Speeding up short-term finance

As a mechanism to fund short-term transactions, letters of credit have been notoriously clumsy to use. But as courts around the world identify poor practices, this may be about to change. Amanda Greene reports.

Financing the short-term sale of a shipment of goods using a letter of credit (LC) couldn’t be easier – in theory. In reality, using these instruments has been an exercise in frustration for legions of corporates and the bankers who support them. In short, one of the surest ways for a global trader to wind up in court is to use an LC to buy or sell a product on a regular basis. Sooner or later, one of the myriad legal points – or lack thereof – surrounding their use will be challenged in court. Any court that is, not just your home domicile.

The good news, though, say those experts who delight in the finer points of commercial law, is that courts have made slow but steady progress in clarifying many of these issues.

“I wouldn’t say there have been dramatic developments either domestically or globally in the last year, but taken cumulatively there are trends that are of considerable significance,” says Professor James E. Byrne, head of the Institute of International Banking Law & Practice (IIBLP), a US-based educational and research organisation.

It’s not that short-term financing by letter of credit is getting any easier – although there are certainly transactions to which one can point where the paperwork went off without a hitch. Rather, Byrne says, as cases make their way through judicial systems around the world, some of the obstacles facing the use of LCs are becoming clearer – and are being addressed, if not being removed entirely. A few of the cases have raised additional issues, leaving some legal observers feeling unsettled. But, by and large, the consensus is progress is being made.

Virtual acceptance

Byrne points to a handful of cases that, over the past 18 months, have further clarified the points of law surrounding ‘banker’s acceptance’, a key process supporting the typical LC transaction in short-term financing. Most of the cases occurred in foreign courts – at least foreign to the US-based IIBLP – with questions occasionally arising about translation points. But the overwhelming verdict has been a positive one for the trade-finance community.

One such case unfolded last year in a Chinese court. “In that case, the court noted that the SWIFT telefax from the issuing bank indicated that it had accepted a draft accompanied by documents that were presented under an LC. This was ruled to constitute an acceptance even though in fact the bank did not sign or stamp the draft,” Byrne says.

“When the bank argued there was no acceptance, the court rejected its arguments.” Byrne said it was unclear, due to translation issues, whether the court reached this decision because of an ‘estoppel’ (a legal term that refers to the preclusion of anyone denying in court the truth of a fact that had been already determined in an official proceeding or by an authority) or whether it was because the separate telefax was deemed a virtual acceptance by the bank.

“But the end result was a clear and consistent finding with the established law in Singapore and the UK,” he says.

Ironically, this particular finding would not have followed in the US under Article Three of the Uniform Commercial Code, Byrne says. “But it would have under the principal of estoppel.”

Fraud and banker’s acceptances

Another recent case – Emirates Bank International PJSC versus Credit Lyonnais (Suisse) – was decided by the highest commercial court in France. It involved fraud on the part of the beneficiary against a bank that had accepted a draft drawn under an LC.

Despite the fraud, the court cited UCP500 as the source of law, even though it wasn’t clear the credit was subject to these rules.

“This decision reflects the universal respect given to the UCP in matters related to commercial letters of credit,” the IIBLP said in a position paper explaining the case. “Its position is augmented considerably by the fact that, with the exception of the US, there is virtually no systematic set of statutes dealing with LCs.”

At the same time, issues arose leaving some in the legal community feeling unsettled regarding the court’s intent.

Although the case was a satisfactory finding for users of LCs overall, there were also issues raised that opened questions. One was how this third-party assignee was dealt with in the proceedings. It was unclear to Byrne whether this assignee could not recover because of the fraud.

If the latter is true, this might prove to be a troublesome ruling in future acceptance financings. “It is an issue of interest and possible concern to those relying on acceptance financing,” Byrne says.

In the US, the results might have been different under revised UCC section 5109. But that is small comfort to a US party if the bank on which reimbursement is claimed is subject to a different legal regime.

Still, as Byrne notes, UCP500 is in the final stages of revision and its successor will go into effect in July 2007.

“At this stage there has been a vote by a large majority of those consulted in favour of protecting those who discount in advance of their deferred payment undertakings. But the language has not yet been agreed upon.” Again, he says, it is something to watch.

Standby LCs

Finally, Byrne notes, there has been increasing use of short-term financing via standby LCs. “Unlike commercial LCs, standby LCs, if properly structured can cover a number of different transactions. They make the most economic sense when there are a regular series of performances, such as a bi-monthly payment schedule lasting a year,” Byrne says.

Typically these cost more, but they are also less likely to have amendment or discrepancy fees levied on them.

Byrne points to the case, Middlesex Bank & Trust versus Mark Equipment Corp, in which the court considered the meaning of several provisions of ISP 98, which covers standby letters of credit. “The court interpreted them in a manner consistent with the drafters’ intent.” According to Byrne, it’s a pleasant development for trade experts watching the case unfold.

“On the whole, the case was able to navigate confusing arguments made by opposing counsel to come up with a sensible decision,” he says. “It suggests the courts are able to work with these rules.”

Specifically, the court rejected a rigid interpretation of the strict compliance doctrine, according to a summary of the case prepared by the IIBLP. It noted, for example, that the alleged discrepancy involved incorrect data not required to be contained in the certification – so-called extraneous data. “The extraneous data was the issuance date of the standby. Instead of giving the correct date of the standby against which the drawing was made, the certification referred to a previous standby which was replaced by the one on which the drawing was made. Where this information did not mislead the issuer, the court classified it as a technical variance,” the IIBLP said.