Article

by Chang-Soon Thomas Song

Scholars in the law investigate the source of law in any field of human endeavour, and letters of credit are no exception. The law closest to the letters of credit law and the law that most commercial lawyers are familiar with is the law of contracts. Thus, often lawyers and the courts apply the law of contracts to letter of credit cases being litigated. However, though some aspects of the letters of credit transaction are amenable to the law of contracts, the law is not quite appropriate in others.

When a court looks carefully at the best practices in the field to come up with the principles it enunciates, as in the time of Lord Mansfield, these sound principles undergird the practices in international banking transactions and help lead to a sustained development in world trade.

However, when the court, in all good faith, tries to look at the best practices in the field, yet ends up with an inconclusive result due either to insufficient pleadings by the lawyers involved or the inability or the unwillingness of the court to see the practices in sufficient depth to come up with the correct best practices, the final court decision can play havoc with the international banking practice in letters of credit. When the legal principle stated by the courts does not comport with the best practices in the field, confusion and wasted efforts to comply are the result. For this reason, Article 5 "Letters of Credit" in the US Uniform Commercial Code, as well as the UN Convention on Standby Letters of Credit and Independent Undertakings, defer to standard practice in formulating best practices and legal principles as well.

Examples

There are two notable examples concerning letters of credit where the courts did not formulate the right legal principle to embody the best L/C practices. The first is the Banco Santander decision of the English appellate court, the second, the Glencore decision. I will discuss only Banco Santander in this article, but both are good examples.

The issue in the case was whether or not the nominated bank under the deferred payment credit was authorized to negotiate the shipping documents under the said credit. The English appellate court, after some hesitation, ruled that since there was nothing in UCP 500 or in the letter of credit itself that authorized negotiation under the deferred payment credit, the negotiation by the nominated bank of the shipping documents was effected at its own risk, and thus the nominated bank was not protected from the fraud of the beneficiary which occurred in the case.

Banco Santander is the largest bank in its country of domicile and one of the major players in the international arena, and one would not be amiss in assuming that the bank knew what the best practices were in the case at hand. While the converse could be true, my view is that the bank was fully aware of the practices. It is, of course, possible that its lawyers failed to carry the burden of proof and also that the English court did not agree that the practice was what the bank claimed it was.

Letters of credit jurisprudence is generally in harmony worldwide despite the fact that there is usually no local law on the subject. (Banco Santander is one of the rare cases where courts' decisions diverged between countries.) The UCP, while universally used, are not legal rules.

Deferred payment credit

From its inception, the deferred payment credit was an acceptance credit with a draft and a usance period that allowed the applicant to receive financing and to make payment after the financing period. The acceptance credit had a draft that was used to accept the shipping documents, and in the US and in Britain it was used as a money market instrument in the bankers' acceptance market. In other countries, although the draft was used, it was simply held by the banks and not generally used, as in the US or in Britain.

In both common law and civil law countries, bills of exchange laws provide for a holder in due course and give the holder of a draft more rights than the transferor of the draft. This was necessary to provide commercial certainty and stability and, in most countries, this principle was strictly adhered to by the courts.

With the bill of exchange law applying to the acceptance credit, once the bill of exchange was accepted by the issuing bank, it was colloquially said to be "as good as gold", since the accepting bank guaranteed its payment at maturity. Even in the event of fraud discovered after the acceptance and before the maturity date, the payment on the bill of exchange would not be disturbed.

One should note that in the above acceptance credit case, the bank that negotiated the draft under the acceptance credit did not need to be a nominated bank to be protected from beneficiary fraud. Even though the negotiating bank was not a nominated bank, once the issuing bank accepted the draft, the negotiating bank was the holder in due course and protected in the event of beneficiary fraud. Under usual letter of credit law, unless the negotiating bank has been nominated by the issuing bank, the negotiating bank cannot claim the status of the holder in due course. Under the acceptance credit, although the negotiating bank is not a nominated bank, it is still protected under the holder in due course principle.

Although the bill of exchange law provided a useful rationale to explain why the negotiating bank in good faith (without notice of fraud) should be protected in the event of fraud, one should note that it is not the only rationale and that, more importantly, the protection of the negotiating bank in good faith is the bedrock of the letter of credit transaction.

Opinions

In one of the old ICC Banking Commission Opinions, though the Commission simply deferred to local law whenever the query concerned fraud, a case which spoke of a forged bill of lading received a reply from the Commission which stressed that, in such a case, the negotiating bank should be protected and further noted that courts in most countries followed this line of reasoning. There was no detailed explanation concerning the status of the negotiating bank, whether it was nominated or not or whether the credit provided for any bank by negotiation.

Although courts rarely refer to this provision of the UCP in discussing fraud, and merely say that the UCP does not deal with fraud, in fact UCP 600 article 34, "Disclaimer on Effectiveness of Documents", speaks about fraud by saying that a bank is not liable or responsible for the falsification of any document for the simple reason that banks are not able to discover this fraud and the law does not demand that they do so. Thus, the negotiating bank that negotiated a forged bill of lading would be protected under the equivalent provision in UCP 500, which was applicable at the time of the Banco Santander case.

Consequently, when the bill of exchange was dropped in some countries due to the stamp tax, the resulting payment credit for sight payment and deferred payment credit for usance payment were simply modified forms of the sight negotiation credit and the acceptance credit, nothing more.

When the courts, however, came across the deferred payment credit, they noted the absence of the bill of exchange and thus came up with a legal principle that differed from the one concerning an acceptance credit that had a bill of exchange. (In Article 5 of the US Uniform Commercial Code, a bank negotiating under an acceptance credit and a deferred payment credit are both afforded protection in the event of fraud, without considering whether they were nominated under the credit.)

Court decisions

The English court ruled that under the deferred payment credit there was no authorization to negotiate by any bank, and moreover that even if the negotiating bank had been nominated (as in the case of the confirming bank), it did not have the authority to negotiate the shipping documents before the maturity date.

The Korean Supreme Court ruled otherwise, stating that when a bank is nominated under the deferred payment credit, the nominated bank should be deemed to have been authorized to negotiate the shipping documents under the credit (a position taken in the recent UCP revision). Had the English court been a bit more aware that, despite the presence or absence of the bill of exchange, the deferred payment credit and the acceptance credit both should provide for the protection of the negotiating bank in good faith under article 15 of UCP 500 (article 34 of UCP 600), there would have been no need for the inclusion of the deferred payment credit provision in UCP 600 or the confusion which resulted from the English court decision.

Chang-Soon Thomas Song holds a J.D. degree from the University of Arizona (US) and is Senior Manager, International Dispute Resolution (Letters of Credit), Trade & Services Division, Korea Exchange Bank, Seoul, Korea. His e-mail is thomas@keb.co.kr