Standby Letters of Credit

Letters of credit were originally created to function in international trade, reducing the risk of nonpayment in situations where credit was extended to strangers in far away locations. Interposing a known and solvent institution’s credit (such as a bank) for that of a foreign buyer in a sale of goods transaction achieved this objective. See, Paramount Export Co. v. Asia Trust Bank, Ltd. (1997) 193 Cal.App.3d 1474, 1480, 238 Cal.Rptr. 920, 923. Thus, a letter of credit provides assurance to the selling party of prompt payment purely based on documents through banking channels. Id., 193 Cal.App.3d at 1476, n.1, 238 Cal.Rptr. at 921.

1. Governing Statutes.

In California, the Commercial Code (“Code”), Division 5, governs Letters of Credit. See, Comm.C. §5101 et.seq. The Official Comment to Section 5101 states, in part, that a letter of credit is a “form of undertaking” supporting performance of an obligation incurred in a separate transaction or arrangement. However, Division 5 is not intended to be a comprehensive codification of all aspects of letter of credit law, and has no rules on many issues concerning letter of credit transactions. Comm.C. §5103, Official Comment 2.

The Code defines a letter of credit as a “definite undertaking” that satisfies the formal requirements of §5104 to a beneficiary at the request or for the account of an applicant to honor a documentary presentation by payment or delivery of an item of value. Comm.C. §5102(a)(10). The Code specifically defines “definite undertaking” (§5104); “issuer” (§5102(9)); “beneficiary” (§5102(3)); and “applicant” (§5102(2)). The Code also points out that a true guaranty or suretyship contract is not the same as a letter of credit. §5102 (Official Comment 6); UCC §5103 (Official Comment 1).

Consideration is not required to issue, amend, transfer or cancel a letter of credit, advice, or confirmation. Comm.C. §5105.

1. General Nature of the Letter of Credit Transaction.

Letter of credit transactions typically involve commercial letters issued by banks specializing in international trade. Commercial letters are issued on behalf of an applicant (“buyer”) purchasing goods from a foreign seller (“beneficiary”), who uses the letter to pay for the goods purchased from the foreign seller. The buyer applies to a California bank (the “issuer”) to issue a commercial letter of credit in favor of the foreign seller as payment for the goods. See, 3 Witkin, Summary of California Law (9th Ed., 2002 Supp.), “Negotiable Instruments,” Section 11 D, p. 137.

A letter will identify the beneficiary, the amount of the credit, the date when it expires, the place where presentation should be made, and the documents that must be furnished (i.e., invoice, bill of lading, insurance certificate, and/or inspection certificate). A beneficiary must furnish the specified documents in order to obtain payment under the letter of credit. Comm.C. §5104, Official Comment, 1. Thus, under the letter of credit transaction, the foreign seller will be assured of payment before the goods leave his possession, and the buyer will receive documentary proof that the seller has complied with the terms of the underlying contract before payment has been made. 3 Witkin, supra, §11 D., page 139.

1. Types of Letters of Credit.

The type of documents that must be presented to draw on the letter of credit determine the types of letters of credit that may be used. Some of the more typical examples of letters of credit are the following:

1. Clean letter (beneficiary presents a payment draft for the issuer to honor the letter);

1. Documentary letter (beneficiary presents documents in addition to a demand for payment, such as bills of lading or inspection certificates);

1. Direct pay letter (beneficiary expects to receive payment under the letter); and

1. Standby letter (beneficiary expects the applicant to pay the beneficiary directly, and a certificate of nonpayment from the applicant may also be required to obtain payment. Beneficiary makes use of the letter only if the applicant fails to pay the beneficiary).

1. Sequence of Transactional Events.

A letter of credit is usually transmitted to a correspondent bank located in the same country as the beneficiary. After the letter has been transmitted, it is enforceable against the issuer. Section 5106(a). A correspondent bank may either “advise” the beneficiary of the issuance of the letter, or it may “confirm” the letter. An “advising” bank does not assume any obligation to honor drafts or demand for payment. Sections 5102(a)(1); §5107(c). A “confirming” bank assumes the obligations of an issuer and acquires an issuer’s rights. Sections 5102(a)(4); 5107(a).

Generally, except where there is fraud or forgery, when documents are presented to obtain payment under a letter of credit, the issuer within a reasonable time (not to exceed 7 business days) must either honor the presentation up to the limit of the letter of credit if the documents appear on their face strictly to comply with the terms and conditions of the letter, or dishonor the presentation if the documents do not comply (in which case, the issuer must notify the beneficiary of the discrepancies and return the documents to the beneficiary, or hold them for the beneficiary). Sections 5108(a), (b), (e), (h).

