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Letters of credit: another case when the LC issuing bank must pay despite discrepancies. (Business Law).

A letter of credit (LC) beneficiary must present complying documents in order to receive payment on an LC. However, a beneficiary that presents noncomplying documents to the LC issuing bank may still receive payment on the LC when the LC issuer fails to follow the requirements for dishonoring an LC draw.

In Voest-Alpine Trading U.S.A. Corp. v. Bank of China, a Texas case, the LC issuing bank messed up. The bank had failed to give timely notice to the LC beneficiary that the bank was rejecting a drawing on the LC because of the presentation of documents containing discrepancies. The United States District Court for the Southern District of Texas held that the notice was deficient because it did not timely state that the issuing bank had refused the documents. As a result, the bank was precluded from claiming that the documents presented as part of the LC drawing did not comply with the terms of the LC. The court also ruled that the discrepancies were not sufficient to justify dishonor of the drawing: A home run for the beneficiary!

What Is a Letter of Credit?

A letter of credit is an undertaking, usually by a bank, to a named person, the beneficiary, to honor a presentation of documents that complies with the requirements of the letter of credit. A letter of credit can be used as a means of payment in international trade and other business transactions, such as in the export and import of goods and services. A letter of credit can also be issued as security for a party's performance of its obligations. For example, a letter of credit can be offered in lieu of the security deposit on a lease and can be issued to secure payment of various note and indenture obligations.

A letter of credit transaction involves three parties and three independent contracts. The first contract is the agreement for which the letter of credit is to be the means of payment or collateral security. This agreement could be a contract for the sale of goods. When the letter of credit is the method of payment of the purchase price of goods to the seller, the seller is the LC beneficiary, the buyer is the LC account party or applicant and the bank issuing the LC is the LC issuer.

The second contract is the agreement between the LC issuing bank and the applicant/account party, such as a buyer of goods. The bank agrees to issue a letter of credit based on terms contained in the agreement and the LC applicant/account party/buyer agrees to reimburse the issuing bank for payments made to the beneficiary upon the presentation of all of the documents required by the LC. The LC applicant/account party also agrees to pay all commissions and fees provided in the agreement. The agreement also sometimes provides for collateral to secure payment of the account party's reimbursement obligation to the bank.

The third contract is the LC itself that the bank issues in favor of the beneficiary/seller. The beneficiary/seller must present all of the documents required under the LC as a condition of payment by the LC issuing bank. The documents may include a draft (demand for payment), invoices, delivery and insurance documents.

Each of these contracts is independent of the other. For example, if the seller presents the required documents, the issuing bank must pay on the LC regardless of disputes between the seller and the buyer in the sale transaction and/or the buyer's financial inability to reimburse the bank for LC payments and charges. Moreover, the issuing bank's payment to the beneficiary/seller based upon the seller's presentation of noncomplying documents extinguishes the buyer's obligation to reimburse the bank for that payment.

The LC bank's primary concern is to determine whether the seller/beneficiary has presented documents that comply with the terms of the LC. The bank deals only in documents presented by the beneficiary when deciding whether to pay on an LC. If the documents comply with the LC, the bank must pay the seller, and if the documents do not comply, the bank cannot make payment under the LC unless the buyer agrees otherwise. Most courts hold that the documents must strictly comply with the LC before payment can be made. A minority of courts follow the more flexible substantial compliance rule that excuses immaterial discrepancies.

A major concern is when the issuing bank decides that the documents presented do not comply with the LC and refuses to make payment to the seller/beneficiary. When the issuing bank fails to follow the requirements for communicating notice of dishonor, the seller may still be entitled to payment from the bank, despite having presented nonconforming documents. This tempers the effect of the requirement that the beneficiary presents documents that strictly comply with the requirements of the LC. Worse yet for the bank, if the documents presented by the seller/beneficiary do not comply with the LC, the buyer/applicant may be released from its obligation to reimburse the bank. A careful seller/beneficiary presenting noncomplying documents should recognize that it may still have claims against the issuing bank if the bank messes up and fails to timely and properly communicate its decision to dishonor an LC draw. The seller/beneficiary should also recognize that minor discrepancies might not be grounds for dishonor of a drawing on an LC

Requirements for the LC Issuing Bank's Rejection of Noncomplying Documents

When determining whether to honor an LC beneficiary's presentation of documents, the issuing bank must examine the documents and decide whether to accept or reject them within a reasonable time. If the bank determines that the documents do not comply with the LC, the bank must give notice of rejection by telecommunication, or if that is not possible, by other expeditious means without delay, and no later than the close of the seventh banking day following the day of receipt of the documents.

