A. Joyce Furfero, Ph.D., J.D.
December 15, 1995
Section 1-203 of the Uniform Commercial Code (U.C.C.) provides that "[e]very contact or duty within this Act imposes an obligation of good faith in its performance and enforcement." FN1. The problem is that there is not one, but several different definitions of "good faith." The U.C.C., itself, is governed by two different definitions of "good faith" FN2 --- the "narrow" definition, a subjective standard FN3 and the "broad" definition, an objective standard. FN4. In revising Article 5 of the U.C.C., FN5 which article governs letter of credit transactions, FN6 the drafters chose to continue with the narrow definition of good faith FN7 even though most of the other U.C.C. articles incorporate the broad or expanded definition of good faith. FN8.
The issue of good faith in letter of credit transactions most often arises in cases where the issuer has dishonored a beneficiary's demand for payment. FN9. A substantial percentage of all presentations fail to strictly comply with the terms and conditions of the letter of credit. FN10. Fortunately, most discrepancies are timely cured by these beneficiaries. FN11. However, a few nonconforming presentations are not cured on time. In these instances, the aggrieved beneficiary brings suit against the issuer to recover, alleging bad faith dishonor. FN12.
The inquiry in these cases shifts from the issuer's good faith in verifying the supporting documents for facial compliance to a consideration of whether the issuer had actual knowledge of either its customer's dissatisfaction with the underlying transaction, or its insolvent condition. FN13. If the issuer had reason to believe that its customer was dissatisfied with the transaction and would not want the issuer to pay on the letter of credit, then the issuer may look for minor flaws in documents or delay notice of dishonor or offer ambiguous or no explanations of the discrepancies as a pretext for avoiding payment, even where the documents could have been timely cured. Such pretextual dishonor is "solely for the ulterior motive of helping a dissatisfied customer" FN14 and constitutes bad faith. If the issuer was afraid that it would not be reimbursed because its customer was insolvent or on the verge of insolvency, then the issuer's pretextual dishonor was "solely for the ulterior motive of avoiding [its own] financial loss." FN15.
In both cases, the issuer is liable for wrongful dishonor, if the beneficiary's documents were timely and conforming, and the prevailing beneficiary is entitled to damages on the letter. FN16. In neither case, however, is the issuer liable for wrongful dishonor, if the beneficiary's documents were neither timely nor conforming.
Opponents of the "narrow" definition of good faith believe that a beneficiary should have a cause of action for bad faith against an issuer in both cases. They want a beneficiary to be able to sue an issuer for bad faith pretextual dishonor, even if the documents were totally incurable. They argue that the overall policy goal in defining good faith for letter of credit law is "to effectuate the intent of the parties," FN17 and that the narrow definition fails to do this. They argue that the outcome is unfair, because it permits the issuer to avoid its obligation at precisely the time when the beneficiary is most vulnerable and needs the protection of a letter of credit, FN18 and that this unfairness invalidates the intent of the parties. They also argue that the dual-definition approach is illogical, that it will give rise to serious interpretative problems, and that it will lead to judicial confusion and uncertainty. FN19. In addition, the opponents want to make consequential and punitive damages available to the beneficiary in cases of bad faith dishonor by an issuer. FN20.
Proponents of the "narrow" definition of good faith believe that the above outcome is fair, because a cause of action for bad faith dishonor is redundant where the beneficiary already has a legitimate claim for wrongful dishonor. FN21. They argue that the overall policy goal in defining good faith for letter of credit law is "to effectuate prompt, reliable payment of facially conforming documents," FN22. and that the "narrow" definition achieves this goal by promoting the commercial utility of the letter of credit and the solvency of the financial system. FN23. They believe that "it does not make sense to slavishly insert a more expansive definition on the grounds of mere consistency in every mercantile specialty without assessing the harm to the particular specialty and its commercial usefulness." FN24. They would not allow a beneficiary to assert a claim for consequential or punitive damages, because allowing such damages increases the costs of a letter of credit and poses a real threat to its commercial vitality. FN25.
This author believes that the proponents' arguments for the narrow definition of good faith are more valid in light of the unique role that letters of credit, and their issuers (primarily banks), play in facilitating the primary or underlying transactions, both domestic and international. FN26. Letters of credit are extremely important in commercial and, more recently, financial transactions, because they serve both as payment mechanisms and as assurances of the payment or performance of underlying obligations. FN27. To maintain the commercial and financial viability of letters of credit, the laws governing letters of credit must necessarily be designed to minimize their cost, maximize their availability, effectuate the expectations of the parties, and protect the safety and solvency of their issuers --- the banks. There is nothing distorted or stilted or even inherently unjust or unfair about rules of law which promote global economic and financial interests over the parochial squabbles of two narrowly defined parties to a specific contract, especially when the latter can be easily remedied by education and experience, but an international economic or financial crisis cannot. Therefore, "[w]hen analyzing [letter of credit] law the unique characteristics of a letter of credit must be kept firmly in mind." FN28.
The purpose of this paper is to explain why letter of credit transactions are special and unique and to demonstrate conclusively why the drafters' choice of the narrow definition of good faith is correct in the letter of credit context. Part II of this paper differentiates between the two definitions of good faith. Part III examines the uniqueness of the letter of credit transaction. Part IV rebuts the arguments advanced by the opponents of the narrow definition. Part V offers with some recommendations or solutions for improving honor rates to assuage the concerns of the opponents of the narrow definition. Part VI summarizes the preceding concepts and arguments and concludes that the drafters' choice of the narrow definition of good faith is the correct choice.
II. GOOD FAITH
Good faith is part of every transaction under the U.C.C. FN29. However, good faith takes on different meanings, depending on the particular type of transaction, and, to some extent, on the parties to the transaction. Alternatively, these different definitions have been described as the "narrow" definition and the "broad" definition. FN30.A. The Narrow Definition of Good Faith
The narrow definition of "good faith" is "honesty in fact in the conduct or transaction concerned." FN31. It is a subjective, internal standard involving only a determination of intent or state of mind of the party concerned, taking into account the actual knowledge of the person and his or her motive(s). FN32. The narrow definition goes only to the actual belief of the party in question and not the reasonableness of that belief. FN33. Proof of how other persons similarly situated would have acted is irrelevant. FN34. It imposes on the party no duty to investigate suspicious circumstances even where the party might have notice that something is wrong, FN35 and it is immaterial whether or not the party acted stupidly, or negligently, as long as the party acted honestly. FN36.
The narrow definition of good faith is the default option under Article 1 (Goals, Purposes, and Policies) of the U.C.C. FN37. In particular, it governs Article 2 (Sales of Goods (non-merchants)), Article 2A (Leases of Goods (non-merchants)), Article 5 (Letters of Credit), Article 7 (Warehouse Receipts, Bills of Lading, and Other Documents of Title), and Article 9 (Secured Transactions). The transactions in these articles are different from other U.C.C. transactions. First of all, for transactions in Articles 2 and 2A involving individuals and non-merchants, the conduct of the parties is not readily amenable to the establishment of "reasonable commercial standards," because no well-defined customs and practices exist. FN38. Second, for transactions in Articles 5, 7, and 9, the conduct of the parties is ministerial in nature, rather than discretionary. Finally, the transactions in Articles 5, 7, and 9 are not autonomous in their own right, but rather they are derived from the need to facilitate other transactions; FN39. that is, no one obtains a letter of credit, a warehouse receipt, a bill of lading, or any other document of title, or a security interest in an asset, but for the commitment to another, underlying transaction.
B. The Broad Definition of Good Faith
The broad definition of "good faith" is "honesty in fact" and the "observance of reasonable commercial standards of fair dealing." FN40. The broad definition goes to the decency, fairness, or reasonableness of the party's conduct in the transaction. FN41. The broad definition goes not only to the actual belief of the party in question, but also to the reasonableness of that belief. FN42. In addition to the subjective test, it adds an objective test for determining whether a party acted in good faith. FN43. The objective test involves an analysis of what persons with ordinary prudence would do given the same circumstances without accounting for any particular knowledge or skill. FN44. It is an external standard and involves a comparison of a particular issuer's activities with those of similarly situated issuers.
The broad definition of good faith governs the remaining articles of the U.C.C. provisions which include Article 2 (Sales of Goods (merchants)), FN45 Article 2A (Leases of Goods (merchants)), FN46 Article 3 (Negotiable Instruments), FN47 Article 4 (Bank Deposits and Collections), FN48 Article 4A (Funds Transfer), FN49 and Article 8 (Commercial Paper). FN50. The broad definition of good faith is more aptly suited to these types of transactions, because (1) they are transactions in which the parties' conduct is more readily amenable to the establishment of "reasonable commercial standards," i.e., well-defined customs and practices exist; FN51 (2) they are transactions in which the parties' conduct is discretionary and, therefore, must be judged by an objective standard of what is reasonable in the commercial context; and (3) they are autonomous or independent transactions, which stand on their own.
