Article

by John Dolan

Anyone who has participated in the revision of a statute, regulation or the like will testify that it is a challenge. One group among the parties that utilize the old rules have their own notions of what should be done, and those notions invariably conflict. What's worse, many of the drafters' constituents (Group 2) want the revised rules to address every little problem they were confronted with under the old rules. It is impossible for the drafters to satisfy the conflicting views of the first group, and efforts to satisfy Group 2 would drown the revision in a swamp of detail.

Consequently, there was some anxiety that attended a drafting project with 11 at the drafting table, a phalanx of 40 experts consulting the drafters and a herd of 50 national committees commenting on every stage of the drafting process, all of whom (drafters, consultants and national committees) had good ideas that the drafters had to sift, balance and address calmly and carefully.

Well, the good news is that the final product, UCP 600, is not a disaster, and the better news is that it resolves a host of questions, is cleaner than its predecessors and makes no mistakes that I can find. Is it perfect? No, and we must all be thankful the drafters did not try to draft a perfect UCP. Recognizing the futility of such an effort, calculating the education costs of any major changes in letter of credit practices, balancing them against risks of confusion in detail and striving always for clarity, the drafters have given us a balanced UCP product that should serve the letter of credit industry well. Now it is time for the rest of us to begin learning and living with UCP 600.

This article addresses two changes in UCP 600 that merit attention. The first deals with the question of recourse on the beneficiary's draft drawn on the issuer. I argue below that under UCP 600, the nominated bank may refuse to take the beneficiary's draft unless the beneficiary draws or endorses with recourse. The beneficiary can no longer insist that the negotiating bank negotiate the beneficiary's drafts without recourse.

The second change in UCP 600 deals with the nominated bank's authority to prepay its own deferred payment undertakings (DPUs). Under UCP 600, nominated banks have the right, if the credit is silent on the issue, to prepay or discount, contrary to the rule in those countries that followed the UK court's ruling in the Banco Santander case.

These two changes in UCP 600 reflect deference to conflicting policies, and both are probably subject to alteration by explicit language in the credit.

With or without recourse

UCP 600 article 2 defines "negotiation" without mentioning whether the negotiating bank must negotiate without recourse, and courts are bound to conclude that, in fact, the without recourse obligation did not survive the revision process. UCP 500 sub-article 9(iv) stipulated that the issuer of a negotiation credit undertook the negotiation of the beneficiary's draft without recourse. Many read that language under UCP 500 as requiring the issuer to nominate a bank that will negotiate without recourse. The "without recourse" language is now absent from the "negotiation" definition, however; and courts will read that absence as a change in the rule. What's more, UCP 600 sub-article 8(a)(ii) explicitly requires a confirmer to negotiate without recourse if the credit is available by negotiation with the confirmer. The absence of the "without recourse" language in the "negotiation" definition article and its presence in the confirmer obligation article are strong indications that the negotiating bank may refuse to negotiate without recourse while the confirmer may not. There is little doubt, then, that courts will read UCP 600 as permitting the negotiating bank to require the beneficiary to draw and endorse its draft with recourse.

In virtually all trading states, as a matter of negotiable instruments law, parties that draw a draft with recourse or endorse it with recourse are liable to the negotiating bank if the issuer or other drawee does not reimburse the negotiating bank.

The effect of this change, then, is to diminish considerably the attractive features of a negotiation credit which, were the rule to the contrary, would permit the beneficiary with a complying presentation to walk away from the counters of the negotiating bank with its money or with an obligation that did not depend on the negotiating bank's reimbursement from the issuer. Under UCP 600, the beneficiary must now book a contingent liability - the prospect that the issuer will not reimburse and that the nominated bank will seek recourse against the beneficiary.

In theory, this change is a significant reallocation of the fraud risk. If a beneficiary may obtain funds under a negotiation credit without recourse, the applicant bears the risk of a short or otherwise defective shipment. Even if the shortage or defects rise to the level of fraud, i.e., more than a mere breach of contract, the beneficiary is not amenable to suit or set-off by the nominated bank. In such cases, the applicant must bring that suit, and the beneficiary will hold the funds during the litigation. In practice, that means that many applicants will not pursue fraud claims.