The bank's notice of dishonor must list all of the discrepancies in the documents presented. In other words, the bank must list every ground for its refusal to make payment on the LC. If the issuing bank fails to follow all of these requirements and gives an untimely, incomplete or improperly communicated notice of rejection, the bank is precluded from claiming that the presented documents are nonconforming and must make payment to the LC beneficiary.

The reason for this procedure and the penalty it imposes on the LC issuing bank is to force the bank to respond in a timely manner and notify the beneficiary of all the mistakes in the LC drawing and of the resulting refusal by the issuing bank to pay on the LC. This is designed to give the beneficiary an opportunity (if the LC has not already expired) to correct the mistakes in the documents initially presented and make a second presentation of conforming documents that would require payment by the bank.

The Voest-Alpine Case

In Voest-Alpine Trading U.S.A. Corp. v. Bank of China, Voest-Alpine entered into a contract to sell goods to a Chinese company. The sale price of the goods was $1.2 million. The Chinese buyer arranged for defendant Bank of China to issue a letter of credit in favor of the seller. The seller had presented documents containing the following discrepancies: (i) the LC indicated the seller's/beneficiary's name as Voest-Alpine U.S.A. Trading Corp. while the documents presented indicated the seller's name as Voest-Alpine Trading U.S.A. Corp. (i.e., the "Trading U.S.A. Corp." portion was inverted); (ii) the port of destination of the goods in certain of the documents was mistakenly identified as "Zhanjliagng" or "Zhangjliagng" instead of the correct name, "Zhangjliagang"; (iii) certain documents were not marked "original" as required under the LC and (iv) the LC number on the fax presented to the bank was LC 95231033/95 instead of LC 9521033/95 as indicated in the LC.

The problem for the seller was that by the time the product was ready for shipment to the buyer, the market price of the product had dropped significantly below the contract price. The buyer had asked for a price reduction; the seller refused and shipped the goods.

The documents were received by the LC issuing bank, Bank of China, on August 9, 1995. On August 11, 1995, Bank of China sent a telex identifying the discrepancies. However, the telex did not state that the bank was refusing the documents and rejecting the drawing. Instead, the telex stated that the bank was contacting the LC applicant/buyer about the discrepancies.

Belatedly, Bank of China sent another telex identifying the discrepancies and stating the bank's rejection of the documents and refusal to honor the LC drawing more than seven banking clays after receiving the first presentation of documents. Too late!

The United States District Court for the Southern District of Texas directed Bank of China to make payment to the beneficiary/seller. The court found the bank's first notice of dishonor deficient. The notice failed to state that the bank was rejecting the documents and refusing to honor the letter of credit. The notice should have stated the bank's decision to reject the drawing. The bank's omission was compounded by its statement that it would contact the applicant to determine whether the applicant would waive the discrepancies in the documents. This held open the possibility that the bank would accept the drawing upon the applicant's waiver of the discrepancies and showed that the bank had not refused the documents and rejected the drawing.

The bank's second notice belatedly rejecting the drawing was too late. The seven banking day period for the bank to reject the drawing had already expired. Accordingly, the court directed the bank to pay, even if the court were to find that there were discrepancies in the documents. The bank's failure to give timely notice of rejection of the drawing precluded the bank from claiming that the documents did not comply with the letter of credit.

Nitpicking, Misspelling and Other Minor Errors in Documents May Not Be Grounds for Dishonor

The court went further and held that the discrepancies did not warrant the bank's rejection of the drawing. The court had to decide whether discrepancies, such as the inversion of the beneficiary's name, the misspelling of the port of destination of the goods, the failure to mark certain documents as "originals" and the incorrect LC number in one of the draw documents justified dishonor of the LC drawing.

