negotiation in letter of credit practice and law: the evolution of the

09 Byrne Publication 7/30/2007 11:21:59 AM

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

PROFESSOR 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).

* Professor Byrne teaches law at George Mason University School of Law and directs the Institute of

International Banking Law & Practice, Inc. He has played important roles in connection with the reform of letter of credit law and practice on the national and international levels, including the revision of U.C.C. Article 5, the International Standby Practices, and the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit. The support of George Mason University School of Law and its Law & Economics Center in the research necessary to prepare this Article and the active collaboration of attorney Lee H. Davis, Senior Attorney for the Institute of International Banking Law & Practice, is gratefully acknowledged. While I have not consulted with colleagues regarding the text of this paper, their ideas and insights form a part of my thought process and, in this sense, they will recognize these things, hopefully well digested. In particular, Mr. James G. Barnes, Professor Boris Kozolchyk, Professor E. Peter Ellinger, and Mr. Vincent Maulella have over recent years discussed issues with me that are addressed in this paper and, while not seeking to taint them with the outcome, I thank them for their friendship, patience, and willingness to seek a conceptual consensus. Hopefully, this work will contribute to it.


562 TEXAS INTERNATIONAL LAW JOURNAL VOL. 42:561

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

I. SURVEY OF NEGOTIATION OF DRAFTS IN THE LAW OF NEGOTIABLE

INSTRUMENTS ......................................................................................................563 II. NEGOTIATION IN LETTER OF CREDIT PRACTICE ............................................565

A. Pre-UCP400 Terminology..........................................................................565 B. Post-UCP400 Terminology ........................................................................567

III. ISSUES REGARDING NEGOTIATION OF LCS.....................................................570

A. The Requirement of a Draft .......................................................................570 B. Formality Requirements .............................................................................572 C. Who Negotiates?..........................................................................................575 D. How Does Negotiation Occur? ..................................................................575 E. Recourse .......................................................................................................577 F. Protection of Banks That Negotiate in the Event of LC Fraud ..............579

1. The Presumption of Entitlement ........................................................580 2. What Defense is Good Against a Beneficiary? The LC Fraud

Exception to the Independence Principle .........................................581 3. The LC Exception to the Fraud Defense: Protected Persons .........584 4. Nomination............................................................................................585

a. Protected Status Where There Is Negotiation by the Issuing or Confirming Bank ......................................................................586

b. Protected Status Where There Is Negotiation by a Negotiating Bank ..........................................................................588

5. Value......................................................................................................588 6. Notice.....................................................................................................593

IV. TOWARDS A DEFINITION OF LC NEGOTIATION..............................................593 V. CONCLUSION .......................................................................................................594


2007 NEGOTIATION IN LETTER OF CREDIT PRACTICE AND LAW 563

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

1. While both bills of exchange and promises can be negotiable instruments, this paper deals exclusively with the former since letters of credit (hereinafter LCs) do not use promissory notes in connection with their negotiability. For convenience, the term “draft” is used in this article rather than “bill of exchange,” since it is the term that has been chiefly used in the Uniform Customs and Practice for Documentary Credits (hereinafter UCP). “Draft” is not used in the U.K. Bills of Exchange Act, 1882, 45 & 46 Vict. c. 61, § 2, but is used in U.S. statutory law. See, e.g., U.C.C. § 3-104(e) (2006). A draft or bill of exchange is a formal order to pay money. Id. §3-104(a)-(b), (e). Although the first two versions of the UCP used the term “draft” without mention of the term “bill of exchange,” see UCP82 (1933), UCP151 (1951), the 1962 Revision used the term “bill of exchange,” signifying that it meant “draft” by the use of a parenthetical and thereafter used the word “draft.” UCP222 (1962). UCP222 General Provisions and Definitions (b) provides that “a bank . . . is to pay, accept, or negotiate bills of exchange (drafts) drawn by the beneficiary . . . .” The 2007 Revision continues this tradition by inserting the parenthetical in Article 2 (Definitions), paragraph 9, “Honour,” providing that the meaning of “honour” includes “to accept a bill of exchange (‘draft’) drawn by . . . .” UCP600 (2007). Which term is used in practice depends on the discipline involved, tradition, and the names used in local law. The term “bill of exchange” is older, but “draft” has a long tradition of use. The word “bill” is derived from the Latin “bulla,” which was used to describe an ornament or a bubble. A bulla was worn by aristocratic Roman youths until they assumed manhood. THE OXFORD ENGLISH DICTIONARY, (J.A. Simpson & E.S.C. Weiner eds., 2d ed. 1989) links its use in English to the seal with which documents were authenticated and reports the first use of it in the sense of an order to pay in 1579. The word “draft” is a derivative of the word “draught” (sometime rendered in later Medieval English as “drawt,” which makes the linkage clearer). Its first reported use in the sense of an order to pay money was in 1633. Blackstone states that “[i]n common speech, such a bill is frequently called a draught, but a bill of exchange is the more legal as well as mercantile expression.” WILLIAM BLACKSTONE, 2 COMMENTARIES *467. Although there are some technical differences, the terms are effectively interchangeable. The principal difference between a classical bill of exchange and a draft is that the bill of exchange is a four-party instrument stating the name of the remitter, whereas a draft is typically a three-party instrument stating only the name of the drawer, drawee, and payee. Except for emphasis where both terms are used, the term “draft” will be used in this paper to signify either a draft or bill of exchange. The terms “draft” and “bill of exchange” are used commonly (but not necessarily) to signify an undertaking that meets the formal requirements of negotiable instruments law to qualify as a negotiable instrument.

2. See U.C.C. § 3-201 (2006) (stating that “‘[n]egotiation’ means a transfer of possession, whether voluntary or involuntary, of an instrument by a person other than the issuer to a person who thereby becomes its holder. . . . Except for negotiation by a remitter, if an instrument is payable to an identified person, negotiation requires transfer of possession of the instrument and its indorsement by the holder. If an instrument is payable to bearer, it may be negotiated by transfer of possession alone”); United Nations Convention on International Bills of Exchange and International Promissory Notes, G.A. Res. 43/165, art. 13, U.N. Doc. A/RES/43/165 (Dec. 9, 1988) [hereinafter U.N. Bills of Exchange Convention] (stating that “[a]n instrument is transferred: (a) By endorsement and delivery of the instrument by the endorser to the endorsee; or (b) By mere delivery of the instrument if the last endorsement is in blank”); Bills of Exchange Act art. 31 (stating that “[a] bill is negotiated when it is transferred from one person to another in such a manner as to constitute the transferee the holder of the bill”); The Convention Providing a Uniform Law for Bills of Exchange and Promissory Notes, League of Nations, art. 11, June 7, 1930, reg. no. 3313 [hereinafter Geneva Convention on Bills of Exchange] (stating that “[e]very bill of exchange, even if not expressly drawn to order, may be transferred by means of endorsement”); art. 14 (stating that “[a]n endorsement transfers all the rights arising out of a bill of exchange”). Negotiable instruments law marks a unique intersection of the law of property and commerce in which the rights of ownership are embodied or merged in the special piece of paper. See PETER ELLINGER, Negotiable Instruments, in 9 INTERNATIONAL



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.

ENCYCLOPEDIA OF COMPARATIVE LAW, (Jacob S. Ziegel ed., 2000). While some of the property law features of negotiable instruments are retained in letters of credit, they are less fixed, and the undertaking is closer to its commercial law antecedents. Id.

3. See ELLINGER, supra note 2, §§ 404-27. 4. U.C.C. § 3-104(a) (2006) (stating that “‘negotiable instrument’ means an unconditional promise or

order to pay a fixed amount of money”); U.N. Bills of Exchange Convention, supra note 2, art. 3 (stating that “a bill of exchange is a written instrument which: (a) Contains an unconditional order whereby the drawer directs the drawee to pay a definite sum of money to the payee or to his order”); Geneva Convention on Bills of Exchange, supra note 2, art. 1 (stating that “[a] bill of exchange contains: . . . 2. An unconditional order to pay a determinate sum of money”); Bills of Exchange Act art. 3 (stating that “[a] bill of exchange is an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to the order of a specified person, or to bearer”).

