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
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
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
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
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.
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
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
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.
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
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
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
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