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Published Articles by David Balovich

Title: UCC Article 5: Letters Of Credit
Published in: Creditworthy News
Date: 7/13/2011

I have often subscribed to the belief that the Uniform Commercial Code and the articles contained within its chapters is the “bible” of the credit professional. In this column I would like to address one of the most overlooked and misunderstood of all the articles contained in the Uniform Commercial Code. Article 5, Letters of Credit.

A letter of credit is an instrument that can be effectively used in the extension of credit and collections along with drafts, checks, electronic fund transfers, and money. It also includes a unique creditor-debtor relationship that separates it from the other methods of payment that are included in Article 3 of the Uniform Commercial Code, and has specific uses in the extension of credit not shared with other kinds of payment. It is specifically defined in Revised Article 5 as an undertaking by an issuer of the credit to a beneficiary, the individual who gets paid, on behalf of an applicant, the individual to whom credit is extended by the issuer. As defined, payment requires the presentation of a document, usually a draft on behalf of the beneficiary to the issuer.

Commonly, the issuer is a bank or similar financial institution. Commonly, the applicant is a customer of that bank, and the beneficiary is somebody with whom the applicant is doing business and who wants assurance that he or she will be paid.

A typical example of a letter of credit involves a company intending to buy goods from another business. The seller is willing to do business providing that it has assurances of payment for the goods that are to be purchased. The buyer applies to its bank, with whom it has accounts and lines of credit, for a letter of credit. The bank issues a document that is in actual letter form. In the letter it guarantees to the seller that it will pay money up to a specific amount, upon receipt of an appropriate documents, usually a draft, on behalf of the seller. The letter contains any other documentary conditions agreed upon by seller, buyer, and the bank.

The buyer (applicant) then takes the letter to the seller while negotiating the purchase of the goods. The letter provides guarantee of payment, facilitating the transaction. At the appropriate time in the transaction, the seller is paid upon presentation of the draft to the bank.

The bank then debits the appropriate account of the buyer or establishes whatever creditor-debtor relationship is negotiated between bank and the buyer. Ultimately the bank is paid.

It is possible that there may be other parties to the transaction recognized by law. There may be a confirmer on the letter. The confirmer can be another institution or individual obligated to pay on the letter when the appropriate document is presented by the beneficiary. In the example, to facilitate payment, the buyers bank may engage a local bank as a confirmer so the seller will actually present the required draft for payment to the buyers bank. A confirmer is always liable on a letter of credit.

There may also be an "advisor" on a letter of credit. The advisor is a third party who facilitates the transaction by advising the beneficiary either directly or through another advisor that the letter of credit has been issued, confirmed, or amended. Institutions or individuals acting as advisors give beneficiaries an added assurance that a letter of credit is valid. In the example, the buyers bank can employ the services of another local bank to notify the seller that the letter of credit has been issued in the name of the seller. An advisor does not have direct liability on the letter of credit.

The letter of credit is of particular importance in international trade. With different payment systems in different countries, different laws governing fundamental transactions, business deals that must be transacted between strangers who are domiciled in different countries and who speak different languages, the letter of credit has become a common and accepted method of guaranteeing and obtaining payment. The foreign company has the comfort of the credit of the large, well-known financial institution when doing business with the domestic company.

The expansion of foreign trade is partly responsible for the large increase in the use of letters of credit in the United States. But there are other factors that have increased the use. Letters of credit generally are either ordinary commercial credits or standby letters of credit. The transaction used to illustrate typical use above involves an ordinary commercial credit. Standby letters of credit are used to back-up other primary creditor-debtor relationships, and in that sense are widely used as a continuing guaranty of payment. What kind of large increase in use has occurred in the United States? In 1950 there were an estimated one-half billion dollars in outstanding letters of credit. In 1989, the figure was $200 billion. By 2009 the number had grown to almost a trillion dollars.

The revision to Article 5 in the 1990’s did not change the basic principles found in the original article. The drafters' original intent was to provide a theoretical framework which would accommodate business practices however they would evolve. Original Article 5 defines the letter of credit and key terms, sets rules for establishing a letter of credit, provides some very basic rules prescribing the obligations of parties to a letter, including the obligations of confirmers and advisors, and establishes basic remedies for breach of these obligations. The revisions made to Article 5 continued these objectives.

The revised Article 5 provides more leeway for the evolution of business practices. Although revised Article 5 did not change the basic orientation of the original drafters, it considerably simplified the rules.

For example, original Article 5 has rules for "notation credits" which are defined as credits that are payable only upon a notation of the amount of the payment on the actual letter. Honor of the draft or demand for payment requires the notation. It is one of those formal requirements with legal effect that results in dishonor of otherwise perfectly presented drafts or documents, impeding legitimate transactions. This concept is not continued in revised Article 5.

Here is another example of simplification in the revised Article 5. The Original Article 5 permitted beneficiaries to use portions of a credit unless otherwise specified. Revised Article 5 simply leaves the issue to existing standards of practice.

The primary reason for such simplifications is the specific inclusion of standards of practice in revised Article 5. It provides that "An issuer shall observe standard practice of financial institutions that regularly issue letters of credit. Determination of the issuer's observance of that standard practice is a matter of interpretation for the court." The original Article 5 assumes that standards of practice are assumable as a matter of contract between the parties to a letter of credit. In revised Article 5, the standards apply unless the contract otherwise specifies.