5. The civil law, unlike the common law, would require only regularity of appearance in the indorsements regardless of whether they are genuine. ELLINGER, supra note 2, § 416.

6. This obligation operates when a negotiable instrument is issued or negotiated by indorsement. Under some systems of law, it is impacted or even discharged by a subsequent acceptance of the instrument. See U.C.C. §§ 3-414(c)-(d), 3-415(d) (2006).



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

7. A letter of credit, unlike a negotiable instrument, is a promise to pay that is conditioned on the

timely presentation of complying documents and not an unconditional promise or order to pay. Under the U.S. Negotiable Instruments Law, the predecessor to U.C.C. Article 3, a virtual acceptance was recognized. BRANNAN’S NEGOTIABLE INSTRUMENTS LAW, § 135 (Frederick K. Beutel ed., W.H. Anderson, 7th ed. 1948) [hereinafter Negotiable Instruments Law] (“[a]n unconditional promise in writing to accept a bill before it is drawn is deemed an actual acceptance in favor of every person who, upon the faith thereof, receives the bill for value”). A virtual acceptance was, in effect, a form of letter of credit. While Lord Mansfield recognized this aspect of negotiation in Pillans v. Van Mierop, (1764) 97 Eng. Rep. 1035 (K.B.), subsequent English cases did not follow his lead.

8. The UCP is promulgated by the Commission on Banking Technique and Practice of the International Chamber of Commerce headquartered in Paris, France. It articulates standard international commercial letter of credit practice. The current revision at the time this paper was written, January 2007, ICC Publication No. 500 (UCP500), became effective January 1994. This version will be replaced July 1 2007 by ICC Publication No. 600 , UCP600. Prior versions were issued in 1933 (UCP82), 1951 (UCP151), 1962 (UCP222), 1974 (UCP290), and 1983 (UCP400). Although UCP500 has been translated into virtually every language in which international commerce is conducted, the official version is in English. See generally JAMES E. BYRNE, THE COMPARISON OF UCP600 & UCP500 (Institute of International Banking Law & Practice 2007); JAMES E. BYRNE, ISP98 & UCP500 COMPARED (2000); James E. Byrne, Ten Major Stages in the Evolution of Letter of Credit Practice, DOCUMENTARY CREDIT WORLD, Nov./Dec. 2003, at 28, reprinted in 2004 ANNUAL SURVEY 19; Dan Taylor, The History of the UCP, DOCUMENTARY CREDIT

WORLD, Dec. 1999, at 11, reprinted in 2000 ANNUAL SURVEY 201. 9. Letters of credit are sometimes traced to ancient commerce. These undertakings, however,

differed in important ways from the modern commercial LC. Most importantly, they were general LCs, that is, there was no named beneficiary. They were addressed to correspondents and requested payment in favor of the bearer who was a customer of the issuer. They resembled in form and function traveler’s credits or even the modern credit card. The modern LC came into widespread use in post Napoleonic Wars trade between Europe and North America. These credits were special credits in that they were made in favor of a named beneficiary in the sense that the obligation to honor ran only to that named person and no one else. While there are reported LC cases that precede the 1920s, there is little literature and no serious doctrinal work. Most LC business was dominated by the London clearing banks and there was little room for dispute within these networks. When London financial institutions lost their hegemony during World War I, the purchase of war material was financed by LCs and the banks of neutral countries or allies handled them through their relatively new export departments. During the War, no presentations were refused because of the high demand, but after it ended, there were numerous refusals. At that point,



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

a number of books were published describing this business and the first attempts at rules of practice were made. See generally Boris Kozolchyk, Letters of Credit, in 9 INTERNATIONAL ENCYCLOPEDIA OF

COMPARATIVE LAW (Jacob S. Ziegel ed., 2000). 10. However, an LC calling for only the presentation of a draft was and is possible. Credits of this

type are generally referred to as “clean” or colloquially, “suicide” LCs. See INTERNATIONAL STANDBY

PRACTICES (ISP98), ICC Publication No. 590, (1998) Rule 1.10(a)(5); JAMES E. BYRNE, THE OFFICIAL

COMMENTARY ON THE INTERNATIONAL STANDBY PRACTICES 52 (1998) [hereinafter The Official Commentary].

11. There is a related banking function in which a draft is accompanied by documents, described by bankers as a collection and by US lawyers as a documentary collection (to distinguish it from a domestic check collection). There are also ICC Banking Commission Rules that are widely used in connection with them, the INTERNATIONAL CHAMBER OF COMMERCE, UNIFORM RULES FOR COLLECTIONS, URC 522

(revised 1995). The essential distinction between these two operations is that the bank makes no undertaking to honor in the case of a collection whereas it does in the case of a letter of credit. Accordingly, the attitude of the bank towards the documents is quite different. In a collection, the bank counts the documents to see if the number indicated on the collection letter is present. In a letter of credit transaction, the bank will examine the documents to determine whether they comply on their face with the terms and conditions of the letter of credit. Even in a collection, however, the primary role is not accorded to the draft but to the collection letter. See URC 522 art. 4(a)(1)(“All documents sent for collection must be accompanied by a collection instruction indicating that the collection is subject to URC 522 and giving complete and precise instructions. Banks are only permitted to act upon the instructions given in such collection instruction . . .”). The draft is not a source of instructions. This point is illustrated in a “clean check collection” in which the document being collected on is a check. In that case, the drawee of the collection is not the drawee of check but the entity indicated in the collection instructions. See SCADIF, S.A. v. First Union Nat’l Bank, 344 F.3d 1123, 1129 (11th Cir. 2003) (sustaining the district court’s finding that a bank to whom a “clean check collection” is transmitted is a collecting bank, despite the check’s designation of the bank as a drawee).

12. WILBERT WARD, AMERICAN COMMERCIAL CREDITS 186 (1922). 13. Id. at 187. 14. See UCP600 art. 8(b) (2007) (stating “A confirming bank is irrevocably bound to honour or

negotiate as of the time it adds its confirmation to the credit.) and UCP500 art. 9(b) (1993) (stating “[a] confirmation of an irrevocable Credit by another bank (the ‘Confirming Bank’) upon the authorisation or request of the Issuing Bank, constitutes a definite undertaking of the Confirming Bank, in addition to that



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

of the Issuing Bank . . : iv. if the Credit provides for negotiation—to negotiate without recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit”). A clause to the same effect appears in all versions of the UCP since 1951.

15. See UCP82 art. 9 (1933) (“[w]hen an irrevocable credit is opened in the form of a Commercial Letter of Credit, the Letter of Credit itself must include notification of the opening of an irrevocable credit and constitute the definite engagement by the issuing Bank towards the beneficiary and holder in good faith to honour all drafts issued by virtue of and in conformity with the clauses and conditions contained in the document”). While payment at sight originally meant that the document was examined on presentation and either honored or dishonored, a bank now has time within which to examine documents. Under UCP500 Article 13(b), it has a reasonable time not to exceed seven banking days. Under UCP600 Article 14(b), it has a maximum of five banking days. See also Seaconsar Far East Ltd. v. Bank Markazi Jomhouri Islami Iran, (1997) 2 Lloyd’s Rep. 89 (Q.B.) (indicating and discussing the original meaning of ‘available by sight payment’).

16. See UCP151 art. 5 (1951) (stating “[i]n case of credits available by negotiation of drafts, the confirmation implies only the undertaking of the confirming Bank to negotiate drafts without recourse to drawer”); UCP500 art. 9(b)(iv) (1993) (“A confirmation of an irrevocable Credit . . . constitutes a definite undertaking . . . if the Credit provides for negotiation—to negotiate without recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit.”).

