Letters of credit (LC) and bank guarantees are financial tools used to secure payment obligations. However, they differ from regular guarantees in terms of the defences against payment demands. An LC is simply an agreement to pay under certain conditions, and the law governing LCs is determined by the national jurisdiction where the LC is issued.
There are two primary types of LCs: documentary credits and standby letters of credit. Both require the issuer (generally a bank) to pay a third party upon acceptance and payment of a bill of exchange submitted by that third party. The issuer also has the authority to accept or negotiate the documents presented by the third party.
Documentary credits entail a bank’s commitment to pay a specified amount of money, either immediately or at a future date, in exchange for specified documents presented by the third party. On the other hand, standby letters of credit serve as a backup source of payment in the event of non-payment or non-performance by the primary obligor. Payment obligations are typically activated by a written demand along with evidence of default in the underlying transaction.
Documentary credits are typically created with the purpose of making a payment upon presentation of the required documents. Standby letters of credit, however, are supplementary credit instruments that are meant to be honoured only if default occurs and are often used in foreign structured finance arrangements to ensure payment can be made within the intended jurisdiction without transferring funds.
The LC is a contract and is governed by the Uniform Customs and Practices (UCP) and international banking standards, which are recognized by Canadian law. Conflicts of laws are rare in LCs, with the UCP being the sole reference to choice of law. However, local jurisdiction may still apply to certain aspects of the LC.
For proper LC application, three interlocking principles must be considered. First, the LC is a separate contract, distinct from the underlying business transactions between the applicant and beneficiary and from the reimbursement agreement between the applicant and issuer. Second, the LC is self-contained, and no other agreements or documents should be referenced. Lastly, all LCs are document-based, and the issuer deals exclusively with documents. The LC transaction is considered complete if the draft and other documents outlined in the LC text are presented.