Letter of Credit

By Jay Winston, Winston and Winston P.C.

When a person first encounters the transaction of a letter of credit, or

arranges for the issuance of the letter of credit, or is the recipient of the letter
of credit, the transaction surrounding the letter of credit may seem somewhat
complex. We will attempt to furnish a basic explanation.

First, the letter of credit is a direct agreement between the issuing

bank and the beneficiary (selling party) of the credit. Basically, the
beneficiary of the credit is the party who is to receive payment and the
bank is the party who is to issue payment to the beneficiary (seller).

Second, a separate agreement lies between the account party (buyer)

and the issuing bank. The account party (purchasing party) is a debtor
and owes the bank money in the event that a letter of credit is
exercised. The account party has a separate agreement with the bank,
and under the terms of this agreement must pay the bank in advance
or reimburse the bank for any monies paid under the letter of credit,
i.e., for any monies that the bank pays to the beneficiary. This
agreement between the issuing bank and the account party is totally
separate and distinct from the actual letter of credit, which is a
separate agreement between the issuing bank and the beneficiary
(seller).

Distinct and apart from the above two contracts, a separate contract
exists between the beneficiary (seller) and the account party (buyer),
which is the contract for the sale of the goods and the terms and
conditions of payment for the goods by a letter of credit.

Therefore, three contracts exist:

(1) a contract between the issuing bank and the beneficiary (the selling party)
of the credit;

(2) a contract between the issuing bank and the account party (the purchasing
party) who is obligated to advance or to reimburse the bank for any monies
paid out by the bank; and

(3) the contract between the beneficiary (the selling party) and the account
party (the purchasing party) who arranges for the issuance of the letter of
credit.
One of the results of the above contractual relationships is that in a
bankruptcy proceeding of the account party, the selling party is still
entitled to enforce the letter of credit because the account party is not
involved in nor has any connection with the agreement between the
beneficiary and the issuing bank.

The concept that each contract is separate and distinct from the other
contract is most important to understand in the letter of credit
transaction. Each contract is independent and can be enforced by the
parties to the contract regardless of the other two contracts.

Where a seller delivers defective goods to a buyer, the buyer attempts

to persuade the bank not to pay the letter of credit. Because of the
separateness of the contracts, the bank is under a direct obligation to
fulfill the letter of credit if the seller presents the proper documents of
title to the bank. The failure of the bank to honor the said letter of
credit will expose the bank to a lawsuit directly by the seller. After the
bank pays the seller, the buyer may institute suit for a breach of
contract or a breach of warranty (or whatever other remedies are
available against the seller) for the seller’s failure to deliver the
merchandise as it was ordered.

On the other hand, situations arise where a bank may choose to

dishonor a letter of credit even on presentation of proper documents or
titles. If the buyer can produce a clear evidence of fraud in the
underlying contract that was entered into between the buyer and
seller, the bank may have a right to refuse to honor the letter of credit
in a fraudulent situation. The buyer must produce convincing evidence
that the entire transaction was a total fraud, e.g., the shipment
consists of empty cartons with no furniture in the cartons. What is
more likely to happen is that the buyer would retain counsel, make an
application to court, and have the court issue an injunction directing
the bank not to make payment under its obligation to the seller.

If the bank does honor the letter of credit and pays the seller, the
buyer may now sue the seller to recover all or part of the letter of
credit proceeds from the seller. The seller cannot avail itself of the
defense that a separate contract existed between the seller and the
bank to defend itself against the buyer’s suit, because the theory of
independence is not applicable once the payment by the bank has
been made. Whereas the separate contract guarantees that the money
will reach the seller upon presentation of the proper documents of title,
the independence theory does not affect the contract between the
seller and the buyer after payment has been made by the bank. A
buyer may sue the seller for a breach of contract.
In a situation where the bank honors its obligation to the seller, but the
buyer does not reimburse the bank, the bank may immediately
commence suit against the buyer for reimbursement. The bank also
may claim to be subjugated to the seller’s rights against the buyer.
Accordingly, the bank would have two claims against the buyer. The
first claim would be under its contract with the buyer to reimburse, and
the second claim would be under the seller’s contract with the buyer to
be paid for the goods.

Types of Letters of Credit—Commercial and

Standby
There are two types of letters of credit. The first is the commercial letter of
credit facilitating the sale of goods and protecting a third party against the
customer’s default in the underlying obligation. The buyer arranges for a bank
to issue a letter of credit for the benefit of the seller. The buyer is the
applicant, the seller is the beneficiary, and the bank is the issuer. The letter is
an undertaking by the bank to honor all drafts drawn by the seller for the
purchase price as long as the drafts are accompanied by the necessary
documents in the letter such as the invoice, a bill of lading, or an inspection
certificate. The risk of the buyer’s insolvency is shifted to the bank, as is the
risk of the buyer trying to renege on the agreement. The seller receives the
benefit of the bank’s undertaking upon the seller complying with the
documentary requirements.

The second type of letter of credit is the standby letter of credit. The
standby letter of credit guarantees that the bank will honor its
customer’s performance of obligations in a variety of situations. For
example, instead of a performance bond from a surety, an owner of
real estate may require the contractor to procure a letter of credit
obligating its bank to pay the owner upon presentment of a certificate
of default accompanied by a draft demanding payment. The letter of
credit was a standby letter of credit, which is common in the
construction industry.

