Revised Article 5 to the UCC

By Margaret L. Moses
Of Counsel

©1995 New Jersey Law Journal

In August 1995, a revised version of Uniform Commercial Code Article 5, which governs letters of credit, was forwarded to state legislatures for adoption. Article 5 was originally drafted 40 years ago. In the intervening years, innovations in communications and technology, and the development of standby letters of credit have affected letter-of-credit law. While the revisions generally bring the UCC more into line with current practice, several provisions shold be excised by the Legislature before the revised article is enacted in New Jersey.

The revision process began almost ten years ago with the appointment of an American Bar Association Task Force, whose report was published in 1990. (45 The Business Lawyer 1521). The American Law Institute approved a proposed final draft last spring, and the Uniform Commissioners accepted the final draft four months ago.

In attempting to clarify the law and make it more consistent with international practice, the drafters of Article 5 pursued four stated goals:

• Conforming Article 5 rules to current customs and practices.
• Accommodating new forms of letters of credit, changes in customs and practices, and evolving technology, particularly the use of electronic media.
• Maintaining letters of credit as an inexpensive and efficient instrument facilitating trade; and
• Resolving conflicts among reported decisions.

[Revised Article 5, Prefatory Note.]

To a great extent, these goals were achieved by the drafters. In harmonizing the law with current customs and practices, Article 5 was brought into conformity with the Uniform Customs and Practice for Documentary Credits, International Chamber of Commerce publication No. 500 (UCP). This codification of rules is made applicable to virtually all letters of credit. Like the UCP, Revised Article 5 requires that an issuer notify a beneficiary of dishonor within a reasonable time, not to exceed seven days. 5-108(b). It adopts the UCP's rule of preclusion, prohibiting dishonor when an issuing bank has not given timely notice of dishonor, or has not listed discrepancies in the notice. 5-108(c). Similarly to the UCP, Article 5 declares that a nondocumentary condition in a letter of credit may be disregarded by the bank. 5-109(b). Finally, just as in the UCP, Article 5 provides that the letter of credit is considered irrevocable unless it expressly provides that it is revocable. 5-106(a).

The drafters attempted to accommodate evolving technology by providing that a letter of credit may be issued in any form that is a record and is authenticated. 5-104. "Record" is defined as information "that is inscribed on a tangible medium, or that is stored in an electronic or other medium and is retrievable in perceivable form." 5-102(a)(14).

Revised Article 5 has clarified the law in several areas. It sets forth for the first time, for example, the independence principle as a rule of law. 5-103(d). Under this principle, the bank's obligations are completely independent of the underlying contract between buyer and seller. In other words, the bank's obligation to pay the beneficiary's draft under the letter of credit is triggered solely by the beneficiary's presentation of proper, conforming documents required by the letter of credit. The bank does not get drawn into any disputes between buyer and seller over the performance of the underlying contract, because its obligation is independent of the underlying contract.

The Revised Article also states for the first time that documents must on their face "strictly comply" with the terms and conditions of the letter of credit. 5-108(a). The strict compliance standard has been developed and applied by banks, but some courts had adopted a less stringent "substantial compliance" standard. That standard is rejected. The Official Comment notes, however, that strict compliance does not mean slavish conformity, and acknowledges that standard practice, which issuers are required to observe does not demand oppressive perfectionism.

Revised Article 5 also expressly permits deferred payment letters of credit (5-102(a)(8)), and two party letters of credit. 5-106(d). It establishes rules for successors by operation of law. Sections 5-102(a)(15), and 5-113. It also clarifies the subrogation rights of certain parties to a letter of credit transaction (5-117), establishes a one-year statute of limitations (5-115), limits the effect of general disclaimers and waivers (5-103(a)), and conforms the law to the existing practice for assignment of proceeds. 5-114.

The new rules on fraud make it more difficult to obtain an injunction, so that applicants will have less ability to stop a bank from paying under a letter of credit. 5-109. Moreover, the new language makes clear that fraud must be "material", and that it must be found either in the documents, or must have been committed by the beneficiary on the issuer or the applicant.

While many provisions contain useful clarifications, and others conform to international practice, a few provisions of Article 5 seem unsupported by any valid public policy, and may in fact be detrimental to New Jersey companies who will be using letters of credit. The following are areas of concern:

1. MANDATORY ATTORNEYS' FEES

Reasonable attorney's fees and other expenses of litigation must be awarded to the prevailing party in an action in which a remedy is sought under this article.

