18 Nov, 2022
Security Agreements in International Trade
International trade is dependent on security agreements or financial instruments provided by banking institutions or third parties to support the contracts of sale that are negotiated between transacting parties. These instruments include letters of credit, bank guarantees, and performance bonds. This is because international trade exposes transacting parties to various risks, particularly where if the buyer fails to the exporter pay on time, consequently negatively impacting the exporter’s cash-flow.
This article examines the differences in credit arrangements or financial instruments that are available as well as the International Chamber of Commerce Uniform Customs and Practice for Documentary Credit (UCP 600), and Uniform Rules for Demand Guarantee (URDG 758).
REDUCING RISK OF NON-PERFORMANCE
Mitigating financial risks has become an area of enhanced documentation support to international trade. Financial institutions, through their trade-finance services, offer specialised documentary credit arrangements in the form of letters of credit (LCs), bonds, performance guarantees, demand guarantees and other such security agreements. These are all designed to protect the parties entering into the transaction and to enable global trade, while reducing the risk of non-payment by a party, or failed performance of obligations.
There are various bodies in international trade finance whose primary objective is to facilitate international ‘deal flow’. The International Chamber of Commerce (ICC) is one such organisation, which aims to promote international trade and investment as vehicles for inclusive growth and prosperity. It also resolves disputes when they arise in international commerce in a bid to support global efforts to streamline customs and border procedures. The ICC sets about correcting international trade dissonance and harmonising documentary credit practices across the globe.
UNDERSTANDING LETTERS OF CREDIT AND PERFORMANCE GUARANTEES International security agreements or financial instruments are negotiated directly with banking institutions by the parties to the transaction. These can be in the form of letters of credit, bonds, performance guarantees, demand guarantees and other such security agreements that suit the transaction.
Letters of credit and performance guarantees or demand guarantees provide certainty of performance of payment, even where the exporter and buyer are transacting for the first time. These instruments alleviate the ‘Distrust Divide’ tension that arises due to the timing difference that can happen regarding payment and performance of the underlying contract. In other words, “the general course of international commerce involves the practice of raising money on the documents so as to abridge the period between the shipment and the time of obtaining payments against documents” as described by Lord Wright.
Article 2 of UCP 600 defines a credit as, “any arrangement, however named or described, that is irrevocable and constitutes a definite undertaking of the issuing bank to honour a complying presentation.” This means the status of irrevocability is presumed, thereby creating a binding obligation on the financial institution or issuing bank to perform, and providing the beneficiary with financial reassurance.
It is for this reason that banking institutions that provide security agreements or financial instruments do not concern themselves with the underlying transaction: rather, they focus on the documents evidencing security, and payment obligations of the banking institution captured therein. Article 4(a) of UCP 600 captures this succinctly by stating that “A credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the credit. Consequently, the undertaking of a bank to honour, to negotiate or to fulfill any other obligation under the credit is not subject to claims or defenses by the applicant resulting from its relationships with the issuing bank or the beneficiary.”
Letters of credit provide security for exporters in that in the event of a breach of payment by the buyer, the exporter has recourse against the bank issuing the letter of credit. The doctrine of strict compliance compels the bank to pay irrespective of the status of the underlying debt. The bank’s interest is ensuring the client’s instructions are adhered to regarding payment to the beneficiary of the letter of credit. If the presentation of the documents is non-conforming, the issuing bank is not obliged to make payments without consent
On the other hand, performance guarantees or demand guarantees have different features. The first is that these are often provided by a third party, for a stated amount, normally a percentage of the contract value, which amount is payable in the event of a breach, or when the beneficiary suffers loss as a result of negotiated terms of the contract. Next, the guarantee may take two forms: it may kick-in in the event of default by the buyer or in the event of demand by the exporter. For a demand guarantee, the issuing bank agrees to make payment on the production of the demand or when there is a written notification of default. A performance guarantee has been described in case law as follows: “a performance bond is a new creature …it has many similarities to a letter of credit, ...it has long been established that when a letter of credit is issued and confirmed by a bank, the bank must pay it if the documents are in order, and the terms of the credit are satisfied.”
The difference between letters of credit and performance guarantees or demand guarantees can be summarised as this: a letter of credit is a facilitation tool that provides a mechanism of payment, which is subject to the transaction performing smoothly. A demand or performance guarantee comes into effect when the transaction has fallen through or when a default is expected to occur, and provides financial security.
Nonetheless, for either letters of credit or performance or demand guarantees, if they are structured correctly according to the commercial context, the obligation of banking institutions to make payments against these security documents is clearly expressed in Articles 14(a) and 15 of UCP 600. The exception of payment is when there is ‘clear fraud of which the bank has notice’.
UNIFORM RULES FOR DEMAND GUARANTEE (URDG 758)
URDG 758 applies to guarantees that expressly indicate that they are subject to these rules. It provides for rules for the guarantee process, effectiveness of guarantees, content and instruction of guarantees, amendment of guarantees, extent of liability, rights of parties, and counter measures. Under demand guarantees, the obligation to make payment arises on the instance of a written demand. The payment is not conditioned on an actual failure to perform, but rather the demand by the exporter.
THE PRINCIPAL OF AUTONOMY
The Courts recognise the autonomy of letters of credit and performance guarantees or demand guarantees as standalone security documents. These are independent of the actual transaction to which they provide security, and also of the direct relationship between the buyer and the issuing bank.
A reading of Article 5 of UCP 600 makes it evident that banks do not concern themselves with the goods or services in the underlying contract, but rather, that the security document has been called up as required, and must be fulfilled. Article 34 states that the banking institution’s exclusive obligation is to check whether the presented documents are in compliance. Therefore, the principle of compliance to payment on demand must be honoured by the issuing bank or third party, except for any known or implied fraud.
In the same vein, Article 5 of URDG 758 reads: “A guarantee is by its nature independent of the underlying relationship and the application, and the guarantor is in no way concerned with or bound by such relationship. A reference in the guarantee to the underlying relationship for the purpose of identifying it does not change the independent nature of the guarantee. The undertaking of a guarantor to pay under the guarantee is not subject to claims or defences arising from any relationship other than a relationship between the guarantor and the beneficiary.”
Courts have held that “It is only in exceptional cases that the courts will interfere with the machinery of irrevocable obligations assumed by banks. They are the life-blood of international commerce. Such obligations are regarded as collateral to the underlying rights and obligations between the merchants at either end of the banking chain.”
Further, it has been held that “Under the terms of the guarantees an absolute obligation to pay arose simply from a demand for payment by the buyers. The bank had given its own guarantee, and in effect pledged its own credit, to… pay on demand. Its reputation depends on strict compliance with its obligations. This has always been an essential feature of banking practice.”
It is clear that for international trade to run smoothly, there is need for security agreements or financial instruments that reduce the risk of non-payment by a buyer. These security documents issued by banking institutions or third parties, place obligations on the contracting parties to honour payment as specified therein. The security agreement or financial instruments are independent of the underlying contracts, as they are themselves standalone contracts, that exporters can call upon and litigate on if the banking institution or third party fails to comply with the payment obligations.