17. The term “nomination” was first introduced in reference to a bank in UCP290(e) (1974) (General Provisions and Definitions), which spoke of a bank being “authorized to pay or accept under a credit by being specifically nominated in the credit” or being “authorized to negotiate under a credit either i. by being specifically nominated in the credit, or ii. by the credit being freely negotiable by any bank.” These references were developed in UCP400 (1983), which introduced and defined the term “Nominated Bank” in Article 11(b): “All credits must nominate the bank (nominated bank) which is authorized to pay (paying bank), or to accept drafts (accepting bank), or to negotiate (negotiating bank), unless the credit allows negotiation by any bank (negotiating bank).” The name was used more extensively in UCP500 (1993) and is used throughout UCP600 (2007), which contains an article 12 entitled “Nomination” in addition to a definition of the term in article 2.



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

18. See UCP600 art. 12(a) (noting that “[u]nless a nominated bank is the confirming bank, an

authorization to honour or negotiate does not impose any obligation on that nominated bank to honour or negotiate, except when expressly agreed to by that nominated bank and so communicated to the beneficiary”); id. 12(c) (stating “[r]eceipt or examination and forwarding of documents by a nominated bank that is not a confirming bank does not make that nominated bank liable to honour or negotiate, nor does it constitute honour or negotiation”).

19. The UCP has never systematically addressed the role of the paying bank. Neither a paying bank nor a negotiating bank make an undertaking to honor but if the paying bank acts, it is to pay as opposed to negotiate. When drafts are used, the draft would be drawn on a paying bank. As the drawee, its payment would be final since payment by the drawee would extinguish the draft without there being any right of recourse. On the other hand, the draft would be endorsed to the negotiating bank and any negotiation by it would not be final unless it disclaimed its right to recourse or the indorsement to it was without recourse. The UCP has always referred to the role of a paying bank however obscurely. UCP82 (1933) Article 10 links a paying bank with the negotiating bank with respect to notice of refusal. Similar oblique references to the paying bank occur in UCP151 (1951) Article 43 (right to refuse presentation if unduly delayed), Article 49 (Transfer); UCP222 (1962) Articles 41 (same as UCP151 Article 43), Article 46 (Transfer); UCP290 (1974) Articles 13 (Reimbursement), 46 (Transfer); UCP400 (1983) Articles 11 (Nominated Banks) (which contains a parenthetical definition of the term), 21(a) & (c) (Reimbursement), 54(f) (Transfer); UCP500 Article 19 (Bank-to-Bank Reimbursement Arrangements). In addition, there have been regular references to payment (as opposed to negotiation) by a bank which have been understood to refer to a nominated bank other than the confirming bank. UCP600 has deleted express reference to a paying bank although it contains what might be regarded as oblique references to it. UCP600 (2007) Article 2 (Definitions) paragraph 11 “Negotiation” excludes banks on whom a draft is drawn which would include paying banks where the credit called for a draft drawn on the paying bank. UCP600 Article 12(a) (Nomination) refers to an authorization to pay in a context that makes it apparent that it is referring to a bank other than the confirming bank. Likewise, UCP600 Article 8(i)(b) can be read to refer to such a bank (although it could also encompass another confirming bank whom the confirmer was required to reimburse).

20. A credit could provide for a draft drawn on an applicant in which case the issuer and any confirmer would undertake to negotiate without recourse. The consequences of expecting the applicant to accept or otherwise honor such a draft were not fully addressed in the UCP and concern about drafts drawn on the applicant arose as a result of claims made by some banks that they were not liable as an issuer where the draft was drawn on the applicant or accepted by the applicant. The ICC Banking Commission rejected this position but the concern lingered. See CHARLES DEL BUSTO, UCP 500 & 400

COMPARED 23 (1993) (References to drafts on the applicant that “or payment will be made” in UCP400 Articles 10(a)(i) and 10(a)(ii) were deleted because they “defined a less certain and less reliable promise



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

than the Issuing Bank or Confirming Bank’s irrevocable promise and primary liability ‘to pay.’ . . . A Beneficiary attempting to rely on such an undefined promise did not know who the primarily liable payor was, or when the bank’s liability to pay was enforceable.”). See also THE INTERNATIONAL CHAMBER OF

COMMERCE, OPINIONS OF THE ICC BANKING COMMISSION 1995-1996, ICC Publication No. 565, Resp. 205, at 25 (Gary Collyer ed., 1997). As is typical with UCP drafting, it addressed the issue obliquely and did not make an outright statement of the liability of the issuer or confirmer notwithstanding the draft being drawn on the applicant. UCP600 (2007) Article 6(c) (Availability, Expiry Date and Place for Presentation) turns this approach around. It states that “[a] credit must not be issued available by a draft drawn on the applicant.” The UCP600 prohibition is stronger than the statement of UCP500 but, since the UCP is variable, a term in the credit requiring the presentation of a draft drawn on the applicant would expressly vary UCP600 Article 6(c). Where it is varied, the absence of direction regarding the impact of such a draft is regrettable, but is not fatal since it is apparent that the draft is peripheral to the issuer or confirmer’s obligation. In that sense, it is just another document and should be so treated notwithstanding the silence of UCP600 on this point. Interestingly, where a bank issues a credit for its own account as permitted under UCP600 Article 2 (Definitions) paragraph 10 (“Issuing Bank”), a draft drawn on it is in effect dawn on the applicant. In such a situation, the draft would also be treated as a bank document.

21. See UCP600 art. 2 para. 9 (artificially excluding negotiation from the meaning of “honour”). The ordinary sense of the term “honour” is the fulfillment of an undertaking which, in the case of an issuer or confirmer, would included an undertaking to negotiate.

22. How can there be an agency relationship where the supposed “agent” cannot bind the principal? A negotiating bank has no ability under the UCP or international letter of credit practice to bind the issuing bank. Whether or not it acts is within its sole discretion. If it does so, it is able to do so with or without recourse against the beneficiary in the event that it has erred with respect to the compliance of the documents and with respect to issuer solvency or country risk. It can make its decision as to whether to act after it has examined the documents and, until it elects to act, is not bound by any time limits. While its right to be reimbursed may be affected if the documents do not comply, it has no duties to the issuing bank. See JAMES G. BARNES, JAMES E. BYRNE, & AMELIA H. BOSS, THE ABCS OF UCC ARTICLE 5: LETTERS

OF CREDIT 45 (1998) (“Nominated persons are best viewed as independent contractors whose various roles are defined by LC practice. . . . They may be viewed as agents for the issuer or as agents for beneficiaries or both, but application of agency law will often as not lead to the wrong conclusion. Nominated persons have little or no right to bind issuers or beneficiaries” ). See also RICHARD KING, GUTTERIDGE AND

MEGRAH’S THE LAW OF BANKERS’ COMMERCIAL CREDITS 106 (8th ed. 2001) (“A negotiating bank negotiates on the invitation contained in the credit and not as an agent . . .”); JOHN F. DOLAN, THE LAW

OF LETTERS OF CREDIT, para. 8.02[6] n.59 (2003) (noting “[t]hat is not to say that the negotiating bank is an agent of the issuer.”); Bank of N.S. v. Angelica-Whitewear Ltd., [2003] 1 S.C.R. 59, 86-87 (suggesting that the negotiating bank acts for itself, but it does so with the understanding that the issuer’s undertaking runs to the negotiating bank and not just to the beneficiary”).

23. There is another sense in which the term negotiation is used in letter of credit practice—the payment of any undertaking involving another bank. This use derives from the pre-UCP400 distinction between straight and circular credits. It is a use which has been officially discouraged. See ICC BANKING

COMMISSION, UCP1974/1983 REVISIONS COMPARED AND EXPLAINED 12 (1984). Nonetheless, it still surfaces in the casual vocabulary of bankers because it offers a shorthand means of capturing the concept of reimbursement.



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.

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

24. See UCP600 art. 6(a)-(b) (“A credit must state the bank with which it is available or whether it is

available with any bank. A credit available with a nominated bank is also available with the issuing bank. . . . A credit must state whether it is available by sight payment, deferred payment, acceptance or negotiation.”). This data is contained in SWIFT MT700 Field 41a (Available With ... By ...) which is a mandatory field.