Standards of practice for letters of credit are very well formalized. First and foremost are the Uniform Customs and Practices for Documentary Credits (UCP), I.C.C. Publication No. 600, which are promulgated by the International Chamber of Commerce. The UCP is updated on a decadal basis, and is much relied upon in international trade as a common language of letter of credit transactions. The simplification in revised Article 5 suggests a clear recognition of the UCP as the source for many of the formal requirements and details of letters of credit. This permits business practices to govern the evolution of letters of credit within the aforementioned basic framework that Article 5 intends to provide.

Since almost the entirety of Article 5 in revised or original form is variable by agreement, specific provisions of the UCP may also become part of the agreement between the parties, or its provisions may be waived by agreement as well.

Between the expanded reliance upon existing standards of business practices as a default rule in revised Article 5 and the ordinary ability to vary the default rules in revised Article 5, people and institutions are given maximum flexibility in the tailoring of their relationships under letters of credit.

Although the standard of practice provision in revised Article 5 is undoubtedly the most significant part of these revisions, there exist other significant changes.

One of the stated purposes for the revisions to Article 5 was bring Article 5 into the age of electronic communications. Original Article 5's statutes of fraud requirements—calling for writings for enforcement—were abolished. Under revised Article 5, "A letter of credit, confirmation, advice, transfer, amendment, or cancellation may be issued in any form that is a record and is authenticated (I) by a signature or (ii) in accordance with the agreement of the parties or the standard practice."

The way to interpret this language is, simply, to say that a written document is no longer absolutely necessary to establish the existence of a valid letter of credit or of any other associated obligation. All that is required is an authenticated "record." For example, a properly preserved computer record will suffice.

Another of the important changes concerns fraud and forgery in presentation for payment. As noted above, a letter of credit requires the presentation of a document, commonly a draft, for payment. What if the draft is fraudulent in some aspect or is forged? What is the issuer required to do? In certain instances under original Article 5, the issuer was required to honor such a draft, and in other cases may honor the draft. The issuer is not required under original Article 5 to police the process by which payment is obtained. However, in those situations in which the issuer had the discretion to honor the draft, the customer could petition the appropriate court to enjoin honoring the draft.

Original Article 5 used the terminology of fraud in the transaction, and provided no guidelines with respect to which a court could consider the level of fraud that triggered the issuance of an injunction. In revised Article 5, the terminology of fraud in the transaction was eliminated. A fraud that affects an injunction must be a "material" fraud. Further, revised Article 5 established standards that the court must apply in determining whether to enjoin the issuer from honoring the draft. Included are factors of prohibition of injunction by other law, adverse effect upon the beneficiary, and availability of a remedy for fraud or forgery against the responsible individual or institution.

The remedies against an issuer for wrongful repudiation or dishonor of a letter of credit became more consistent under revised Article 5 for letter of credit transactions. An issuer is bound to honor a proper documentary presentation. Repudiation occurs when the issuer communicates that a presentation will not be honored. A dishonor occurs when the issuer does not pay when the appropriate document is presented. Like any other legal obligation, the issuer is liable for wrongful repudiation or dishonor.

In original Article 5, the injured party could obtain the amount of the dishonored document plus incidental damages less the amount realized on the underlying transaction. If goods or documents of value, as a result of the transaction, were not sold to cover the losses, the issuer was entitled to them upon payment of judgment.

In revised Article 5, the beneficiary or appropriate nominee is entitled to "the amount that is the subject of the dishonor or repudiation." If the obligation is not for payment of money, the injured party may have specific performance in lieu of damages, at the option of the injured person. Incidental damages are allowed, but not consequential damages. There is no obligation to cover the losses. If there is cover, the savings must be deducted from the recovered damages.

The applicant has a remedy for damages "resulting from breach," including incidental but not consequential damages. A breach by a confirmer or advisor gives rise to actual damages plus incidentals. Interest is due for any damages from the date of breach or dishonor. The prevailing party has a right to attorney's fees. There is now a specific authority for prior agreement to liquidate damages. These provisions vastly improve and make more specific, the remedies available under Article 5.

A subject not specifically addressed in original Article 5 was the subject of subrogation of one party to another party to a letter of credit, upon payment of the other party's obligations. Subrogation rights were available by contract under original Article 5. However, the courts did not always agree upon their availability, giving rise to confusion in the law.

Revised Article 5 provides specific rules. For example, if the issuer pays the beneficiary, the issuer is subrogated to the rights of the beneficiary and the applicant to the same extent as if the issuer were a secondary obligor of the underlying obligation. Subrogation rights do not arise until there has been an actual payment to the party whose rights are subrogated.

Subrogation puts the person with the subrogation right in the shoes of the person who benefited by the payment that triggers the subrogation right. Subrogation rights balance equities between parties in complex transactions like letters of credit. Revised Article 5 solved the judicial quandary under original Article 5 as to whether automatic rights of subrogation exist.

It is not possible to list entirely in this column all the problems under original Article 5 that were corrected in revised Article 5. For example, it was not clear under original Article 5 whether a letter of credit had to be a documentary letter of credit. It was not entirely clear under original Article 5 that a letter of credit was any different from a guarantee. Revised Article 5 erases these ambiguities.

Letters of credit can be used as an integral part of credit approval and prompt payment. The application of letters of credit under revised Article 5 should be considered by all credit professionals in the credit decision process.

I wish you well.  

The information provided above is for educational purposes only and not provided as legal advice. Legal advice should be obtained from a licensed attorney in good standing with the Bar Association and preferably Board Certified in either Creditor Rights or Bankruptcy.  

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