Volume 43 | Number 3

Negotiation in Letter of Credit Practice and Law: The Evolution of the Doctrine

by James E. Byrne

Abstract

The concept of negotiation in letter of credit practice and law has evolved from being an appendage of the law of negotiable instruments to an independent discipline that often alters basic assumptions of negotiable instruments law.  From playing a central role in the letter of credit process, the draft or bill of exchange has become incidental and atrophied.  Indeed, with respect to banks nominated in the letter of credit to “negotiate,” negotiation can occur without there being a draft or bill of exchange.  Nonetheless, negotiation, as used in letters of credit, is an important aspect of letter of credit practice, enabling it to serve as a means of trade facilitation and finance.  The latest revision of the Uniform Customs and Practice for Documentary Credits, UCP600, reflects the currency of this concept in its attempts to define “negotiation” and to clarify its role in letter of credit practice.

This paper surveys and compares the concept of negotiation in both fields.  It summarizes the law of negotiable instruments (Part I), studying, analyzing, and comparing negotiation in letter of credit practice (Part II).  It then considers important issues that arise in the negotiation of LCs, such as the requirement of a draft, formalities, recourse, and letter of credit fraud (Part III), and ends by suggesting an approach to the definition of “negotiation” in letter of credit practice and law (Part IV).

It suggests that negotiation—whether by a bank that undertakes to do so in its letter of credit undertaking or by a bank nominated to do so without having made such an undertaking—gives rise to a basis of liability that is separate and preemptive from, if sometimes parallel to, that which arises on negotiable instrument that may be involved.  Although the letter of credit concept of negotiation readily borrows from the law of negotiable instruments with respect to protection of the right to a protected status, important differences arise based on the nature of the letter of credit undertaking.  Where there is a letter of credit undertaking to negotiate, negotiation is the means by which the bank honors its letter of credit obligation to the beneficiary, taking up the documents presented and any draft, and discounting the amount due to present value in the event of a time obligation without any right to seek recourse against the beneficiary.  Where there is no undertaking, a bank that negotiates pursuant to a nomination is the transferee of the right to the proceeds of the letter of credit.

Summary

  1. Survey of Negotiation of Drafts in the Law of Negotiable Instruments

  2. Negotiation in Letter of Credit Practice
    1. Pre-UPC400 Terminology
    2. Post-UPC400 Terminology
  3. Issues Regarding Negotiation of LCs
    1. The Requirement of a Draft
    2. Formality Requirements
    3. Who Negotiates?
    4. How Does Negotiation Occur?
    5. Recourse
    6. Protection of Banks That Negotiate in the Event of LC Fraud
      1. The Presumption of Entitlement
      2. What Defense is Good Against a Beneficiary? The LC Fraud Exception to the Independence Principle
      3. The LC Exception to the Fraud Defense: Protected Persons
      4. Nomination
        1. Protected Status Where There Is Negotiation by the Issuing or Confirming Bank
        2. Protected Status Where There Is Negotiation by a Negotiating Bank
      5. Value
      6. Notice
  4. Towards a Definition of LC Negotiation

  5. Conclusion

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    I. Survey of Negotiation of Drafts in the Law of Negotiable Instruments1

    Negotiation in the law of negotiable instruments is a special transfer of intangible rights in a negotiable instrument, which entitles the transferee to claim under the instrument as if it were payable directly to it, transfer it in a similar manner to others, and claim under appropriate circumstances that it takes free of certain defenses that could have been raised against the drawer or prior transferees.2

    While there are differences as to how one becomes entitled to exercise these rights, these differences have little practical significance in discussing negotiability in connection with letters of credit, and the common law and civil law identify this person as a “holder.”3

    Negotiation in the law of negotiable instruments has certain formal prerequisites. Not just any promise or order to pay can be negotiated. To be negotiated, it must be in the form of a negotiable instrument—it must meet certain formal requirements, which include being unconditional.4

    Because the concept of negotiation necessarily involves the use of abstract terminology drawn from the major legal regimes, it is easier to explain how negotiation occurs than what it is. Negotiation of a negotiable instrument always entails the delivery of the instrument to an entity who becomes a holder. Where the instrument is issued in bearer form or indorsed in blank or to bearer, only delivery is required to effect a negotiation. Where the instrument is issued to the order of a named entity or entities or issued in bearer form and indorsed to a named entity or its order, the delivery must be accompanied by the indorsement of that entity.5

    By issuing a negotiable instrument as a drawer or by indorsing it, an entity makes certain promises to subsequent holders to whom the instrument is negotiated or who can claim as a transferee of such a person, namely that it will honor the instrument if it is dishonored on maturity by the drawee or a subsequent indorser provided that any necessary notice is given.6 To disclaim this obligation on the instrument, it is necessary to indicate that the indorsement (or issuance) is “without recourse.” An indorsement or issuance without recourse signifies that in the event of its dishonor by the drawee, there is no recourse available on the instrument against the indorser or issuer. Absent such a disclaimer, it is assumed that any person signing an instrument as drawer or indorser makes such an undertaking.

    In the case of a negotiable instrument, negotiation is undertaken by the entity that is in possession of the instrument to whom it runs (holder) and is transferring (negotiating) it. One would typically speak of negotiation by the transferor and not by the transferee. It is the transferee to whom the negotiable instrument is negotiated.
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    II. Negotiation in Letter of Credit Practice

    A letter of credit is not a negotiable instrument.7 There are, however, negotiation credits—credits under which negotiation is permitted.

    Although letter of credit practice was originally linked with negotiable instrument practice, the ties between the two fields of commercial law have become increasingly attenuated. Under standard international letter of credit practice, with the exception of acceptances, negotiable drafts or bills of exchange are an anachronism. The declining status of the draft can best be viewed from the perspective of the doctrinal evolution of the letter of credit concept of negotiation in the rules of practice that are applicable to most commercial letters of credit, the Uniform Customs and Practice for Documentary Credits (hereinafter UCP).8

    A. Pre-UCP400 Terminology

    Negotiation is a concept that has been with modern letters of credit from the early twentieth century, the first point in time where LC doctrine can be reliably tracked.9 LC undertakings at that time invariably involved a draft that was typically accompanied by documents.10 While the parties to the underlying transaction were interested in the documents, the focus of the banker’s attention was on the draft that accompanied them.11 For a banker, the draft contained his or her instructions. The banker read the draft as a merchant would read the commercial invoice—as the compass for the transaction. The draft informed the banker who was to be paid, the terms of payment expected, the amount, the currency, and who was expected to make the payment.