A letter of credit may state that it is governed by the Uniform Customs

and Practices for Commercial Documentary Credit. Unfortunately, the
Uniform Customs and Practices for Documentary Credit has no
provisions that cover fraud. The Uniform Customs does not specifically
prohibit the defense of fraud in a transaction; but being silent on the
subject, the court may use the Uniform Commercial Code. The Uniform
Commercial Code allows the dishonor of a draft on a letter of credit
when fraud is in the transaction.
UCC Section 5-114 states:

(1) issuer must honor a draft or demand for payment that complies with the
terms of the relevant credit regardless of whether the goods or documents
conform to the underlying contract for sale or other contract between the
customer and the

beneficiary...

(2) unless otherwise agreed when documents appear on the face to comply
with the terms of credit but...there is fraud in the transaction:

Subdivision B...an issuer acting in good faith may honor the draft or demand for
payment despite notification from the customer of fraud, forgery, or other
defect not apparent on the face of the document, but a court of appropriate
jurisdiction may enjoin such honor.

A commercial letter of credit is made up of three independent

contracts: one between the customer (buyer) and the issuer, one
between the issuer and the beneficiary (seller), and one between the
beneficiary and the customer. A standby letter of credit involves the
customer (construction firm), the issuer (the bank), and the insurer
beneficiary (the bonding company). Each contract is independent of
the other contract, and for this reason, the courts interpret the
contracts on a strict basis. Nevertheless, the UCC states that the bank
may honor a letter of credit in the case of fraud and the courts
interpret this to mean that the bank may also decide not to honor the
letter of credit. The option is with the issuer of the letter of credit.

The fraud in the transaction must stem from the conduct of the
beneficiary against the customer. The purpose of the letter of credit is
to allow the beneficiary to rely thereon. Fraud in this connection is
defined as "of such an egregious nature as to vitiate the entire
transaction."

A bank may dishonor a sight draft drawn on a letter of credit valid on

its face and made in compliance with the terms of the letter of credit if
it determines fraud was committed. The fraud must be of a serious
nature to outweigh the public policy consideration requiring issuing
banks to pay upon demand under the letter of credit if the documents
submitted comply with the terms of the letter of credit. Where there is
a blatant fraud being practiced, and evidence of the fraud is present, a
bank can refuse to pay the letter of credit.
To what extent the customer would have to indemnify the bank is an
open question since banks recognize that if they do not pay a letter of
credit when the sight draft complies strictly with the requirements of
the letter of credit, a suit will be instituted and a claim may be made
upon the bank not only for the funds that it refuses to pay, but for
consequential damages flowing from the failure to honor the letter of
credit and even punitive damage. It is a rare situation, even with fraud,
that a bank will refuse to honor a letter of credit. What is more likely is
that the customer obtains a court order expressly enjoining the bank
from paying the letter of credit. Consult with experienced counsel.

Letters of Credit—Strict Interpretation

The strict interpretation that courts apply to letters of credit has produced
significant litigation over the years. Many courts in other nations use their own
national law as the United States would apply the appropriate sections of the
Uniform Commercial Code. On the other hand, many domestic letters of credit
incorporate the rules set forth by the Uniform Customs and Practices for
Documentary Credit. A case in New York analyzed problems in two
irrevocable letters of credit. The purchaser placed an order for clothing
with the plaintiff; the plaintiff (seller) would ship the clothing to the
purchaser and would submit to the bank that issued the letter of credit
whatever documents of the shipment the irrevocable letter of credit
required. The bank that issued the letter of credit on behalf of the
purchaser would pay the balance under the irrevocable letter of credit.
This is the simple triparty transaction where there are three separate
contracts: one between the purchaser and the plaintiff seller, one
between the plaintiff and the bank, and one between the seller and the
bank.

The UCP Article 14 addresses the issues of banks’ and beneficiaries’

rights when the beneficiary’s documents contain discrepancies in a
payment demand. The standard of strict compliance applies to the
beneficiary’s duty to provide the documentation that the letter of
credit requires, which means that even slight discrepancies in
compliance with the terms of the letter of credit justify refusal to pay.
The courts have carved a narrow exception to the standard of strict
compliance for variations in documents so insignificant that said
variations do not relieve the issuing bank of its obligation to pay,
including a situation where a word in the document is unmistakably
clear despite an obvious typographical error, or where the customer
provides only five copies of the documents instead of six.

When documents containing discrepancies are presented to an issuing

bank, the issuing bank must provide notice of the refusal decision
within seven days, stating exactly what the discrepancies are and why
the bank is refusing the documents. If the bank doesn’t provide such
notice, it is precluded from claiming that the documents are not in
compliance with the terms and conditions of the letter of credit. The
bank must explain which discrepancies are the basis for its refusal to
accept the letter of credit. Merely listing discrepancies and not
distinguishing which are immaterial and which are significant is
insufficient. The notice must set forth in clear language the exact
grounds for refusal to accept the letter of credit. A letter listing all the
discrepancies without distinguishing between the material and the
immaterial, would not be an adequate notice, and the issuer of the
letter of credit may be liable if the documents submitted were rejected.