Publication Date: March 03, The documentary credit; From zero to hero

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1 Documentary Credits on the mend international letter of credit practice receives a welcome boost from English and US Court decisions. Article 16 rejection procedure and Documentary Credit Structures. Author: Robert Parson, Partner, London Author: J. Michael Brown Jr, Partner, Chicago Author: Daniel P. Gallagher Jr, Partner, Pittsburgh Publication Date: March 03, 2011 The documentary credit; From zero to hero Bankers and traders looking for further encouraging signs that the documentary credit has a new lease of life since the credit crunch will have had plenty to cheer about over the last few weeks. Given the pressure - both economic and legal - that was building against the documentary credit practice up to 2007 the recovery over the last three years has been remarkable. Some court decisions prior to 2007, such as the decision of the English Court in Mahonia Ltd v JP Morgan Chase (2004) 1 arising out of the Enron collapse even flirted with the unwelcome concept of an "illegality" defence which would effectively diminish the cherished "autonomy" of the credit by inviting scrutiny of the propriety (from a local law standpoint) of the underlying transaction. The bounce-back in the fortunes of the documentary credit is partly due to a renewed interest in security of payment since the global economic crisis coupled with a successful launch of UCP 600 ("the UCP") in the summer of 2007 which has restored the fortunes of a product that many had considered on its last legs in the boom days of open account business prior to One global economic crisis later, the documentary credit is alive and well in London, New York, Hong Kong and everywhere else that carries on the business of international trade. One of the great strengths of the UCP which underpins the documentary credit is that it has global buy-in. To achieve this, its authors had to hold back from presenting a complete code of law which might have borrowed too heavily from one juridical tradition or another. Instead, the UCP sets down a basic structure with a clear intention that it should represent and mirror current international practice - a fine example of common ownership of a set of international rules. Of course that means that from time to time a measure of local law and some common sense will have to be applied to fill any gaps left intentionally or unintentionally in the wording. The lightness of hand with which local courts approach interpretation of the UCP, however, is something which is monitored closely by practitioners across the world who seek to maintain a global consensus on the application of the Articles of the UCP.

2 Fortis Bank/Stemcor v Indian Overseas Bank : Article 16 under scrutiny In (1) Fortis Bank SA/NV (2) Stemcor UK Ltd v Indian Overseas Bank 2 decided by the English Court of Appeal on 31 January 2011, the court was asked to interpret the new rejection provisions in Article 16 (c) UCP which provide as follows: When a nominated bank acting on its nomination, a confirming bank, if any, or the issuing bank decides to refuse to honour or negotiate, it must give a single notice to that effect to the presenter. The notice must state: i. that the bank is refusing to honour and negotiate; and ii. each discrepancy in respect of which the bank refuses to honour or negotiate; and iii. a) that the bank is holding the documents pending further instructions from the presenter; or b) that the issuing bank is holding the documents until it receives a waiver from the applicant and agrees to accept it, or receives further instructions from the presenter prior to agreeing to accept a waiver; or c) that the bank is returning the documents; or d) that the bank is acting in accordance with instructions previously received from the presenter. The sanction for failing to follow the new procedure is set out at Article 16 (f): If an issuing bank or a confirming bank fails to act in accordance with the provisions of this article, it shall be precluded from claiming that the documents do not constitute a complying presentation. IOB issued 5 letters of credit in favour of Stemcor, three of which were confirmed by Fortis. On presentation of documents, IOB raised a number of discrepancies but the court had held that just one of those, common to each presentation of documents had any validity. In principle even one valid discrepancy would have been sufficient to defeat a claim for something in excess of US$8 million in respect of the shipment of steel. Fortis, as confirming bank, had paid Stemcor approximately US$5 million for 3 of the sets of documents and Stemcor had then presented a further 2 sets of documents with a value over US$3 million through Fortis to IOB for direct payment. IOB, having identified the one valid discrepancy (and a host of invalid discrepancies), sent a notice pursuant to Article 16 (c) describing the discrepancies and included a statement covering option (iii) (c) (i.e. indicating that the documents were being returned by them to the beneficiary). The court found that IOB then failed to return any documents until some weeks after saying that they were doing so. Fortis and Stemcor claimed that even if the discrepancies (or just one of them) were valid, the failure to promptly return the documents as per the Article 16 notice precluded IOB from relying on any of the