    At the advent of the modern era, letters of credit required that a draft be drawn on the issuing bank. An LC contained one of two clauses. Straight credits, in which the draft was drawn on the issuing bank and could only be presented to the issuing bank, contained a clause of the following type: “We engage with the beneficiary that all drafts drawn under and in compliance with the terms of the credit will be duly honored on delivery of documents as specified if presented at your office on or before . . . 19 . . . .”12 Where presentation could be made to another bank, the credit would contain a clause of this type: “We engage with the drawers, endorsers, and bona fide holders of drafts drawn under and in compliance with the terms of the credit that the same shall be duly honored on due presentation and delivery of documents as specified . . . if negotiated or presented at . . . on or before . . . 19 . . . .”13 In effect, this latter engagement was understood to render the credit negotiable by this other bank. Where the bank was instructed to add its confirmation, that bank effectively engaged to negotiate drafts drawn on the issuer.14

    Where the draft was payable at sight, negotiation consisted of paying the amount due under the letter of credit to the beneficiary after having examined the documents and concluding that they complied with its terms and conditions.15 Where the draft was a time draft, negotiation consisted of paying the amount due under the letter of credit to the beneficiary discounted to present value after having examined the documents. Where the bank had issued the credit or added its confirmation, it negotiated without recourse.16

    B. Post-UCP400 Terminology

    The term “nominated” was first introduced in UCP290 (1974) and the concept of nomination seriously developed in UCP400 (1983).17 A nomination entitles the person nominated to act under the credit and embodies an undertaking by the issuer and any confirmer to reimburse the nominated bank. The nomination empowers the nominated bank to act within the scope of the nomination and to undertake any act not inconsistent with it.

    Nomination can effect to whom presentation may be made, the status of the bank with respect to amendments, the status of the bank with respect to revocable credits, the status of the bank in the event of claims of fraud on the part of the beneficiary or forged or fraudulent documents, or the ability of the bank to effect the transfer of drawing rights, and the entitlement to reimbursement. Nomination of a bank under an irrevocable credit gives an irrevocable right to a beneficiary to present documents to that bank for purposes of satisfying the condition that documents be timely presented prior to the expiration of the letter of credit whether or not it takes up its nomination. A nominated bank is not obligated to act by virtue of being nominated and may elect not to do so. With the exception of a confirming bank, a nominated bank does not make any engagement by advising the credit or by receiving a presentation, examining the credit, or forwarding it to the confirmer or issuer unless it expressly so indicates.18

    Instead of distinguishing only between straight and circular (undertakings that were meant to circulate) as did earlier UCP versions, by UCP400 (1983) it was recognized that a bank could be nominated to confirm (confirming bank), pay (paying bank),19 or negotiate (negotiating bank).

    These categories tended to overlap. Negotiation did not necessarily entail nomination and could be undertaken by the issuing bank which had engaged itself under its letter of credit. Nor was it confined to a negotiating bank since a confirming bank could make an undertaking to negotiate as well. Although not always fully grasped even by LC bankers, negotiation in post UCP400 LC practice encompasses two quite different functions. On the one hand, it represents a type of undertaking given by either an issuing or confirming bank to negotiate drafts drawn on either the applicant20 or issuer respectively and the fulfillment or honor of that undertaking.21 On the other hand, negotiation also consists of a nomination by the issuing bank of a bank that is authorized to negotiate drafts drawn under the credit but is not requested or authorized to add its own undertaking to the beneficiary. Such a nominated bank is characterized as a “negotiating bank” in LC practice. Although some writers and a few courts have confused the notion of nomination and negotiation with the doctrine of agency, agency is inapt to describe either.22 While this designation is somewhat illogical since both issuers and confirmers can also negotiate when they so undertake and could have been described as negotiating banks, it serves to reinforce the distinction between a bank that is obligated on the LC and one that is not. Where a negotiating bank is involved, the drafts can be drawn on a paying bank, the confirming bank, the issuer, the applicant, or a third person but not the negotiating bank.23

    Following the format of SWIFT MT700 messages, UCP600 distinguishes between the notions of “Available With . . .” and “Available By . . . .”24 A credit is “available with” the issuer, or a nominated bank which can include a negotiating bank. It can be “available by” payment, deferred payment, acceptance, or negotiation. Where the credit is “available by” negotiation, the bank it is “available with” the negotiating bank.
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    III. Issues Regarding Negotiation of LCS

    Under modern letter of credit practice and law, there are several issues which dominate the concept of negotiation and which, to an extent, mark the difference between negotiation under negotiable instrument law and under letter of credit practice and law. They are a. the requirement of a draft; b. formality requirements for a draft; c. who negotiates; d. how negotiation occurs; e. recourse; and f. protection of banks that negotiate in the event of letter of credit fraud. These issues overlap and, for clarity, there is some redundancy in explaining them.

    A. The Requirement of a Draft

    Under negotiable instrument law and practice, there must be a negotiable instrument (for our purposes, a draft) in order for negotiation to occur.

    In its evolution, letter of credit practice has deviated considerably from its original focus on the draft (to pay it or to accept it or to reimburse another bank who accepted or negotiated it) whether or not there was “negotiation.” The early unwritten expectation that a draft would always be presented under an LC no longer obtains. With the exception of credits that contain an undertaking to accept, it is not uncommon for UCP commercial credits to dispense with the requirement of a draft. For standbys, a draft is unnecessary and irrelevant. Even with respect to an acceptance, the role of the draft has been supplanted by the deferred payment undertaking in which an obligation to pay over time is incurred under the terms of the credit. Properly understood, this undertaking is the functional equivalent of a acceptance.25

    Most importantly for this analysis, a draft is not even required under LC practice, where the LC contains an undertaking to negotiate or authorizes a nominated bank to negotiate. LC negotiation can be against the documents themselves without there being a draft at all.26 UCP600 (2007) Article 2 (Definitions) paragraph 2 states that “Negotiation” can be of “drafts (drawn on a bank other than the nominated bank) and/or documents.”

    Even where a letter of credit requires a draft, its role is diminished. Under modern LC practice, a simple demand can suffice to indicate the tenor of the drawing. Moreover a draft is for the bank’s internal records and banks retain them and do not regularly forward them to the applicant and, as will be discussed, there is some confusion about the status of a draft when it is required by the credit.

