2.2.1. D efinition
A standby letter of credit^® is an undertaking by a bank to make payment to a third party (the beneficiary of the credit) or to accept bills of exchange drawn by him. English law has tried to describe such a device in a series of decided cases. It is in general accepted that performance bonds/ guarantees are in principle similar to the traditional commercial letter of credit. For instance, Lord Denning, M R., in Edward Owen v. Barclays Bank International,^^ expressly said that "The performance guarantee stands on a similar footing to a letter of credit."^® The autonomous character of a performance guarantee/bond has been also noted in another case.^®
In the USA there is no precise definition of the standby letter of credit in Article 5 of UCC; but in practice it has also been accepted that Article 5 applies to SLCs. However, SLCs are defined by The Federal Reserve Board and the Federal Deposit Insurance Corporation in the USA in the following terms; "Any letter of
See Section A in Chapter X for other points related to the UNClTRAL's activities.
This type o f credit was also called "guarantee letter o f credit"; but this title was quickly changed because it was understood that the word "guarantee" was inappropriate term and might bearing in mind the prohibition o f issuing guarantee inside the United States o f America; Banks, supra (f.n. 3), p. 74, f.n. 20 and see also G.A. Penn, A.M . Shea, and A. Arora, "The Law and Practice o f Internationa! Banking". Banking Law, Vol. 2, London, Sweet & Maxwell, 1987 [hereinafter referred to as International Banking Law (Int.B.L.)], at p. 287, f.n. 77.
[1978] 1 A ll ER 976; [1978] 1 Ll.L.R. 166.
See Lloyd's Report, head note o f the case, col. 2; R.D. H arbottle v. Nat West. [1977] 2 A ll E.R. 862. Howe Richardson Scale Co. v. Plhnex Corp.. [1981] 1 Ll.L.R. 161, at p. 165, col. 2, Roskill, L.J., said: "The bank in principle, is in a position not to identical with very similar to the position o f a bank which has opened a confirmed irrevocable letter o f credit. Whether the obligation arises under a letter o f credit or under a guarantee, the obligation o f the bank is to perform that which is required to perform by that particular contract and that obligation does not in the ordinaiy way depend on the correct resolution o f a dispute as to the sufficiency o f performance by the seller to the buyer or by the buyer to the seller as the case may be under the sale and purchase contract."
credit which represents an obligation to the beneficiary on the part of the issuer, (1) to repay money borrowed by or advanced to or for the account of the account party, or (2) to make payment on account of any indebtedness undertaken by the account party, or (3) to make payment on account of any default by the account party in the performance of an obligation."®® in Article 2 of UCP 500 a standby letter of credit is defined in a way similar to that of a letter of credit.®^
2.2.2. C lassification o f standby letters o f credit
Nowadays there are different types of SLCs or bonds in domestic and international trade practice. In one general classification SLCs or bonds are divided into "on demand" and "conditional". In another category the contractual obligations of the account party differ, for example as to performance bonds, or tender or bid bonds (described below).
2.2.2.1. On demand and conditional bonds 1. First demand bonds
This is a type of SLC/bond, also called a "suicide form" among bankers and traders; it is noteworthy as the most popular kind of bond among the issuers and beneficiaries of issued credits, because the rights and duties of the parties to a credit contract are therewith made clear and precise. Although in a first demand SLC the burden of proof is on the beneficiary, he has no great difficulty to prove the failure of the account party or the bank's customer, since such type of credit is payable on the beneficiary’s first demand without any particular document(s) required to be presented (as proof for his allegation(s) or conditions for payment). Moreover, the bank's duty under such a credit is an absolute obligation and the bankers are obliged to honour the amount of the credit on demand by the beneficiary.®®
21
Banks, supra (f.n. 3), p. 74, f.n. 21, Regulation H. 12 C.F.R. S.S. 208. 7(d), 32.2(e) 337.2(a), (1983). See ICC Publication No. 500.
See H arbottle case, supra (f.n. 18); Int. B.L., supra (f.n. 16), p. 268; G.A. Penn, "Perform ance Bondi A re bankers free from the under-lying contract?". L.M.C.L.Q., 1985, pp. 132-35 [hereinafter refened to as Penn].
2. Conditional bonds
in the case of conditional bonds the mechanism is similar to that used for a traditional letter of credit, i.e., the beneficiary has to prove the failure of the bank’s client according to the terms of contract. In other words the bank must determine whether the customer's default is a breach of the contract or not. Of course, in most cases bankers are faced with the legal arguments of both parties; so, to avoid such a situation, most bankers insist on an arbitration clause being included in all conditional bonds.®®
2.2.2.2. Other types of bonds
There are different sorts of bonds/guarantees which a bank's customer may ask for the beneficiary of the credit. They are:
1. Performance bonds
This kind of bond has been used for a long time by beneficiaries to protect themselves against default of the other parties in sale or construction contracts.®'^ 2. Tender or bid bonds
In order to ensure the customer’s signing of a bid contract, the other party to the contract (beneficiary bidder) usually requires tender/bid bonds. Unfortunately, fluctuation of market prices means that many customers try to avoid their contractual obligations, and the bidders are obliged to include additional costs in re-awarding the contract to another party. Therefore, the beneficiary bidder usually uses this mechanism, and this type of bond is usually issued for a period of 90 days at first instance, but because of lengthy negotiations they are nearly always unilaterally extended creating a common problem with this type of bonds.®®
See Penn, ibid.; Int. B.L., supra (f.n. 16), pp. 268-70.
