, we explain the various forms in which credits are made available and highlight the major differences between them. Any letter of credit issued today is available (realizable) by:

• –  Sight payment;

• –  Deferred payment;

• –  Acceptance of a bill of exchange drawn in a prescribed manner; or by

• –  Negotiation

1.34  Of the four modes of availability, credit by sight payment is the least utilized in financing major international sales transactions. The principal reason is that its use allows the applicant no interval of time before becoming obligated to put his banker, the credit issuer, in funds to meet the payment effected on the credit, an obligation which most applicants assume because they want credit. Importantly, however, standby credits issued to secure due performance of a contractual arrangement, such as a construction project or the repayment of a loan, are usually payable upon the issuer’s sight of the stipulated document. Standby credits are discussed in some detail later in this chapter.

1.35  A credit of this type represents an undertaking to effect payment (normally cash) at a stated future date following receipt of a complying presentation. The pertinent clauses routinely read: ‘This documentary credit is available with ... in ... by deferred payment at ... days⁷³ from Bills of Lading date against presentation of the following documents ... We hereby agree that documents presented under and in compliance with the terms and conditions of the Credit will be duly accepted and payment made at maturity’.⁷⁴ Deferred payment credit developed in the late seventies and began to feature in the Uniform Customs since the UCP 400; parties employ it mainly in order to obviate the use of bills of exchange and payment of the associated stamp duty, a notoriously high tax levied on such drafts in many countries around the world. The credit is usually available to the beneficiary at a nominated bank’s counters. After receipt of the stipulated documents, the bank informs the beneficiary in writing that it will pay the amount of the credit on the day the credit matures. Banks consider such written communication to make a payment in the future an unconditional promise, capable of being discounted by the beneficiary to the promisor bank, or other finance house in the banking or forfait market.

1.36  English⁷⁵ and French⁷⁶ courts interpreted the old UCP regime⁷⁷ as meaning that the nominated bank would not be breaching its nomination by prepaying (discounting) its payment (p. 19) obligation to the beneficiary. According to the interpretation, however, if a fraud came to light subsequent to the prepayment, the issuer had no obligation under the credit to reimburse the bank. The ruling rested on the supposed theory that the discounted payment only constituted the nominated bank an assignee of the beneficiary’s rights, thus rendering the bank subject to the equities existing in favour of the issuer against the beneficiary.

1.37  Importantly, by current banking practice set forth under Article 12 (a)⁷⁸ of the UCP 600, a bank nominated to incur a deferred payment undertaking is deemed to have the authority of the issuing bank to discount its obligation incurred against a complying presentation; but the reimbursement of the amount is not due until maturity.⁷⁹ This position, which presumably applies solely to a deferred payment credit that incorporates the UCP 600, offers a much narrower scope than section 5–109 (a) (1) of the UCC Revised Article 5, in that the subsection empowers any bona fide discounter of a deferred payment, such as a forfaiter, to obtain reimbursement from the issuer, regardless of the discovery of the beneficiary’s fraud before the maturity date. Ultimately, as will be seen later⁸⁰ in this book, the risk of fraud on the part of the beneficiary now lies effectively with the applicant buyer, since the issuing bank normally has the right to be recouped the sum paid to the discounting party.

1.38  Acceptance credit is an issuer’s engagement⁸¹ (and a confirmer’s undertaking, if it had added its confirmation to the instrument) to accept a bill of exchange drawn in accordance with the terms of the credit if accompanied by the stipulated documents, and to pay the bill at maturity. In some cases the credit may require the beneficiary to draw his drafts on a nominated bank⁸² (or on the buyer-applicant) instead of the issuer. When properly drawn bills are presented with the stipulated documents and the drawee accepts them, its liability on the bill will be engaged as would any acceptor’s under negotiable instruments law; but if dishonoured by non-acceptance, the beneficiary’s right to do battle with the dishonouring drawee will substantially depend on the terms of the latter’s nomination.

1.39  A nominated acceptor of drafts under a credit can discount the accepted bills to the beneficiary, but the discounting must occur in good faith for its right to reimbursement at the maturity date of the credit to be valid. If the acceptor discounts its own acceptance, and holds the bills at maturity, the instruments are deemed discharged.⁸³

1.40  Negotiation credit is usually easily distinguishable from acceptance or deferred payment credit by its engagement clause under which the issuer ‘engages with drawers and bona fide (p. 20) holders that drafts drawn and negotiated in conformity with the terms of this credit will be duly honoured on presentation’.