    B. Formality Requirements

    While there may be greater or lesser degrees of rigidity in the formal requirements for an undertaking to be a negotiable instrument under the various statutes or codes, each sets forth its own requirements with clarity and there is little doubt as to the necessary elements.27 The codes commonly require a signed writing, a promise to pay that is not conditioned on any event or term not stated in the undertaking, words of negotiability usually in an accepted formulation, a certain amount, and no other promise or obligation that affects these undertakings. There can be other requirements, but there are also default rules that imply some of these provisions, and there are often provisions that address various issues such as interest.28

    Since the UCP does not address the contents of drafts, one might conclude that there are no LC formality requirements for a draft.29 That conclusion is not correct for commercial letters of credit. There are requirements that are intermittently applied to drafts but they are not necessarily the requirements of negotiable instruments law. Some of these requirements are reflected in the International Standard Banking Practices (ISBP 2003) which are formal interpretations of UCP500 issued by the ICC Banking Commission.30

    Unlike negotiable instrument law which implies a tenor, ISBP paragraph 45 (Tenor) requires that the tenor of the draft correspond with that of the credit.31 ISBP paragraph 45(a) also requires that, except for a sight draft, it be possible “to establish the maturity date from the data in the draft itself”32 and other subparagraphs and paragraphs provide detailed rules for calculation of the time. Thus, where the LC requires that the tenor of the draft be “30 days from B/L date,” LC practice as reflected in the ISBP would require that the B/L date or the maturity date be stated in the draft in order to provide a basis for calculation since it would be necessary to look to the bill of lading (even if it was presented in tandem with the draft) to ascertain the date if it was not stated in the draft. This approach leads to the somewhat odd result that a draft that literally replicated the terms of the LC (draft drawn “30 days for bill of lading date” under an LC with precisely that requirement) would be regarded as non complying.33

    This result is consistent with traditional negotiable instrument law. Although negotiable instrument law focuses on the draft itself, letter of credit practice need not do so since there are other documents that accompany the draft, namely the bill of lading which would enable the bank to make the calculation. This rule is particularly bizarre where the draft is not negotiated or accepted. Despite the rigid rule, where a draft is presented that does not contain the date from which the calculation of maturity is to take place, many banks to whom the documents are presented do such a calculation and note it on the draft. Such a practice should be given effect and not regarded as an alteration of the draft.

    ISBP paragraphs 52 and 53, 54 and 55, respectively, also require that drafts drawn under UCP500 letters of credit contain an amount reflecting the amount drawn under the LC, be drawn on the party stated in the LC, and be drawn by the beneficiary.34

    As to the other requirements of local law regarding the formality requirements for a draft, banking practice is largely silent. There is, however, one additional respect in which a LC banker would probably require compliance, namely the presence of the “magic words” of negotiability, namely “order” or “bearer.” Although this requirement is not reflected in the UCP or ISBP, the presence or absence of the words “or order” is arguably the only technical indicium of negotiability (other than the correspondence of obvious data regarding parties, the tenor, and the amount with the terms of the LC) that registers with bankers.35

    Where a court concludes that the requirement of a draft on an LC means a draft that meets the requirements of local law, the question of which law arises. While there are similarities under various legal regimes and while LC bankers usually do not insist on the specifics where they disagree, there are some issues that can impact the question of whether a draft is adequate under local law. Two that have arisen are the language in which the draft is written and whether there are corrections.

    Where the LC requires that all documents be written in English, a court has concluded that a required draft may be in French, where mandated by the law governing the beneficiary (who draws the draft).36 While standard international letter of credit practice permits corrections or alterations to drafts provided that they are authenticated, the laws of some countries do not permit corrections or alterations to drafts.37

    Whether the risk of the application of local law is to rest on the applicant, intermediary banks, or the beneficiary is not altogether clear. Absent a special requirement otherwise, it would seem that a beneficiary would be entitled to draw a draft in accordance with its own law and that doing so would not constitute a discrepancy. Had the applicant required another form, it should have so specified in the LC. It is clear that where a bank honors the presentation of such a draft, it is entitled to reimbursement since the UCP provides that the applicant bears the risk of the application of local law.38

    The reality, however, is that the use of a legally negotiable instrument only matters in the discrete situation where there is to be acceptance financing. Accordingly, there are some cases that have recognized that a draft is simply an order to pay and concluded that such an order may be inferred from any demand to pay.39 Absent these situations, there is little, if any, difference between a demand—a draft that does not qualify under applicable law as a negotiable instrument—and a draft that does so qualify. Indeed, it is possible to infer a demand from a presentation of documents.

    ISP98, the rules of practice for standby letters of credit, takes this approach to drafts. It provides that a required demand need not be separate from other documents presented, and, if a separate demand is required, it need not be in the form of a draft unless the standby expressly so requires, in which case, the required “draft” “need not be in negotiable form . . . .”40

    It is also unclear whether and to what extent an issuer can waive requirements about a draft or even presentation of a draft itself and retain its right to reimbursement. Since the draft is rarely, if ever, required by the applicant, and is retained by the issuer—except where it is drawn on the applicant—any objection to a defective draft by the applicant would be seizing on a fortuitous circumstance to avoid its obligation to reimburse.

    Where it is required, then, the position of the draft in LC practice is curious at best and ambiguous at worst.

    C. Who Negotiates?

    Under the law applicable to negotiable instruments, any entity to whom a draft is issued or indorsed and delivered, or who is in possession of it if it is in bearer form, can negotiate it. There need be no special designation or nomination of a person for it to do so. Generally speaking, this person is the transferor or negotiator.

    Under LC practice, however, it is only the bank that is nominated to do so (and not the beneficiary/drawer) that is said to negotiate. Absent nomination, there can be no LC negotiation of a draft.

    Where a bank is not nominated in the letter of credit to negotiate, negotiation does not occur even if the draft is in fact made payable to the beneficiary’s order and legally negotiated (in the negotiable-instruments sense) to a non-nominated (collecting bank). In effect, in LC practice and law, negotiation is limited to banks so nominated. Negotiation of a draft under negotiable instrument law does not constitute LC negotiation unless the transferee is a nominated bank.

    D. How Does Negotiation Occur?

    Under negotiable instruments law, a negotiable instrument is negotiated by indorsement by the transferor and delivery if it is issued or indorsed to the order of a named entity or, if in bearer form, by delivery alone. Negotiation is a special form of transfer by which the rights inherent in the instrument are transferred in such a way that the transferee becomes a holder who is entitled to exercise them. A mere assignment of the instrument does not achieve this effect, although an assignee is able to succeed and exercise certain rights to the instrument of the assignor and indirectly shelter under the status of one to whom the instrument has been negotiated.

    The negotiation of a draft drawn under a letter of credit in accordance with the law of negotiable instruments not only is not LC negotiation, but it has no effect whatsoever with respect to rights under the LC. If the beneficiary of an LC draws a draft in accordance with the terms of the LC, makes the draft payable to itself, and indorses and delivers it to a person or entity not nominated in the LC as a negotiating bank, there has been negotiation under the law of negotiable instruments, but no negotiation under LC practice or law.