If the beneficiary must draw with recourse and if the applicant is dissatisfied with the shipment, the issuer will refuse to reimburse, and the nominated bank will dishonour. A lawsuit may still eventuate, but the beneficiary will be the plaintiff, and it must sue the applicant while the applicant holds the funds. In practice, given the cost of litigating in a foreign jurisdiction and given the relatively low dollar volume of most commercial credits, many beneficiaries will not bother. In short, the "without recourse" change allocates fraud costs to beneficiaries, even honest beneficiaries.

Prepaying DPUs

The second change in UCP 600 relates to the authority of a nominated bank to prepay its own DPU. As everyone knows, there has been a split of legal authority on this question. Courts in some states have followed the UK court's decision in Banco Santander to the effect that without explicit authority, the nominated bank that takes its own DPU by assignment from the beneficiary takes it subject to any fraud defence that the issuer discovered before the DPU came due. Courts in other states and legislation in US jurisdictions take the opposite approach and render the DPU free of the fraud defence.

UCP 600 sub-article 12(b) stipulates that the issuer's nomination of a bank to accept or incur a DPU authorizes that bank to "prepay or purchase" its DPU. That provision eliminates the Banco Santander assumption that if the credit is silent, the nominated bank that takes an assignment of its own DPU stands in the shoes of the beneficiary and is subject to the fraud defence. Consequently, nominated banks may now assume that if the credit is silent, the nominated bank may discount its own DPU without fear that the issuer will discover beneficiary fraud and refuse to reimburse.

This second change tends to allocate fraud risk to the applicant. If the applicant discovers fraud before payment of the DPU is due, its issuer bank cannot raise the fraud defence, for the assignee of the DPU takes free of that defence.

Altering UCP 600

The impact of these two rules may be limited, however. The parties might avoid them with explicit language in the credit. First, a beneficiary might insist in the underlying contract for sale that payment be by "without recourse letter of credit". In that case, an applicant that causes its bank to issue a letter of credit subject to UCP 600, but does not indicate that the nominated bank must negotiate drafts drawn and endorsed without recourse, has not satisfied the underlying contract's terms. The beneficiary may refuse to ship unless the applicant and the issuer agree to an amendment. Thus, by altering the terms of UCP 600, the beneficiary can protect itself.

By the same token, altering the terms of UCP 600 can deflect the effort to overcome the Banco Santander ruling. Subarticle 12(b), which addresses the Banco Santander issue, does not address the case in which the issuer explicitly denies the nominated bank's authorization to discount its own DPU. Arguably, UCP 600 cannot prevent an issuer from adding language to the credit such as: "discount of deferred payment obligation not allowed". That language will result in a credit that probably would not satisfy the UK court or any courts that follow Banco Santander and would render the assignee of the DPU subject to the fraud defence.

While some justify use of the DPU instead of an acceptance as a response to stamp taxes, the real nature of the credit available by DPU may be an effort to avoid fraud costs. By making the credit available by a DPU payable, say, 30 days after shipment, the issuer and the applicant are confident that the applicant will have the shipment before the issuer parts with funds; and if the applicant discovers fraud, the issuer will not part with them, for if the holder of the nominated bank's DPU is not protected from the fraud defence, the issuer need not reimburse. In short, if the credit recites that the DPU may not be discounted, Banco Santander may remain the law in many important trading states.

One may well ask where all of this leaves the applicant who asks the issuer to issue a credit available by DPU with an express provision forbidding prepayment of the DPU precisely because the applicant is concerned about the beneficiary's trustworthiness. The answer remains uncertain. The nominated bank will probably not prepay, but the nominated bank cannot prevent the beneficiary from assigning the DPU. In that case, the assignee may be able to raise the arguments noted here. Most issuers, one suspects, will resist reimbursement; and most nominated banks will face a dilemma. Unfortunately, it is too early to say whether courts will permit the assignee to force the payment.

In sum, UCP 600, in abandoning any requirement that negotiating banks negotiate without recourse, alleviates the applicant's fraud risk. Yet, on the other hand, in allowing the negotiating bank to prepay, UCP 600 is willing to permit the beneficiary to walk away with its money before the applicant has the opportunity to open the cartons. These apparently inconsistent rules, however, are subject to exception via express language in the credit.

John Dolan is Distinguished Professor of Law, Wayne State University Law School, Detroit, Michigan, US. His e-mail is j.dolan@wayne.edu