Deferred payment letters of credit
Alan L Tyree

Documentary letters of credit are well known instruments used primarily in financing international trade. Most, if not all, credits are issued subject to the rules of the Uniform Customs and Practice for Documentary Credits (UCP) sponsored by and published by the International Chamber of Commerce (ICC).

The first UCP was published in 1933, and the rules have been revised periodically since that time. The latest version is the 2007 revision and is known as the UCP 600. The previous reversion, the UCP 500, was published in 1993.

In a standard documentary credit transaction, the applicant for the credit, the 'account party', is the buyer in an international sale of goods. The beneficiary of the credit is the seller who obtains payment by presenting required documents at a bank where the credit is available.

Provided the documents are in order, a so-called 'complying presentation', the bank must pay unless the presentation of documents is known by the beneficiary and the bank to be fraudulent: the so-called 'fraud rule'.

Both the UCP 500 and the UCP 600 provide for credits to be 'realised', that is, paid to the beneficiary in different ways. The most favourable for the beneficiary is a 'sight payment' credit which must be paid by the bank on the acceptance of documents.

Where the bargaining position of the account party is stronger, payment under the credit may be delayed. The UCP provides two types of credit which involve delayed payment, the acceptance credit and the deferred payment credit.

An acceptance credit is honoured by the bank accepting a bill of exchange drawn on the issuing bank or the bank where the credit is available. A deferred payment credit is honoured by the bank making a promise to pay at a later date. An acceptance credit is obviously more favourable to the beneficiary since the bank bill may then be discounted in the bill market.

Deferred credits were developed in those countries which still have stamp duty on bills of exchange. The practice developed of 'discounting' deferred credits by advancing sums to the beneficiary before the payment due date.

What happens if fraud by the beneficiary is discovered after the deferred credit is discounted, but before the due date for payment? In particular, is the issuing bank required to reimburse a bank that has discounted the credit? Since the issuing bank cannot recover from the account party, the question is one of which bank bears the risk of fraud by the beneficiary.

The issue arose in a stark form in Banco Santander S A v Banque Paribas [2000] EWCA Civ 57. Paribas had issued a deferred payment letter of credit in favour of Bayfern as beneficiary for a sum in excess of US$20m. Santander was a confirming bank, and the credit was issued subject to the UCP 500.

Bayfern presented documents to Santander which appeared to be in order and were accepted by Santander. Payment under the credit was due 180 days after the date on the bill of lading, and the credit expressly provided that Paribas undertook 'at maturity … to cover Santander in accordance with their instruction.'

Santander offered to discount the letter of credit, an offer which Bayfern accepted. As security, Santander asked and received a letter from Bayfern 'irrevocably and unconditionally assign[ing] to you our rights under this letter of credit.' No notice of this assignment was given to Paribus but the documents were handed by Santander to Paribus.

Fraud on the part of Bayfern was discovered before the maturity date of the credit, and Paribas refused to reimburse Santander. The UK Court of Appeal considered that:

• if Santander was claiming as assignee, then it had to overcome the problem that it was, like any assignee, subject to the defences which could be raised against the assignor;
• if, on the other hand, Santander was claiming as a confirming bank under the UCP, it had to overcome the problem that it had not followed its mandate, namely to pay at the maturity date.

The court held that if Santander was claiming as an assignee, there was no reason to displace the general rule concerning defences. The court based part of its reasoning on the existence of acceptance credits: if the parties wished to allow discounting, an acceptance credit could have been used. Since Paribas had a defence against a claim for payment from Bayfern, the fraud rule, it also had a defence against Santander claiming as assignee.

As to the claim under Art 14 of the UCP 500, the court noted that reimbursement under that article could only occur on payment, but payment could not be made before the maturity date. Art 14(A)(i) of the UCP 500 states that the Issuing bank is bound:

to reimburse the Nominated Bank which has paid, incurred or deferred payment undertaking, accepted Draft(s) or negotiated

The court also considered the instructions by the issuing bank. Paribas did not request Santander to discount, merely to incur a deferred payment undertaking. Santander had no authority from Paribas to discount although it was something that they were entitled to do on their own account.

Santander attempted to argue that the discounting practice and reimbursement was established banking practice but failed on the evidence.

The ICC considered the question of deferred credits when considering the revision of the UCP 500. Much of the banking community thought that deferred credits should be on a par with acceptance credits.

However, there were strong arguments that the decision in the Santander case was the right one. If the parties wished to provide for discounting then acceptance credits could be used. Further, case law showed that, had Santander sought and obtained approval from Paribas for discounting the credit, then Paribas would have been liable to reimburse: see European Asian Bank AG v Punjab & Sind Bank (No.2) [1983] 1 WLR 642.

On another view, the question is one of allocation of the risk of fraud. With an acceptance credit, if fraud is discovered after discounting but before maturity, the issuing bank bears the loss. With a deferred payment credit, if Banco Santander is correct, the loss falls on the discounting bank.

In the end, the proponents of equality succeeded, and the UCP 600 includes provisions intended to elevate the deferred credit to the status of the acceptance credit.

One of the more important changes in the UCP 600 is the treatment of deferred credits. Picking up on the major reasons given by the court in Banco Santander, the UCP 600 makes it clear that a nominated bank has authority to discount a deferred credit.

The first step in this procedure is to grant authority to the nominated bank to discount. This is achieved in Art 12(b) which provides that by nominating a bank to incur a deferred payment undertaking, the issuing bank authorises the nominated bank to prepay.

Art 12(b) would probably be enough to achieve the aim of overturning Banco Santander, but Art 7(c) provides that the issuing bank must reimburse the nominated bank 'whether or not the nominated bank prepaid…before maturity.' Art 8(c) places a similar obligation on a confirming bank.

The UCP 600 seems to have succeeded in making deferred payment credits the equal of acceptance credits so far as the initial discounting is concerned. This is good news for beneficiaries and nominated banks, bad news for issuing banks.

It is still theoretically possible for an issuing bank to prohibit the nominated bank from discounting a deferred credit. The UCP 600 applies only to the extent that the credit does not modify or exclude them: Art 1. Thus, an issuing bank could issue a credit that excluded the operation of the new articles. This action might, however, result in a breach of the contract between the applicant and the beneficiary is that contract called for a credit 'on usual terms' or some such requirement.

Unless there is some good reason to use deferred payment credits, such as the stamp duty issue, acceptance credits provide a better solution for the nominated bank since it may further discount the bill of exchange if desired.