Article

by John F. Dolan

This article discusses sources of confusion in L/C practice that result from the fact that law and banking give some terms different meanings. The confusion lies in the terms "negotiate" and "discount".

The misunderstandings have nothing to do with the gran333d controversies over negotiation credits, but they do bear on the use of drafts and deferred payment obligations, and resolving matters explains and perhaps justifies a UK court ruling that was not well received in international trading circles. The confusion arises when a nominated bank takes an acceptance or deferred payment undertaking (DPU) arising out of a letter of credit transaction.

"Negotiation" in banking

In banking, under UCP 600 article 2, "negotiation" occurs when a nominated bank purchases the beneficiary's draft and/or documents and then presents them to the issuer for reimbursement. Traditionally, in this transaction, the beneficiary draws on the issuer. If there is a draft, the negotiating bank does not pay the draft or accept it. The UCP differentiate the negotiating bank from a nominated bank that holds a mandate to pay, accept or incur a deferred payment obligation. Rather, the negotiating bank "negotiates".

Negotiation may occur, moreover, without any draft or other negotiable instrument. Under UCP 600, negotiation is essentially the act of giving value to a beneficiary that presents to the negotiating bank documents that comply with the terms of the credit.

"Negotiation" in law

In law, to negotiate is to transfer to a taker rights greater than those of the transferor. While the Romans teach us that one cannot give what one does not have, Nemo dat quod non habet, the law merchant, which in this respect is the law of virtually all trading nations, has accepted the doctrine of negotiation with its illogical rule that one who takes from A holds more than A held. The law merchant cared and still cares less for logic and more for the need to support sound credit practices. It is the sources of credit that concerned the medieval merchants or the Phoenicians or whoever it was, probably different traders at different times, who cried for credit and found a source of it in their own inability to pay promptly.

Imagine the medieval transaction. A well-regarded merchant house buys wool from producers or their factors. The merchant house resells to weavers, who take the raw wool and transform it into garments, carpets and tapestries of greater value than the raw wool. The trouble was that it took the weavers far longer to weave, sell and pay the trading house than the producers and their factor were willing to wait. Producers wanted payment when they delivered the wool. Factors wanted payment before they left the fair or the port for the next fair or the next port. But, argued the merchant house, "I will give you the weavers' paper with my endorsement, and my endorsement is good because my reputation is one of financial strength."

The wool sellers were unimpressed. They needed cash or its equivalent, and their bankers were unwilling to advance funds against the weavers' paper. If the wool, which the bankers had never seen, proved defective, the weavers would have a defence to payment and would assert their defence against the banker who held their paper when it came due.

So, the merchant house and the weavers decided to enhance the value of the weavers' paper by making it free of defences, and the sellers and their lenders, the banks, found this to be an excellent idea. They invented what in law is "negotiation." The merchant house held the weavers' paper subject to the defence that the wool was defective, but the taker from the house took it free of the defences.

The law merchant recognized, however, that it must differentiate paper that was negotiable, i.e., paper that passed free of the obligor's defences, from paper that was non-negotiable, i.e., paper that the lender took subject to defences. The merchants made the difference stand on the language of the paper. Negotiable paper was paper payable to "order" or to "bearer." Paper lacking that language was non-negotiable. The law, moreover, generally limited negotiability to four payment devices: notes, drafts, cheques and certificates of deposit. A lender that takes a negotiable instrument in regular course will almost always qualify as a "holder in due course" of such an instrument and will take it free of the obligor's defences.

Discounting

Now comes the part that bankers call "discounting" and the law calls "negotiation." When an issuer or nominated bank accepts a draft or issues a DPU, the beneficiary holds something of considerable value - a bank obligation. Yet, the obligation is not due for, say, ninety days, and the beneficiary wants its funds immediately. The bank tells the beneficiary that the bank will discount the acceptance or the DPU. Thus, the beneficiary receives the face amount of the obligation less a discount - a traditional commercial bank function - and receives it promptly, the whole point of discounting.