This provision overturns the basic American rule that each party pays its own attorneys' fees. While there are, of course, a number of fee shifting statutes which allocate this burden to the losing party, fee shifting has typically been prompted by a substantial public policy. In Civil Rights cases, for example, the purpose of permitting a prevailing plaintiff to recover attorneys' fees is to facilitate the ability of individuals to act as "private attorneys' generals". Although most civil rights plaintiffs cannot individually afford the cost of litigating such cases, fee shifting encourages lawyers to take these cases. Antitrust statutes and consumer fraud statutes also contain fee shifting provisions in order to deter a specific kind of conduct deemed detrimental to society.

In Article 5, there is no policy reason to support mandatory fee shifting. Communications among various members of the Drafting Committee and from other participants in the process indicated that the adoption of this provision was a trade-off for not imposing consequential damages on banks. Federal Reserve representatives had stated that consequential damages would present a regulatory problem, because they created an unquantified exposure. They thus proposed to the drafters this compromise, using a broader standard of good faith, and making attorneys' fees mandatory as a means of discouraging frivolous dishonor by banks.

The banks quickly endorsed mandatory attorneys' fees. While it may be true that mandatory attorneys' fees may discourage some amount of frivolous dishonor by banks, the main effect of such a provision will be on beneficiaries. The threat of having to pay a banks' attorneys' fees will severely chill a beneficiary's desire to sue a bank for wrongful dishonor of a letter of credit. The result, sought by the banks, will be a reduction of litigation brought by beneficiaries against banks, even where such litigation might succeed.

There is no policy reason for placing this burden on the beneficiary of a letter of credit gone awry. Beneficiaries who bring wrongful dishonor suits are usually small and mid-sized companies. They do not bring such suits frivolously. When a beneficiary sues a bank for wrongful dishonor, it is because what he thought was a secure payment mechanism has failed completely, and the buyer is probably insolvent.

The great irony underlying letters of credit is that they work well most of the time, except in those very situations which they are supposed to protect against. Most wrongful dishonor suits occur when the buyer-applicant has become insolvent, and the bank, afraid of not being reimbursed by the applicant, which is its customer, reviews the letter of credit for discrepancies with a fine tooth comb. In most cases a bank can find such discrepancies, since, according to various estimates, there are discrepancies in 50 percent to 90 percent of documentary presentations. The bank can thus refuse to pay on the basis of any one of a myriad of possible discrepancies, and a litigation frequently ensues.

In a large percentage of wrongful dishonor cases, beneficiaries lose, because the rules governing letters of credit are very strict, and protect banks quite effectively.

While beneficiaries have an uphill battle against a bank in a wrongful dishonor case, they do win a fair number of cases where the banks have not followed standard practice. In many instances, it is hard to predict just where a court will come out on a particular issue, and there is a fair amount of inconsistency in judicial decisions. There is no reason, however, to punish a company that, in good faith, brings a wrongful dishonor suit by requiring it to pay the banks' attorneys' fees if it loses.

In the Official Comment to 5-111(e) (Comment 6), there is no reference to the fact that the mandatory attorneys' fee provision was proposed as an alternative to consequential damages for discouraging frivolous dishonor by banks. Rather, the Comment points out that banks frequently protect themselves by contract with the applicant, their customer, by requiring the applicant to pay the banks attorneys' fees in any litigation over the letter of credit. It states that collecting those fees from the beneficiary protects the applicant from "undeserved losses". But a bank's desire to have its customer reimbursed for fees it has imposed upon it by contract does not rise to the level of a public policy reason for fee shifting. It certainly does not offset the deterrent effect on New Jersey companies who may have a valid reason for suing a bank, but who cannot afford the risk of assuming the banks' attorneys' fees.

A more balanced approach would make the award of attorneys' fees discretionary with the judge. This scheme would serve the purpose of discouraging frivolous dishonor, without punishing beneficiaries. The judge could impose attorneys' fees on a bank which frivolously dishonors, but would have discretion not to impose them on a plaintiff which brought a reasonable, though ultimately unsuccessful action. The judge would also maintain discretion not to impose fees on a bank in cases where such a penalty was not warranted. Maintaining such discretion would provide a fair resolution.

2. SEVENTH AMENDMENT AND STATE CONSTITUTIONAL RIGHT TO A JURY TRIAL

An issuer shall observe standard practice of financial institutions that regularly issue letters of credit. Determination of the issuer's observance of the standard practice is a matter of interpretation for the court. The court shall offer the parties a reasonable opportunity to present evidence of the standard practice.

It is clear that a letter of credit plaintiff is entitled to a jury trial, and it is clear with respect to 5-108(e) that either the Seventh Amendment or state constitutional right to a jury trial is implicated.