1.41  There are two types of negotiation credit, namely, an ‘unrestricted negotiation credit’ and a ‘restricted negotiation credit’. In the former, negotiation of the credit is available with any bank; in the latter, it is available with the designated bank. ‘Negotiation’ means the purchase by the nominated bank of complying drafts and/or documents by advancing or agreeing to advance funds to the seller on or before the banking day on which the credit matures.⁸⁴

1.42  Negotiation credit holds a number of advantages for both the seller and potential negotiating bank. In the first place, it enhances the seller’s ability to discount his drafts and accompanying documents in his business locality. In particular, where negotiation is unrestricted, the seller can shop among banks for the most favourable discount and exchange rates. Second, an authorized negotiating bank that purchases (i.e. negotiates) the seller’s presentation in good faith, enjoys special rights and protection. The issuing bank must reimburse the negotiating bank the face amount of the credit, even though the documents that it had taken up turn out to be fraudulent or forged, or that the shipment they purport to represent is rubbish—in the case of acceptance credits, no such protection is available to a discounter of drafts that have yet to be accepted.

1.43  Third, in making a presentation to the issuing bank, a negotiating bank neither acts as an agent neither of the issuing bank nor of the seller; rather it acts in its own right and is entitled to enforce the credit in its own name. Fourth, a negotiating bank has a right of recourse against the seller if for some reason the drafts as well as the documents it purchased are dishonoured—unless, of course, the negotiation was without recourse (which rarely happens in practice), or the negotiating bank also confirmed the credit, in which case Article 8 (a) (ii) of the UCP 600⁸⁵ will apply, so the contingent liability of the seller as drawer to the negotiating/confirming bank would not arise.

1.44  To enjoy the foregoing advantages, however, the authorized purchasing bank must have actually negotiated in good faith, the seller’s drafts and other documents. If it merely examines them for compliance, and then forwards them to the issuing bank without having given value (i.e. by advancing or agreeing to advance funds), negotiation has not taken place, and the bank acts not as a negotiating bank, but as a collecting bank for the seller.⁸⁶ The question whether negotiation has indeed occurred is very often difficult to resolve; much depends on the facts and construction of the relevant credit terms in the individual cases.⁸⁷

1.45  What have thus far been elucidated are chiefly the various basic types of letters of credit as to the form in which a credit can be made available to the beneficiary. It is worth pointing out that the individual advantages of the various forms explored used to matter greatly prior to the implementation of the UCP 600. Before that time, crucial legal distinctions were assumed to exist—implicitly denied by the American UCC Revised Article 5-109 (a) (1)—between, on the one hand, deferred payment credit, and on the other hand acceptance and (p. 21) negotiation credits. It took the insertion of Article 12 in the UCP 600 to explode the myth that a nominated bank’s discounting of its deferred payment obligation was not entitled to the same protection as the law of negotiable instruments affords such bona fide discounter of an accepted draft or an apparently regular presentation under a negotiation credit. With the intervention of letter of credit law through the agency of the present UCP edition, all the nominated banks are now equally protected, though the sources of their respective legal safeguards differ quite remarkably.

1.46  Modes of availability of credits only answer whether the issuing bank or a nominated bank should honour a conforming presentation at sight, or by incurring a deferred payment obligation, or by accepting a properly drawn draft, or by negotiation. But there are credits, the distinguishing features of which are identified other than through the form in which the particular credit is available. They include clean credit, Red clause credit, Transferable and Non-transferable Credits, back-to-back credit, and standby credit.

1.47  A credit is regarded as a ‘clean letter of credit’ if the issuer’s undertaking is to honour the beneficiary’s drafts unaccompanied by any documents. This is in marked contrast to the traditional letter of credit under which the bank’s promise to make a payment or to honour drafts is conditional upon the presentation of specified documents. In practice, clean credits are not used in international trade, though they are frequently to be found in the standby letter of credit context.

1.48  Occasionally, on the applicant’s instructions, the issuing bank adds to a letter of credit a clause, often in red ink, authorizing the nominated bank to pay the beneficiary’s drafts against a written promise by the beneficiary to present the shipping and other specified documents when he obtains them. A credit containing a clause to that effect is known as a ‘red clause letter of credit’. Its basic function is to provide a cash advance to the beneficiary to enable him to tap into the interior markets of a particular country, purchase raw materials at the best possible price and of the best quality, and then freight them down to the importer account party. Upon shipment, the beneficiary will then be in a position to deliver the requisite documents to the nominated bank, who will in turn forward them—together with a request for reimbursement of the sum it had advanced and a commission—to the issuing bank and, by it, to the buyer.

