Getting Paid Through a Standby Letter of Credit

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Easton, a general contractor, engaged Polly Tree as a subcontractor for a construction project. Since Polly was unable to post a performance bond, Easton agreed to accept a standby letter of credit. Polly obtained the standby letter of credit from Hospital Trust, and Easton was the named beneficiary. The letter was subject to the Uniform Custom and Practices for Documentary Credits and covered defaults or failures to perform by Polly Tree. The letter specified that if Polly failed to perform as required, drafts were to be presented not prior to September 5 nor later than September 30.

In the event, Easton was dissatisfied with Polly's performance, terminated the contract, and performed the work themselves. On Tuesday, September 24, Easton prepared a presentation for payment and posted it to Hospital Trust. Hospital Trust received it on Thursday, September 26. Because hurricane Gloria struck on Friday, Hospital Trust was closed that day and the next banking day was Monday, September 30, the expiration date of the standby letter of credit.

The Hospital Trust manager testified he had reviewed the presentation and found three deficiencies:

It was not accompanied by a draft.
One of the invoices was addressed to Hospital rather than to Easton.
It did not specify the amount that Easton wished to withdraw.

After a jury trial and a suit by Hospital Trust for declaratory judgment, the court found that Hospital Trust had acted properly in denying payment to Easton under the letter of credit.

Easton appealed. Do they have a case?

Make your decision and click on "next" below for the answer and analysis of this situation.

Unlike the traditional letter of credit (which is issued to a creditor and routinely used as a payment procedure), the standby letter of credit creates a fund from which the letter's beneficiary may seek recourse for nonperformance.

A standby letter of credit is more akin to a bond that insures against unsatisfactory or nonperformance than to an account for credit from which a beneficiary regularly withdraws payments for goods or services. As a result, it is generally because there is some dispute that a standby letter of credit becomes an issue. The possibility of litigation always exists with a standby letter of credit, since it is issued in lieu of a bond wherein performance is somehow guaranteed. Thus, it is never exercised unless there is a failure of performance that inevitably leads to some type of litigation.

In this case the court took notice of the Uniform Custom and Practices for Documentary Credit (UCP), which was first issued in 1930 by the National Chamber of Commerce. The UCP is a combination of internationally accepted commercial practices that may be incorporated into the private law of contract between parties. Although it is not law, the UCP applies to most letters of credit because issuers typically incorporate it into their credits.

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Under the UCP, the court noted that normal banking procedure would give a standby letter of credit priority over other types of credit, ensuring that the expiration date would be ascertained immediately upon receipt of a presentation for payment. If the day of receipt was close to the expiration date, the presentation should be reviewed and the appropriate actions should be taken promptly.

On the basis of the banker's knowledge of the UCP and of common banking procedures, Hospital Trust should have reviewed the presentation within a reasonable time. Because Easton knew that they were making a presentment with only three days remaining before the expiration date, Easton assumed the risk that if its presentation were defective, it would not receive notice of such defects in time to cure its defective presentation.

Easton relied on UCC Section 5-112, which states that a bank presented with a draft may defer honoring until the close of the third banking day following receipt of the documents. The court disregarded the UCC, stating the USP should apply and noting the UCP allows the issuing bank a reasonable time (not the three-day banking standard set by the UCC) in which to examine the documents submitted in a presentation for payment of the letter of credit.

The court examined some other cases that seem to say that the bank had an obligation to notify the beneficiary by telecommunications or other electronic means rather than by mail when the presentation was made so close to the expiration date. The court failed to take the opportunity to make a final decision and took the posture that it was a question of fact whether the Hospital Trust acted within a reasonable time. They did say that the case should be tried under the UCP and not the UCC, and that the test should be whether the bank acted properly within a reasonable time. The court did offer the fact that the three banking days allowed for a review under the UCC was prima facie evidence of a reasonable period of time.

This case illustrates again the strict compliance required in letter of credit litigation. In most letter of credit litigation, the issue revolves around whether the bank has the right to enforce strict compliance or whether there must only be substantial compliance. Certainly the party presenting the documents should be careful to present the required documents set forth by the letter of credit. The second urgent requirement is to make the presentation within the time prescribed before the expiration of the letter of credit. When the institution fails to make payment on a letter of credit, recourse usually may be had in the courts, but litigation is not only expensive, it may take years.

Editor's Note: The above article originally appeared in the Credit & Collection Manager's Letter, a newsletter purchased by Credit Today in 2006. This article originally appeared prior to 2000.