    In effect, LC negotiation starts at the other end, with the transferee. Negotiation under a letter of credit takes place when a nominated negotiating bank purchases the presentation (which need not include a draft) under a letter of credit. The nature of the exchange is linked to the meaning of LC negotiation and is addressed later in this paper. It is clear, however, that something more than the physical transfer of a draft with necessary indorsements is involved in LC negotiation.

    Indeed, indorsement is almost irrelevant to LC negotiation. Of course, where there is no draft, it is without meaning. Even where there is a draft, as indicated, LC practice hardly pays attention to it. There is no provision in the UCP regarding indorsement of a draft. Nor does the UCP indicate to whom the draft must be made payable, and it is rare for the LC to so specify. The general expectation is that a draft will be made payable to the order of the beneficiary or to its bank.41

    Where the draft is payable to the named beneficiary, it is usually endorsed in blank, but credits requiring indorsement of a draft are virtually unknown, and no reported cases have been found in which dishonor of a credit was based on the absence of a necessary indorsement on a draft.

    When documents are forwarded, it is not uncommon for the issuer or confirming bank to demand that a nominated bank add its indorsement to the draft. Where the draft is indorsed in blank by the beneficiary, there is no basis for such a requirement in the UCP in letter of credit practice or in the law of negotiable instruments. The desire for such an indorsement is probably driven by the thought that it yields an additional right against the bank outside of letter of credit law and practice. The value of any such right, however, is tied up with the right of recourse, which is discussed in the next section.

    While addressing the issue obliquely, the drafters of the ISBP effectively ducked it. ISBP (2003) paragraph 51 provides that “[t]he draft must be endorsed, if necessary.” It is unfortunate that the ISBP did not make it clear that refusal to honor or pay without adding an indorsement where the documents otherwise comply constitutes wrongful refusal, unless the letter of credit expressly requires that the draft contain the indorsement of the negotiating bank.42

    E. Recourse

    Where a draft presented under an LC is drawn on the issuer and the issuer refuses to honor or where it is drawn on the applicant and the applicant refuses to honor, questions arise concerning the ability of a bank that has negotiated it to obtain recourse against prior indorsers and the drawer.

    Under negotiable instruments law, the notion of recourse relates to the obligations that arise from signing an instrument. It signifies a right arising from the issuance or transfer of the instrument by indorsement that enables a transferee to recover from the transferor based on the transferor’s obligation on the instrument itself that arises from signing it in the event that the instrument is dishonored or unpaid when it is due.43 Recourse on a negotiable instrument operates unless affirmatively disclaimed44 or, under some systems, the obligation of a person signing is discharged by an acceptance or by the failure to give any necessary notice or some other action.45

    While recourse is mentioned in the UCP, the rules have never coherently addressed it—possibly for the same reasons that they have not addressed issues relating to drafts. Under letter of credit law and practice, recourse means the ability to reclaim the proceeds paid under a letter of credit presentation. There are significant differences between recourse under a LC and a negotiable instrument.

    In the first place, it operates with respect to LCs regardless of whether or not there is a draft.

    In the second place, under letter of credit practice and law, recourse against the beneficiary is not available to an issuer or confirmer regardless of whether or not there is an express disclaimer. While the unavailability of recourse for issuing and confirming banks has been stated in the various versions of the UCP, there is no right of recourse even were the UCP not to so state.46 Having undertaken to honor, these banks are obligated on the credit, and payment by them is final in favor of the beneficiary.47 The notion is therefore linked to finality. The issuer or confirmer bears the risk of paying against discrepant documents or obtaining reimbursement. Should the issuer or confirmer have made an erroneous or unlucky credit decision or have erred as to whether or not the documents are discrepant, it may not seek recourse against the beneficiary after it has negotiated.48

    Were a draft indorsed without disclaiming recourse on the draft, the issue arises as to whether there is recourse under negotiable instruments law. Where recourse can be disclaimed other than on the face of negotiable instrument, the terms of the UCP could suffice as a disclaimer as to the issuer or confirmer who undertakes to negotiate.49 Where they cannot be, there is a conflict between the two regimes. In such a situation, negotiable instrument law should be displaced by the law of letters of credit.50

    A different result obtains where a bank other than the confirmer is nominated to negotiate under the letter of credit. The UCP does not address this situation. It is thought that the general rule of negotiable instruments—that there is recourse unless it is disclaimed—applies in such a situation, although its contours are debated.51 There is considerable debate over the scope of recourse, particularly whether or not it extends to errors regarding discrepancies on the part of the negotiating bank (or at least those discrepancies that could have been cured).52 While practices differ, and banks are free to disclaim or waive their right to recourse, the concept itself admits of no such distinction. In effect, some banks distinguish themselves in their market, or are pressured by others in their market, by voluntarily assuming the risk of bank error with respect to missed discrepancies. Other risks include issuing bank risk, country risk, currency risk, and risk of beneficiary fraud. Unless expressly disclaimed, it is generally thought that these risks rest with the beneficiary instead of the negotiating bank.

    F. Protection of Banks That Negotiate in the Event of LC Fraud

    One of the critical tests of the workability of any aspect of commercial law is the manner in which it addresses issues of fraud and balances the relative rights of various parties and broader commercial interests in the integrity of the institution it governs.

    It is with respect to fraud that negotiable instruments are most commonly distinguished from traditional contracts.53 The entity to whom a negotiable instrument is negotiated qualifies for greater rights that may have been possessed by the transferor. This abstraction of the rights inherent in the paper from the transaction that gave rise to it is the hallmark of the doctrine of negotiability. Letters of credit take this abstraction to a higher level.

    Generally speaking, under the common law of negotiable instruments, there is an entire apparatus of substantive and procedural law designed to support the notion of negotiability. On negotiation, a presumption can be said to arise that a person to whom a draft has been negotiated, or one who claims under that person, is entitled to recover on the instrument unless the person obligated on the instrument is able to prove a defense. The defense may be any defense that sounds in contract or recoupment. Once a defense is proven, the holder who has acted with good faith is entitled to a protected status either in its own right or in that of a person under whom it claims. Even if it is so entitled, there are certain defenses deemed so basic that this protection fails as to them.54

    The law of fraud with respect to letters of credit is a relatively recent creation, dating its origins by most accounts to the 1941 decision of the New York Supreme Court (a trial court of general jurisdiction) in Sztejn v. J. Henry Shroeder Banking Corp.55

    When bankers hear of a bank being embroiled in a dispute between an applicant and a beneficiary, they sometimes express the wistful opinion that the letter of credit should operate without regard to fraud. Upon being pressed, however, they generally do not mean that it should be fraud-proof. With the possible exception of the U.K.,56 courts have generally grasped this point for the very good reason that an instrument that can be used with impunity by fraudsters loses its credibility as readily as one whose liquidity can be frozen based on any dispute over the transaction that gave rise to it. The challenge is to find a balance that favors the integrity of the letter of credit while providing a remedy for the rare case where letter of credit fraud is sufficiently demonstrated and the merits of judicial intervention are apparent.57

    There are several dimensions to LC fraud that involve negotiation by issuers, confirmers, and negotiating banks under letter of credit practice and law that externally resemble the law of negotiable instruments, but that manifest significant differences. While the courts that have decided cases on this topic commonly recite or draw on principles of negotiable instruments law, it is not entirely clear that they appreciate the differences.