1.49  In order to function effectively, a red clause credit requires the buyer to have absolute confidence in the beneficiary. The reason is that he runs considerable risks from the moment the credit is issued to the beneficiary: the advance made to the beneficiary is not against the furnishing of any security, but against a promise to deliver proper documents, with the result that if he fails to keep the promise, the issuing bank or credit applicant will be exposed to losing the funds. Moreover, an indebtedness of the beneficiary might supervene, with the likely consequence that the red clause advances will be utilized to satisfy the debt rather than be used to meet the buyer’s order. On the other hand, sensing imminent insolvency of the beneficiary, the nominated bank might itself induce the application of the advances to an existing call loan account maintained by the beneficiary. In such circumstances, the question may arise as to the reciprocal rights of the parties. The autonomy doctrine proclaims that the relationship between the issuing bank and the nominatee (p. 22) is separate from the transaction between the issuing bank and the (credit applicant) account party, and will apply to preclude the buyer from raising a claim against the nominated bank.⁸⁸ It has long been recognized, however, that there is no privity of contract between the credit applicant (usually the buyer) and the nominated bank; and a cause of action in tort at the suit of the former against the latter will, on the current state of the authorities,⁸⁹ not lie.

1.50  Under most letters of credit, the seller beneficiary is a middleman in a string of contracts. To perform his obligation under the sales contract and then realize the credit, he has to obtain the goods from his supplier. Funds may thus be required to meet his purchases. Rather than take a loan at a possibly astronomical interest rate, the seller may utilize his letter of credit to overcome his problem in one of three ways, namely, by assignment of the proceeds of the credit, or by transfer of the credit, or by using his letter of credit as security for the issuance of a separate credit in favour of the supplier.

1.51  Proceeds of the letter of credit may be assigned to the supplier to cover the purchase price of the goods,⁹⁰ provided the credit does not prohibit the assignment.⁹¹ But the supplier may be reluctant to accept the assignment because an assignee of a receivable takes subject to equities, i.e. all the defences and rights of set-off available to the debtor against the assignor.⁹² Moreover, in banking practice, an issuing or nominated bank need not recognize an assignment of proceeds of a letter of credit unless it consents to the assignment.⁹³

1.52  If an assignment is not acceptable to the supplier, there is yet another solution, but it will hinge on whether the letter of credit issued in the beneficiary’s favour is a transferable credit. Vitally, a letter of credit is either transferable or non-transferable. ‘A transferable credit’ means a letter of credit that specifically states it is transferable.⁹⁴ The implications of being so designated are that the beneficiary is entitled to request the nominated bank to transfer a portion or the whole of the credit to one or more of his suppliers or other parties.(p. 23)

1.53  By Article 38 (a), UCP 600, the nominated bank has no obligation to carry out transfer instructions except to the extent and in the manner to which it has consented. But, upon transfer, the terms and conditions of the transferred credit must be a mirror image of those of the original credit, including confirmation, if any, save that the amount, unit price of the goods, the expiry date, the period of presentation, the latest shipment date, and period of shipment set forth in the original credit may be curtailed. In addition, as long as the contrary is not expressly required in the prime credit, the transferred credit may require that documents stipulated in it be produced in the name of the first beneficiary.⁹⁵

1.54  Generally, to realize a transferred credit, the second beneficiary must tender the requisite documents to the transferring banker, which has to honour them promptly. The first beneficiary has the right to substitute his own invoice and drafts for those of the second beneficiary for an amount that does not exceed that stipulated in the original credit; upon the substitution, he is paid the difference between his own invoice and the invoice of the second beneficiary.⁹⁶ Thereafter, the transferring bank transmits the entire set of documents to the issuing bank to claim reimbursement and a commission.

