By Mohammed Assayed, Head of M&A and Restructuring & Solandia Jurdi, Paralegal
1. Background
The underlying reason for the existence of the concept of financing of international trade was mainly to mitigate and reduce the inherent tensions between the contractual parties due to the timing of payment and performance under the underlying contract, called ‘Distrust Divide’. As a result, various finance modalities and mechanisms that usually engage banks as intermediaries are created. Both Demand Guarantees (“DG”) (performance guarantees) and Letter of Credits (“LC”) are a good example of such modalities.
DG, pursuant to Art 2 of URDG 758, is defined “as any signed undertaking, however named or described, providing for payment on presentation of complying demand”. Art 2, additionally, clarifies the key constituents of the DG and shed lights on the overall process of guarantee. DG is issued by a bank, insurance company, or other person (the “Guarantor”), in writing for the payment of monies on presentation in compliance with the terms of the undertaking and other documents that might be specified in the DG. Such undertaking is issued in favour of a Buyer (the “Beneficiary”) as per the instructions of the Seller (the “Applicant or Principle”).
On the other hand, LC is defined under Art 2 of UCP 600 as “any arrangement, however named or described, that is irrevocable and constitutes a definite undertaking of the issuing bank to honour a complying presentation”. As DG, the LC is issued by a bank (the “Issuing Bank”) at the request of the Buyer (the “Applicant”) in writing for the payment of monies to the Seller (the “Beneficiary”) conditional of submitting a presentation in conformity with the terms of the LC and other documents specified in it.
We can easily notice from the above definitions of DG and LC that although not identical, there are a great degree of key similarities and some differences between them. This article starts by highlighting the essential common features and differences between DG and LC by referring and discussing the relevant international laws, specifically articles of URDG 758 and UCP 600 supported by case laws, then applying the same approach to the Unites Arab Emirates (the “UAE”) legal system.
2. Where they cross paths?
LC and DG shares many common grounds and principles to an extent that made it difficult to distinguish between them, importantly, the doctrine of strict compliance, the autonomy rule, and fraud as an exception to the autonomy rule.
The Doctrine of Strict Compliance
The general legal principle here, is that banks or guarantors have the authority to reject presented documents which are not strictly compliant with its own terms, the terms of the LC and DG, along with the provisions of the UCP 600 and URDG 758. Such important principle is explicitly mentioned under Art 2 UCP 600 and Art 19 (b) URDG 758, in other words, there must be no material discrepancies between the submitted documents and the LC and/or DG. What is the criteria of categorizing discrepancies as material or not?
According to Art 14 (d) UCP 600, presented documents need not be identical. And as clearly stipulated in Art 14 (c ) UCP 600, insignificant or trivial discrepancies are permitted. This also mentioned in Art 19 (b) URDG 758, as typographical errors or simple differences in wording is not material. To further elaborate on this point, it’s worth highlighting Lord Sumner expression in Equitable Trust Company of New York v Dawson Partners Ltd “there is no room for a document which are almost the same, or which will do just as which will do just as well”. Additionally, in Art 30 UCP 600 the tolerance of approximation when it comes to credit amount, quantity and unit price set to not exceed 10% more or 10% less than the LC. In Art 14 (e ) UCP 600, general description of goods and services is acceptable if its listed outside the commercial invoice. For the commercial invoice, the description of good and services must correspond with the LC. This is confirmed in the case of Seaconsar Far East Ltd v Bank Markazi Jomhouri Islami Iran.
Important guidelines have been set in the recent case of Bulgarians & Co Limited v Shinhan Bank, firstly, banks did not have to assume risk, and therefore can reject the documents at first sight if not compliant. Secondly, clarified the process of the ‘Notice of Dishonour’ in line with Art 16 (c ) UCP 600. The court highlighted that the Bank must state refusing to honour or negotiate submitted documents as per Art 16 (c )(i) UCP 600. Then, Banks must state one of the options as per Art 16 (c )(iii), and added that even if the notice is incompliant, the bank can amend it by furbishing the correct one in time. Furthermore, Beneficiary does not have to receive notice as per Art 35 UCP 600.
In the case of DG, the process of rejection is very similar to LC. As per Art 24(d) URDG 758, the Bank i.e. the guarantor, can reject a demand by giving a notice of rejection or may seek a waiver of the discrepancies if identified.
The Autonomy Rule
The main principle here is that both LC and DG are independent and separate of the underlying contract between the parties, including the direct relationship between the Applicant and the Issuing Bank. Thus, a Seller breach of the sale contract is no defense to not service the payment under LC or DG i.e. the goods are faulty and doesn’t fit the purpose. Additionally, an Issuing Bank cannot object or use as a defense to pay a Confirming Bank on the basis of the Importer didn’t provide funds.
The Autonomy rule is covered extensively in both UCP 600 and URDG 758. Under UCP 600, a Beneficiary cannot leverage on the existing contractual relationships among banks or between the Applicant and Issuing Bank, as per Art 4(a). In Art 5 UCP 600, it is clear that banks only deals with documents and not facts such as, goods, services or performance to which such documents refer to. Furthermore, Art 34 UCP 600, emphasized on the above point by explicitly stating the Bank’s exclusive obligation is to check whether the presented documents are in compliance. The case of Hamzeh Malas v British Imex confirmed the Autonomy principle by the statement of Lord Jenkin LJ of furbishing a LC is considered “a bargain between the banker and the vendor of goods” which means the any dispute or contractual relationship between the parties is irrelevant.