III. THE UNIQUENESS OF THE LETTER OF CREDIT TRANSACTIONA. The Nature of the Letter of Credit Transaction
The letter of credit is the third commitment in a triangular transaction. FN52. These triangular transactions now include both commercial letters of credit FN53 and standby letters of credit. FN54. The letter of credit may be either revocable FN55 or irrevocable. FN56. Most letters of credit are irrevocable, and this irrevocability is what maintains the viability and credibility of the letter of credit as a form of credit intermediation and payment mechanism. Revised Article 5 provides that all letters of credit are presumed to be irrevocable, unless revocability is otherwise stated. FN57.
The letter of credit transaction involves, at minimum, three parties and three commitments. FN58. The first commitment is the [underlying] contract between the primary contracting parties (the applicant and the beneficiary). The second commitment is the contract between the applicant FN59 and the issuer (generally a bank). FN60. In the second contract, the issuer promises, on behalf of the applicant, to substitute its creditworthiness for that of the applicant by issuing a letter of credit to a third party (the beneficiary), and the applicant promises to reimburse the issuer for any payment made by the issuer to the beneficiary on its behalf. The third commitment is the letter of credit. In the letter of credit, the issuer promises, on behalf of the applicant, to pay a certain sum to the beneficiary upon its successful presentment of documents which "strictly comply" FN61 with the terms and conditions of the letter of credit. Thus, each commitment is separate and "independent" FN62 of the other commitments, and no party to any of the three commitments is responsible for performance of the obligations of another commitment. FN63.
B. The Principles Governing the Letter of Credit Transaction
The letter of credit transaction is governed by two principles --- the "independence" principle and the "strict compliance" principle.
1. The "independence" principle
The "independence principle" states that the letter of credit is an undertaking separate and apart from the underlying transaction. FN64. This separation facilitates payment on the letter of credit upon a mere facial examination of documents making the letter of credit "a unique commercial device which assures prompt payment." FN65. It "prohibits the issuer of a letter of credit from looking at any material or facts other than those appearing in the draw documents themselves." FN66. "Since the great utility of letters of credit arises from the independent obligation of the issuing bank, attempts to avoid payment premised on extrinsic considerations--contrary to the instruments' formal documentary nature--tend to compromise their chief virtue of predictable reliability as a payment mechanism." FN67.
2. The "strict compliance" principle
The "strict compliance principle" states that, upon presentation of conforming documents, the issuer has an absolute obligation to accept the documents and pay the beneficiary. FN68. Its corollary is that the issuer has an absolute right to reject the documents and not to pay the beneficiary, if the documents are neither timely FN69 nor conforming. FN70. Strict compliance helps the beneficiary by "ensur[ing] that banks will be able to act quickly, enhancing the letter of credit's fluidity." FN71.
C. The Letter of Credit is a Payment Mechanism
The letter of credit, like the bank note, book credit, checking account, and electronic funds transfer, is a payment mechanism FN72 which evolved to "grease the wheels of trade." FN73. It allows individuals to engage in profitable transactions which would not occur in its absence. FN74. It has no intrinsic value, but rather its value is derived from the underlying transaction. It is a promise by the issuer to pay a certain sum to the beneficiary, either on demand or on time, FN75 based on the beneficiary's presentment of certain documents and their facial compliance with the terms and conditions specified in the letter of credit.
To function successfully as a payment mechanism, payment must be prompt, certain, reliable, efficient, and economical. Promptness, certainty, reliability, and efficiency are achieved by separating the letter of credit transaction from the underlying transaction (the "independence" principle) and limiting payment processes to a ministerial inspection and confirmation of documents (the "strict compliance" principle). In the case a commercial letter of credit, the seller can demand payment upon shipment of the goods without worrying about whether or not the buyer will default on payment for the goods. The seller can then take the payment and immediately buy raw materials and semi-finished goods for the next production period to keep the wheels of trade turning. In the case of a standby letter of credit, the obligee can demand payment upon default, without having to litigate the issue, and immediately enter into another financial transaction to keep money flowing through the economy.
Economy is achieved by keeping transaction costs low. These transaction costs include information costs, administrative costs, risk costs, and litigation costs.
1. Information costs
Information costs are those costs associated with gathering and communicating information. FN76. In the absence of a letter of credit, the seller would have to investigate the buyer's creditworthiness and the buyer would have to investigate the seller's performance history. With a letter of credit, these investigative costs are minimized.
On the one hand, the issuer is generally familiar with the applicant's creditworthiness, especially where the parties have worked together in the past. FN77. By the same token, the beneficiary is familiar with the issuer's creditworthiness, especially where the issuer is a large, well-known bank. This familiarity eliminates the need of both parties to run extensive and expensive investigations on each other. FN78.
On the other hand, the issuer is indifferent about the beneficiary's actual performance, because letters of credit are document driven. FN79. If the beneficiary does not perform according to the terms of the letter of credit, regardless of its performance on the underlying contract, the beneficiary does not get paid. This asymmetrical approach to the parties' payment and performance credibility keeps information costs low.
2. Administrative costs
Administrative costs are those costs associated with processing the letter of credit. They include issuing costs and payment costs.
On issuing a letter of credit, the issuer wants an assurance that the buyer will reimburse the issuer. This assurance requires, perhaps, a background credit check of the applicant or a secured interest in the goods of the underlying contract or some other security such as compensating balances. Banks, who are the primary issuers of letters of credit, are ideally situated to be issuers, because their banking activities, of necessity, require credit verification. Banks are already experts in the business of checking credit and securing collateral as part of their lending activities. FN80.
On paying a letter of credit, the issuer demands a "no-frills approach" to verifying that payment is due. Under a letter of credit, the issuer need only determine whether the documents presented appear on their face to be in accordance with the terms and conditions of the letter of credit. The issuer merely examines documents for facial compliance. FN81. If the documents presented conform to those requested in the letter of credit, the issuer must pay. No questions asked. If the documents do not conform, the issuer has the absolute right not to pay, FN82 and the beneficiary cannot enforce performance. FN83. If the issuer pays against nonconforming documents, it does so at its own peril. FN84.
The issuer has no responsibility to monitor the underlying contract. FN85. The issuer is not obligated to ascertain, and assumes no responsibility for the genuineness, accuracy, or truthfulness of the documents. FN86. The issuer is not even obligated to look at attached documents to resolve any facial discrepancies. FN87. This ministerial approach to letter of credit transactions keeps administrative costs low.
3. Risk costs
Risk costs are those costs associated with financial loss on a transaction. FN88. They include risks on the underlying contract as well as the issuer's risk in extending credit and in paying the beneficiary. First of all, certain risks are inherent in the underlying transaction. These risks are the beneficiary's risk of the applicant's insolvency, the applicant's risk of non-performance or late performance by the beneficiary, the beneficiary's risk of having to litigate without payment in hand, the applicant's risk of having to litigate without the promised goods or financing, the risk of both parties having to litigate in a foreign forum, and, in the case of international transactions, currency exchange risk. FN89.
By using a letter of credit to consummate the transaction, these risks are shifted, in whole or in part, to a "neutral" third party, the issuer, who specializes in risk-reducing activities. Insolvency risk for the beneficiary is reduced by substituting the issuer's creditworthiness for that of the applicant. Non-performance risk for the applicant is reduced by demanding strict compliance in the presentment of documents. Litigation risk between the applicant and the beneficiary is reduced by separating the letter of credit from the underlying transaction. Foreign forum risk is reduced by having the beneficiary designate a confirming or collecting bank in its own country to act on behalf of the issuer. Currency exchange risk is reduced by writing the underlying contract in the market exchange rate prevailing at the time of contract and then letting the banks settle between themselves at the prevailing exchange rate when the letter of credit is collected.
Second, certain risks are inherent in the extension of credit by the issuer to the applicant. FN90. The letter of credit is a form of credit intermediation, wherein the creditworthiness of the issuer is substituted for the creditworthiness of the applicant. Credit risk is reduced by quantifying the probability of default by the applicant. The issuer quantifies this risk "by thoroughly investigating the financial stability of the applicant." FN91. The results of this investigation "establish whether the issuer can rely solely on the credit of its applicant (i.e., an unsecured loan), or whether the issuer must impose certain conditions to safeguard its interests (i.e., a mortgage, a guarantee, [collateral], etc.)." FN92. Since most issuers are banks and banks are already in the business of credit verification, they are ideally suited to reduce credit risk.
Finally, certain risks are inherent when the issuer pays the beneficiary. The major payment risk is fraud by the beneficiary, either on the underlying transaction, or in its presentment of "forged or materially fraudulent" documents. FN93. "When a bank issues a letter of credit, it knows that the beneficiary will have to present certain documents before the bank is bound to honor the letter. The bank, however, has no guarantee that these documents will be genuine, nor is it entitled to one." FN94. Moreover, because "the underlying rationale behind the letter-of-credit ... transaction ... is that neither the buyer nor the seller trusts the credit of the other, the bank has no reason to rely upon the good faith of the beneficiary." FN95.