1.55  It would be useful to put in a nutshell the major distinctions between a transferee and an assignee of a letter of credit.⁹⁷ A transferable credit can only be transferred once; a second beneficiary cannot transfer to a subsequent beneficiary. Transferability is exhausted upon a transfer by the first beneficiary to the second beneficiary. A purported transfer by a second beneficiary to another party may only create in that party, the rights of an assignee, whereas an assignee of the proceeds of a letter of credit may re-assign his interest to subsequent parties. Moreover, an assignee acquires only a right to receive the proceeds of a letter of credit, conditional on performance by the assignor of the terms and conditions of the credit; he has no right whatever to draw on the credit.⁹⁸ A transferee, as opposed to an assignee, is substituted for the original beneficiary to the extent of the portion of the credit transferred to him, which portion he may not draw down without complying with the requirements of the credit.

1.56  Where the letter of credit is non-transferable, in that it is not clearly designated as transferable, the beneficiary may nevertheless utilize the credit to overcome his cash flow difficulty by requesting both the account party and issuing bank—as well as the confirming bank, if any—to amend the credit by making it transferable.⁹⁹

1.57  On the other hand, the beneficiary may arrange for the nominated bank or a different bank to issue in favour of the supplier, a separate letter of credit secured by the beneficiary’s expectation of payment on the original credit.¹⁰⁰ The subsequent credit thus opened is commonly known as ‘a back-to-back letter of credit’ or less frequently, ‘a secondary credit’, or ‘a subsidiary credit’.¹⁰¹ The requirements of the original or prime credit are reflected in the secondary credit, so as to make certain that a complying presentation under the subsidiary credit will equally constitute a complying presentation under the prime credit, otherwise the security of the latter will be unavailable. Notably, however, the amount of the secondary credit will be smaller and the expiry date shorter than those of the original credit.

1.58  The distinguishing features of a back-to-back credit are to some extent slippery. Essentially, however, the issuance of a back-to-back letter of credit does not transfer the original credit.¹⁰² Although both the prime credit and the secondary credit involve the same merchandise sold, and that payment under the second is to be secured against funds received under the first, the two credits remain entirely distinct from each other; the acceptance of a presentation under the one does not necessarily trigger off the obligation to pay under the other. By the same token, payment under the secondary credit is not dependent on receipt of funds under the prime credit.¹⁰³ Moreover, the issuer of a secondary credit cannot set-off the funds received under the prime credit against what is due to the supplier under the secondary credit, although it is perfectly entitled to set-off the amount in respect of what is due and payable to the first beneficiary.¹⁰⁴

1.59  The mechanics of realizing the back-to-back credit strikingly resemble the position under a transferable credit. The supplier presents conforming documents and receives payment under the secondary credit. For the documents honoured under the secondary credit to make a complete set under the prime credit, the issuer of the subsidiary credit substitutes the invoice and drafts of the prime beneficiary for those of the supplier, pays him the difference between the amount due to him under the prime credit and the amount paid to the supplier under the secondary credit, and then passes on the documents to the bank with which the prime credit is available.

1.60  The standby letter of credit is an undertaking by a bank or other financial institution at the instance of a party (i.e. the account party) to pay a certain sum of money to the beneficiary should a specified event occur. The contemplated event is almost always a default by the applicant on its obligation to the beneficiary. Standby credit performs the function of the conventional performance bond or on-demand guarantee. The instrument differs from the traditional guarantee in that the issuing bank’s obligation to pay under the former is conditional upon the presentation by the beneficiary of proper documents asserting the applicant’s default, whereas under a guarantee, payment is conditional upon proof of the fact of default. In other words, a standby credit creates a primary liability to pay on presentation of the required documents, whilst a guarantee creates a secondary liability to pay only if the beneficiary establishes the fact of the applicant’s default.¹⁰⁵

1.61  The type of document usually called for under a standby credit varies markedly from credit to credit. The credit may stipulate for the presentation of a sight draft, or a draft accompanied by a certificate drawn up by the beneficiary himself, or by a third party attesting that the applicant has failed to perform a certain obligation envisaged in the credit, or the certificate of a court judgment, or an arbitration award evidencing the indebtedness of the applicant to the beneficiary. Whichever of such requirements is set and stated in the credit, insofar as the issuing bank, in order to make a payment, is not obliged to go beyond documents to determine whether the applicant has in fact failed to perform, or whether the contemplated event has indeed materialized, the instrument is a standby credit that falls squarely within the scope of a letter of credit as articulated by Article 2 of the UCP 600; and it would be immaterial that it is a clean standby credit in the sense that payment is to be made upon the mere presentation of a draft,¹⁰⁶ a single document.