    1. The Presumption of Entitlement

    Under negotiable instruments law, it is the holder or a person claiming under it who is entitled to a presumption of entitlement (that they are entitled to exercise rights free of the transferor and recover), which narrowly circumscribes the defenses that can be asserted. On the other hand, where there is no transfer by negotiation, any defense between the drawer and the person to whom the draft is issued (usually the payee) can be asserted.

    Under letter of credit law, it is the beneficiary (in a situation roughly comparable to the payee) who is effectively so entitled and, unlike a negotiable instrument, even where there is no negotiation, the defenses that are able to be asserted against the beneficiary are severely circumscribed and effectively limited. The protected person in LC law and practice is immune to even these defenses, and thus, the scope of the doctrine of negotiability under a letter of credit is much broader than is the case with a negotiable instrument.

    Under letter of credit practice and law, the applicant bears the risk of disputes regarding the performance of the underlying transactions that gave rise to the letter of credit. In effect, the letter of credit represents an allocation of the risk of who holds funds pending the resolution of these disputes. In the ordinary case under a letter of credit, the beneficiary is entitled to hold the funds until things can be sorted out.58 Although payment to the beneficiary is final with respect to the letter of credit obligation, the obligation that gave rise to it remains and may be a basis for recovery by the applicant to the credit or any assignee of its rights in a post-payment action against the beneficiary on the underlying transaction. The abstract status of the beneficiary, therefore, can be understood as temporary or interim. That of the LC issuer or nominated bank is permanent. The rule protects these banks, as it should, if the system is to have currency, since where these banks, as intermediaries, have in good faith paid funds to the fraudster pursuant to their undertaking or nomination, they ought to be able to obtain reimbursement. Assuming that lending or credit decisions were sound, the loss will be thrown onto the applicant who either elected to deal with the beneficiary or used its credit to obtain the LC for the person who did so.

    2. What Defense Is Good Against a Beneficiary? The LC Fraud Exception to the Independence Principle

    Under negotiable instruments law, the proof of a defense brings into question entitlement under a protected status.59 Only if this status is present will the holder of the instrument recover, and then only with respect to certain defenses. Defenses are cut off by a protected holder. However, depending on the system, there are certain defenses based in public policy, such as incapacity, that can be asserted even against a protected holder.60 Under the civil law, a person obligated on a bill “cannot set up against the holder defenses founded on their personal relations with the drawer or with previous holders, unless the holder, in acquiring the bill, has knowingly acted to the detriment of the holder.”61 In effect, defenses that are “personal defenses related to the bill and the underlying transaction” are excluded.62 However, certain defenses are good even against a good faith holder. Ellinger lists them as incapacity, forgery of the drawer’s signature, and duress. Under the American system, once a defense in contract or recoupment is proven, the burden of proof shifts to the holder to the prove holder in due course status. Even if proven, a holder in due course takes the instrument subject to “real” defenses (in rem) of infancy, duress, lack of capacity, illegality (which nullifies the undertaking under local law), and fraud resulting under excusable ignorance.63 The English system differs in this respect. A holder’s rights “are easily assailable.”64 A holder in due course takes the instrument free of title defects and fraud relating to the underlying transaction.65 Ellinger characterizes the position as “iron-clad,” subject only to defenses of capacity or consent, such as a plea of non est factum when a party is tricked into signing a bill, which closely resembles the defense of fraud due to excusable ignorance under U.S. law.66

    In an LC scenario, the beneficiary takes free of defenses that could be asserted under negotiable instruments law against a holder who had not proven its protected status. In effect, the level of abstraction for negotiable instruments is ratcheted up a notch and narrowed compared to the law of negotiable instruments.

    Under letter of credit law, it is the equivalent of one of these “real” defenses (as opposed to “personal” defenses) of negotiable instruments law67 that gives rise to an excuse to the letter of credit obligation in the face a demand by the beneficiary. A defense that is “personal” to the applicant and beneficiary is not a defense to an LC unless it is LC fraud. The other “real” defenses to negotiable instruments are not, as a practical matter, likely to arise in the case of letters of credit.68 As a result, defenses that can be asserted under letter of credit practice are limited to fraud on the part of the beneficiary that is so serious as to render the pretense of operating on the basis of documentary representations meaningless. There are a variety of names for this fraud, and even more descriptions of it.69 For purposes of convenience, and to distinguish it from other types of fraud—including fraud in the inducement (procurement), securities fraud, and misrepresentation—this type of fraud is called “letter of credit fraud” (or “LC fraud”) in this article.

    The word “fraud” is unfortunate. In the civil law system, the name “fraud” suggests criminal complicity, and what is meant by LC fraud perhaps is better captured by the notion of abusive drawing (abus de droit). In the common law system, it connotes scienter or intent on the part of the fraudster. It is this unfortunate connection that has led to a series of decisions by various courts to the effect that a beneficiary is entitled to recover from a bank where a required document that it presents is fraudulent (forged or otherwise fraudulent), but where the beneficiary is innocent of the fraud.70 This result reflects a misunderstanding of the undertaking inherent in a letter of credit. A letter of credit bank undertakes to honor a document that represents the underlying transaction. It does not undertake to honor a document that is fraudulent regardless of the innocence of the person presenting it. Where there is no question of reimbursement of a protected bank that has honored or negotiated against documents that on their face comply with the terms and conditions of the credit, the risk of documentary fraud is on the innocent beneficiary who dealt with the fraudulent document where the issuer or confirmer is able to prove its fraudulent character and resists payment on that basis. As to the issuer, confirmer, or other nominated bank, the beneficiary’s obligation is to present a genuine document. The ability of the issuer or confirmer to refuse payment to a beneficiary or a collecting bank on the basis of letter of credit fraud should not be confused with its right to recover reimbursement, notwithstanding that fraud where it honors in good faith.