The issuer can reduce its payment risk for fraud by not honoring a beneficiary's presentment of facially complying documents. FN96. However, mere suspicion is insufficient reason to withhold payment. FN97. The issuer must have actual knowledge of the fraud FN98 or "the circumstances of which he has knowledge rise to the level that the failure to inquire reveals a deliberate desire on his part to evade knowledge because of a belief or fear that investigation would disclose a defense arising from the transaction." FN99. Even with notice of the fraud, the issuer may pay the beneficiary; FN100 however, it does so at its own peril. The better approach would be to apply to a court of competent jurisdiction for a temporary or permanent injunction against payment. FN101.
4. Litigation costs
Litigation costs are those costs associated with protracted prosecution of a letter of credit claim. They vary directly with the number and complexity of legal and factual issues raised. As the number and complexity of these issues increase, the greater and more complex are the evidentiary requirements at trial and the greater the cost of litigation.
Litigation costs can be reduced with rules of law which lend themselves to summary judgment motions. Ordinarily, summary judgment is a drastic remedy and is to be used with great caution. FN102. However, where there are no genuine material issues of fact to litigate, summary judgment is an efficient and economical device for disposing of a party's claims. FN103. In the alternative, where summary judgment is inappropriate, governing principles which minimize factual issues and economize on judicial resources are preferred to those which require extensive and protracted trial time.
D. The Letter of Credit is not a Contract
Opponents of the narrow definition believe that the letter of credit is a contract and should, therefore, be governed by the same principles as other contracts between and among commercial parties. These principles, found in the Restatements FN104 and common law, FN105 call for an expanded definition of good faith which includes both "honesty in fact" and "fair dealing." However, the letter of credit is not a contract in the traditional sense. Whereas a contract is the product of mutual assent --- offer and acceptance --- and consideration between the parties, the letter of credit lacks mutual assent between the issuer and the beneficiary and requires no consideration to be legally binding and enforceable. FN106. Therefore, it should not be governed blindly by the general law of contracts or the contractual concept of good faith. FN107.
Opponents of the narrow definition concede that the letter of credit is not a true bilateral contract, but they argue that it can be characterized in such a way as to make it a contract. First, they would characterize the letter of credit as a unilateral contract, whereby the letter of credit is an irrevocable offer which the beneficiary accepts by performing the specified terms, i.e., presenting conforming documents. Having submitted the requisite conforming documents in a timely fashion, the beneficiary has an unequivocal right to be paid. If the issuer dishonors the presentation, the beneficiary has a direct cause of action against the issuer for wrongful dishonor. If the beneficiary presents nonconforming documents, then he has not performed according to the terms of the letter of credit; no contract exists, because the beneficiary has not commenced performance; and the beneficiary has no cause of action for wrongful dishonor. However, unlike a unilateral contract, a beneficiary may have a cause of action against an issuer if, upon presentation of nonconforming documents, the issuer fails to timely notify the beneficiary, in unambiguous terms, of the nonconforming discrepancies. Therefore, the letter of credit is not a unilateral contract.
Alternatively, the opponents would characterize the letter of credit as a third-party beneficiary contract, whereby the applicant and the issuer negotiate a contract intended for the direct benefit of the beneficiary. In a third-party beneficiary contract, no performance is required by the beneficiary to get the benefit of the contract. It falls to him as a matter of right and if the promisor fails to perform, the beneficiary has a direct cause of action against the promisor. In the letter of credit transaction, however, the beneficiary is required to perform --- to present timely, conforming documents --- in order to get paid. If the beneficiary fails to present timely, conforming documents, then he cannot recover, unless the issuer has failed to timely notify the beneficiary, in unambiguous terms, of the nonconforming discrepancies and the beneficiary is able to cure the discrepancies before the credit expires. Therefore, the letter of credit is not a third-party contract.
To the contrary, the letter of credit is very unlike a contract. Articles 2, 2A, 3, 4, 4A, and 8 of the U.C.C. govern the types of underlying obligations for which the contacting parties may secure a letter of credit. Each of the obligations governed by these articles is a transaction complete unto itself and can be accomplished by the exchange of money for goods or financial services. The letter of credit, on the other hand, has no independent existence or intrinsic value outside of the underlying obligation. Its value is derived solely from the underlying obligation and the need to facilitate the underlying obligation. To facilitate these underlying obligations, the letter of credit must be governed by its own set of rules and principles which promote prompt, certain, reliable, and efficient payment while at the same time ensuring their convenience, flexibility, and low cost availability. Moreover, a letter of credit is governed by two principles --- the "independence principle" and the "strict compliance principle" --- which are totally alien to traditional contract law. FN108. Therefore, there is no a priori reason why contract principles, including the broad definition of good faith, should be blindly applied to letter of credit transactions.
E. The Letter of Credit is not a Guaranty
Opponents of the narrow definition believe that the letter of credit is akin to a guaranty. However, the letter of credit is not a guaranty. FN109. It differs from a guaranty in that the sole duty of the issuer under a letter of credit is to verify documents. The issuer has none of the rights or defenses of a guarantor. The issuer does not step into the shoes of the applicant in case of a failure to perform by the beneficiary. The issuer does not become involved in any dispute(s) between the parties to the underlying transaction. Any dispute(s) between the parties to the underlying contract are isolated and confined to a single incident outside the general flow of money and goods. Moreover, a letter of credit is governed by two principles --- the "independence principle" and the "strict compliance principle" --- which are totally alien to traditional guaranty law. FN110. Therefore, there is no a priori reason why contract principles, including the broad definition of good faith, should be blindly applied to letter of credit transactions.
F. The Letter of Credit is a Mercantile Specialty
The letter of credit is a mercantile specialty, FN111 which evolved "entirely separate from common law contract concepts" and it "must still be viewed as [an entity] unto [itself]." FN112. It is neither indigenous nor unique to the United States. Rather it is an old and venerable institution with "an origin that may be traced deeply into history" nearly 3000 year ago. FN113. The principles which govern it --- the "independence principle" and the "strict compliance principle" --- are well established, FN114 and commonly accepted across all countries in the world. The letter of credit has survived because of its inherent reliability, convenience, economy, flexibility," FN115 and simplicity. The narrow definition of good faith is a universally accepted tenet of letter of credit law which reinforces these principles and promotes the letter's desirable characteristics.
IV. WHY THE PROPONENTS OF THE NARROW DEFINITION OF GOOD FAITH ARE RIGHTA. The Narrow Definition Is Fair
Opponents of the narrow definition argue that it is unfair. FN116. Although fair dealing is a broad term that must be defined in context, it is clear that it is concerned with the fairness of conduct rather than the care with which an act is performed. FN117. Fair dealing requires a person to be honest in fact, to act in a fair manner as defined by reasonable commercial standards of fair dealing, and to consider the other party's expectations. FN118.
In judging fairness, principles of equity must be observed. There are two principles of equity: horizontal and vertical equity. The principle of horizontal equity states that persons similarly situated should be treated similarly. The principle of vertical equity states that persons in different situations should be treated differently.
Applying these principles to the U.C.C. requires that all parties to like mercantile specialties should be treated alike and all parties to different mercantile specialties should be treated differently. Not all mercantile specialties conform to the same laws. To the extent that mercantile specialties differ, the laws governing these specialties should differ. The goal should not be to have uniform laws for all mercantile specialties, but rather to have the laws governing the individual mercantile specialties uniformly adopted --- across-the-board --- by all 50 states. FN119.
B. The Narrow Definition Validates the Intent of the Parties
Opponents of the narrow definition argue that it invalidates the intent of the parties. FN120. To the contrary. The intent of the parties to a letter of credit transaction is twofold: (1) that the beneficiary should receive payment upon proper evidence of performance on the underlying contract; and (2) that the applicant should not have to pay unless and until it is satisfied that the beneficiary has performed. FN121. The reason that the parties open a letter of credit is because they want to do business with one another but, for some reason, do not trust each other. Rather than go through extensive and expensive investigations of each other, they agree that a third party, the issuer, will act as an "intermediary." As an intermediary, the issuer prevents the beneficiary from getting paid unless and until it presents certain documents, which the parties have agreed, evidence performance by the beneficiary; and it prevents the applicant from getting his benefits unless and until it has paid the issuer.
In providing these services, the issuer performs the ministerial act of document checking. The issuer has no discretion. It simply compares the presented documents with the terms and conditions in the letter of credit. If the documents are timely and comply with the terms and conditions of the letter of credit, the issuer has a legal obligation to pay the beneficiary and a legal right to reimbursement from the applicant. If the documents are timely, but do not comply the issuer has an obligation to facilitate cure. FN122. If the issuer does not facilitate cure in time for compliance, the beneficiary has a legal cause of action against the issuer for "the amount that is the subject of the dishonor," plus incidental damages, less damages avoided. FN123. If the documents are untimely or incurable, the issuer has no obligation to pay the beneficiary and the beneficiary has no cause of action. These are the rules of law concerning letters of credit and any party who uses a letter of credit must have these intents.