25. The deferred payment undertaking was first recognized in UCP400 (1983) article 10(a)(ii). Its emergence was noted in ROLF EBERTH & E.P. ELLINGER, Deferred Payment Credits: A Comparative Analysis of Their Special Problems, 14 J. MAR. L. & COM. 387, 390-91 (1983). It emerged in Post World War II commerce to avoid stamp taxes or limitations on the term of finance imposed on drafts by central banks. Because the ICC Banking Commission never fully addressed the implications of the deferred payment undertaking, the questions of the right to an acknowledgment by the beneficiary of the obligation incurred and the implications of beneficiary LC fraud were not expressly addressed in the UCP. They were answered comprehensively in U.C.C. § 5-109(a) (Fraud and Forgery) (2006), which provided that

[i]f a presentation is made that appears on its face strictly to comply with the terms and conditions of the letter of credit, but a required document is forged or materially fraudulent, or honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant: (1) the issuer shall honor the presentation, if honor is demanded by (i) a nominated



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.

person who has given value in good faith and without notice of forgery or material fraud, (ii) a confirmer who has honored its confirmation in good faith, (iii) a holder in due course of a draft drawn under the letter of credit which was taken after acceptance by the issuer or nominated person, or (iv) an assignee of the issuer’s or nominated person’s deferred obligation that was taken for value and without notice of forgery or material fraud after the obligation was incurred by the issuer or nominated person; and (2) the issuer, acting in good faith, may honor or dishonor the presentation in any other case.

The problem forecast by Eberth and Ellinger surfaced in a series of cases in the 1990s starting with Banco Santander S.A. v. Bayfern Ltd. & Ors., [1999] 2 All E.R. (Comm.) (Q.B.) 18, aff’d, Banco Santander SA v. Banque Paribas, [2000] 1 All E.R. (Comm.) (C.A.) 776, in which the courts ruled that a confirmer that discounted its own deferred payment undertaking was not entitled to reimbursement where they was supervening LC fraud by the beneficiary before the maturity of the obligation. The English court in Banco Santander noted the absence of direction in the UCP. That direction has been provided by UCP600 Article 7(c) (Issuing Bank Undertaking), 8(c) (Confirming Bank Undertaking), and 12(b) (Nomination). UCP600 Article 7(c) provides that

[a]n issuing bank undertakes to reimburse a nominated bank that has honoured or negotiated a complying presentation and forwarded the documents to the issuing bank. Reimbursement for the amount of a complying presentation under a credit available by acceptance or deferred payment is due at maturity, whether or not the nominated bank prepaid or purchased before maturity. An issuing bank's undertaking to reimburse a nominated bank is independent of the issuing bank’s undertaking to the beneficiary.

26. The notion of negotiation of documents without drafts is not new. There is an ambiguous reference in UCP82 (1933) Article 45 that may indicate the early recognition of the negotiation of documents without drafts. It stated an extension of the deadline for shipment also extends the time “for presentation or negotiation of documents or drafts.” The reference is not unambiguous as the words presentation/documents and negotiation/drafts could be in parallel instead of meaning that both “documents and drafts” could be subject to “presentation and negotiation.” This provision is continued in similar form in UCP151 (1951) Article 45. However, UCP290 (1974) Article 8(b) and UCP400 (1983) Article 16(a) speak of “[p]ayment, acceptance, or negotiation against documents.” By this point, it is clear that the letter of credit community recognized that a draft was not necessary for letter of credit negotiation. UCP500 (1993) Article 9(a)(iv) defines negotiation as involving “Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit.” UCP600 (2007) continues to recognize negotiation of documents without drafts in Article 2 (Definitions) paragraph 11 “Negotiation” which provides in part that it “means the purchase by the nominated bank of drafts and/or documents . . . .” To some extent, this practice can be said to have evolved from the requirement of a demand in lieu of draft but it readily came to be recognized that the demand could be fictionalized from the presentation of documents which was deemed to constitute a demand.



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

27. See generally ELLINGER, supra note 2, §§ 279-310. 28. See, e.g., U.C.C. § 2-104(a)(2) (2006) (requiring that a negotiable instrument be on demand or for

a definite time). On the other hand, it implies that the instrument is a demand instrument when it is silent. Therefore, this rule is only applicable where it is apparent on its face that the instrument is neither for demand nor for a definite time. An issue that has been recently of considerable interest is the use of an outside source such as a published rate provided that it is readily determinable. See U.C.C. § 3-112(b) (permitting reference to an objective source outside the “four corners” of the instrument for interest provided that it is objectively determinable).

29. Banking practice is, in fact, of two minds about whether or not the draft, if required, is to be regarded as a “document” to be presented under the letter of credit. The distinction surfaced in UCP500 Article 9(a)(iv) (Liability of Issuing and Confirming Banks) in addressing problems raised by LCs requiring documents drawn on the applicant or another entity other than the issuer or a nominated bank. It provides, in part, that “[i]f the Credit nevertheless calls for Draft(s) on the Applicant, banks will consider such Draft(s) as an additional document(s).” This verbiage is intended to signify that the issuer remains obligated under the LC, regardless of the draft. The implication is that in other credits, the draft is not just “another document.” This notion, however, has little impact on the examination of the draft. For purposes of determining compliance of a required draft, the draft is to be examined as if it were another document. The real question is not whether it is to be examined but by what standard.

30. At its May 2000 meeting, the Commission on Banking Technique and Practice of the International Chamber of Commerce (ICC Banking Commission) established a task force to document international standard banking practice for the examination of documents presented under documentary credits issued subject to the UCP. See ICC BANKING COMMISSION, INTERNATIONAL STANDARD BANKING PRACTICE

FOR THE EXAMINATION OF DOCUMENTS UNDER DOCUMENTARY CREDITS 3 (2003) [hereinafter ISBP (2003)] (describing how the ISBP complements the UCP500 by filling in gaps and explaining the practices that underline UCP500). The ISBP is a statement of the “standard banking practice” referenced in UCP500 Article 13(a), sentence 2. The ISBP is based on ICC Banking Commission Opinions and Decisions and its understanding of the practices reflected in them. Revisions, finalized at the Spring 2007 ICC Banking Commission Meeting, have been made to the ISBP to align it with and make it applicable to UCP600 [hereinafter ISBP (2007)].

31. There is no indication in the ISBP as to whether a credit that requires presentation of a sight draft would be satisfied by a draft that requires payment without stating that it is drawn at sight. Since the default rule would make such a draft payable at sight, it should be regarded as complying with such an LC



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

term.

32. ISBP (2003), supra note 30, para. 45(a) (stating that “[i]f a draft is drawn at a tenor other than sight, or other than a certain period after sight, it must be possible to establish the maturity date from the data in the draft itself.”). ISBP (2007), supra note 30, para. 43(a) is identical.

33. This result is not only ironic in light of certain rigid interpretations of the strict compliance rule since there is a literal replication of the terms of the credit. It is unfortunate that the drafters did not structure an alternative in this situation, either permitting the banker to insert the date on the draft or permitting the bank to calculate it on the basis of the attached bill of lading. As long as the tenor is correctly calculated, the applicant should not be permitted to refuse documents because of the failure to reflect the actual date of the bill of lading in the way that the draft is drawn. For that reason, neither should the issuer since it is able to make the necessary calculation. As to the ability of anyone else to make the calculation, they can decide whether or not to purchase the draft. If they were to decide not to do so, it is the beneficiary whose options are reduced, but there is no impact on the issuer or applicant.

34. See ISBP (2003), supra note 30, paras. 52-55 (stating that (52) “[t]he amount in words must accurately reflect the amount in figures if both are shown, and indicate the currency, as stated in the credit”; that (53) “[t]he amount must agree with that of the invoice, unless otherwise stated in the credit or as a result of UCP sub-Article 37(b)”; that (54) “[t]he draft must be drawn on the party stated in the credit”; and that (55) “[t]he draft must be drawn by the beneficiary”). These practices appear as ISBP (2007), supra note 30, paras. 50-53.



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

35. Although, given banker’s mania for having everything dated, see ISBP (2003) paras. 13-19 and

ISBP (2007) paras. 13-18, the absence of a date may also register with them although at least some legal systems would imply that the date of the draft was the date on which it was issued.