    3. The LC Exception to the Fraud Defense: Protected Persons

    As indicated, the effect of protected holder status under negotiable instruments law entitles its occupant to recover notwithstanding certain defenses. Once a real defense such as fraud resulting from trickery is proven, a protected holder is subject to it under negotiable instruments law.

    Even where it is proven that there is Letter of Credit Fraud, recovery under an LC is not prevented for protected parties to the letter of credit transaction who are able to claim reimbursement notwithstanding beneficiary letter of credit fraud. There is no equivalent in negotiable instruments law, under which the protected parties only are protected against personal defenses, but not against real ones. The LC protection is, so to speak, supercharged.

    The protected status of banks under letter of credit practice must be pieced together from rules of practice and their implications. Bankers are rarely interested in formulating rules addressing pathological problems.71 The foundation of this supercharged protected status, however, can be seen in UCP600 Article 34 (Disclaimer on Effectiveness of Documents). It disclaims all liability and responsibility of banks for the “genuineness, falsification . . . of any document(s), or for the general or particular conditions stipulated in a document or superimposed thereon; nor does it assume any liability or responsibility for the . . . existence of the goods, services or other performance represented by any document, or for the good faith or acts or omissions, . . . performance . . . of . . . any other person.”72 The new provisions in UCP600 Articles 7(c) (Issuing Bank Obligation), 8(c) (Confirming Bank Obligation), and 12(b) (Nomination) also address the issue of the right to reimbursement in the event of LC fraud. In the absence of a statute, these provisions provide a useful framework for the fraud exception, but in the absence of a systematic treatment of LC fraud, it is doubtful that courts will be able to build a comprehensive jurisprudence, particularly where they have gotten off to a false start.

    While rules of practice cannot themselves create exceptions to the legal effect to be given to fraudulent or abusive drawings, they can allocate the risk of such actions, and modern commercial law typically gives effect to such an allocation if it is commercially reasonable.73 Under standard international letter of credit practice, where an issuer or nominated bank acting pursuant to its nomination honors, the risk of fraud or forgery is allocated to the applicant.

    4. Nomination

    Under the law of negotiable instruments, any person to whom an instrument has been transferred by negotiation is eligible for protected status provided that they behave with the requisite good faith, give value, and act without notice of a defense or that the instrument is overdue.

    The availability of this protected status under LCs does not, in the first instance, turn on the relative culpability or innocence of the person or entity involved. As discussed above, a protected status is only available to those who have issued the LC or been nominated to act under the letter of credit.74 Thus, where the LC involves an undertaking to negotiate drafts by the issuer, confirmer, or a negotiating bank, protected status extends only to the nominated bank or the issuer. A bank that acts without nomination (a collecting bank) takes subject to any defense that can be asserted against the beneficiary.

    While the test of the bank’s good faith and the burden of proving it are procedural matters under local law, whether a bank is nominated to negotiate will be apparent from the face of the credit or amendments.75

    If an issuer or nominated bank acts pursuant to its nomination, the risk of the consequences of LC fraud of any other person is allocated to the applicant. The nominated bank is entitled to be reimbursed for any payment made pursuant to any obligation occurred provided that the nominated bank has not itself been a party to the fraud, abuse, or forgery.

    If the issuer, confirmer, or negotiating bank duly negotiates, it is entitled to protected status notwithstanding LC fraud. But what constitutes due negotiation differs between banks that are irrevocably obligated on the letter of credit and those that are not—that is, between issuing and confirming banks on the one hand and negotiating banks on the other hand.

    a. Protected Status Where There Is Negotiation by the Issuing or Confirming Bank

    As indicated, under negotiable instrument law, a protected person is entitled to limited protection. Under all systems, even a protected person is vulnerable to certain defenses founded in trickery regarding the instrument or fraud in the factum.

    Under letter of credit practice and law, an issuing bank and a confirming bank, having undertaken to honor, are entitled to the enhanced protected status available under letter of credit practice and law, which enables them to be reimbursed regardless of the nature of the defense against the beneficiary where they have acted in good faith, that is, without actual knowledge of the fraud and for value.76

    Where the issuer or confirmer have given their irrevocable promise, there is no question of value. The need to have given value can be said to be met by having made an irrevocable promise or to be irrelevant where there is such a promise.77 In either event, value is not an issue.

    Notice of default or that the undertaking is overdue, issues under the law of negotiable instruments, are inapt as letter of credit categories. If the default relates to the underlying transaction, the issuer or confirmer can ignore it unless they have actual indisputable knowledge of the default and are aware that the default is so serious that it disentitles the beneficiary to any conceivable right to draw. There is no notion of a LC being “overdue” applicable to letters of credit. If the credit has expired—that is, ceased to be available for a presentation—the obligation of an issuer or confirmer is discharged, and if a deadline has passed,78 the documents do not comply, and the bank is not entitled to be reimbursed unless waived by the issuer or applicant respectively.

    As to notice of fraud, the right to reimbursement of an issuer or confirmer who has made an irrevocable undertaking to honor is not affected by notice of fraud provided that they act in good faith.79 For this purpose, the notion of “good faith” is limited severely. Under negotiable instruments law, the focus of the inquiry of whether one has acted in good faith is on the time when the purchase takes place. Under a letter of credit, an issuer or confirmer are already obligated, and their only focus is on the documents and not the underlying transaction. Their “good faith” relates only to what actual knowledge they have about the documents. They are under no duty to investigate allegations or suspicions. A bank acts in good faith unless it has actual and incontrovertible knowledge of letter of credit fraud.80 Therefore, the mere allegation of fraud by the applicant will not impede recovery by the issuer or confirmer.81

    This rule exists to protect the letter of credit system. If the mere allegation of fraud were sufficient to inhibit a letter of credit promise to pay, it would be of little more value than a simple contract. Banks do not and should not have the power to make a binding determination of the validity of claims of letter of credit fraud, and cannot compel the submission of evidence. Therefore, they should not be placed in the position of an investigator. The starkness of this result for the applicant is ameliorated by the ability of the applicant to seek extraordinary judicial relief in the form of a special court order attaching or freezing the presentation, payment, or proceeds.82

    b. Protected Status Where There Is Negotiation by a Negotiating Bank

    A bank that is nominated to negotiate without adding its confirmation is a negotiating bank and, should it elect to negotiate and duly do so, is entitled to reimbursement by the issuer or confirmer.83 As to negotiation by a nominated negotiating bank other than the confirmer, a different regime exists, and it is necessary to revisit the elements of protected status.