The narrow definition of good faith does meet the intent of the parties. The fact that the issuer's role is mechanistic and ministerial eliminates the need to go behind the documents. As long as the issuer's job in checking the documents remains ministerial and it has no discretion to inquire into the transaction itself, the need to reference and adjudicate "reasonable commercial standards of fair dealing" is absent. At best, the issuer's observance of "the standard practice of financial institutions issuing letters of credit" becomes a question of law for the court to decide and not a matter for trial litigation. FN124.
C. The Narrow Definition Meets the Expectations of the Parties
The narrow definition meets the expectations of the parties. The expectation of the parties to a letter of credit is that the beneficiary gets prompt, certain, and reliable payment on presentation of conforming documents. This is the expectation which has existed for hundreds of years and this is the expectation which must be met, if the letter of credit is to retain its commercial vitality.
If the "broad" definition of good faith were to govern letter of credit law, payment would become less prompt. less certain, and less reliable. Promptness would disappear because issuers would be required, in many cases, to take substantial amounts of time to investigate the underlying transaction to resolve discrepancies in the documents and, possibly, disputes between the applicant and the beneficiary. The further an issuer is required to investigate facts and circumstances surrounding a dispute on the underlying transaction, the greater are the costs of issuing a letter of credit. FN125. Certainty would disappear, because the beneficiary would not know what criteria outside the letter of credit the issuer might use to determine whether the beneficiary had successfully performed and whether payment were due. Reliability would disappear, because the beneficiary could not depend on the terms and conditions of the letter of credit alone.
D. The Narrow Definition Promotes Uniformity, Reduces Judicial Confusion and Uncertainty, and Standardizes Judicial Interpretation
Opponents of the narrow definition argue that the dual-definition approach is illogical, that it will give rise to serious interpretative problems, and that it will lead to judicial confusion and uncertainty. FN126. Uniformity should not necessarily mean that all mercantile specialties conform to the same uniform laws. Rather, horizontal and vertical principles of uniformity should apply. Uniformity in the U.C.C. should mean uniformity across all mercantile specialties independently and across all parties to that mercantile specialty, and where need be, different laws should govern the different mercantile specialties. FN127.
The letter of credit is neither indigenous nor unique to the United States. Legal scholars have traced its lineage back about 3,000 years to "use by bankers in Renaissance Europe, Imperial Rome, ancient Greece, Phoenicia and even early Egypt." FN128. Over the last 3,000 years, letter of credit principles have been developed and refined. These principles are currently systematized in the Uniform Customs and Practices for Documentary Letters of Credit (U.C.P.), FN129 which has been adopted in over 140 countries. FN130.
In negotiating a letter of credit, the parties most often adopt the U.C.P. to govern the transaction.FN131. One of the major goals of the Drafting Committee in revising Article 5 was to harmonize Article 5 with these international rules and practices and to resolve conflicts among reported decisions. FN132. "Letter of credit law should remain responsive to commercial reality and in particular to the customs and expectations of the international banking and mercantile community." FN133. Aligning Article 5 of the U.C.C. with the U.C.P. would have the effect of assuring uniformity and compatibility of US letter of credit law with non-US letter of credit law. This alignment is important because the majority of all letters of credit are issued to support international transactions. FN134.
Additionally, Article 5 of the U.C.C. competes not only with the U.C.P., but also with non-US laws governing letters of credit issued outside the US and with the proposed convention on independent guarantees and standby letters of credit being drafted by the United Nations Committee on International Trade Law (UNCITRAL). FN135. Even within the US, the provisions of Article 5 are not homogenous among the states. Each state is free to adopt, reject, or modify Article 5 as it sees fit. In fact, New York and three other states FN136 have modified their codification of Article 5 to provide that where a letter of credit is subject to the U.C.P., it is not governed by the U.C.C. FN137. Some states have modified the U.C.C. through case law. FN138. Some states recognize the U.C.P. where it is not inconsistent or in conflict with the U.C.C. FN139. Still other states mandate governance of letters of credit by the U.C.C. FN140.
International law and practice recognizes the narrow definition of good faith in the conduct or transaction. Therefore, to avoid confusion and conflict with existing domestic and foreign letter of credit law and practice, governing law must be uniform across national borders. To achieve this uniformity, the drafters selected the narrow definition of "good faith." This definition accords with the traditional function and role of the issuer and the expectations of the parties under common letter of credit practices.
E. The Narrow Definition Minimizes Costs
Another major goal of the Drafting Committee was to maintain letters of credit as an inexpensive instrument facilitating trade. FN141. The definitional differences of good faith translate into different obligations on the transaction. These different obligations, in turn, make it easier or more costly for issuers to make letters of credit available. The narrow definition, which excludes any consideration of reasonable commercial standards of fair dealing, maximizes promptness, certainty, reliability, and efficiency, while, at the same time, minimizes the costs of a letter of credit and maximizes its availability. FN142.
1. Information costs
If the broad definition of good faith were to govern letter of credit transactions, issuers would be required to become familiar with all terms, customs, and usages of all trades and to apply them when investigating the significance of discrepancies in document presentations. This increase in information costs would significantly increase the overall cost of a letter of credit and reduce its availability and commercial utility.
2. Administrative costs
If the broad definition of good faith were to govern letter of credit transactions, issuers would be required to monitor the underlying transaction, to investigate document discrepancies, and to adjudicate any disputes between the applicant and beneficiary before honoring or dishonoring a beneficiary's presentation. This increase in the processing costs component of administration costs would significantly increase the overall cost of a letter of credit and reduce its availability and commercial utility.
3. Risk costs
If the broad definition of good faith were to govern letter of credit transactions, issuers would be able to avoid their risk-bearing duties and to shift credit, performance, litigation, foreign forum, and currency exchange risks back onto the contracting parties. This shift totally defeats the risk-reducing function of letters of credit for the contracting parties.
4. Litigation costs
If the broad definition of good faith were to govern letter of credit transactions, issuers would be subject to much higher litigation costs. FN143. The ability to resolve disputes on motions for summary judgment minimizes litigation costs. Most letter of credit disputes are well suited to determination by motion for summary judgment because they normally present solely legal issues relating to an exchange of documents." FN144. Generally, the facts regarding a letter of credit's terms and the beneficiary's presentation are not in dispute. This leaves only the legal issue of whether the beneficiary's presentation complied with the terms of the credit. FN145. If a presentation did not comply and the issuer was not obligated to pay on the draft, the question of good faith never arises, FN146 and summary judgment may be granted as a matter of law.
Good faith, however, is a question of fact. FN147. When the issue of good faith is raised, it must be tried in a court of law. At trial, the different definitions of good faith translate into different evidentiary requirements. These different evidentiary requirements, in turn, affect the costs of litigation. The narrow definition of good faith is less expensive and easier to litigate. It is "uninhibited by vague notions of fairness and equity that accompany an objective good faith standard and may promote certainty and uniformity in the law." FN148. The test for "good faith," narrowly defined is the state of mind of the particular party and not what state of mind a prudent man should have had. FN149. It requires no comparison of a particular party's activities with those of other parties similarly situated.
Under the narrow definition of good faith, its antithesis, "bad faith," must be "a thing done when it is in fact done dishonestly." FN150. It "contemplates a state of mind affirmatively operating with a furtive design or some motive of interest or ill will." FN151. Under the narrow definition, evidence of bad faith hinges only on a showing that the person's conduct was dishonest or corrupt. FN152. Therefore, litigation is still relatively inexpensive, because a court can readily determine honesty in fact from the credibility of the witnesses. FN153.
The broader the definition of good faith, the more detailed and complex are the evidentiary requirements and the more costly and time-consuming is the litigation. It would require the court to consider objective factors in addition to the subjective testimony. The more objective factors a court must consider, the higher the litigation costs involved in interpretation and administration of an expanded good faith standard and in creating and enforcing a remedy for its breach. FN154.
Under the broad definition, bad faith requires more than just the absence of an evil motive. FN155. It requires an assessment of whether the issuer dealt fairly with the beneficiary, as other reasonable issuers would have dealt under similar circumstances and of whether the party had notice of such facts as would put a reasonably prudent person on inquiry which would lead to discovery. FN156.
In addition, if the definition of bad faith were expanded, then, "[i]n due course, beneficiary lawsuits for wrongful dishonor would be accompanied by a separate count for bad-faith dishonor. This would permit the beneficiary to discover and introduce evidence as to whether application of the strict-compliance rule was unreasonable and unfair in light of the beneficiary's ignorance of letter of credit practice, the beneficiary's substantial performance of the underlying contract, or the applicant's efforts to influence the issuer's decision to dishonor." FN157. "This kind of evidence, of course, would be immaterial and irrelevant in an ordinary wrongful dishonor case, where the liability issues are limited to whether the presentation strictly complied and whether the issuer preserved its defenses by timely notice of dishonor." FN158.
By the same token, "the issuer's defenses based on the discrepancies raised in its notice of dishonor would be supplemented by a separate defense of bad faith presentation so as to permit the issuer to discover and introduce evidence as to whether the beneficiary knew the presentation was facially noncomplying or that the documents were untruthful." FN159. Issuers alleged to have acted in bad faith would become embroiled in expensive and protracted litigation. FN160. All of these allegations of bad faith would substantially raise litigation costs, raise the cost of a letter of credit, restrict the availability of letters of credit to all but a bank's most trustworthy customers, and ultimately defeat the commercial utility of the letter of credit. FN161.