1. The Independence Principle.

Absent fraud, a letter of credit issuer must pay upon proper presentment, regardless of any defenses the customer may have against the beneficiary in the underlying transaction. See, Western Sec. Bank v. Superior Court (1997) 15 Cal.4th 232, 251, 252, 62 Cal.Rptr.2d 243. This is consistent with Article 5, which forcefully states the “independence principle” such that letter of credit obligations are independent from the underlying transactions. The Prefatory Note to Article 5 states that “certainty of payment, independent of other claims, setoffs and other causes of action, is a core element of the commercial utility of letters of credit.”
1. The Strict Compliance Doctrine

An additional feature of letters of credit is the “strict compliance” doctrine, codified in the Commercial Code. Section 5108 provides that absent agreement to the contrary, the issuer must dishonor a presentation that does not strictly comply under standard practice with the terms and conditions of the letter of credit.

The Official Comment to §5108 explains the scope of the strict compliance doctrine. The Comment states in part that:

The standard of strict compliance governs the issuer’s obligation to the beneficiary and to the applicant. By requiring that a “presentation” appear strictly to comply, the section requires not only that the documents themselves appear on their face strictly to comply, but also that the other terms of the letter of credit such as those dealing with the time and place of presentation are strictly complied with.
* * *
Strict compliance does not mean slavish conformity to the terms of the letter of credit. For example, standard practice (what issuers do) may recognize certain presentations as complying that an unschooled layman would regard as discrepant.

Thus, “strict” compliance does not demand oppressive perfectionism.

This section also provides that the issuer is precluded from asserting any discrepancy not stated in its notice timely given, except for fraud, forgery, or expiration. Finally, this section requires examination and notice of any discrepancies within a reasonable time not to exceed seven (7) business days after presentation of the documents.

By conditioning payments solely upon the terms set forth in the letter of credit, justifications for an issuing bank’s refusal to honor the credit are severely restricted, which assures reliability of letters of credit as a payment medium. Paramount Export Co. v. Asia Trust Bank, Ltd., supra, 493 Cal.App.3d at 1480, 238 Cal.Rptr. at 923. Viewed in this context, the doctrine of strict compliance functions to protect the bank, which carries the absolute obligation to pay the beneficiary. Similarly, since banks deal only in documents, they will be able to act quickly, enhancing the letter of credit’s fluidity. Id. Literal compliance with a letter of credit is also essential so as not to impose a duty on the bank that it did not undertake, so that the bank’s right to indemnity from its customers is not jeopardized. Id., 193 Cal.App.3d at 1480, 238 Cal.Rptr. at 923-924.

1. General Principles Governing Standby Letter of Credit Transactions.

In a “commercial” letter of credit, the beneficiary is a seller of goods. See, e.g., San Diego Gas and Elec. Co. v. Bank Leumi (1996) 42 Cal.App.4th 928, 936, 50 Cal.Rptr.2d 20, 25. A letter of credit involving a sale of goods almost always requires that title documents to the goods accompany the draft. Upon dishonor, the injured party would then sell the goods to recover the loss. Id., 42 Cal.App.4th at 937, 50 Cal.Rptr.2d at 26.

San Diego Gas and Elec. Co., explained that three contractual relationships exist in a typical letter of credit transaction:

1. The contract between the bank’s customer and the beneficiary of the letter of credit, consisting of the business agreement between the parties;

1. The contract between the bank and its customer, under which the bank agrees to issue the letter of credit and the customer agrees to repay the bank for the amounts paid under the letter of credit; and

1. The contract between the bank and the beneficiary of the letter of credit created by the letter of credit.

Id., 42 Cal.App.4th at 933, 50 Cal.Rptr.2d at 23.

Thus, the bank agrees to honor the beneficiary’s drafts (demands for payment) which conform to the terms of the letter of credit. Id., 42 Cal.App.4th at 933, 50 Cal.Rptr.2d at 23. The court also observed that although the relationship between the issuer and beneficiary is often loosely described as “contractual,” this is inaccurate, and it is better to refer to the relationship as an “undertaking,” to avoid the implication that contract principles might apply. Id.

While a “commercial” letter of credit is used in transactions concerning the sale of goods, a “standby” letter of credit generally relates to a performance obligation. Thus, in a standby credit arrangement, the issuing bank stands by its support of the obligation of the applicant borrower to the lending beneficiary in a separate credit transaction.