36. Credit Industriel et Commercial v. China Merchants Bank, (2002) 2 All E.R. (Comm.) 427, 436-37 (Q.B.).

37. See ISBP (2003), supra note 30, para. 58 (warning that “[i]n some countries draft(s) showing corrections and alterations are not acceptable even with the drawer’s authentication. Issuing Banks in such countries should make a statement in the credit to the effect that no correction or alteration must appear in the drafts(s)”). This practice appears as ISBP (2007), supra note 30, para. 56.

38. See UCP600 art. 37(d) (2007) (stating that “[t]he applicant shall be bound by and liable to indemnify a bank against all obligations and responsibilities imposed by foreign laws and usages”).

39. See, e.g., All Am. Semiconductor, Inc. v. Wells Fargo Bank Minnesota, N.A., 105 Fed.Appx. 886 (8th Cir. 2004) aff’d Civ. No. 01-1441, 2003 WL 22455502 (D. Minn. filed Jan. 3, 2003).



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

40. ISP98, supra note 10, Rule 4.16(c) (Demand for Payment) (stating that “[a] demand may be in the

form of a draft or other instruction, order, or request to pay. If a standby requires presentation of a ‘draft’ or ‘bill of exchange,’ that draft or bill of exchange need not be in negotiable form unless the standby so states.”).



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

41. Where a draft accompanying documents is not payable to the named beneficiary or the bank

processing the presentations, the concern is not with respect to negotiation, but rather that an indirect assignment of proceeds is taking place without paying required fees and adding to the risk of the bank that pays who is expected to pay the named beneficiary. While this point has not been tested, many banks would refuse to pay the LC proceeds to anyone but the named beneficiary or transferee absent an assignment of proceeds. See ISP98, supra note 10, Rule 4.13(b) (No Responsibility to Identify Beneficiary).

42. The parallel provision of ISBP (2007) is para. 49. The ISBP should have provided that “unless the credit requires otherwise, no indorsement of a draft by a negotiating bank may be required unless the draft is issued to the order of the negotiating bank or indorsed to it or its order. In that case, the negotiating bank may indorse the draft without recourse.”



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

43. There may be other parallel theories of liability that are functionally similar, but that do not arise from obligations on the instrument. U.S. law, for example, posits warranties (a curiosity of the common law) that arise as a result of transfer and presentment that are not directly affected by whether or not one has indorsed. Under U.C.C. section 3-416(a) (2006), for example, a transfer warranty arises whether or not there is indorsement, but, if the transfer does not include an indorsement, only runs to the immediate transferee. An indorsement disclaiming liability on the indorsement (“without recourse”) does not affect or otherwise limit warranties.

44. ELLINGER, supra note 2, section 373 notes that the right of recourse must be be “‘negatived’ (viz. Excluded)” under section 16(a) of the U.K. Bills of Exchange Act, 1882, 45 & 46 Vict. c. 61.

45. By signing a draft, an entity assumed liability on it unless disclaimed. The nature of the liability depended on the manner in which it was signed, whether as drawer, acceptor, or indorser. Under local negotiable instruments law, there were certain conditions to each type of liability. For example, the obligation of an indorser is typically conditioned on presentation of the draft and any necessary notice of dishonor. Under civil law, formal protest is necessary, Geneva Convention, supra note 2, Articles 44, 46, whereas it is necessary under the U.K. Bills of Exchange Act sections 4(1) and 51(1)-(2) only for a foreign bill and not at all under U.S. U.C.C. section 3-415. See generally, ELLINGER, supra note 2, § 443. Under LC law, when the beneficiary draws a draft, it incurs liability as the drawer in the event that it is dishonored. When the payee (sometimes also the beneficiary) indorses the draft in blank or to the negotiating bank or its order, it also incurs liability as an indorser. In the event of dishonor, the person entitled to enforce the draft has recourse on the instrument against prior indorsers and the drawer unless that liability has been disclaimed, waived, or discharged. Failure to give timely notice of dishonor of an instrument to an indorser who is not the principal obligor can result in discharge of the indorser’s liability. See U.C.C. § 3-415(c). Since the indorser is typically in a zero-sum position, having paid and received funds for the instrument as it is received and subsequently transferred, the requirement of timely notice is proper so that it can move promptly to protect its position. Where there is a subsequent acceptance, under some local laws the liability of a prior indorser is discharged. See U.C.C. § 3-415(d).



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

46. Recourse was not mentioned in UCP82 (1933). It first appeared in UCP151 Article 5 (1951), which provided that “[i]n case of credits available by negotiation of drafts, the confirmation implies only the undertaking of the confirming Bank to negotiate drafts without recourse to drawer.” UCP290 Article 3 (1974) recognized that the issuer did not negotiate with recourse, and this approach continued until UCP600, which drops reference to negotiation by the issuer and seeks to forbid drafts drawn on the applicant—impotently, since the terms of the credit can vary the rules. UCP600 Article 8 (a)(ii) (Confirming Bank Undertaking) continues to recognize that a confirmer negotiates without recourse. Even without these references, payment under a letter of credit by a bank obligated as an issuer or confirmer is final. This principle will be relevant with respect to drafts drawn on the applicant, or a third person, under UCP600, which does not contain such a provision.

47. An exception to this principle is letter of credit fraud on the part of the beneficiary. But the value of a right against the fraudster beneficiary is questionable.

48. It is necessary, however, to distinguish between recourse against the beneficiary on the LC payment and any other rights that the applicant may have against the beneficiary that may be assigned to the bank or to which the bank may be subrogated. See Revised U.C.C. § 5-117 (revised 1995) (Subrogation of Issuer, Applicant, and Nominated Person) (offering a complete statement of subrogation). These rights depend on whether the beneficiary has breached its contract with the applicant and do not relate to the letter of credit or the documentary character of the presentation.

49. See ELLINGER, supra note 2, § 373 n.817 (citing cases for the proposition that recourse may be disclaimed in a collateral document or even verbally). The omission from UCP600 of any reference to negotiation by an issuer and, correspondingly, negotiation without recourse, could be problematic where a UCP600 credit provided for a draft drawn on the applicant. The correct rule, however, is that negotiation under such a credit by the issuer is without recourse.

50. See, e.g., Revised U.C.C. § 5-116(d) (showing a preference for the law of letters of credit by stating that “[i]f there is a conflict between this article and Article 3, 4, 4A, or 9, this article governs”). The two systems could be reconciled by reference to the UCP non-recourse provision. It could be concluded that this provision constitutes a disclaimer of the right to recourse. That theory, however, would not work with respect to negotiation by an issuer under UCP600. The failure of UCP600 to address negotiation by an issuer of a draft drawn on the applicant or another person gives rise to the question of whether the principle of finality will be applied without an express reference in the UCP. While it should be, a prudent beneficiary will require that the credit so state or draw and endorse the draft without recourse.

51. A negotiating bank does not rely solely on reimbursement from the issuer or confirmer. In the event that the issuer and confirmer are insolvent and prevented by the laws of their countries from effecting reimbursement, it can have recourse against the beneficiary. U.C.C. § 5-110 (2006).



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

52. What the fees paid by beneficiaries for negotiation cover, if not examination for discrepancies, is a

persuasive question. 53. A stimulating revisionist study suggests that the doctrine of negotiability emerged from the

common law system itself in response to economic requirements of the late 18th century, challenging the notion that it was an assimilation of the law merchant. JAMES S. ROGERS, THE EARLY HISTORY OF THE

LAW OF BILLS AND NOTES (1995). Whatever the historical antecedents, there is no doubt that by the end of the nineteenth century, negotiable instruments were distinct from the traditional doctrine of assignment under contract law by which the assignee took subject to defenses against the assignor.

54. See generally ELLINGER, supra note 2, § 417. 55. 31 N.Y.S.2d 631, 634 (N.Y.Sup.Ct., 1941)



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

56. While the English courts recite the proposition that injunctive relief is available in the event of

letter of credit fraud, there is no case in which it has been awarded. Indeed, the approach of the English courts to letter of credit fraud has with few exceptions been an exercise in distorting letter of credit practice. See, e.g., Banco Santander S.A. v. Bayfern Ltd. & Ors., [1999] 2 All E.R. (Comm.) (Q.B.) 18, aff’d Banco Santander SA v. Banque Paribas, [2000] 1 All E.R. (Comm.) (C.A.) 776. The definitive study of English LC fraud law has yet to be written. What exists is either written by apologists or by treatise writers whose mission is to explain within the context of the system rather than to analyze in a critical mode.