F. The Narrow Definition Protects the Safety and Solvency of Banks and the Banking System
If the broad definition of good faith were to govern letter of credit transactions, letter of credit issuers would be subject to increased risk across-the-board. The issuer is a third-party risk-bearer. Most issuers are banks. Banks are very special institutions. As financial intermediaries, they absorb credit risk and payment risk for the global economy. The narrow definition protects the safety and solvency of banks and the banking system.
The narrow definition of good faith in letter of credit law helps to insulate banks from financial crises. Once having agreed to issue a letter of credit, and presumably having secured its reimbursement, the issuer is removed from any disputes between the parties to the underlying contract. The independence principle requires that issuers deal only with documents and not with merchandise or other terms and conditions of the underlying contract. The issuer is under no obligation to investigate discrepancies which relate to the terms and conditions of the underlying contract. The duties and obligations of the issuer in examining the beneficiary's documents is purely ministerial. FN162. The prime duty of the issuer and any other bank undertaking to honor the beneficiary's draft is to exercise good faith in examining the documents to determine whether they appear on their face strictly to comply with the terms and conditions of the letter of credit, regardless of whether the documents are fraudulent or the goods do not conform to the contract between the customer and beneficiary. FN163. Likewise, even if it were proved that the issuer was motivated to reject the beneficiary's documents by economic factors outside the transaction, or even by outright greed, no dishonesty is shown where only legal rights are being enforced. Reasons or lack of reasons are thus irrelevant and a court of law is correct in refusing evidence thereof.
G. Punitive Damages May do More Harm Than Good
There seems to be a presumption that only banks act in bad faith and that only banks should be liable for punitive damages. However, if the definition of good faith is expanded, it would apply to all three parties to the letter of credit transaction. It is equally likely that the banks could have bad faith claims against either the beneficiary or its customer under the expanded definition. If the bank proves its case, then either the applicant or the beneficiary would be liable for punitive damages. This author doubts seriously that this outcome is what the opponents of the narrow definition have in mind. However, this may well be the result. --- What is good for the goose is good for the gander!!!
V. RECOMMENDATIONS AND SOLUTIONS
The solutions to the potential for good faith dishonor lie not in changing the well-grounded rules of letter of credit law, but rather in simplifying and standardizing the form and application requirements for a letter of credit, in educating its users, in mandating good faith facilitation of cure by issuers, and in shifting the costs of litigation. The letter of credit community must simplify and standardize both documentation and documentary letters of credit so that the degree of expertise required by applicants and beneficiaries can be substantially reduced. FN164. Where documentation and the letter of credit are incapable of standardization, education and training for parties to a letter of credit can expand their expertise in timely and conforming presentation. FN165.
In the event presentations are still in error, the issuer must be obligated to have a good faith duty to facilitate cure of documentary defects. FN166. If the issuer fails in this duty, then the beneficiary can prevail in a cause of action for "bad faith" wrongful dishonor. In such cases, mandatory fee shifting would not only punish an issuer culpable of a pretextual bad faith dishonor, but it would also discourage freestanding claims of bad faith breach, without allegations of an underlying substantive claim. FN167. It would prevent unnecessary, prolonged, and unmeritorious litigation, because all the alleging party could gain would be its costs of litigation. In effect, the alleging party would be suing merely to recover its own litigation costs.
Finally, beneficiaries should be advised to take special steps to ensure that they are able to take advantage of cure --- they should work closely with the applicant to ensure that the letter of credit incorporates terms that are easy to understand and possible to satisfy and they should always make its presentation sufficiently ahead of the credit's expiration so that it has sufficient time to cure any defects before the credit expires. FN168.
VI. CONCLUSIONS - WHAT DO WE REALLY WANT FROM A LETTER OF CREDIT TRANSACTION?
In conclusion, the commercial utility of a letter of credit is its prompt, certain, reliable, efficient, and economical payment against facially conforming documents. FN169. Commercial utility is best served when the conduct of the parties is reduced to mechanistic and ministerial actions. In particular, the issuer should not be placed in the intolerable position as the arbiter of disputes between the contracting parties. FN170. More to the point, the issuer should not be placed in the untenable position of having its safety and solvency compromised by holding it responsible for knowledge and understanding of all of the terms, customs, and usages of all trades and of all practices in the dealings between the parties to the underlying contract. The narrow definition supports these position; the broad definition does not. Therefore, the drafters of Revised Article 5 were correct in retaining the narrow definition of good faith to govern letter of credit transactions.
FN1. U.C.C. § 1-203 (Revised 1994).
FN2. See notes 29-51, infra, and accompanying text.
FN3. U.C.C. § 1-201(19) (Revised 1994) ("Good faith" means "honesty in fact in the conduct or transaction concerned.").
FN4. U.C.C. § 2-103(1)(b) (Revised 1994) ("Good faith" is "honesty in fact" and the "observance of reasonable commercial standards of fair dealing.").
FN5. All references herein to Revised Article 5 of the U.C.C. are to reprints of the Proposed Official Draft published in 1995 by the American Law Institute.
FN6. U.C.C. Revised Article 5 (Proposed Official Draft 1995).
FN7. U.C.C. § 5-102(7) (Proposed Official Draft 1995).
FN8. U.C.C. § 5-102 cmt. 3 (Proposed Official Draft 1995). See Articles 2, 2A, 3, 4, 4A, and 8 of the U.C.C. (Revised 1994).
FN9. Other cases which involve allegations of bad faith include (1) a beneficiary, who demands payment against documents that the beneficiary knows or should know are noncomplying or untruthful, Philadelphia Gear Corp. v. Central Bank, 717 F.2d 230 (5th Cir. 1983); Republic National Bank of Miami v. Fidelity and Deposit Co. of Maryland, 894 F.2d 1255 (11th Cir.(Fla.) 1990); (2) an issuer, who honors documents that the issuer knows or should know are fraudulent -- or presented in bad faith, Michigan National Bank v. Metro Institutional Food Service, Inc., 497 N.W.2d 225 (Mich.App. 1993); Lustrelon, Inc. v. Prutscher, 428 A.2d 518 (N.J. 1981); (3) an applicant, who refuses to reimburse when the applicant clearly has no defense, Republic National Bank of Dallas v. Northwest National Bank of Fort Worth, 578 S.W.2d 109 (Tex. 1978); (4) an applicant, who asserts groundless claims of beneficiary fraud--or bad faith--for the purpose of delaying honor by the issuer; and (5) an applicant and/or beneficiary, who asserts a bad faith claim against an issuer for failure to amend a letter of credit, First National Bank of Jefferson Parish v. Carmouche, 515 So.2d 785 (La. 1987); AMF Head Sports Wear, Inc. v. Ray Scott's All American Sports Club, Inc., 448 F.Supp. 222 (D.Ariz. 1978). See generally, James G. Barnes, Defining Good Faith Letter of Credit Practices , 28 LOY. L.A. L. REV. 101 (1994).
FN10. See SITPRO, Letter of Credit Management and Control 1, 10-15, 28-29 (1985).
FN11. See id. at 10-15.
FN12. See Barnes, supra note 9.
FN13. Kerry L. MacIntosh, Letters of Credit: Curbing Bad-Faith Dishonor, 25 U.C.C.L.J. 3, 10-11 (1992) (The issuer offers minor flaws as pretextual bases for dishonor); Barnes, supra note 9 (The issuer has no justifiable defenses to its dishonor). Justifiable defenses include document discrepancies, late presentment, and fraud. See U.C.C. §§ 5-108, 5-109 (Proposed Official Draft 1995).
FN14. MacIntosh, supra note 13, at 10-11.
FN15. Id. at 11.
FN16. U.C.C. § 5-111(a), (b) (Proposed Official Draft 1995). In addition, the beneficiary is entitled to interest from the date of wrongful dishonor (U.C.C. § 5-111(d)) and reasonable attorney fees and other litigation expenses (U.C.C. § 5-111(e)).
FN17. Coca-Cola Bottling Co. v. Coca-Cola Co., 668 F.Supp. 906, 919 (D.Del. 1987).
FN18. Margaret Moses, International Law Seminar, Pace University School of Law, October 5, 12, and 19, 1995.
FN19. See, e.g., Donald J. Rapson, Why Revised Articles 5 and 9 Should Incorporate a Standard of "Good Faith" That Includes "Honesty in Fact" and "Reasonable Commercial Standards of Fair Dealing," UCC Bulletin, April 1995, 1, at 4 (hereinafter, Rapson, Articles 5 and 9); Comment, Commercial Transactions: U.C.C. Section 1-201(19) Good Faith -- Is Now The Time To Abandon The Pure Heart/Empty Head Test? 45 OKLA. L. REV. 647 (1992).
