Article

by James Barnes

Picture a bank undertaking that recites that it is a letter of credit and that it is "available by payment against presentation to us [the issuing bank] of the following documents:

1. draft for the default amount;

2. certificate from the beneficiary stating that [the applicant] failed to perform its obligation as per agreement [between the beneficiary and the applicant];

3. authenticated SWIFT msg and tested telex addressed to the beneficiary's bank through advising bank issued by us [the issuing bank] confirming the beneficiary's fulfilment of their commitments towards [the applicant]."

Should condition number 3 be disregarded (as a non-documentary condition)? Should the undertaking be treated as a letter of credit (rather than as an ordinary promise or suretyship undertaking)? The above language is taken from a recent UK case (the Oliver case), but the questions raised by this language in a purported L/C undertaking should be considered in a wider context.

The wider context

For a wider context, picture a differently worded condition number 3. What if the undertaking conditioned payment on "completed performance of the beneficiary's obligations to the applicant", or on "the issuing bank's determination of completed performance of the beneficiary's obligations to the applicant"? As conditions to honour of a letter of credit, all three quoted conditions raise essentially the same concerns and deserve the same treatment. None of these conditions belongs in an independent undertaking. Or, to put it differently, inclusion of any of these conditions in an undertaking would, unless disregarded, deprive the undertaking of independence.

L/C law and practice safeguard the independence of issuer obligations by requiring that non-documentary conditions (NDCs) be disregarded.

Issuing banks are generally good about limiting their L/C undertakings to conditions that allow them to perform independently of the parties' performance of the underlying transaction. Accordingly, L/C obligations are conditioned on presentation of documents to be provided by (i) the beneficiary, (ii) a third party and, occasionally, (iii) the applicant.

L/C conditions calling for beneficiary statements that the applicant has defaulted in the underlying transaction are common. Also common are applicant efforts to dispute such statements by a pre-honour injunction claim based on fraud or a post-honour accounting claim based on the underlying contract. L/C conditions calling for documents provided by the applicant are discouraged (see ISP98 Rule 4.10) and are a trap for the unwary beneficiary, but they are enforceable under L/C law and practice. Occasionally, beneficiaries sue applicants or third parties to compel them to provide a document that they should provide based on the beneficiary's rights against them in the underlying transaction, but these suits are difficult to pursue in the time allowed.

Documents to be provided by the L/C issuer, other than the L/C and any L/C amendment, are rarely included as conditions to performance by an issuer under an LC. In my experience, when they are included, they concern banking activity, such as receipt of funds by the issuing bank; they do not concern the issuing bank's determination of a party's performance in the underlying transaction. Under L/C law and practice (see ISP98 Rule 4.11), requiring presentation of a bank receipt is unnecessary; an issuing bank's receipt of funds, whether or not documented, falls outside the "disregard NDCs" rules. And, of course, an issuing bank is unlikely to withhold a written receipt for funds that it has received. This kind of condition, however worded, does not detract from the issuing bank's ability to perform its L/C obligations independently of the underlying transaction.

Determining non-documentary conditions

Condition number 3 quoted above is cast in terms of requiring presentation of a document, but the required document is not like a bank receipt of funds. The required document includes the issuing bank's statement of facts and conclusions outside its own records and operations. An issuing bank could examine such a document for compliance under L/C law and practice, but it could not, consistent with the L/C independence principle, undertake to determine the facts and conclusions to be stated in the document.

Determining what constitutes a non-documentary condition that is to be disregarded under L/C practice and law is not a technical exercise. Some background is in order here. UCP 500 sub-article 13 (c) first recorded the "ignore NDCs" rule, which was continued in UCP 600, subarticle 14 (h). ISP98 Rule 4.11 enhances and elaborates on the the rule.

The "ignore NDCs" rule was codified in US law - Uniform Commercial Code (UCC) §5-108(g), which is the subject of substantial official comment on that aspect of the UCC as well as the UCC provisions limiting the scope of undertakings that may qualify as "independent". Ultimately, the "ignore NDCs" rule requires determining whether a purported letter of credit strays too far from the independence principle, in which case either the offending L/C provision should be disregarded or, in extreme cases, the undertaking should be recharacterized as an ordinary promise or suretyship undertaking. US law addressed this topic head on in the 1974 Wichita Eagle case, which involved a suretyship undertaking mislabelled as a letter of credit.

The topic was heavily considered in the 1995 revision of UCC Article 5. The consensus position was that NDCs were incompatible with the independence of an issuer's L/C obligations. They were to be deterred and, if nonetheless included in L/C text, disregarded as L/C conditions or, as an even more drastic alternative, the independence of the undertaking was to be disregarded. The consensus position accepted that NDCs are popular, that they must be deterred to protect the unique status of L/C undertakings generally and that it would not do to allocate the risk of eliminating or satisfying NDCs to beneficiaries (or nominated banks).

In this context, including a requirement in an L/C that the issuer provide a document reciting that the underlying trans action has or has not been performed by the beneficiary or applicant clearly would trigger the consensus position. Including such a requirement would leave only the question of whether to disregard the condition or to disregard the independence of the undertaking. I think the US solution would be to disregard such a condition, as that is the generally preferred solution in the case of a bank issued undertaking that would otherwise qualify as a letter of credit under revised UCC Article 5. Moreover, the alternative solution is preferred only in cases where it clearly appears that an unsophisticated issuer did not intend to issue an independent undertaking.

Citations

For those readers desiring citations for the two cases mentioned above, see Oliver v. Dubai Bank Kenya Ltd, [2007] All ER (D) 135 (Sep), EWHC 2165 (Comm) [England] and Wichita Eagle & Beacon Pub. Co. v. Pacific National Bank, 493 F. 2d 1285 (9th Cir. 1974). It should be clear to readers that I believe the Oliver case would be differently analyzed and decided under revised UCC Article 5 as applied to a UCP L/C. For those readers desiring citations to the referenced revised UCC Article 5 comments, see Official Comment 6 to UCC 5-102 and Official Comment 9 to UCC 5-108 (on the scope of undertakings that qualify as "letters of credit" and on disregarding non-documentary conditions) and note particularly the excerpt below:

The lesson is clear: L/C honour should not be conditioned on performance by the beneficiary or applicant in the underlying transaction or on a determination or representation by the issuing bank about such performance.

James Barnes is senior counsel at Baker & McKenzie LLP, Chicago, Illinois. His email is James.G.Barnes@BakerNet.com