    5. Value

    In the law of negotiable instruments, there is some confusion as to the relationship between value and negotiation. The absence of an exchange may in the common law systems constitute a defense to the enforceability of the instrument, but should be unrelated to the question of whether or not it has been negotiated. Only in the U.S. system, however, is this distinction made. There, value is a question that arises in regard to whether the person to whom the instrument has been negotiated is entitled to a protected status. What constitutes value is a matter of some interest in comparing the U.K. and U.S. system.

    U.S. negotiable instruments law distinguishes between “consideration” and “value,” concluding that an executory promise is good consideration, but not “value” for purposes of determining protected status.84 The English Bills of Exchange Act does not make this distinction. It defines “value” as including “[a]ny consideration sufficient to support a simple contract.”85 Apparently, the problem of executory promises in favor of fraudsters has not arisen in English cases or claimed the attention of the courts.

    As described by Ellinger, the civil law looks only to the regularity of the chain of title by which the instrument has been passed.86 This approach must make aspects of the protected status under LC law confusing and explains why efforts to identify those entitled to that status have resulted in confusion.

    On being nominated to negotiate, a negotiating bank does not make an irrevocable commitment to negotiate under the LC.87 With respect to letters of credit, the question to which giving value is an answer is a factor in determining whether or not there has been negotiation. The questions arise, then, whether or not and when it has purchased or given value for purposes of achieving protected status. This notion and related concepts have figured considerably in the efforts of the ICC Banking Commission to define “negotiation.” At various times, it has been described as “negotiate/purchase,”88 “value,”89 and, once again in UCP600, “purchase.”90

    In light of negotiable instruments law, these questions are highly confusing. Under common law, negotiation is the act of transfer by which the transferee becomes a holder. Holder in due course status is a separate question. Under the civil law, one looks to the chain of transfers to determine whether or not it has been regular on its face.

    There are two different perspectives in which LC negotiation is viewed. Bankers view it as an entitlement to claim reimbursement. Lawyers tend to approach negotiation from the perspective of the implications of letter of credit fraud. This diverse approach is apparent with respect to “value” or “purchase.”

    At the time UCP500 was drafted, it was thought that the reimbursement system was being abused by banks who merely examined documents and claimed reimbursement as negotiating banks without having negotiated, but merely having forwarded the documents.91 The point of the UCP500 definition of negotiation as “value” was to make it clear that this practice was not proper. It soon became clear, however, that LC bankers in claiming reimbursement did not understand what was meant by “value” and, in particular, whether a promise to pay constituted value. To address the considerable concern that had been voiced, the Chair of the ICC Banking Commission issued Position Paper No. 2, which states that “‘giving of value’ in UCP500 Article 10(b)(ii) may be interpreted as either ‘making immediate payment’ (e.g., by cash, by cheque, by remittance through a Clearing System or by credit to an account) or ‘undertaking an obligation to make payment’ (other than giving a deferred payment undertaking or accepting a draft).”92

    Unsatisfied with this approach, the drafters of UCP600 defined negotiation in Article 2 (Definitions) paragraph 11 as “the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.” Whatever else “purchase” connotes, it does include a promise to advance funds as well as the actual advance of funds, as stated.

    While this redefinition solved one problem, it gave rise to another, namely whether a negotiating bank could claim a protected status in the event of beneficiary fraud as a result of a simple executory promise running to the fraudster.93 Unless the promise were in the form of a negotiable instrument that could be negotiated to innocent third persons or an irrevocable promise to an innocent person, the negotiating bank would have a complete excuse against a claim by the beneficiary in such a situation since fraud unravels all in every modern system of commercial law.94 In this scenario, would a court permit the negotiating bank that has not paid to recover from the issuer with a view to fulfilling in the future a promise to pay a fraudster or for fraudulent documents?

    The analysis is rendered more complex by the difference in common law systems with respect to whether executory promises constitute value. It may be expected that U.S. courts at least would refuse to accord protected status to a negotiating bank that merely promises to advance funds without having done so, and the same result should follow for whatever reason in other systems. On the other hand, where the negotiating bank has not yet paid but given a letter of credit to a third person or a negotiable instrument that may fall into the hands of an innocent third party, the negotiating bank has a complete defense if there is LC fraud.

    However it may be characterized, LC practice and law have sensed that there must be something additional to the mere transfer of the documents in order for there to be negotiation and that it must be a transfer that entitles the negotiating bank to assert rights to the documents. Such a transfer only takes place where the bank has purchased the documents in some fashion.

    While negotiation is typically thought of in the one-dimensional framework of a sight draft, time drafts can also be negotiated under letter of credit practice. Where a negotiating bank negotiates a time draft, it forwards the documents to the issuer or confirmer and engages in trade finance by discounting the amount due to its present value. The negotiating bank is then entitled to reimbursement at maturity. Where there is a time draft, there is always a possibility that LC fraud could be discovered or claimed in the interim period between the purchase of the draft or documents and the maturity date. In that situation, the question arises as to whether or not the negotiating bank is entitled to be reimbursed notwithstanding the fraud.

    This problem has been a serious difficulty with respect to deferred payment undertakings. The problem was highlighted by the English decision in Banco Santander SA v. Banque Paribas.95 Banco Santander intimated in dicta that the result would be different had there been negotiation of a draft by a nominated negotiating bank.96 However, a recent decision by the French Cour de Cassation concluded that under French negotiable instruments law, a confirming bank that discounted its own acceptance was not entitled to reimbursement as a protected party where letter of credit fraud had emerged after the discount and before maturity.97 One would have thought that an acceptance would be entitled to a higher level of abstraction than negotiation. But then one might have thought that a confirming bank that had discounted its own confirmation would be entitled to a higher level of abstraction than a negotiating bank.

    In any event, UCP600 addresses this matter in three articles intended to preserve the rights of banks that discount to reimbursement.98 Although the term “discount” is not used, probably in order to emphasize that it is not every discounting bank, but only a nominated bank to which it applies, the terms “purchase” and “prepay” achieve the same end.99 Under UCP600, a negotiating bank that negotiates a time draft should have added comfort with respect to its entitlement to reimbursement in the event of intervening discovery of letter of credit fraud.