FN20. See Barnes, supra note 9, at n.11, citing Attachments to Memorandum from Carlyle C. Ring, Jr., Chair, to the NCCUSL Drafting Committee (Jan. 12, 1994) (on file with the Loyola of Los Angeles Law Review), which memorandum contained supplemental materials for the 1994 San Francisco meeting, including a Memorandum from Paul S. Turner to Carlyle C. Ring, Jr. and James J. White 3 - 6 (Jan. 5, 1994).
FN21. MacIntosh, supra note 13, at 34, arguing that, under current international letter of credit policy, as embodied in the U.C.P., if an issuer has delayed dishonor, failed to give timely notice of dishonor, or failed to identify the specific documentary defects, the issuer is strictly precluded from asserting that the documents were nonconforming, leaving the beneficiary with an ironclad claim for wrongful dishonor --- even if the beneficiary could not have cured the defects.
FN22. Id. at 47.
FN23. See e.g., Barnes, supra note 9.
FN24. Memorandum to the ALI Council from the Chairman of the Article 5 Drafting Committee (September 29, 1994), quoted in Rapson, Articles 5 and 9, supra note 19, at 5.
FN25. UCC Article 5 Revision: Consequential Damages, 11 Letter of Credit Update 20 (April 1995) (Letter by Ernest T. Patrikis).
FN26. U.C.C. Revised Article 5 prefatory note at 2 (Proposed Official Draft 1995).
FN27. Donald J. Rapson, Who is Looking Out for The Public Interest? Thoughts About the UCC Revision Process in the Light (And Shadows) of Professor Rubin's Observations, 28 LOY. L.A. L. REV. 249 (1994); SITPRO, supra note 10, at 16.
FN28. Voest-Alpine International Corp. v. Chase Manhattan Bank, N.A., 707 F.2d 680, 682 (2d Cir. 1983).
FN29. U.C.C. § 1-203 (Revised 1994). Good faith applies to sales contracts (U.C.C. Article 2 (Revised 1994)), leases (U.C.C. Article 2A (Revised 1994)), negotiable instrument transactions (U.C.C. Article 3 (Revised 1994)), bank transactions (U.C.C. Article 4 (Revised 1994)), funds transfers (U.C.C. Article 4A (Revised 1994)), commercial paper issues (U.C.C. Article 8 (Revised 1994)), security agreements (U.C.C. Article 9 (Revised 1994)), and letters of credit (U.C.C. Article 5 (Revised 1994)).
FN30. For a general discussion of these definitional differences, see Phillipe v. Thomas, 489 A.2d 1056, 1059-1060 (Conn. 1985).
FN31. U.C.C. § 1-201(19) (Revised 1994); U.C.C. § 5-102(a)(7) (Proposed Official Draft 1995).
FN32. 489 A.2d at 1059.
FN33. La Sara Grain Co. v. First National Bank of Mercedes, 673 S.W.2d 558, 563 (Tex. 1984). See also Comment, supra note 19, at 657 and n.63 and n.65 (citing cases).
FN34. Comment, supra note 19, at 658.
FN35. Money Mart Check Cashing Center v. Epicycle, 667 P.2d 1372, 1374 (Colo. 1983). In cases of fraud, for example, actual knowledge of the fraud by the issuer is required before it can reject timely, conforming documents. The issuer is obligated to pay on the presentation of documents alone. It is not required to resolve disputes between the applicant and the beneficiary or to inquire into any suspicion it might have about the documents or fraud on the underlying transaction. If the issuer rejects the presentation and it turns out that there was no fraud, the beneficiary has a claim against the issuer for wrongful dishonor. If the issuer accepts the presentation and it turns out that there was fraud, then the issuer is liable to the applicant for wrongful dishonor, only if it had actual knowledge of the fraud. The fact that an issuer might have had notice or a suspicion of the fraud is insufficient to delay payment on an otherwise timely, conforming presentation. See Intraworld Industries, Inc. v. Girard Trust, 336 A.2d 316 (Pa. 1975) (Even if bad faith on part of issuer of international letter of credit, which authorized hotel lessor to draw draft on issuer if lessee failed to pay rent when due, was a circumstance justifying injunction against honoring draft under letter of credit, mere fact that issuer failed to resolve dispute over rights and obligations of parties to hotel lease in lessee's favor did not constitute bad faith.); Sztejn v. Henry Schroder Banking Corp., 177 Misc. 719, 31 N.Y.S.2d 631 (N.Y. Sup. Ct. 1941).
FN36. 667 P.2d at 1373, 1374 (Colo. 1983); Riley v. First State Bank, Spearman, 469 S.W.2d 812, 816 (Tex.Civ.App. 1971).
FN37. U.C.C. § 1-201(19) (Revised 1994).
FN38. Comment, supra note 19, at 653, 678-679.
FN39. First State Bank v. Diamond Plastics Corp., 891 P.2d 1262, 1264-1265, 1266 (Okla. 1995).
FN40. See UCC §§ 2-103(1)(b), 2A-103(3), 3-103(a)(4), 4-104(c), 4A-105(a)(6), 8-102(a)(9) (Revised 1994).
FN41. Comment, supra note 19, at 648, 663, 677, citing E. Allen Farnsworth, Good Faith Performance and Commercial Reasonableness Under the Uniform Commercial Code, 30 U.CHI.L.REV. 666, 668 (1963).
FN42. 673 S.W.2d at 562.
FN43. Ledbetter v. Darwin Dobbs Co., Inc., 473 So.2d 197, 201 (Ala.Civ.App. 1985).
FN44. 489 A.2d at 1059 (Conn. 1985). Like the narrow definition, the broad definition does not punish a party for mere negligence in its actions. Comment, supra note 19, at 674.
FN45. UCC § 2-103(1)(b) (Revised 1994).
FN46. UCC § 2A-103(3) (Revised 1994).
FN47. UCC § 3-103(a)(4) (Revised 1994).
FN48. UCC § 4-104(c) (Revised 1994).
FN49. UCC § 4A-105(a)(6) (Revised 1994).
FN50. UCC § 8-102(a)(9) (Revised 1994).
FN51. Comment, supra note 19, at 653, 678.
FN52. According to Black's Law Dictionary, a letter of credit is "[a]n engagement by a bank or other person made at the request of a customer that the issuer will honor drafts or other demands for payment upon compliance with the conditions specified in the credit." Black's Law Dictionary, 5th ed. at 903-904.
FN53. The commercial letter of credit is "intended generally to facilitate the purchase and sale of goods by providing assurance to the seller of prompt payment upon compliance with specified conditions or presentation of stipulated documents without the seller's having to rely upon the solvency and good faith of the buyer." 428 A.2d at 523. In a commercial letter of credit, the parties are the "buyer" and "seller;" the buyer is the "applicant;" the seller is the "beneficiary;" and the required documents generally include a bill of lading, an invoice, etc., evidencing the seller's required performance on the underlying contract for a sale of goods with the buyer. Black's Law Dictionary, 5th ed. at 904.
FN54. The standby letter of credit is intended to facilitate payment on a financial obligation without having to rely on upon the solvency and good faith of the obligor. 428 A.2d at 523. In a standby letter of credit, the parties are the "obligor" --- a borrower or a construction contractor --- and the "obligee" --- a lender, a landlord, a mortgagee, a municipality, etc.; the obligor is the "applicant;" the obligee is the "beneficiary;" and the required documents generally include a declaration of default by the beneficiary that the applicant has failed to perform the obligation. Black's Law Dictionary, 5th ed. at 904. The obligation may be for payment on a mortgage, payment of rent over a period of time, payment on a lease, or payment by an investment bank or dealer to the borrower on an unsuccessful commercial paper issue, or it may be to cover performance on a construction contract.
FN55. A revocable letter of credit is one in which the issuer "reserves the right to cancel and withdraw from the transaction upon appropriate notice." Id.
FN56. An irrevocable letter of credit is one in which the issuer guarantees that it will not withdraw the credit or cancel the letter before the expiration date. Id.
FN57. U.C.C. § 5-106(a) (Proposed Official Draft 1995).
FN58. Especially in an international transaction, the letter of credit will involve several parties and several commitments. At minimum, an international transaction generally involves a commitment between the customer and the issuer, a commitment between the issuer and the correspondent bank, and a commitment between the correspondent bank and the beneficiary, as well as the underlying commitment between the customer and the beneficiary. See, e.g., John F. Dolan, The Correspondent Bank in the Letter-of-Credit Transaction, 109 BANKING L.J. 396 September-October, 1992.
FN59. The applicant may also be called the customer or the account party.
FN60. Barnes, supra note 9. See also Dolan, supra note 58.
FN61. See notes 68-71, infra, and accompanying text.
FN62. See notes 64-67, infra, and accompanying text.
FN63. Central Savings and Loan Association v. Stemmons Northwest Bank, N.A., 848 S.W.2d 232, 240 (Tex. 1992).
FN64. Revised Article 5 clearly and forcefully states this principle of separation which was "unexpressed in, but fundamental predicate for, the original Article 5. U.C.C. Revised Article 5, commentary at 5 (Proposed Official Draft 1995). See U.C.C. §§ 5-103(d), 5-108(f) (Proposed Official Draft 1995).
