Letter of Credit - Legal Basis

Legal Basis

Legal writers have failed to satisfactorily reconcile the bank’s undertaking with any contractual analysis. The theories include: the implied promise, assignment theory, the novation theory, reliance theory, agency theories, estoppels and trust theories, anticipatory theory, and the guarantee theory. Davis, Treitel, Goode, Finkelstein and Ellinger have all accepted the view that documentary credits should be analyzed outside the legal framework of contractual principles, which require the presence of consideration. Accordingly, whether the documentary credit is referred to as a promise, an undertaking, a chose in action, an engagement or a contract, it is acceptable in English jurisprudence to treat it as contractual in nature, despite the fact that it possesses distinctive features, which make it sui generis.

Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. In addition, the performance of an existing duty under a contract cannot be a valid consideration for a new promise made by the bank: the delivery of the goods is consideration for enforcing the underlying contract of sale and cannot be used, as it were, a second time to establish the enforceability of the bank-beneficiary relation.

A theory sustains that is feasible to typify letter of credit as contracts for a third-party beneficiary because there are in fact three different entities participating in the letter of credit transaction the seller, the buyer, and the banker. Because letters of credit are prompted by the buyer’s necessity and in application of the theory of Jean Domat the cause of a Letter of Credit is to release the buyer of his obligation to pay directly to the seller with legal tender. Therefore, Letter of Credit theoretically fits as a collateral contract accepted by conduct or in other words, an Implied-in-fact contract under the framework for third party beneficiary where the buyer participate as the third party beneficiary with the bank acting as the stipulator and the seller as the promisor. The term "beneficiary" is not used properly in the scheme of a letter of credit because a beneficiary (also, in trust law, cestui que use) in the broadest sense is a natural person or other legal entity who receives money or other benefits from a benefactor. Note that under the scheme of letters of credit, banks are neither benefactors of sellers nor benefactors of the buyers, and the seller doesn’t receive money in gratuity mode. Thus is possible that “letter of credit” was one of those contracts that needed to be masked to disguise the “consideration or Privity requrement”, as a result this kind of arrangement, would make letter of credit to be enforceable under the action assumpsit because of its promissory connotation.

A few countries including the United States (see Article 5 of the Uniform Commercial Code) have created statutes in relation to the operation of letters of credit. These statutes are designed to work with the rules of practice including the UCP and the ISP98. These rules of practice are incorporated into the transaction by agreement of the parties. The latest version of the UCP is the UCP600 effective July 1, 2007. The previous revision was the UCP500 and became effective on 1 January 1994. Since the UCP are not laws, parties have to include them into their arrangements as normal contractual provisions. .