1. Introduction:
Trade finance instruments have been characterised as the “lifeblood of international commerce” providing a unique form of security to the market. In Cyprus, commercial instruments such as the letters of credit and guarantees are increasingly used to facilitate the completion of either commercial or construction agreements. Although letters of credit and guarantees may be constructed in such ways as to provide relatively the same protection to the interested beneficiary, they may also be constructed in such ways as to constitute two fundamentally different types of security.
2. Letters of Credit
A letter of credit or otherwise a documentary credit, is in essence a promise made by its issuer, being a financial institution, to the beneficiary that a specified action shall take place on a specific time and/or for a specified amount (to be received in full).
For instance, in the scenario where S, the seller, has made an agreement with B, the buyer, for the purchase of goods, S may request for a letter of credit in order to minimize his risks in the transaction. In order to satisfy his request, B applies for a letter of credit to be issued by a bank of his choice. The bank issuing the letter of credit holds the payment on behalf of B until it is provided with a confirmation that the products ordered by B have been shipped. Subsequently, the bank shall proceed with the payment to S once it is satisfied that all terms of the sale agreement are met or until any other specified event takes place (e.g. confirmation by the buyer).
Therefore, the function of a letter of credit is essentially to procure the issuing bank to proceed to payment on behalf of its client, the principal, in order to ensure the prompt and accurate compliance of his obligations under the sale agreement.
Letters of credit are also commonly used in construction transactions to secure the prompt and quality completion of construction projects. In such cases a landlord may request the contractor to request for the issuance of a letter of credit as form of security for the quality of the Project. A letter of credit in such transactions usually enables the landlord to receive damages from the issuing bank in case of delay or any other default in relation to the construction works. The beneficiary of the letter of credit is usually entitled to receive such payments upon presenting a written letter of his own or upon submitting a relevant application.
2.1 Types of Letters of Credit:
2.1.1 Transferable or Non-Transferable:
A transferable letter of credit is a letter of credit which allows the beneficiary to request for the transfer of the whole of the credit or any part of it to a secondary beneficiary.
In that way the beneficiary may arrange for the settlement of his own obligations owed to a third party such as his supplier.
Pursuant to article 38 of the UCP 600, in order for a letter of credit to be transferable there is the need for an express term to be included in the contract to that effect.
2.1.2 Revocable or Irrevocable
A recoverable letter of credit allows the issuing bank to amend or revoke the document at any time and without prior notice.
Pursuant to article 3 of the UCP 600, in order for a letter of credit to be recoverable there is the need for an express term to be included in the contract to that effect.
An irrecoverable letter of credit does not allow the bank to amend or withdraw the credit without the consent of all of the parties involved.
Given that an irrecoverable letter of credit offers significantly higher protection than a recoverable letter of credit, it is much more commonly used in commercial transactions.
2.1.3 Negotiable or Non-Negotiable
A negotiable letter of credit is the undertaking of the issuing bank to reimburse the beneficiary of the credit but which may address to any party who becomes the holder of the credit (usually the bank nominated by the initial beneficiary).
The effect of such an instrument is to enable the beneficiary to exchange a document for cash immediately when the document itself does not provide for immediate payment.
As there is no clarity with respect to the effect of a silent letter of credit when it comes to transferability, a clause should always be included if the parties wish for the instrument to be transferable.
2.1.4 Commercial Letters of Credit
Commercial letters of credit are usually used in international trade transactions.
A commercial letter of credit is in essence a contractual promise from the issuing bank to authorize another bank (“the advising bank”), usually located at the beneficiary’s jurisdiction, to reimburse the beneficiary.
In brief a commercial letter of credit operates as follows:
– The principal (usually the buyer) arranges for the issuance of a letter of credit in favour of the beneficiary (usually the seller).
– Following the issuance of a letter of credit, the issuing bank essentially agrees to make a payment to the beneficiary upon the presentation of specific documents and the principal agrees to reimburse the issuing bank for all the amounts paid accordingly.
– The advising bank confirms the credit and undertakes to reimburse the beneficiary while the issuing bank undertakes to reimburse the advising bank for any payments made.
2.1.5 Standby Letters of Credit
A standby letter of credit operates to enable the innocent party to a contract to get paid when the other party has failed or is alleged to have failed to perform his own obligations under the contract.
The function of a standby letter of credit resembles the function of a traditional bank guarantee in that it constitutes a contractual promise made from the issuing bank to procure a payment to the beneficiary upon the event of non-performance.
The difference between a standby letter of credit with a bank guarantee is that a letter of credit is a contractual promise to pay against documents. This means that the issuing bank undertakes a primary obligation independent from the underlying contract. In this way a beneficiary may acquire payment by providing the issuing bank merely with a written statement by himself that there has been a default.
2.2 Principles Governing Letters of Credit
Many of the principles followed in the United Kingdom in relation to letters of credit have been adopted by the Supreme Court of Cyprus in a number of recent cases. The Supreme Court following the cases of Edward Owen Engg Ltd v. Barclays Bank Intl Ltd (1978) and R D Harbottle (Mercantile) v. National Westminister Bank Ltd a.o. (1987) has adopted the principle of independence of credit.
The independence principle provides that the credit is an autonomous transaction the performance of which is separate and unaffected by the underlying agreement between the principal and the beneficiary.
Further, it has been held that a letter of credit, in the absence of a term to the contrary, is an irrevocable contractual promise made by the issuing bank to pay the beneficiary if the conditions specified in the credit are met regardless of any objections made by the principal.
Lastly, a letter of credit is a transaction in documents and the issuing bank undertakes to proceed with the payment to the beneficiary if the necessary documents are presented.
Generally, the Courts appear to be reluctant to interfere with the performance of a letter of credit but they will not hesitate to do so if there is fraud.
3. Guarantees (or Performance Bonds)
A bank guarantee is usually an instrument representing the contractual undertaking of the issuing bank to pay the beneficiary when certain specified conditions are met.
A bank guarantee may operate in several different ways. For instance, such instrument may be issued as security for the delivery of certain goods, non-performance of services, performance of warranty obligations or for the provision of liquidated damages in case of delay.
The instrument is essentially a confirmation that principal’s liabilities will be met. In essence, it is a contractual undertaking of the issuing bank providing that in case the principal is in default, the issuing bank will step in to settle his debt.
The bank guarantee loses its independent status if it is made conditional upon obligations imposed by the underlying contract. This means that a bank guarantee which is conditional, for instance, upon the default of one party to perform will no longer constitute either a primary obligation or a liability independent from the underlying contract.
A bank guarantee has been described by Andrews and Millet in the Law of Guarantees, 6th ed., 2011, as follows:
The secondary nature of the issuing bank’s obligation essentially means that it is under no duty to conduct any action prior to a default of the principal in accordance with the terms of the underlying agreement between the principal and the beneficiary.
3.1 Types of Guarantees
3.1.1 Simple (or Specific) Guarantees
A simple guarantee is the agreement for the provision of an undertaking guaranteeing the performance of the principal in relation to a specified transaction.
3.1.2 Continuous Guarantees
Pursuant to article 87 of the Cyprus Contract Law, a guarantee for the provision of an undertaking guaranteeing the performance of the principal in a sequence of transactions between the principal and the beneficiary is a “continuous guarantee”.
Whether a guarantee is a simple or a continuous guarantee is decided following an examination of the intention of the parties involved and the circumstances of each case. This means that a Court will assess the terms and the wording used in the instrument as well as the surrounding circumstances of the guarantee agreement.