FN65. Ward Petroleum Corp. v. Federal Deposit Ins. Corp., 903 F.2d 1297, 1299 (10th Cir.1990). See generally, J. Dolan, The Law of Letters of Credit ¶¶ 2.01, 3.07 (1984); 2 J. White and R. Summers, Uniform Commercial Code § 19-2, at 8 (3d ed. 1988).
FN66. Integrated Measurement Systems, Inc. v. International Commercial Bank of China, 757 F.Supp. 938, 942 (N.D.Ill. 1991), citing Occidental Fire & Casualty Co. of North Carolina v. Continental Bank N.A., 918 F.2d 1312, 1315 (7th Cir. 1990).
FN67. 707 F.2d at 682. See Note, Judicial Development of Letters of Credit Law: A Reappraisal, 66 CORNELL L.REV. 144, 160 (1980); Justice, Letters of Credit: Expectations and Frustrations--Part 2, 94 BANKING L.J. 493, 505-06 (1977).
FN68. Beyene v. Irving Trust Co., 762 F.2d 4, 6 (2d Cir.(N.Y.) 1985). Revised Article 5 consolidates the duties and obligations of the original Article 5 (§§ 5-114 and 5-109) in one section. See U.C.C. § 5-108(a), § 5-108 cmt. 1 (Proposed Official Draft 1995).
FN69. Consolidated Aluminum Corp. v. Bank of Virginia, 544 F.Supp. 386 (D.C.Md. 1982), aff'd 704 F.2d 136 (1983).
FN70. Marino Industries v. Chase Manhattan Bank, N.A., 686 F.2d 112, 114-15 (2d Cir. 1982); Venizelos, S.A. v. Chase Manhattan Bank, 425 F.2d 461, 464-65 (2d Cir. 1970).
FN71. 707 F.2d at 682-83.
FN72. Dolan, supra note 58, at 398.
FN73. A. Joyce Furfero, Ph.D., Money and Banking Lectures, St. John's University, Jamaica, New York.
FN74. MacIntosh, supra note 13, at 43.
FN75. Some letters of credit may call for a sight draft, which is payable on demand. Other letters of credit may call for a time draft, which is payable 30, 60, or 90 days after a date.
FN76. See generally, R. Glenn Hubbard, Money, the Financial System, and the Economy 42 (1994).
FN77. Most issuers are banks. Banks are warehouses of financial information, because they are in the business of lending and extending credit. As part of their normal lending procedures, they require borrowers to fill out detailed loan applications and to submit financial statements. If a bank feels that a particular borrower is financially unstable, it can demand collateral or other additional security. See generally, id. at 48.
FN78. On the one hand, the seller wants to establish the creditworthiness of the buyer. On the other hand, the buyer wants to know the performance history of the seller.
FN79. Dolan, supra note 58, at 398.
FN80. See generally, Hubbard, supra note 76, at 48.
FN81. 428 A.2d at 524.
FN82. Very often, when the presentment has discrepancies, the issuer will contact its customer to see if the discrepancies may be waived. However, the issuer has no obligation to make such contact or request.
FN83. 428 A.2d at 524.
FN87. Courtaulds North America, Inc. v. North Carolina National Bank, N.A., 528 F.2d 802, 806 (4th Cir. 1975).
FN88. See generally, Hubbard, supra note 76, at 48.
FN89. Dolan, supra note 58, at 400 n.11.
FN90. See generally, Hubbard, supra note 76, at 48.
FN91. 894 F.2d at 1263 n.9; see generally, Hubbard, supra note 76, at 48.
FN93. U.C.C. § 5-109(a) (Proposed Official Draft 1995). For a detailed explanation of payment risk, see 894 F.2d at 1263, 1263 n.9.
FN94. 894 F.2d at 1263.
FN95. Id. n.9.
FN96. U.C.C. § 5-109(a)(2) (Proposed Official Draft 1995). Paragraph (1) of subsection (a) protects an issuer against payment if the presenter is person who took the letter of credit in good faith, for consideration, and without notice the fraud e.g., (a nominated person, a confirmer, a holder in due course, or an assignee). U.C.C. § 5-109(a)(1) (Proposed Official Draft 1995).
FN97. 428 A.2d at 526 (N.J. 1981).
FN98. 667 P.2d at 1374 (Colo. 1983). In cases of fraud, for example, actual knowledge of the fraud by the issuer is required before it can reject timely, conforming documents. The issuer is obligated to pay on the presentation of documents alone. It is not required to resolve disputes between the applicant and the beneficiary or to inquire into any suspicion it might have about the documents or fraud on the underlying transaction. If the issuer rejects the presentation and it turns out that there was no fraud, the beneficiary has a claim against the issuer for wrongful dishonor. If the issuer accepts the presentation and it turns out that there was fraud, then the issuer is liable to the applicant for wrongful dishonor, only if it had actual knowledge of the fraud. The fact that an issuer might have had notice or a suspicion of the fraud is insufficient to delay payment on an otherwise timely, conforming presentation. See Intraworld Industries, Inc. v. Girard Trust, 336 A.2d 316 (Pa. 1975) (Even if bad faith on part of issuer of international letter of credit, which authorized hotel lessor to draw draft on issuer if lessee failed to pay rent when due, was a circumstance justifying injunction against honoring draft under letter of credit, mere fact that issuer failed to resolve dispute over rights and obligations of parties to hotel lease in lessee's favor did not constitute bad faith.); Sztejn v. Henry Schroder Banking Corp., 177 Misc. 719, 31 N.Y.S.2d 631 (N.Y. Sup. Ct. 1941).
FN99. 428 A.2d at 526 (N.J. 1981).
FN100. U.C.C. § 5-109(a)(2) (Proposed Official Draft 1995). Paragraph (1) of subsection (a) protects an issuer against payment if the presenter is person who took the letter of credit in good faith, for consideration, and without notice the fraud e.g., (a nominated person, a confirmer, a holder in due course, or an assignee). U.C.C. § 5-109(a)(1) (Proposed Official Draft 1995).
FN101. U.C.C. § 5-109(b) (Proposed Official Draft 1995).
FN102. McKay v. Farmers and Stockmens Bank of Clayton, 585 P.2d 325, 326 (N.M.App. 1978).
FN103. In 1986, the United States Supreme Court finally recognized that summary judgment was "an integral part of the Federal Rules as a whole, which are designed 'to secure the just, speedy and inexpensive determination of every action.'" Celotex Corp. v. Catrett, 477 U.S. 317, 327 (1986) (citing FED. R. CIV. P. 1). See also Amy D. Ronner, Destructive Rules of Certainty And Efficiency: A Study in the Context of Summary Judgment Procedure and the Uniform Customs and Practice for Documentary Credits, 28 LOY. L.A. L. REV. 619, 621 (1995), citing Robert Holmes Bell, Summary Judgment in the Federal Courts, 69 MICH. B.J. 1038, 1038 (1990) (Summary judgment "saves the expense of further trial preparation and the uncertainty of trial.").
FN104. Restatements (Second) of Contracts § 205 (1979) ("Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.").
FN105. See, e.g., 848 S.W.2d 232.
FN106. MacIntosh, supra note 13, at 17.
FN107. Id. See also Eastland Bank v. Massbank for Savings, 767 F.Supp. 29, aff'd, 953 F.2d 633 (D.R.I. 1991) (Letter of credit beneficiary's remedy for issuer's wrongful dishonor was founded in Uniform Commercial Code, not in principles of contract law.).
FN108. See notes 64-71, supra, and accompanying text.
FN109. 2 J. White & R. Summers, supra note 65, § 19-2 at 9.
FN110. See notes 64-71, supra, and accompanying text.
FN111. MacIntosh, supra note 13, at 17.
FN112. 707 F.2d at 682.
FN113. Legal scholars have evidence that "letters of credit were used by bankers in Renaissance Europe, Imperial Rome, ancient Greece, Phoenicia and even early Egypt." 707 F.2d at 682.
FN114. Kingdom of Sweden v. New York Trust Co., 96 N.Y.S.2d 779, 441-442 (N.Y. Sup. Ct. 1949)
FN115. 707 F.2d at 682. For a brief history of the letter of credit, see Boris Kozolchyk, Letters of Credit, in 9 INTERNATIONAL ENCYCLOPEDIA OF COMPARATIVE LAW ch. 5, at 3-5 (1979) (published in a separate fascicle as B. Kozolchyk, Letters of Credit (1979)). For a more extensive history, see Boris Kozolchyk, The Legal Nature of the Irrevocable Commercial Letter of Credit, 14 AM. J. COMP. L. 395, 395-400 (1965-1966) (reviewing history of letters of credit); G. Malynes, THE ANCIENT LAW MERCHANT ch. 14 (1686) (discussing history of letters of credit); Rufus J. Trimble, The Law Merchant and The Letter of Credit, 61 HARV. L. REV. 981, 982-85 (1948).
FN116. Margaret Moses, International Law Seminar, Pace University School of Law, October 5, 12, and 19, 1995.