The court held that minor typographical errors did not justify dishonor. The issuing bank must examine a particular document with a minor discrepancy in light of all of the documents presented and use common sense to determine whether it relates to the same transaction as all of the other presented documents. Applying this more relaxed test of compliance, the court refused to reject documents that listed the beneficiary as "Voest-Alpine Trading U.S.A. Corp." instead of "Voest-Alpine U.S.A. Trading Corp." as indicated in the letter of credit. All of the documents listed the beneficiary as "Voest-Alpine Trading U.S.A., Corp." Further, the address of the beneficiary in each of the presented documents was the same as the beneficiary's address in the letter of credit. In addition, the cover letter containing the documents presented as part of the LC drawing identified the beneficiary as Voest-Alpine Trading U.S.A Corp. A letter of credit containing a minor error in the beneficiary's name with obvious links to the documents presented by the beneficiary did not justify rejecting the documents.

Similarly, the fact that certain presented documents were not stamped as "originals" did not necessarily mean they were not original documents as required by the letter of credit. The court noted that these documents were original wet ink signed documents and need not be stamped as originals.

Next, the court felt that the misspelling of the port of destination as "Zhanjliagng" and "Zhangjliagng" rather than "Zhangjliagang" (missing a "g" and an "a"), was not a sufficient discrepancy to warrant dishonor. The misspelling of the destination did not justify dishonor when the balance of the document on its face demonstrated a sufficient relationship with the transaction.

Finally, the reference in the fax transmitting the presentation documents to LC 95231033/95 rather than the correct letter of credit number, LC 9521033/95 was also not a problem. The bank could have verified the letter of credit number in any other document presented or looked to the balance of the information contained in the fax to find that the document as a whole bore an obvious relation with the transaction.

The court rejected a nitpicking approach to reviewing documents presented as part of a letter of credit drawing. It disregarded minor discrepancies by looking at all of the information contained in each document to find that the documents as a whole bore an obvious relationship with the underlying transaction.

But a word of caution--where the drawing documents contain a different name for the beneficiary than the name stated in the letter of credit, the issuing bank has grounds for dishonor. Another case in the United States District Court for the Southern District of New York, Hanil Bank v. PT. Bank Negara Indonesia, upheld the dishonor of a letter of credit drawing where the letter of credit incorrectly identified the beneficiary as "Sung Jin Electronics Co., Ltd." rather than the beneficiary's correct name contained in the documents presented to the bank, "Sung Jun Electronics Co., Ltd.", an obvious instance of misspelling. Another New York case, Beyene v. Irving Trust Co., upheld dishonor of a letter of credit drawing where the name of the notify party in a bill of lading was misspelled as "Mohammed Soran" rather than "Mohammed Sofan" as indicated in the letter of credit.

Conclusion

A letter of credit beneficiary that presents documents not complying with the requirements of the letter of credit is not necessarily out of luck. The letter of credit issuing bank has certain duties to timely and properly notify the beneficiary of discrepancies before dishonoring a drawing on an LC. These duties leave no room for tardiness or variance by the bank. If the bank fails to follow these rules to the letter, the bank may be forced to make payment to a beneficiary that presents noncomplying documents, therefore saving the beneficiary from its own mistakes.

The beneficiary also may be saved where the errors in the presented documents are sufficiently minor and the court follows the broader more practical oriented view of the standard for documentary compliance followed in Voest-Alpine.

However, beneficiaries, be on your guard! You may not always be so lucky. The moral of the story is to review the letter of credit carefully to make sure that the beneficiary can submit all of the documents required by the letter of credit. A beneficiary cannot always rely on the issuing bank's mistakes and a favorable court to take it off the hook from a submission of nonconforming documents.

Bruce S. Nathan, Esq. is a partner in the law firm of Davidoff & Malito, LLP in New York He is also a member of NACM and the American Bankruptcy Institute.
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Title Annotation:letter of credit
Author:Nathan, Bruce
Publication:Business Credit
Geographic Code:9TAIW
Date:Jan 1, 2002
Words:2548
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