According to statistic in construction industiy the number o f failures in completion the contract by contractors and number o f insolvencies are veiy high. See for instance Williams, K.P., "Perform ance bonds: used and usefulness". L.M.C.L.Q., 1983, pp. 423-39, at p. 423, f.n. 1 [hereinafter refeired to as W illiams]; Int. B.L., supra (f.n. 16), pp. 263-65.
Int. B.L., supra (f.n. 16), pp. 262-63; Williams, ibid., p. 423, f.n. 4.
3. Advanced payment bonds
The employer (buyer) usually pays to the other contracting party, particularly in construction contracts, a percentage of the contract price (usually 10 to 20 per cent) as an advance payment, in order to enable to commence work. Sometimes the employee (seller or contractor) fails to carry out his obligation. So, to safeguard his position, the employer requires an advanced payment bond.®® 4. Retention money bonds
An employee contractor is usually, under the terms of contract, entitled to receive a percentage of the contract price after completion of his duty in each stage of the work. So when the contract is completed, the total amount of the contract price will have been paid by the employer. To safeguard the employer/ buyer's payment during the progress of the contract, a sort of device called a "release of retention money bond" is used. Such a bond puts the contractor/seller under an undertaking to return any money they have received from the employer/ buyer in case of failure to complete a contractual duty at each stage of the work.®^ 2.2.3. The mechanism o f standby letters o f credit
As described above, SLCs or bonds are one type of credit. So, like a traditional commercial letter of credit, a standby letter of credit is simply an engagement by an issuer, usually a bank, to honour drafts or demands for payment by the beneficiary under the terms of the credit contract. Moreover, it is a low cost system like the traditional commercial letter of credit.
Differences between SLCs or bonds and LCs arise from different purposes and duties included in the contract by both parties, and also from the documentation (explained below). As a matter of fact there is a great potential risk
Int. B. L., supra (f.n. 16), p. 265.
Int. B.L., supra (f.n. 16), pp. 265-68; Williams, supra (f.n. 24), p. 423, f.n. 4; there are other types o f bonds like labour and material bonds, maintanance period bonds; and also it is suggested that the bonds could be classified into "documentary" and "non-documentary" bonds, in order to mitigate the disadvantages o f first demand bonds. It is suggested that there could be some cluse in the contract that the beneficiary o f the credit is entitled to use the credit when he can show a good cause o f action against the seller/contractor by giving documents, in support o f his contention, to the bank; see also Int.B.L., supra (f.n. 16), pp. 270-71.
for both the issuing bank and its customer with respect to the "on demand" bonds. Therefore, there are some suggestions to mitigate the risk and safeguard the position of banks and their customers against the beneficiary. They are as follows: 1. "Counter indemnity" by the issuing bank
One solution suggested to support the issuing bank's position in the case of "on demand" bonds is "counter indemnities." It is clear that under English law the issuing bank is bound to make payment promptly, in the absence of fraud, when demand Is made by the beneficiary. It means though, in English law, the issuers of the "first demand" bonds (issuing bank) are bound to make payment promptly when demand is made by the beneficiary of the credit but they are also entitled to obtain the amount of money paid, from their customers under a proper "counter-indemnity" clause.
The second method has been particularly devised in recent years for large contracts involving always large bonds. Individual banks could not afford such a bond and have preferred to syndicate it. Therewith the risk is divided between several banks. This method of syndication is said to be no different in structure from a syndicate loan agreement, apart from the fact that the former is built on a first demand bond.®®
2. Solutions for a bank's customer
Two suggestions may operate to mitigate the risk of on demand bonds and try to help the bank's customer (usually a seller or contractor); firstly by using the services of private insurance to insure the customer against the risk of losing his assets against unreasonable or unjustified demand for bonds; secondly by using the services provided by the Export Credit Guarantee Department (ECGD) In the United Kingdom. The ECGD provides schemes to support users of on demand bonds in case of unfair calling of bonds.®®
Int.B.L., supra (f.n. 16), p. 283, f.n. 66.
Int.B.L., supra (f.n. 16), pp. 285-86 & f.n. 77; Ventris, supra (f.n. 2), p. 135.
S E C T IO N B: A C O M P A R IS O N B E T W E E N SLCs A N K
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SECs A N D P E R FO R M A N C E BONDS A N D G U A R A N TE E S