3 discrepancies and thereby prevented them denying that there had been a complying presentation as provided by Article 16 (f). IOB's defence was to argue that while Article 16 required the notice to state that the documents were being returned, the UCP did not expressly state anywhere that the bank was in fact obliged to physically return the documents even if it had promised to do so. IOB argued that alternatively, if there was an "implied" duty to return the documents then a failure to comply with such an implied duty could not be said to be a failure to "act in accordance with the provisions of [Article 16 (f)]" since the preclusion defence under Article 16 (f) only arose, according to IOB, where Article 16's express terms had been breached. Applying rules of construction under English law, IOB argued, there was no such duty on either basis. There was little dispute between the banking experts who appeared as witnesses in court as to what the current international practice was on rejection. Both accepted that within one or two days at the most the documents referred to in an Article 16 notice would be in fact be returned in fulfilment of the statement made in the notice. What the court had to decide was whether the duty to return the documents fell outside UCP as IOB argued or fell within Article 16 as a matter of construction or by implying a term to that effect. The court took the view that a narrow interpretation of the UCP based on standards imported purely from English law was inappropriate. Instead, a court should recognise the international nature of the UCP and approach its construction in that spirit. The court had to decide, therefore, whether under UCP a bank rejecting documents and giving notice that it was returning them was actually obliged to do so. Rejecting a literal and national approach the court said: "Courts must interpret [the UCP] in accordance with its underlying aims and purposes reflecting international practice and the expectations of international bankers and international traders so that it underpins the operation of letters of credit in international trade." The court held that in applying that approach, there was indeed an obligation on the part of an issuing bank to do the thing which it had said was being done in the notice - i.e. to return the documents (and to do so promptly). Its failure to do so placed it squarely in breach of Article 16 and precluded it from relying on any discrepancy identified in the notice. The issuing bank was therefore liable to pay the face value of the documents it had rejected even though at least one of the discrepancies relied upon was valid. Enthusiasts of the UCP will be encouraged by the court's approach, which sets down a marker for future interpretation. If courts globally will adopt a similar approach then differences in application of the UCP can be minimised. The importance of a consistent international approach to the interpretation of the UCP and the principles set out in it was highlighted by another court decision, this time by a US court. In a case decided in the summer of 2010 in New York, the court's decision shows a welcome trend by the US courts to adopt a similarly robust approach to defences to payment under letters of credit and to uphold the autonomy and independence of the letter of credit as a payment instrument whether used in a traditional international sale of goods context or as part of a more complex structured financing.

4 Letter of credit based structured trades - a green light from the courts In Fortis Bank (Nederland) N.V. v Abu Dhabi Islamic Bank 3 in a decision made on 26 August 2010, the New York Supreme Court had to consider a claim for US$40 million by Fortis as negotiating bank under a structured credit transaction. The transaction had involved the issuance of a documentary credit in June 2008 by Bank Awal, at the request of Al Gosaibi Trading and Services ("Applicant") both part of the now defunct Saudi based Saad Group which subsequently collapsed spectacularly leaving colossal debts across the Gulf and elsewhere. The credit provided for the negotiating bank to be reimbursed after 360 days. Abu Dhabi Islamic Bank ("ADIB") agreed to confirm the credit and Fortis, as negotiating bank, was therefore entitled to look to ADIB for reimbursement. Prior to ADIB confirming the credit, the beneficiary, Bunge S.A., a major commodities company, sent a notice to ADIB giving details of the underlying transaction. The notice described a form of letter of credit based financing structure that has become relatively common in the soft commodities business over the last two decades: "This is a structured transaction whereby Discounting Bank [Fortis] is required to discount or fund the Instrument in favour of the Beneficiary once the documents are deemed in compliance at its counter. Applicant will on-sell the Goods to another Bunge affiliated company ("Bunge Buyer"). Once Beneficiary receives the discounted proceeds under the Instrument, Bunge Buyer will effect sight payment to Applicant immediately. Applicant will enjoy the cash financing during the Tenor before repaying the Issuing Bank on maturity of the Instrument." The structure provided funding to the Applicant by including the Applicant in the trade flow and then arranging the contractual cash flows in favour of the Applicant by allowing the Applicant to buy goods on deferred payment terms but to sell the same goods at sight to a Bunge S.A. affiliate and therefore to enjoy a period of credit. The enduring popularity of the documentary credit is due in no small part to its particular quality as an autonomous and independent payment instrument. In principle, if the documents (be they original or copy documents) are compliant then the issuing or confirming bank must pay. Credits are therefore ideally suited for the type of structure described above because issuing/confirming banks know that their reputations will suffer if they fail to honour their documentary credit commitments and where, as in the structure examined in this case, the parties have agreed a deferred payment of 360 days, the certainty of an underlying bank payment risk gives the structure stability through the extended period of credit. The main purpose of the structure described in Fortis v ADIB, as the notice suggests, is to provide a period of financing for the Applicant ultimately at the risk of the issuing (and any confirming) bank. So the classic ingredients of an international sale of goods are not necessarily present. The Applicant is interposed between the Beneficiary and (usually) another company related to the Beneficiary and the Discounting Bank has the