Similarly, under URDG 758 the Autonomy rule is explicitly covered in Art 5 which reassured the independence nature of a DG, and that the Guarantor shall not be concerned with the underlying contractual relationship. Additionally, Art 6 confirmed the Guarantors sole obligation of dealing with documents and not facts. This was confirmed in Sipomex Trade SA v Banque Indoseuz as the Court reaffirms the absolute nature of DG “The whole commercial purpose of a performance bond is to provide a security which is to be readily, promptly and assuredly available when the prescribed event occurs.”
Thus, based on the Principle of Autonomy, the cardinal rule common to both LC and DG is that it is only possible to provide financial reassurance to a Beneficiary if the credit is viewed as a transaction totally separate from the underlying sales contract.
Nonetheless, the fundamental principle of Autonomy is not an absolute one, there is an important exception that is not found in either UCP 600 or URDG 758, which is ‘Fraud’.
The Exception: Fraud
‘Fraud’ is seen as the main exception to the rule of Autonomy for both LC and DG, and may come in three practical contexts. Firstly, a Bank (or Guarantor) invokes fraud to reject paying the Beneficiary. Secondly, seeking an injunction relief i.e. freezing order by the Applicant to prevent the Bank (Guarantor) from paying the Beneficiary. Lastly, it can be used as a defense in a reimbursement claim i.e. between Confirming Bank and Issuing Bank.
What about the differences between LC and DG, is there any? Or is Lord Denning’s statement of “similar footing’ accurate?
3. Where they differ?
The essential difference between LC and DG is that, the LC is a mechanism of payment which set out the requirements that needed to be met for the payment to be made, therefore it is not an actual payment. Whereas DG is used as security instruments for mitigating the risk of default in international trade, thus securing performance of contract. As such, DG’s is used across a broader range of commercial transactions and contracts, compared to LC’s. Moreover, relatively simpler documents are required when calling the DG, which led to be often abused “unfair calling”. To mitigate this scenario Art 15 URDG 758 required a written demand under the guarantee associated with a statement that the Applicant is in breach, and state the nature of that breach, this is even if the DG required otherwise.
By doing so, an extra layer of additional requirement is imposed which might made the Beneficiary reluctant from “willy nilly” calls of DG where there was no material breach. It is worth mentioning that as per the definition of LC, LC can perform the function of DG.
4. Trade Finance in the Context of the United Arab Emirates:
The UAE applies and explores the scope of trade finance through the lens of LC and DG in a similar manner, as the general and overall understanding of both concepts are rather similar in their common goal to reduce financial risk and instill confidence in the participating parties and the transaction.
Primarily, the UAE Commercial Transactions Law (Federal Law No. 19 of 1993) defines a LC as a contract by which an issuing bank undertakes to open a credit at the request of the buyer, through the scope of the principle of autonomy and the general obligations falling for both the seller (beneficiary) and the buyer (Article 428). The law herein sheds focus on the principle of autonomy as a rather essential principle that allows a letter of credit to be considered as a separate contract & specifically an independent transaction from a sales contract. In practical terms, the issuing bank herein undertakes the liability of the buyer towards the seller or beneficiary, independently without involving itself on the transaction between them, meaning that in case a seller or a beneficiary violates any terms of the sale contract, the buyer would no longer be in any position to request the issuing bank to terminate payment or the correspondent bank to reject payment either. This was evidently noted in Dubai Courts case 848/2017/445, whereby the judged confirmed that the LC was an entirely separate and independent contract from that of the sales contract, and accordingly, reassured that the bank's given commitment and obligations hereby could not be changed or mended or canceled in any form. In addition, the courts confirmed that any disputes caused in the sales contract between the buyer and the seller, in this case, would not affect the relationship and obligations between the bank and the seller due to the autonomy of both contracts.
Similarly, DG in the UAE are defined as an undertaking issued by a bank to settle a debt to a third party in accordance with terms and conditions agreed and included in the guarantee (Article 411). Accordingly, DG also fall independent from any underlying contract and are generally issued to reinforce commitment and guarantee that all involved parties will fulfill their contractual obligations, as it is important to note that the obligations carried and shared between parties involved towards one another under the scope of the bank guarantee are various and distinctive. Interestingly, some of the key features that distinguish a DG from other types of guarantees under the law are that it has no obligation to mention the time frame or limit of the guarantee, and is deemed as expired after 10 years from the date of issuance of the time limit if not mentioned on the DG (CTL, Article 423). Putting that into perspective, the same was similarly witnessed in Dubai Courts case 321/2016/445, where the court saw that the doctrine of strict compliance as a vital element that reinstates the obligation between the parties towards each other as well as the issuing bank's required obligation towards the parties. Nevertheless, the principle of autonomy as well dictated that the DG was self-sufficient and independent from the underlying contact as the issuing bank is not allowed to refuse paying the beneficiary for any reason relating to any relation it has to the buyer or other third party, and that the seller has the right to claim the guarantee for the duration stated in the DG, until its expiry, subject to the conditions and contractual obligation set out accordingly.
5. Conclusion
It becomes evident that in the UAE, that the ways in which LC and DG are explained rather distinguishes the understanding and scope of each and lists out the differences in the aspects of obligation, duties, and legal proceedings. Nevertheless, in contrast to the UAE laws, it is noteworthy to highlight that the UAE courts uphold the laws of UCP & URDG for LC and DG to have precedence over the local UAE laws, if explicitly stated in the related agreements. That being said, it is interesting to look into how the LC and DG will continue to be positioned as "stand alone" tools, independent from underlying contracts, continue to resonate remarkably significant protection and promise in the world of international trade, in the UAE and internationally.