Generally, in law, the party that takes the obligation from the beneficiary will qualify as a holder in due course and will cut off the accepting bank's defences (fraud by the beneficiary) only if the obligation is an acceptance in negotiable form. By definition, a DPU is not a negotiable instrument and cannot be negotiated. In traditional payments law, the discounting party takes subject to the defences. Bankers have long assumed that the discounting bank takes free of defences, and they rightly argue that limiting the protection against defences, notably the fraud defence, with these "legal" concepts will ruin a healthy market for DPUs. Why take a DPU if you don't take free of the fraud defence or any other defence for that matter?

Defending Banco Santander

As every bank that purchases DPUs is aware, the UK Court of Appeal in the case of Banco Santander v. Bayfern Co. created a nuisance for banks that sought to discount DPUs. The UK court and courts in other states that followed the UK lead hold that banks or other investors that take DPUs take them subject to defences the issuer has against the beneficiary and that those banks and investors do not, in law, have the status of a holder in due course. The criticism of the Banco Santander case has been sharp at times, and one must admit that the ruling creates problems for what had become and remains a profitable bank product, the DPU that passed to the discounting bank, making the bank a holder in due course.

Why did the UK court choose that rule? In Banco Santander, the UK court assumed, without stating its assumption, that only one who takes a "negotiable instrument" may benefit from the legal doctrine of "negotiation". Presumably, a debtor, such as the issuer of an acceptance, that signs a negotiable instrument knows it is surrendering its defences, but a debtor that does not sign a negotiable instrument can safely assume under commercial law that it has not surrendered them. The court was not opposed to the negotiation of DPUs, but it was opposed to trapping issuers of the DPUs who thought they retained the right to dishonour if the beneficiary had practised fraud or shipped nonconforming goods. Courts in a number of states accept that policy.

The Banco Santander court was willing to protect the holder of the DPU if the issuer had authorized it to discount, in which case the holder was seeking a reimbursement that was authorized and, therefore, not subject to the fraud defence. In short, by authorizing the discount, the issuer of the DPU knowingly waived the defences, and the court was willing to enforce that waiver.

The UK court and other courts that follow Banco Santander are not opposed to "negotiation" in the law of DPUs. They are opposed to the holder-in-due-course trap of denying defences to an issuer that is unaware that a non-negotiable promise can make the taker a holder in due course who cuts off the issuer's defences against the beneficiary who has shipped, say, rolled up newspapers instead of pharmaceuticals.

Divided authority

After Banco Santander, we have a serious split of authority. Some jurisdictions follow Banco Santander; some don't. Since the 1950s, US jurisdictions anticipated the Banco Santander policy and rejected it in their Uniform Commercial Code. Sub-article 12 (b) of UCP 600 seeks to satisfy the rule of Banco Santander by authorizing the nominated bank to discount the DPU.

Yet, all is not clear. Party autonomy allows parties to issue credits subject to UCP 600 except sub-article 12 (b), or to vary the Uniform Commercial Code rule. Steps to effect that alteration are cumbersome, and they force the nominated bank to double check to see that such attempts are not listed in the credit. The net effect is to increase costs and retard the celerity of DPU discounting. The result is uncertainty - always a problem for payments transactions.

Regrettably, we have to live with the consequences of that uncertainty. Commercial parties are paying for it and, at the moment, we have not been able to avoid it.

In sum, lawyers and bankers ascribe different meanings to the term "negotiation" and different understandings to the practice of discounting. It would be a happy day for some bankers, I suppose, if they could use their understanding of the terms and practices and leave lawyers to the law. If they do, however, they risk disappointment in some jurisdictions where law trumps banking practice.

John F. Dolan is Distinguished Professor of Law, Wayne State University, Detroit, Michigan, USA.

His e-mail is j.dolan@wayne.edu