5 comfort of knowing that the Issuing/Confirming Banks will reimburse it on maturity. In this case, the Applicant was introduced into and placed in a regular trade flow between two Bunge affiliates. What nobody in this particular case had foreseen, however, was that in between the date of discounting and maturity, the Saad Group was to collapse under a mountain of debt leaving ADIB facing an obligation to reimburse Fortis as negotiating bank for approximately US$40 million while having to make its own reimbursement claim in Awal's insolvency. ADIB were in a difficult position. Desperate situations call for desperate measures and ADIB purported to defend the claim for reimbursement by alleging fraud against Fortis, the Applicant and the Beneficiary and by painting the transaction generally as a "sham". Witnesses from the trade were produced to express a view as to whether elements of the transaction described in the letter of credit in the structure described showed signs of fraudulent activity - the aim being to lift the lid of the letter of credit (contrary to UCP) and to examine the link to the underlying transaction. The alleged "fraud", it turned out, was no more than an assertion by ADIB that the underlying structure, whereby the discounted proceeds of the credit were effectively used to provide the Applicant with cash for a 360 day credit period, was "synthetic" and "structured" rather than a traditional documentary credit shipment transaction. The New York court found no merit in that argument. Even if the structure was viewed as "novel" when compared to the generality of documentary credit transactions, the structure could hardly be said to amount to a fraud on ADIB when the very nature of the structure had been spelled out in the notice communication from the Beneficiary to ADIB before ADIB agreed to confirm the credit. Aware as it was of the structure from the outset, ADIB were, said the court, "disingenuous" in claiming that the nature of the structure gave them grounds to refuse to honour Fortis' claim. The court also observed that since ADIB had a role in the transaction that was essentially limited to reimbursing Fortis and claiming the same sum from Awal Bank, it made no difference to them at all whether the transaction structure was traditional or "synthetic" as alleged. Judgement was given for the full US$40 million in Fortis' favour. The judgement represents a ringing endorsement for this type of structure. The attraction of a structured finance deal which liquidates through a letter of credit has always been that the discounting bank can take comfort in the fact that it may rely on the credit risk of the issuing or confirming bank in order to recover their investment and not the credit risk of the Applicant or Beneficiary. Until the ADIB case, brought about by the collapse of the Saad Group and its various financial services affiliates, there was no real test in the courts of the robustness of this structure under stress. The ADIB judgement with its firm rejection of ADIB's insubstantial "fraud" allegation is clearly welcome news for both beneficiaries and discounting banks doing this business - particularly in the soft commodity trades where the harnessing of "dead" time in a shipment transaction is a popular and profitable arrangement. The practice of notifying the parties, including the paying bank of the nature of the structure is clearly both

6 desirable, in terms of providing a transparent platform for the transaction, but also effective in preventing the paying bank, whether as issuer or confirmer of the credit, from later disputing its obligation to reimburse. 1. Mahonia Ltd. v JP Morgan Chase Bank, Court of Appeal - Commercial Court, August 03, 2004, [2004] EWHC 1938 (Comm) 2. (1) Fortis Bank SA/NV (2) Stemcor UK Ltd v Indian Overseas Bank [2011] EWCA Civ Fortis Bank (Nederland) N.V. v. Abu Dhabi Islamic Bank, Index No /09, 08/26/2010 (Schweitzer, J.). About Reed Smith Reed Smith is a global relationship law firm with more than 1,600 lawyers in 23 offices throughout the United States, Europe, Asia and the Middle East. The information contained herein is intended to be a general guide only and not to be comprehensive, nor to provide legal advice. You should not rely on the information contained herein as if it were legal or other professional advice. Reed Smith LLP is a limited liability partnership registered in England and Wales with registered number OC and its registered office at The Broadgate Tower, 20 Primrose Street, London EC2A 2RS. Reed Smith LLP is regulated by the Solicitors Regulation Authority. Any reference to the term partner in connection to Reed Smith LLP is a reference to a member of it or an employee of equivalent status. This Client Alert was compiled up to and including March The business carried on from offices in the United States and Germany is carried on by Reed Smith LLP of Delaware, USA; from the other offices is carried on by Reed Smith LLP of England; but in Hong Kong, the business is carried on by Reed Smith Richards Butler. A list of all Partners and employed attorneys as well as their court admissions can be inspected at the website Reed Smith LLP All rights reserved.