57. See generally GAO XIANG, THE FRAUD RULE ON THE LAW OF LETTERS OF CREDIT: A

COMPARATIVE STUDY (2002) (examining the problems surrounding letter of credit fraud).



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

58. So potent is the abstract status afforded the beneficiary that the transferee beneficiary is immune

from defenses, including LC fraud, that could be asserted against the original beneficiary. See Banca del Sempione v. Provident Bank of Maryland, 160 F.3d 992, 995-96 (4th Cir. 1998). The abstract explanation of LC transfers which differs considerably from assignment of a contract, see, e.g., ISP98, supra note 10, R. 6.01-6.05, is beyond the scope of this paper. The letter of credit makes this allocation possible by providing that the beneficiary is entitled to honor provided that the documents comply on their face with the terms and conditions of the letter of credit and without regard to disputes about the underlying transaction. This principle is the independence doctrine, which captures the documentary and abstract character of the letter of credit. The principle is best formulated in ISP98 Rule 1.06(c) (Nature of Standbys), which provides:

Because a standby is independent, the enforceability of an issuer’s obligations under a standby does not depend on: i. the issuer’s right or ability to obtain reimbursement from the applicant; ii. the beneficiary’s right to obtain payment from the applicant; iii. a reference in the standby to any reimbursement agreement or underlying transaction; or iv. the issuer’s knowledge of performance or breach of any reimbursement agreement or underlying transaction.

It is also scattered throughout the UCP. See, e.g., UCP600 arts. 4 (Credits v. Contracts), 5 (Documents v. Goods, Services or Performance) (2007); see also U.S. Revised U.C.C. § 5-103(d) (revised 1995); United Nations Convention on Independent Guarantees and Stand-by Letters of Credit, G.A. Res. 50/48, art. 3, U.N. Doc. A/RES/50/48 (Jan. 26, 1996) [hereinafter U.N. LC Convention].

59. One of the chief differences between the common law and the civil law systems relates to the consequence of the proof of a defense. Under the Bills of Exchange Act, a holder in due course is distinguished from a holder for value or a mere holder. 1882, 45 & 46 Vict. c. 61, § 29. Under section 30(2) of the Act, every holder is presumed to be a holder unless the defense is fraud, illegality, or duress, in which case the holder must prove its entitled status. Under U.C.C. section 3-308 (2006), a holder is entitled to recover unless the person obligated on the instrument proves any defense good in contract, in which case the holder or person claiming under its rights must prove in all respects that it is a holder in due course. Under Article 16 of the Geneva Convention, supra note 2, the focus is on the regular acquisition of the instrument through a series of facially proper indorsements without regard to their authenticity. Only if it has acquired the bill in bad faith does the holder not acquire good title to the instrument. See generally ELLINGER, supra note 2, §§ 404-27. The differences between these presumptions and the relative burdens attendant on them sheds some light on the absence of uniformity with respect to the presumptions to be accorded to a nominated bank or an issuer, where the issuer arises under letter of credit law and practice.



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

60. See U.C.C. § 3-305(a)(1) (2006); U.N. Bills of Exchange Convention, supra note 2, art. 30(1)(c).

See generally ELLINGER, supra note 2, §§ 417-27. 61. Geneva Convention on Bills of Exchange, supra note 2, art. 17. 62. ELLINGER, supra note 2, § 425. 63. U.C.C. §§ 3-305(a), 3-308 (2006). 64. ELLINGER, supra note 2, § 417. 65. Id.; Bills of Exchange Act, 1882, 45 & 46 Vict. c. 61, § 38(2). 66. ELLINGER, supra note 2, § 418 n.903; U.N. Bills of Exchange Convention, supra note 2, art.

30(1)(b). 67. Real defenses are those that can be asserted even against a holder in due course. They include

infancy, duress, lack of legal capacity, illegality that nullifies the transaction, essential fraud resulting from excusable ignorance, and discharge in insolvency. See, e.g., U.C.C. § 3-305(a)(1) (2006).

68. Since letters of credit are not consumer devices, only the defense of fraud could be asserted by a bank issuing a letter of credit. Illegality is not a defense under letter of credit law or practice. If a bank has issued a letter of credit, it must live with the consequences, which may include regulatory or criminal sanctions, but its error should not excuse its obligation to a beneficiary. Illegal conduct by the beneficiary is a matter of local statutory or regulatory law. The definitive study of illegality with respect to LCs remains to be written.

69. There is no definitive study of LC fraud. A valuable beginning has been essayed in XIANG GAO,



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.

supra note 58. Revised U.C.C. section 5-109(a) (Fraud and Forgery) (revised 1995) provides that LC fraud arises:

[i]f a presentation is made that appears on its face strictly to comply with the terms and conditions of the letter of credit, but a required document is forged or materially fraudulent, or honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant . . . .

U.N. LC Convention, supra note 58, article 19 states that it is present:

[i]f it is manifest and clear that: (a) Any document is not genuine or has been falsified; (b) No payment is due on the basis asserted in the demand and the supporting documents; or (c) Judging by the type and purpose of the undertaking, the demand has no conceivable basis . . . .

The Interpretation of the Sup. People’s Ct. (PRC) [2005] No. 13 Article 8 states:

The letter of credit fraud shall be determined as constituted under any of the following circumstances: (1)The beneficiary forges documents or provides documents containing fraudulent information; (2) The beneficiary maliciously refuses to deliver goods or delivers goods of no value; (3) The beneficiary provides false documents by colluding with the applicant or a third party and there isn’t any true basic transaction; or (4) Other circumstances under which letter of credit fraud is conducted.

70. See Credit Industriel et Commercial v. China Merchants Bank, (2002) 1 All E.R. (Comm.) (Q.B.) 427.



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.

71. ISP98 Rule 1.05(c) (Exclusion of Matters Related to Due Issuance and Fraudulent or Abusive

Drawing) defers to applicable law. But see The Official Commentary, supra note 10, Rule 1.05, cmt. 5(c), 20-21 (delineating the exceptions that are implicit in LC practice).

72. The first version of this article was UCP82 (1933) Article 11, followed by UCP151 (1951) Article 11, which was identical. The rule was rephrased and expanded slightly in UCP222 (1962) Article 9. UCP290 (1974) Article 9 and UCP400 (1983) Article 17 were identical to UCP222 Article 9. UCP500 (1993) Article 15 again slightly rephrased and expanded the rule.

73. See ISP98, supra note 10, R. 1.05(c) (Exclusion of Matters Related to Due Issuance and Fraudulent or Abusive Drawing) (stating that “[t]hese Rules do not define or otherwise provide for: a. power or authority to issue a standby; b. formal requirements for execution of a standby (e.g. a signed writing); or c. defenses to honour based on fraud, abuse, or similar matters. These matters are left to applicable law”). Despite this provision, however, it is noted that “[w]hile ISP98 provides no systematic rule with respect to fraud or abuse, it does contain rules based on principles which would provide important guidance in determining whether and what remedy might be appropriate in the event of fraud.” The Official Commentary, supra note 10, at 20-21.



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.

74. The entitlement of a transferee of a letter of credit to protection from the LC fraud of the

beneficiary is a topic that is beyond the scope of this paper. It arises from what is, in effect, a separate or new LC and not from the process of negotiation of the documents under the original LC. As will be apparent, the transfer of a letter of credit differs greatly from the transfer of a chose in action under general commercial law.