    6. Notice

    Since negotiating banks have not made any irrevocable undertaking to honor under the letter of credit, an allegation of fraud of which they have notice operates differently on them than it would on an issuer or confirmer. A bank has not duly negotiated if it has notice of letter of credit fraud prior to negotiating. While a mere accusation of LC fraud subsequent to the issuance or confirmation of the credit will not defeat the right of an issuer or confirmer to reimbursement since they are obligated to pay, a negotiating bank that has no irrevocable letter of credit obligation can refuse to negotiate if notified before it does so and bears the risk if LC fraud is proven. On the other hand, notice of LC fraud after the negotiating bank duly negotiates does not affect its status.100
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    IV. Towards a Definition of LC Negotiation

    The UCP600 Article 2 (Definitions) paragraph 11 definition of negotiation suffers from the problems of the general UCP600 approach to definitions and drafting, namely the use of interlocking definitions and the avoidance of substance. With respect to the concept of negotiation, at least, the fault cannot be attributed to the drafters. The ICC Banking Commission is constitutionally incapable of addressing such serious doctrinal issues in a coherent manner. Being fundamentally a political body, it is only able to endorse a solution that has achieved consensus among controlling political interests. No such preparatory work has been done with respect to negotiation. Therefore, the “solution” to problems is to shuffle words.

    One of the problems in understanding negotiation in LC practice is the tendency to place too much emphasis on the term “negotiation” and the conceptual and political inability of bankers to address problems of letter of credit fraud in a coherent and objective manner. Negotiation in negotiable instruments law is merely the transfer of a negotiable instrument in such a manner that the transferee becomes the person entitled to exercise special rights under the instrument as its “holder” in the law of negotiable instruments.

    In letter of credit practice, when there is negotiation by a nominated negotiating bank, it is the right to be paid the proceeds under the LC that is transferred to the negotiating bank in its own right as the entity entitled to the proceeds under the LC. The transfer involved is similar to the transfer of drawing rights in that it is to be distinguished from a mere assignment of proceeds.101 Because a letter of credit is a “special” undertaking in that it runs only to the named beneficiary, the right to draw or perform is restricted to the named entity, although payment—as opposed to performance—is less rigidly controlled. There are important practical reasons for this limitation. As a documentary undertaking involving payment against representations, neither the applicant nor the issuer want to incur the risk of performance by a stranger to the underlying transaction absent their express permission.

    Although less clearly appreciated, the same principle applies to payment of the proceeds of a letter of credit. A mere LC assignment does not confer a right to the proceeds, but a transfer does. Yet a transfer is not the only mode by which the right to proceeds can be conveyed.

    Absent a transfer to it, the negotiating bank cannot perform under the credit. But once there is performance, a negotiating bank that has duly negotiated has a separate independent right to the proceeds being paid to it in its own name and not as an assignee of the beneficiary. In effect, LC negotiation is the transfer of the right to the proceeds of the LC.

    Unlike the transferee beneficiary, the negotiating bank is not automatically entitled to an independent status from the beneficiary; it must have negotiated for value, in good faith, and with no notice of the LC fraud. Unlike a LC transfer of drawing rights, the negotiating bank is not entitled to draw in its own name, only to receive the proceeds in its own name. In this sense, negotiation can be understood as the transfer (as opposed to LC “assignment”) of the right to proceeds.102 Whether the negotiating bank, when it is the transferee of proceeds, is entitled to them in the face of beneficiary LC fraud depends on the answer to a different question, namely its bona fide status.
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    V. Conclusion

    This paper lists and identifies detailed technical differences between negotiation with respect to negotiable instruments and negotiation with respect to letters of credit. These differences are substantial and themselves warrant the conclusion that the law of negotiable instruments is inadequate as a basis for governing issues with respect to negotiable instruments presented under letters of credit.

    This paper follows the evolution of the letter of credit from an appendage of negotiable instrument law to a separate system in its own right with some remaining vestiges of negotiable instrument law, albeit in new guise. In one sense, the various matters discussed are elementary. In another sense, comparison between them and analysis of their differences and their significance is challenging. This paper does not claim to be a definitive or systematic study of this area, but is intended to provoke further efforts that will hopefully lead to such a study.

    One of its themes is that letter of credit practice and law have evolved as a separate legal discipline. As a result, letter of credit law has become decoupled from the law of negotiable instruments. Where a negotiable instrument is involved, there may be another cause of action or theory of liability or available recovery—in addition to that under letter of credit law—but the two are separate and distinct areas of law.

    The failure to recognize the existence in letters of credit of a system that is parallel, different, and separate from that of negotiable instruments will lead to confusion and defeat the reasonable expectations of the commercial community. This result has been apparent in cases regarding acceptances arising under letters of credit where a rigid interpretation of the abstract character of an acceptance led the court to the conclusion that payment must be made to a fraudster simply because of the existence of the acceptance.103 This approach results in bad policy, not only with respect to letters of credit, but also with respect to negotiable instruments.

    The attraction of negotiable instruments law as a means of resolving letter of credit issues is, in part, that it represents a codified body of law and, also in part, that lawyers and judges are familiar with it—whereas in many countries, letter of credit law is not codified, and most lawyers and judges are not familiar with it. As a result, it becomes easy to apply the highly technical rules of negotiable instruments as a means of reaching a decision in cases involving letters of credit without delving into the policies which underlie these rules and the appropriateness of their application to a problem involving letters of credit. Without a clear understanding of the policy behind rules, however, it is no longer possible to apply rules in an intelligent manner because it becomes impossible to determine when the rule ceases to achieve the end for which it is designed.

    Under letters of credit, the undertaking embodied in the letter of credit extends beyond bringing into existence a draft to be presented. While there may be a separate set of obligations which arise with respect to the draft, even where it has been accepted, there remain in place obligations concerning the letter of credit undertaking that are not subsumed by the acceptance. Indeed, where there is a conflict, it is the letter of credit obligation that subsumes that which arises with respect to the draft.104

    There is, however, a further point to which attention should be drawn. The letter of credit takes the concept of negotiability beyond that which is achieved under the regime of negotiable instruments. Negotiable instruments shackle the concept of negotiability to the paper with which it is merged, and for historical reasons, immerse it in formal and technical rules. While it may be necessary that a general instrument of debt and credit be surrounded by such technicalities, it is not inevitable. Indeed, an equivalent level of abstractness has been achieved at least in U.S. commercial law with respect to leases of personal property and their hell-or-high-water clauses105 and security interests in personal property, whereby an assignment can be given the effect otherwise achieved by a negotiable instrument.106

    With letters of credit, however, a higher degree of negotiability has been achieved. In this sense, negotiability consists of a free transfer of obligations without or with limited encumbrances. Letters of credit have thus achieved a relatively high form of liquidity. In particular, in the form of standby letters of credit, they have achieved an incomparable level of liquidity—coupled with flexibility in an instrument whose integrity has, on the whole, not been diminished. This remarkable achievement, having arisen historically and conceptually from the doctrine of negotiability, has become a central feature of letter of credit practice and law.

    Footnotes

    For complete footnote citations, download the PDF.

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