FN117. U.C.C. § 3-103 cmts. 4-5 (Revised 1994).
FN118. Comment, supra note 19, at 663, citing Farnsworth.
FN119. Barnes, supra note 9.
FN120. 668 F.Supp. at 919.
FN121. See 578 S.W.2d at 112, where the Texas Supreme Court explained: "One can  describe a traditional letter of credit as an instrument ensuring that neither buyer nor seller has both goods and cash at the same time. Unwilling to sell on credit, the seller instead receives the bank's irrevocable commitment and is thereby assured of payment. Unwilling to pay on credit, the customer pays in advance of receiving the goods, but only upon receipt of documents which indicate that the goods have been shipped. The need to achieve these characteristics and protect the allocation of risks they represent produced the cardinal rule of letter of credit law: the 'independence principle' which holds each commitment in a letter of credit transaction to be independent of the others."
FN122. U.C.C. § 5-108(b) (Proposed Official Draft 1995).
FN123. U.C.C. § 5-111(a), (b) (Proposed Official Draft 1995). In addition, the beneficiary is entitled to interest from the date of wrongful dishonor (U.C.C. § 5-111(d)) and reasonable attorney fees and other litigation expenses (U.C.C. § 5-111(e)).
FN124. U.C.C. § 5-108(e) (Proposed Official Draft 1995).
FN125. MacIntosh, supra note 13, at 16-28.
FN126. See, e.g., Rapson, Articles 5 and 9, supra note 19, at 4; Comment, supra note 19, at 685-686.
FN127. Barnes, supra note 9.
FN128. 707 F.2d at 682.
FN129. International Chamber of Commerce, Uniform Customs and Practices for Documentary Credits Doc. No. 500 (1993).
FN130. Alaska Textile Co., Inc. v. Chase Manhattan Bank, N.A., 982 F.2d 814, 816 n.1 (2d Cir.(N.Y.) 1992).
FN131. U.C.C. § 5-101 commentary at 12 (Proposed Official Draft 1995). The Comment also notes that, when drafted, the Convention on International Guarantees and Standby Letters of Credit may also govern letter of credit transactions. Id. at 12.
FN132. U.C.C. Revised Article 5 prefatory note at 2, 6 (Proposed Official Draft 1995). The prefatory note particularly states that "Section 5-116(c) [of Revised Article 5] expressly recognizes that if the U.C.P. is incorporated by reference into the letter of credit, the agreement varies the provisions of Article 5 with which it may conflict, except for the non-variable provisions." Id. at 6-7.
FN133. U.C.C. § 5-101 commentary at 11-12 (Proposed Official Draft 1995).
FN134. Approximately __% of all annual letters of credit issued are international in scope, while only __% of such letters of credit are issued solely for the US domestic market.
FN135. Barnes, supra note 9, at n.5.
FN136. The four states are Alabama, ALA. CODE § 7-5-102(4) (1993); Arizona, ARIZ. REV. STAT. ANN. § 47-5102(D) (1988); Missouri, MO. ANN. STAT. § 400.5-102(4) (Vernon 1994); and New York, N.Y. U.C.C. LAW § 5-102(4) (McKinney Supp. 1994).
FN137. Barnes, supra note 9, at n.5.
FN138. See, e.g., Illinois case law. Werner Lehara International, Inc. v. Harris Trust & Sav. Bank, 484 F.Supp. 65 (D.C.Mich. 1980) (By virtue of its issuance of a letter of credit to Iranian bank, Illinois bank was subject to the [U.C.P.].).
FN139. See e.g., New Jersey case law. 428 A.2d 518 (Customs and practices defined in the [U.C.P.], unless in conflict with mandatory provisions of [UCC], are valid and binding between parties to the letters of credit.).
FN140. See, e.g., Pennsylvania case law. Sound of Market Street, Inc. v. Continental Bank International, 819 F.2d 384 (3d Cir.(Pa.) 1987) (Under Pennsylvania law, [U.C.P.] constitutes recording of common practice, and not substantive law which contracting parties may choose; thus Pennsylvania's version of [UCC] is governing law even if letter of credit has been made subject to U.C.P.); 336 A.2d 316 (Pa. 1975) (Issue whether Pennsylvania bank's honoring of draft under international letter of credit issued pursuant to agreement, which provided for issuance of letters of credit required by addendum to hotel lease and provided that such agreement would be construed in compliance with Pennsylvania law, should be enjoined was governed by Pennsylvania [UCC], though lease agreement provided that it would be governed by law of Switzerland and letter of credit stated that bank's engagement was subject to the [U.C.P.].).
FN141. U.C.C. Revised Article 5 prefatory note at 2 (Proposed Official Draft 1995).
FN142. See notes 72-103, supra, and accompanying text.
FN143. New York Life Insurance Co. v. Hartford National Bank & Trust Co., 378 A.2d 562, 566 (Conn. 1977) ((O)ne of the expected advantages and essential purposes of a letter of credit is that the beneficiary will be able to rely on assured, prompt payment from a solvent party; necessarily, a part of this expectation of ready payment is that there will be a minimum of litigation and judicial interference, and this is one of the reasons for the value of the letter of credit device in financial transactions.).
FN144. Cooperative Agricole Groupement de Producteurs Bovins de L'Ouest v. Banesto Banking Corp., 1989 WL 82454, 23 (S.D.N.Y. 1989), citing Banque Worms v. Banque Commerciale Privee, 679 F.Supp. 1173, 1178, (S.D.N.Y.), aff'd, 849 F.2d 787 (2d Cir. 1988) (per curiam ). But see Comment, supra note 19, at 686 n.234 (citing cases in which courts "refused to allow summary judgment even under the subjective test," because "the credibility of witness testimony and the availability of facts known to the transacting party were important to a determination of honest intent and required a finding of fact by a jury.").
FN145. See Transamerica Delaval Inc. v. Citibank, N.A., 545 F.Supp. 200, 203 (S.D.N.Y. 1982); Data General Corp. v. Citizens National Bank, 502 F.Supp. 776, 779 (D.Conn. 1980).
FN146. Corporacion de Mercadeo Agricola v. Mellon Bank International, 608 F.2d 43, 49 (2nd Cir.(N.Y.) 1979). See, e.g., Key Appliance, Inc. v. First National City Bank, 37 N.Y.2d 826, 377 N.Y.S.2d 482, 339 N.E.2d 888 (1975). See also 448 F.Supp.at 224 (Dishonor of a demand for payment when the demand does not comply with the terms of the letter of credit cannot constitute bad faith.)
FN147. 918 F.2d at 1317; Lawyers Title Ins. Corp. v. First National Bank, 1989 WL 51191, 6 (N.D.Ill. 1989); 585 P.2d at 327; see MacIntosh, supra note 13, at 24.
FN148. Comment, supra note 19, at 685, citing United States National Bank v. Boge, 814 P.2d 1082, 1088 (Or. 1991).
FN149. 428 A.2d at 526.
FN150. Id., citing New Amsterdam, etc., Co. v. National Newark, etc., Co., 117 N.J.Eq. 264, 277, 175 A. 609 (Ch. 1934), aff'd 119 N.J.Eq. 540, 182 A. 824 (E. & A. 1936).
FN152. Hersch v. Citizens Sav. and Loan Assoc., 146 C.A.3d 1002, 1011 (1983).
FN153. Comment, supra note 19, at 686.
FN155. Luedtke v. Nabors Alaska Drilling, Inc., 834 P.2d 1220, 1224 (Alaska 1992).
FN156. 469 S.W.2d at 816.
FN157. Barnes, supra note 9. In n.27, Mr. Barnes explains that issuers would be subject to attack from both the applicant and beneficiary for any issuer action or inaction that affects the dispute between them, particularly in cases where the applicant's claim of beneficiary fraud appeared to have some merit but attracted a response from the beneficiary, or the beneficiary's bank, to the effect that the applicant was acting in bad faith in making such a claim. Mr. Barnes then laments that it is ironic that an expanded good faith obligation, which is expected to deter misuse of the fraud defense, may itself be misused. Mr. Barnes believes that there is a much greater potential for misusing "fair dealing" than "fraud."
FN159. Id. n.28.
FN160. MacIntosh, supra note 13, at 24.
FN162. Dolan, supra note 58, at 398.
FN163. U.C.C. &sect; 5-108(a) (Proposed Official Draft 1995); 497 N.W.2d at 227; Petra International Banking Corp. v. First American Bank of Virginia, 758 F.Supp. 1120, aff'd 953 F.2d 1383 (E.D.Va. 1991).
FN164. SITPRO, supra note 10, at 8.
FN165. See id. for ways to improve document presentations.
FN166. U.C.C. &sect; 5-108(b) of the Proposed Official Draft 1995 now mandates issuer compliance with good faith facility to cure documents.
FN167. Definition of "Good Faith" in Revised U.C.C. Article 5, 11 Letter of Credit Update at 29 (February 1995) (Letter by Ernest T. Patrikis).
FN168. MacIntosh, supra note 13, at 37.
FN169. Id. at 47.
FN170. 428 A.2d at 527.