75. The question becomes somewhat more complex where the nominated bank is a negotiating bank. In such a situation, letter of credit law often becomes entangled with the law of negotiable instruments, and it is common for the courts to look to the procedures, allocations of burdens of proof, and presumptions related to the doctrine of holder in due course. While this doctrine is related, the presumptions surrounding acceptance financing are more useful than those of negotiable instruments law. That body of law reflects a situation where there is an established market and practice of trade finance through the sale and purchase of abstracted rights, and it has been less susceptible to concerns of issuers of commercial paper who are also consumers and invoke consumer protection doctrines to limit the effect of negotiability. It should be sufficient to establish a prima facie entitlement to recover if a negotiating bank provides a sworn statement of the facts surrounding its negotiation.



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

76. The risks of fraud, abuse, or false or forged documents are not assumed by any bank, including an

issuer or confirmer. This protected status is implicit in the concept of negotiation under standard international letter of credit practice. See UCP500 (1994) art. 15; ISP98 art. 8.01(b).

77. See U.C.C. § 3-303(a)(4) & (5) (2006) (stating that “[a]n instrument is issued or transferred for value if: . . . (4) the instrument is issued or transferred in exchange for a negotiable instrument; or (5) the instrument is issued or transferred in exchange for the incurring of an irrevocable obligation to a third party by the person taking the instrument”).

78. Letters of credit often contain various deadlines such as a period of time after the issuance of the transport document within which documents must be presented—the default rule is twenty-one days under UCP600 Article 14(c) (Standard for Examination of Documents)—and a deadline by which the transport document must be issued.

79. U.C.C. Revised section 5-109(a) (revised 1995) provides:

If a presentation is made that appears on its face strictly to comply with the terms and conditions of the letter of credit, but a required document is forged or materially fraudulent, or honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant: (1) the issuer shall honor the presentation, if honor is demanded by (i) a nominated person who has given value in good faith and without notice of forgery or material fraud, (ii) a confirmer who has honored its confirmation in good faith, (iii) a holder in due course of a draft drawn under the letter of credit which was taken after acceptance by the issuer or nominated person, or (iv) an assignee of the issuer’s or nominated person’s deferred obligation that was taken for value and without notice of forgery or material fraud after the obligation was



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

incurred by the issuer or nominated person; and (2) the issuer, acting in good faith, may honor or dishonor the presentation in any other case.

U.N. LC Convention, supra note 58, Article 19 provides:

(1) If it is manifest and clear that: (a) Any document is not genuine or has been falsified; (b) No payment is due on the basis asserted in the demand and the supporting documents; or (c) Judging by the type and purpose of the undertaking, the demand has no conceivable basis, the guarantor/issuer, acting in good faith, has a right, as against the beneficiary, to withhold payment.

The Interpretation of the Supreme People’s Court (PRC) [2005] No. 13 Article 10 provides:

A people’s court shall make a ruling to suspend the payment or a judgement to permanently stop the payment under a Credit when fraud is established, unless one of the following has happened: (i) The nominated person or the person authorised by the issuing bank has paid in good faith in accordance with the instructions of the issuing bank; (ii) The issuing bank or its nominated or authorized person has accepted the bills of exchange under the Credit in good faith; (iii) The confirming bank has paid in good faith; or (iv) The negotiating bank has negotiated in good faith.

80. It has been properly suggested that such a situation would only arise when the documents are marked “fraudulent.” Short of that, it is difficult to imagine a situation where actual knowledge of fraud could be visited on the issuer or confirmer, unless it or its employees have colluded in the fraud.

81. The issuer or confirmer, however, may at its option refuse payment based on LC fraud. Should they do so, usually when the applicant has undertaken to indemnify them and hold them harmless from any losses or expenses, they are required to prove that there has been LC fraud. This action is discretionary except in the rare situation where the bank is certain of the existence of fraud. In most situations, the bank will not elect to expose itself—or its reputation—to the risk of having to prove fraud in relationship to a transaction in which it is not involved.

82. U.C.C. § 5-109(b) (2006) provides:

If an applicant claims that a required document is forged or materially fraudulent or that honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant, a court of competent jurisdiction may temporarily or permanently enjoin the issuer from honoring a presentation or grant similar relief against the issuer or other persons . . . .



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”

The U.N. Bills of Exchange Convention, supra note 2, Article 20 provides:

(1) Where, on an application by the principal/applicant or the instructing party, it is shown that there is a high probability that, with regard to a demand made, or expected to be made, by the beneficiary, one of the circumstances referred to in subparagraphs (a), (b) and (c) of paragraph (1) of article 19 [Exception to Payment Obligation] is present, the court, on the basis of immediately available strong evidence, may: (a) Issue a provisional order to the effect that the beneficiary does not receive payment, including an order that the guarantor/issuer hold the amount of the undertaking, or (b) Issue a provisional order to the effect that the proceeds of the undertaking paid to the beneficiary are blocked, taking into account whether in the absence of such an order the principal/applicant would be likely to suffer serious harm.

See Chinese LC Rules, supra note 79, art. 10; see also U.N. Commission on International Trade Law [UNCITRAL], Working Group on International Contract Practices, Independent Guarantees and Stand-by Letters of Credit: Discussion of Further Issues of a Uniform Law: Fraud and Other Objections to Payment, Injunctions and Other Court Measures: note by the Secretariat, paras. 90-114, U.N. Doc. A/CN.9/WG.II/WP.70 (Apr. 5, 1991).

83. No distinction is made here between a bank that is specially nominated to negotiate and a freely negotiable credit since both operate identically with respect to negotiation. A freely negotiable credit permits negotiation without designating a specific bank, so that any bank may negotiate. As with negotiation, there is no required or typical manner of indicating that the credit is freely negotiable. Free negotiation may be indicated by a recital that the issuer undertakes to honor presentations by any bank or by stating that the credit is freely negotiable, by checking a box on a form, or by so stating in SWIFT Field 41a (Available With . . . By . . . ). A variation on free negotiation is a credit that is freely negotiable within a stated geographical area (e.g., “negotiable by any bank in Singapore”). Under a freely negotiable credit, any bank is a nominated person under the credit, except that it may not effect a transfer of drawing rights unless it is specifically nominated as a transferring bank. There are operational risks associated with free negotiation regarding control of the documents and presentation in that the issuer and applicant rely on the good faith of any bank with whom the beneficiary may work without necessarily having a working relationship with that bank. There are also issues that affect negotiability where a draft is drawn on the paying bank. The paying bank would either pay or accept. The issues raised here, however, are beyond the scope of this paper.



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

84. This provision is contained in the Model Uniform Commercial Code which is adopted in all fifty

states with some variations. U.C.C. § 3-303(a) (2006) (stating that “[a]n instrument is issued or transferred for value if: (1) the instrument is issued or transferred for a promise of performance, to the extent the promise has been performed . . .”). Section 3-303(a) is based on section 54 of the predecessor statute, the Negotiable Instruments Law, supra note 7, which deviated in this respect from the U.K. Bills of Exchange Act, 1882, 45 & 46 Vict. c. 61, § 27. See also U.C.C. § 3-303, cmt. 2 (stating that “[t]he policy basis for subsection (a)(1) is that the holder who gives an executory promise of performance will not suffer an out-of-pocket loss to the extent the executory promise is underperformed at the time the holder learns of dishonor of the instrument”).

85. Bills of Exchange Act § 27(1)(a) (Value and Holder for Value). 86. ELLINGER, supra note 2, § 413. 87. Where a nominated negotiating bank makes a separate undertaking to the beneficiary to negotiate

drafts drawn under the letter of credit, such an undertaking is commonly (and incorrectly) described as a “silent confirmation.” THE INTERNATIONAL CHAMBER OF COMMERCE, OPINIONS OF THE ICC BANKING

COMMISSION 1995-1996, Resp. 207 at 27 (Gary Collyer ed., 1997) ( stating that “[s]ub-Article 10(c) takes note of the possibility that a nominated bank, not being a confirming bank, agrees with the beneficiary to assume a liability to pay, etc. Silent confirmation may be one of such undertakings”). UCP600 (2007) Article 12(a) also alludes to this possibility. While anticipated in UCP600 Article 12(b), which provides “[b]y nominating a bank to accept a draft or incur a deferred payment undertaking, an issuing bank authorizes that nominated bank to prepay or purchase a draft accepted or a deferred payment undertaking incurred by that nominated bank,” this practice is not regulated or standardized by the UCP. This undertaking is not one under the letter of credit. For more about Silent Confirmation, see Byrne, Barnes, & Maulella, Silent Confirmation (Institute of International Banking Law & Practice 2006) (Available via ON Line Replay or DVD). This topic is one that requires such extensive separate treatment that it is only tagged in this article as an area that is not included in this treatment of negotiation.