In a letter of credit loan transaction, the “applicant” would be the borrower, the “issuer” would be the bank, and the “beneficiary” would be the lender. This credit structure would consist of three contracts, in the same manner as the typical commercial letter of credit described above, with these differences: (1) The borrower-lender loan agreement; (2) the borrower-bank agreement, in which the borrower agrees to reimburse the bank if the bank pays the lender; (3) the letter of credit. The letter of credit will carry an expiration date, after which the bank will not honor any attempt to draw down on the letter of credit.

San Diego Gas and Elec. Co. v. Bank Leumi, supra, 42 Cal.App.4th 928, 50 Cal.Rptr.2d 20, provides a good summary of principles applicable to standby letters of credit. In that case, the beneficiary of a standby letter of credit sued the issuing bank after the bank refused to honor the draft. The court held that the application of the “independence principle” was mandated by the express terms of the letter of credit, as well as the California Commercial Code. Therefore, the letter of credit issuer did not have the right to inquire into the contractual dispute between its customer and the beneficiary in considering whether to honor the demand for payment under the letter of credit. Id., 42 Cal.App.4th at 939, 50 Cal.Rptr.2d at 27.

In discussing the “independence principle,” the San Diego Gas and Elec. Co. Court, construing Section 5114(1), noted that this principle is the primary characteristic of a letter of credit, and that the issuer of a letter of credit is never entitled to defend against payment based on extraneous defenses which might have been available to the primary obligor. Id., 42 Cal.App.4th at 934, 50 Cal.Rptr.2d at 24. Under the independence principle, then, one of the primary reasons for the value of the letter of credit device is that because the issuing bank is not obligated to look beyond the terms of the letter of credit to the underlying contractual controversy between the customer and the beneficiary, the beneficiary can rely on assured, prompt payment from a solvent party. Id.

The San Diego Gas and Elec. Co. court also provided an overview of the history and law concerning letters of credit. The court explained that the letter of credit arose to facilitate international commercial transactions involving the sale of goods. In recent years, the use of the letter of credit expanded to include guaranteeing or securing a bank’s customer’s promised performance to a third party under a “standby” letter of credit. Id., 42 Cal.App.4th at 933, 50 Cal.Rptr.2d at 23.

1. A Letter of Credit is Not a Guaranty

The Official Comment to Section 5102 distinguishes between letters of credit and sureties or other forms of guaranties. The Official Comment observes that when a document requires the issuer to pay upon the determination of an extrinsic fact, such as an applicant’s failure to perform a contract, rather than upon the presentation of documents, and where that condition appears on its face to be fundamental, the issuer’s undertaking is not a letter of credit, but some form of surety or other contractual arrangement. Thus, undertakings whose fundamental terms require an issuer to look beyond documents are not governed by Article 5.

In Western Security Bank v. Superior Court (1997) 15 Cal.4th 232, 62 Cal.Rptr.2d 243, an issuer of standby letters of credit given by debtors to a real property lender as additional security for a deed of trust loan filed an action seeking a declaration that the issuer was not obligated to accept or honor the lender’s tender of letters of credit. The court, distinguishing between letters of credit transactions and surety relationships, stated that rules applicable to surety relationships do not govern relationships between parties to a letter of credit transaction. Id., 15 Cal.4th at 248, 62 Cal.Rptr.2d at 253. Thus, the liability of the issuer of a letter of credit to the beneficiary, unlike the liability of a surety, is direct and independent of the underlying transaction between the beneficiary and the issuer’s customer. Id.

By contrast, Civil Code §2787 defines a surety or a guarantor as “one who promises to answer for the debt, default, or miscarriage of another . . .” Generally, a surety’s liability for an obligation is secondary to, and derivative of, the liability of the principal for that obligation. Western Security Bank v. Superior Court, supra, 15 Cal.4th at 246, 62 Cal.Rptr.2d at 252. Moreover, suretyship involves no counterpart to the independence principle essential to letters of credit. Id., 15 Cal.4th at 251, 62 Cal.Rptr.2d at 254.

The financial device which is the most similar to a letter of credit is the cash collateral deposit. However, the letter of credit differs from a cash deposit because the customer does not have to give up his own funds until payment is made and until he is forced to reimburse the issuing bank. The avoidance of this cash flow burden is a great advantage to a party who enters into a large number of transactions simultaneously using the letter of credit device. Additionally, the beneficiary is protected by the credit of a financial institution, even though it does not actually possess the fund, as it would if a cash deposit were used. Western Security Bank v. Superior Court, supra, 15 Cal.App.4th at 251, and 8, 62 Cal.Rptr.2d at 255.

1. Conclusion

The letter of credit, and particularly the standby letter of credit, can be a creative tool to give assurance of performance between parties located in different countries, through the use of a neutral, stable financial institution. The letter is generally fast, efficient, predictable, litigation averse, and serves to free up cash of the applicant for other uses.