Seventh Amendment

The Seventh Amendment provides for a jury trial "in suits at common law". A jury trial is required on an action that would have been brought in an English law court as opposed to "cases tried in courts of equity or admiralty" which did not traditionally encompass a jury right. Reiner, supra, at 532, citing Tull v. U.S., 481 U.S. 412, 107 S.Ct 1831, 95 L.Ed. 2d 365 (1987). The Supreme Court has interpreted "common law" to mean suits in which legal rights were to be ascertained and determined. Parsons v. Bedford, 3 Pet. 433, 446-447, 7 L. Ed. 732 (1830). It thus applies with equal force to statutory rights, and requires a jury trial upon demand, if the statute creates legal rights and remedies, enforceable in an action for damages in the ordinary courts of law. Curtis v. Loether, 415 U.S. 189, 94 S.Ct 1005, 39 L. Ed. 2d 260 (1973). Since letter of credit law grows out of the law merchant, and since it is clearly legal rather than equitable in nature, it is not disputed that there is a jury trial right in a letter of credit case.

New Jersey Constitution

Given that there is an inviolable right to a jury trial in state or federal court, it is important to examine carefully legislation which appears to violate that right. The Official Comment to 5-108(e), paragraph 5 of Comment 1, provides in pertinent part:

Identifying and determining compliance with standard practice are matters of interpretation for the court, not for the jury. As with similar rules in Sections 4A-202(c) and 2-302, it is hoped that there will be more consistency in the outcomes and speedier resolution of disputes if the responsibility for determining the nature and scope of standard practice is granted to the court, not to a jury. Granting the court authority to make these decisions will also encourage the salutary practice of courts' granting summary judgment in circumstances where there are no significant factual disputes.

The reference to 4A-202(c) for support is surprising, to say the least. The Official Comment (which is combined with the Comment for 4A-203, and is found following 4A-203), supports having a jury, rather than a judge, determine whether a bank's conduct meets a given standard. Subsection 4A-202(c) deals with the commercial reasonableness of a security procedure. The Official Comment (paragraph 2 of Comment 4) states in pertinent part:

The issue of whether a particular security procedure is commercially reasonable is a question of law. Whether the receiving bank complied with the procedure is a question of fact.

By declaring in 5-108(e) that the issue of the bank's compliance with standard of practice is a matter for the court, Revised Article 5 oversteps the bounds of constitutionally permitted legislation, since it effectively denies a plaintiff the right to a jury trial.

It is quite understandable that the financial community wants to have consistency of interpretation among different countries of the world, and that it believes this goal will be achieved more quickly if judges, rather than juries, make most decisions in letter-of-credit cases. But the goal of consistency will never be entirely accomplished regardless of what is done in Revised Article 5, and the goal, worthy as it may be, should not be permitted to impinge upon constitutional rights.

3. GOOD FAITH

While the Official Comment claims that the narrower definition, which does not include "fair dealing", is necessary to reinforce the independence principle and the preclusion doctrine, protect against fraud and encourage strict compliance, it does not explain why the following language, which the Drafting Committee rejected, does not in fact fully satisfy those concerns, and permit the broader definition to be used otherwise in Article 5, as it is in other UCC Articles. The rejected language provided as follows:

Good faith means honesty in fact and the observance of reasonable commercial standards of fair dealing in the letter of credit transaction. An issuer or confirmer acts in good faith if its honor or dishonor of a presentation is based solely on its determination as to whether or not the presentation appears on its face strictly to comply with the terms and conditions of the letter of credit as provided in Section 5-108(a), even though honor or dishonor is made with knowledge of a claim of fraud or forgery made by another person.

In his cogent and thoughtful article, Rapson cited a Memorandum to the ALI Council from the Chairman of the Drafting Committee, in which the Chairman stated that "some in the Drafting Committee believe strongly that fair dealing is an indefinite and mischievous concept and even question its usefulness in other UCC Articles." (Id., pp.4-5). Rapson persuasively argues that this position of some of the Drafting Committee is fundamentally antithetical to the rationale of the Restatement of Contracts 2d, which makes clear that "fair dealing" provides a needed safeguard and deterrent against irrational or capricious conduct. He also points out that the broader standard (with provision made for distinctive letter of credit elements), is needed to promote consistency with the general law of contracts and other provisions of the UCC, which may come into play in any particular transaction, and to which different definitions of good faith would have to be applied.

While the goal of uniform laws is that they be adopted uniformly, it is not in the public interest to adopt provisions which are not supported by public policy, are unconstitutional, or are inconsistent with other provisions of the UCC. With respect to Revised Article 5, the New Jersey legislature should review such provisions critically, and modify them to serve the public interest and the citizens of New Jersey.