In this client alert, we revisit some best practices for using documentary letters of credit as the payment mechanism under commodities contracts. We also look at L/C confirmation and confusion which can arise with "may confirm" provisions. A further alert will look at the problems around price escalation clauses in L/Cs.
A brief introductory reminder - what, why and how?
A letter of credit is defined in the UCP 6001 as "…any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation."
In other words, a letter of credit is an irrevocable undertaking by a bank to make payment to a named beneficiary (Seller) within a specified time, against the presentation of certain documents which comply strictly with the terms of that credit. Essentially, the use of a letter of credit enables a Seller to substitute the creditworthiness of his Buyer with that of a creditworthy bank, provided the correct documents can be presented.
Documentary letters of credit are common in some trades (agri, sugar, veg oils), but less common in the petroleum trade for example, which tends to use a standby L/C which requires a beneficiary statement of non-payment to trigger the bank’s obligation to pay, with no or minimal further documentary requirements.
Best practice pointers
- As a matter of best practice, the agreed form of letter of credit should ideally be set down as an appendix to the sale contract, to preclude any delay or dispute in agreeing the form of credit later. The L/C being opened in a form not in accordance with the sale contract (or the sale contract being imprecise as to the L/C requirements) is a very common issue and leads to many disputes. A Buyer should take care, however, that any form of L/C specified in the sale contract appendix is acceptable to his bank: many banks have particular rules/requirements and a Buyer may find himself caught between the bank and the Seller when seeking an acceptable format.
- If no L/C form is specified in the sale contract, as Buyer, we suggest you send a draft to the Seller, in good time before any deadline, seeking agreement before opening.
- Remember, the other practical consideration which arises is variation – if a form of credit is agreed which departs from the wording of the contract (for example by requiring additional documents to be procured by the Seller, or a different shipment period), the agreed L/C wording will usually be taken to have varied and superseded the terms of the original sale contract. Care and attention therefore needs to be paid to the form and content of the L/C when opened. A Seller should usually reject an L/C which is not in accordance with the sale contract.
- Also remember, time for opening the L/C is of "the essence" and "opening" in this context means that the L/C must be advised/confirmed to the Seller by the bank. A slow bank (even the Seller’s bank which is advising) can lead to a default by the Buyer.
- Since documentary compliance must be strict, Sellers should minimise the number/complexity of documents required to operate the L/C; if more documents are needed by the Buyer, provision should be made for these to be presented outside the L/C.
- A letter of credit transaction is independent from the underlying sale and purchase contract. Therefore, in the absence of fraud, a dispute under the sale contract will not impact on the validity or otherwise of the credit. Practically, this means that a Seller may still obtain payment by making a conforming documentary presentation, even if the Seller and Buyer are embroiled in a dispute over the underlying sale and purchase contract regarding, for example, the quality of the goods.
Recent issues: ‘May Confirm’/Optional Confirmation
Traditionally, sale contracts would require a "confirmed" L/C if the Seller wanted the comfort of a second bank; however one also now sees sale contract terms which seek to make confirmation optional for the Seller. Commercially, the Seller may not be sure if he wants or needs confirmation at the time of the sale, and the Buyer may be unwilling to pay confirmation charges.
Unfortunately, clauses introducing "optional confirmation" are often not clearly drawn and lead to confusion and disputes. Given that the time of opening of the L/C is so important, it is vital to have clearly defined payment provisions within the contract, setting down in detailwhich party is obliged to do what, and when. In particular, if the Seller wants a confirmed credit in an "optional" contract, there should be a specified time for Seller’s notification to the Buyer, so that the Buyer is able to open the correct L/C in time.
Where the sale contract requires confirmation at the option of the Seller, it is unlikely to be sufficient for the Buyer to open a "may confirm" credit. If the Seller exercises the option to have confirmation, the Buyer should ensure the L/C contains an instruction to "confirm" and ensure that the second bank adds its confirmation on time.
To confirm or not to confirm – the Seller’s problem?
Reed Smith recently acted for the successful Sellers in an arbitration which considered a clause in a sale contract requiring payment to be effected "by an irrevocable letter of credit to be opened in favour of Sellers by a first class bank… To be advised and confirmed to them by a first class bank nominated by Sellers". However, the sale contract went on to provide: "Advising bank must consult beneficiary before adding confirmation". The clause also provided that confirmation costs were to be for the beneficiary’s account.
So the parties had used usual confirmation language in the opening part of the L/C provisions, but had added an option for the beneficiary, in terms that the bank had to check with the beneficiary. In addition, there was usual language providing a latest date for opening the L/C.
This highlights several issues:
- The Buyer is rarely in control of the time of confirmation by the confirming bank, and yet the time of confirmation will determine whether the Buyer finds himself in default under the sale contract.
- The above issue is more acute when there is confusion in the sale contract or the credit about who has to do what and by when, for example when will the advising bank check with the beneficiary and when is the last day for confirmation?
- In the confirmation field of the L/C, does the provision "may confirm" rather than the instruction "confirm" do enough to comply with the sale contract (the answer is probably "no" because of the earlier sale wording requiring a "confirmed" L/C).
The clearest solution is to take more care at the contract stage:
- Draft clearly to ensure that the only obligation of the Buyer is to open an L/C "capable of being confirmed".
- Clearly specify in the contract the time limits for: opening the L/C, the Seller making a decision on confirmation, and if relevant, adding of confirmation by the confirming bank.
- Include a clear provision specifying who pays for confirmation.
Note: Buyer still has a risk that the "confirming" bank will refuse to add confirmation or moves too slowly.