Letters of Credit: A Theory on the Legal Basis of the Payment Obligation of Issuing Bank

Abstract

It is argued that, to a businessman nothing is simpler than an irrevocable letter of credit transaction; he or she never thinks about the nature of the obligation incurred by the issuing bank. However, significant uncertainty, ambiguity as to the nature of the obligation arises when lawyers, judges or legal scholars start to think about the legal basis of the bank’s commitment. To a lawyer, judge or legal expert every commitment or obligation must be based on certain legal principle or legal theory. Therefore, from the beginning of the nineteenth century, various legal theories have been advanced to explain, to define or to justify the legal basis of the obligation. Majority of these theories have been based on the traditional legal principles such as law of contracts, law of negotiable instruments. In many cases judges justify the obligation simply assuming that the obligation has come out of contractual relationship between the parties. Careful study of these theories reveals that all these theories have come out of the misperception and misunderstanding of the nature and function of letters of credit. Some of these theories have advanced by ignoring the fundamental purpose of letters of credit. These theories, eventually, may create many problems to the smooth functioning of the successful instrument rather than to solve the puzzle of legal basis.

In fact, the obligation neither based on the law of contract nor based on the law of negotiable instruments; the obligation is of unique nature and based on the repetitive and continuous practices of the merchant ie trade usage. However, there is no option to think that the practice has no legal sanction. The practice, on passing the difficult tests of reasonableness, certainty, continuity, and binding effect, has become an enforceable usage. Judicial notice or judicial recognition of the enforceable usage has conferred upon it with the authority of law. Thus the issuing bank is legally binding to honour the draft of the beneficiary.

Keywords: Letter of Credit, Payment Obligation, Legal Basis

JEL Classification: K00