88. UCP290 (1974) Article 3(a)(iii) stated:

An irrevocable credit constitutes a definite undertaking of the issuing bank, provided that the terms and conditions of the credit are complied with: . . . iii to purchase/negotiate, without recourse to drawers and/or bona fide holders, drafts drawn by the beneficiary, at sight or at a tenor, on the applicant for the credit or on any other drawee specified in the credit, or to provide for purchase/negotiation by another bank, if the credit provides for purchase/negotiation.

See CHARLES DEL BUSTO, UCP 500 & 400 COMPARED 29 (1993) (stating that “[n]egotiation in



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

Documentary Credit practice means more than to examine the documents. When an Issuing Bank issues a negotiation Credit, it is inviting a Nominated Bank to negotiate or to give value in exchange for a Beneficiary’s draft and/or documents”).

89. UCP500 Article 10(b)(ii) (Types of Credit) (1994) (defining “negotiation” as “giving of value for Draft(s) and/or document(s) by the bank authorized to negotiate”).

90. UCP600 Article 2 (Definitions) para. 11 (2007) states:

Negotiation means 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.

91. Signaling the concern that led to the definition, UCP500 (1983) Article 10(b)(ii) provides that “[m]ere examination of the documents without giving of value does not constitute a negotiation.”

92. INTERNATIONAL CHAMBER OF COMMERCE, ICC BANKING COMMISSION POSITION PAPER NO. 2, reprinted in LC RULES AND LAWS at 107 (James E. Byrne ed., 3d ed. 2004).

93. There is another complicating preliminary dimension, namely that the provision in UCP600 admits of two divergent readings. UCP600 Article 7(c) (Issuing Bank Undertaking) sentence 2 states that “[r]eimbursement for the amount of a complying presentation under a credit available by acceptance or



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

deferred payment is due at maturity, whether or not the nominated bank prepaid or purchased before maturity.” This sentence could mean that reimbursement is due at maturity provided that the promise to prepay or purchase was given before maturity or that the actual disbursal took place before maturity. James G. Barnes, whose suggestion lead to this provision but who was regrettably not consulted in its drafting, indicates that the latter interpretation is preferable. Some authorities, however, may interpret it in the former sense.

94. The UNIDROIT Principles of International Commercial Contracts (2004) Article 3.8 provides:

A party may avoid the contract when it has been led to conclude the contract by the other party’s fraudulent misrepresentation, including language or practices, or fraudulent non-disclosure of circumstances which, according to reasonable commercial standards of fair dealing, the latter party should have disclosed.

95. See Banco Santander S.A. v. Bayfern Ltd. & Ors., [1999] 2 All E.R. (Comm.) (Q.B.) 18, aff’d Banco Santander SA v. Banque Paribas, [2000] 1 All E.R. (Comm.) (C.A.) 776; James G. Barnes & James E. Byrne, Letters of Credit: 2000 Cases, 56 BUS. LAW. 1805, 1813 (2001) (criticizing Banco Santander). See also Sinotani Pac. v. Ag. Bank of China, 4 S.L.R. 34 (1999); Czarnikow Rionda Sugar Trading v. Standard Bank, (1999) 2 Lloyd’s Rep. (Q.B.) 187, 202; Bundesgericht [BGer] [Federal Court] June 1, 2004, 130



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

Entscheidungen des Schweizerischen Bundesgerichts [BGE] III 462 (Switz.) (for English translation, see DOCUMENTARY CREDIT WORLD, 2006 ANNUAL SURVEY at 477).

96. The Banco Santander v. Bayfern Ltd. & Ors. court noted that the confirming bank’s “submission was that there was no good reason why the effect of established fraud should differ in the case of acceptance credits and deferred payment credits. An acceptance credit, however, expressly involves authority from the Issuing Bank to the Confirming Bank to accept drafts and pay them at maturity,” whereas a deferred payment credit was not so authorized. Banco Satander, 2 All E.R. (Comm.)(Q.B.) 18.

97. See Cour de cassation [highest court of ordinary jurisdiction] Cass. com., Oct. 11, 2005, Bull. civ, IV, No. 1246 (Fr.). See also Jean Stoufflet, May a Bank Contest the Authenticity of Documents After Accepting the Beneficiary's Draft and Refuse Payment of a Documentary Credit?, in DOCUMENTARY

CREDIT WORLD, Feb. 2006, at 12. 98. In addition to the definition of “Negotiation” in UCP600 Article 2 paragraph 11, Articles 7(c)

(Issuing Bank Undertaking) and 8(c) (Confirming Bank Undertaking) address reimbursement of nominating banks. UCP600 Article 8(c), for example, states:

A confirming bank undertakes to reimburse another nominated bank that has honoured or negotiated a complying presentation and forwarded the documents to the confirming bank. Reimbursement for the amount of a complying presentation under a credit available by acceptance or deferred payment is due at maturity, whether or not another nominated bank prepaid or purchased before maturity. A confirming bank’s undertaking to reimburse another nominated bank is independent of the confirming bank’s undertaking to the beneficiary.

99. UCP600 (2007) Article 12(b) (Nomination) states that nomination of a bank to incur a deferred payment undertaking or to accept authorizes that bank “to prepay or purchase a draft accepted or a deferred payment undertaking incurred by that nominated bank.” Although not explained, “prepay” and “purchase” are quite different in their meaning and implications. While a bank can purchase a draft or documents presented under an LC whether or not it is nominated and whether or not it is obligated on an LC, only a bank that is obligated can prepay its own obligation because prepayment signifies discharge of the obligation whereas an obligation that is purchased is not discharged by the purchase. A further step is required to discharge the obligation. While negotiation without recourse by a confirming bank discharges its obligation under a letter of credit, it is not “prepayment” because negotiation occurs when the documents are presented and negotiation is not a prepayment. That the negotiation is in advance of the time when reimbursement is due does not constitute “prepayment” for purposes of UCP600. The term “purchase” is further explained in the UCP600 Article 2 paragraph 11 definition of negotiation by the term “advance,” which occurs “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.” “Advance” connotes a temporal relationship to something it precedes, namely the reimbursement by an issuer or confirmer. The addition of the phrase limiting the time within which the advance must occur indicates that negotiation may not occur after reimbursement is due. What it does not clarify is whether or not the actual advance of funds must have occurred by the time that reimbursement is due.



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

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

100. To the extent that the value given by the negotiating bank is executory, a possible issue arises.

See supra note 84. 101. Unlike the general law of consensual obligations, “transfer” and “assignment” are distinguished

in letter of credit practice and law. See UCP600 (2007) Articles 38 (Transferable Credits) and 39 (Assignment of Proceeds); ISP98, supra note 10, Rule 6 (Transfer, Assignment, and Transfer by Operation of Law); G.A. Res. 50/48, supra note 58, arts. 9-10; Revised U.C.C. §§ 5-112-5-114.



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.

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

102. This approach elects not to frame the question in terms of reimbursement rights. That

appellation is appropriate for entities that are obligated on the LC such as the confirmer or issuer. It is also appropriate for a paying bank. It is less so for a negotiating bank, which retains its right of recourse and acts more independently than do the other nominated banks.



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

103. See All Services Exportacao, Importacao Comercia v. Banco Bamerindus Do Brazil, 921 F.2d 32,

35-36 (2d Cir. 1990); First Commercial Bank v. Gotham Originals, Inc., 475 N.E.2d 1255, 1260 (N.Y. 1985). 104. U.C.C. § 5-116(d) (2006). 105. See, e.g., U.C.C. § 2A-407 (Irrevocable Promises: Finance Leases). 106. See Revised U.C.C. § 9-403 (revised 2000) (Agreement Not to Assert Defenses Against

Assignee).



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.