1.62  Standby letters of credit originated in the late forties in the United States where most banks were legally forbidden to issue guarantees; it is used in greater classes of transactions, as opposed to the traditional letter of credit, employed mainly as a means of payment in sales of goods contracts. Likewise, standby credits continue to be resorted to extensively in Canada, Australia, and New Zealand. But in the UK, Singapore, and many other Commonwealth countries, the instrument is infrequently utilized; instead its functional equivalent—variously designated as the performance guarantee, performance bond, first demand guarantee, or bank guarantee—features prominently. The standby credit has one major advantage over its counterpart, although both are governed by the same general legal principles: the standby credit has developed into a financial support instrument used for a far wider range of purposes than (p. 26) the performance guarantee, including support for money obligations and the provision of credit enhancement for public bond issues. More importantly, the standby credit is covered by the more detailed and highly successful UCP regime, whereas the performance guarantee has no such a regime except the comparatively seldom used Uniform Rules for Demand Guarantees (URDG)¹⁰⁷ and the, as yet, untested UNCITRAL Convention on Independent Guarantees, completed in 1995, but thus far ratified by only eight small countries.¹⁰⁸

1.63  The standby credit is a necessary complement to the traditional letter of credit in facilitating the consummation of sales of goods transactions. As already indicated, the object of the classic letter of credit is to provide assurance of prompt payment to the seller upon presentation of the required documents. Although it also assures the buyer that when payment is made against the required documents, he will get the goods he bargained for, the reality is that the effectiveness of this assurance is severely limited. Forgery of shipping and insurance documents is a common occurrence in sales transactions. Bills of lading tendered for payment under many letter of credit transactions cover shipments on vessels that are nowhere near the purported port of shipment. Where the goods are indeed shipped, they may be defective or substantially fall short of the promised quantity, though represented in the documents to comply in every particular with the specifications of the sales contract. To some extent, the buyer can protect himself by requesting in the credit, the furnishing by the seller of certificates of quality and quantity issued at the point of shipment by a third party in whom the buyer has sufficient confidence. But such a stipulation might not achieve its intended purpose for at least two reasons. The certificate might be issued upon inspection of only a sample of the merchandise. In many cases, this would be practically inevitable. Besides, where the goods upon arrival are found to be off-grade, an injunction is normally unavailable to stop the bank from honouring its payment obligation, or the seller from receiving payment, under the letter of credit.¹⁰⁹

1.64  As the bank must thus be reimbursed the sum paid out, damages for breach of the sales contract become the only possible remedy, which the buyer might have to obtain by costly and protracted litigation in the seller’s country. If, in the meantime, the seller has become insolvent, the buyer’s position will be virtually hopeless. The standby credit is designed to safeguard the interests of the buyer in such a situation. This may be further illustrated briefly. In a typical sales transaction involving the shipment of say 100,000 tons of ceramic tiles of Chinese origin, the seller may request to be paid by means of a letter of credit. To secure performance of this contract, possibly by a certain date, the buyer may ask the seller to open in its favour, a standby letter of credit, under which a bank promises to pay a specified amount of money against a certificate by the buyer, attesting that the seller has, as of the stipulated date, failed to deliver the goods. The complementary roles played by the two instruments are interestingly plain. In contract, the seller is paid once he delivers the required documents to the bank. Should disputes arise over his performance of the sales contract, the burden of (p. 27) initiating litigation will fall on the buyer. In the meantime, the letter of credit proceeds will be in the pocket of the seller. On the other hand, the buyer has the assurance that the seller will be less likely to default on its promise. But, in the event of non-performance or improper performance, the buyer receives payment of the agreed sum upon the tender of the requisite certificate. If the seller contests the conformity of the certificate, he bears the burden of filing a lawsuit against the buyer. At any rate, while the dispute proceeds to trial, the buyer often occupies a better position, since he has the disputed funds to prosecute the litigation.

1.65  Under a sales contract, the seller and buyer run different types of risks, as do the banks who participate in financing the transaction. To a significant degree, these are natural perils of commercial life. The wisdom of knowing whom to trust and with whom to deal might afford some protection to a party anxious to narrow the chances of the risk happening; and a seller who bargains to be paid the purchase price by means of credit is practically taking one further step towards safeguarding his interest. How well such safeguards give shelter will be uncovered in later chapters. In the meantime, it is intended to examine in Chapter 2, the mechanism for setting up a credit and the position of the parties when a credit stipulated for in the sale contract, fails to open.