[Home] [Databases] [WorldLII] [Search] [Feedback] New Zealand Law Commission

[Database Search] [Name Search] [Previous] [Next] [Download] [Help]

• Nature And Scope Of The Convention
• Other Relevant International Instruments
• Independence
• Non-Documentary Conditions
• Fraudulent Or Unfair Callings
• Current Situation At New Zealand Law
• Impact Of Adoption On New Zealand Parties
• Recommendation

3 United Nations Convention on Independent Guarantees and Stand-by Letters of Credit

NATURE AND SCOPE OF THE CONVENTION

23 THE UNITED NATIONS CONVENTION on Independent Guarantees and Stand-by Letters of Credit was adopted and opened for signature by the General Assembly of the United Nations by Resolution 50/48 of December 1995. It has been ratified or acceded to by five countries: Ecuador, El Salvador, Kuwait, Panama and Tunisia. In addition, both the United States and Belarus have signed the Convention. While signing indicates an intention to ratify the Convention in the future, these countries will not be bound by the Convention until they take this additional step.²⁰

24 As a matter of international law, treaties come into force and take effect according to their own terms (NZLC R45 para 19). Article 28 of the Convention provides that it enters into force on the first day of the month following one year from the date the fifth State ratified the Convention, that is, on 1 January 2000.

25 The Convention applies to those undertakings “known in international practice as an independent guarantee or as a stand-by letter of credit”, which are defined in article 2(1) as an independent commitment to pay a sum of money to a beneficiary on demand, or on presentation of specified documents. Instruments falling outside this definition will not be subject to the Convention, although article 1(2) provides an international letter of credit will be covered if it expressly states that the Convention applies. Even if the Convention applies prima facie to the undertaking, parties are free to exclude it (article 1(1)).

26 Independent guarantees and stand-by letters of credit are usually called upon when a party defaults in the performance of another obligation. However they are independent of such underlying obligations in that payment is conditional only on demand or presentation of documents, and not on establishing any default by another.

27 The main advantage to be gained from using these undertakings is the assurance of payment upon simple demand or presentation of correct documents. They provide an efficient and simple mechanism for recovering money in the event of a default. The main risk associated with the undertakings is that there may be an unfair or fraudulent demand for payment.²¹

Other relevant international instruments

28 The Uniform Rules for Demand Guarantees (URDG), completed by the International Chamber of Commerce (ICC) in 1992, apply to independent guarantees when expressly incorporated. Similarly, stand-by letters of credit can be made subject to the ICC’s Uniform Customs and Practice for Documentary Credits (UCP) when expressly incorporated.

29 UCP purport to apply to all documentary credits, including stand-by letters of credit where applicable (article 1, UCP 500). The term “stand-by” letters of credit originated in the United States and refers to credits which are called on in the event of non-performance of the underlying contract. The beneficiary (or nominee) need only produce a certificate of non-performance when calling on a stand-by letter of credit.²²

30 The need for an UNCITRAL Convention following so quickly on the heels of the URDG has been queried,²³ as arguably the URDG had not been operating for a sufficient period to gauge their effectiveness. However, in a policy statement the ICC recognised that its rules could not be fully effective until incorporated into a State’s domestic law, and that the UNCITRAL Convention “provides an important impetus to obtain this objective”.²⁴ The Convention is intended to work in tandem with rules of practice such as the UCP and URDG.²⁵

31 The influence of the URDG is evident in both the structure and content of the UNCITRAL Convention. An additional feature of the Convention is the provisional court measures in article 20, which allow a court to block payment to a beneficiary where there is a high probability of fraud or where the demand has no basis. Such measures were not provided for in the URDG, a consequence of the difference between a formal Convention involving the national legislature, and uniform rules for contracting.²⁶ Nor did the URDG deal with the transfer of a beneficiary’s right to payment or the assignment of proceeds (covered in articles 9 and 10 of the Convention respectively).

Independence

32 It is implicit from the article 2(1) definition that an undertaking incorporating the terms of the underlying transaction will not be covered by the Convention, which only applies to “independent” undertakings. Article 3 expands on this quality of independence, providing that the obligation to pay must not depend on the existence or validity of any other undertaking, nor must it be subject to any condition not appearing in the undertaking.

Non-documentary conditions

33 Conditions on payment which require more than simple production of documentation may negate the independence principle and prejudice the efficient settlement of an undertaking. Article 3(b) implicitly excludes from its operation any such “conditional” undertakings except for terms requiring presentation of documents or another such act or event within the “sphere of operations” of a guarantor/issuer. An example of such an act or event is a determination by the guarantor/issuer as to whether a required sum had been deposited in a designated account held with that guarantor/issuer.²⁷

Fraudulent or unfair callings

34 Generally, the only exception to paying on demand is in the event of fraud on the part of the beneficiary of the guarantee or letter of credit.²⁸ Such fraud, or a “lack of honest belief” on behalf of the beneficiary that he or she is entitled to claim payment, can be very difficult for the account party to prove.

35 Article 19 of the Convention broadens the grounds on which a demand on an undertaking might be considered fraudulent at common law.²⁹ It provides that a guarantor may withhold payment if it is clear that documents have been falsified, or that no payment is due on the basis asserted in the demand, or that the demand has no conceivable basis. This latter ground is expanded upon in article 19(2) as being where, for example:

• the contingency or risk against which the undertaking was designed to secure has not materialised;
• the underlying obligation has been declared invalid by a court or arbitral tribunal (unless this risk falls within the undertaking);
• the underlying obligation has been fulfilled;
• fulfilment has been prevented by the beneficiary’s wilful misconduct; or
• in the case of demand on a counter-guarantee, the beneficiary has made payment in bad faith.

36 The Convention claims to balance competing interests by permitting but not requiring the guarantor to refuse payment when confronted with fraud.³⁰ However the assertion that “[t]he Convention is sensitive to the concern of guarantors/issuers over preserving the commercial reliability of undertakings” seems unrealistic. If a bank were presented with a fraudulent demand, it is debatable how willing it would be to pay on that demand in order to preserve the integrity of a payment mechanism which is subject to abuse.

CURRENT SITUATION AT NEW ZEALAND LAW

37 An example of the application of the independence principle in New Zealand law lies in Cruickshank v Westpac Banking Corporation,³¹ in which Sinclair J would not allow a defendant to plead an alleged breach of the underlying contract as a defence to paying out on a letter of credit. He referred to authorities in both the United Kingdom and United States in concluding that the bank was neither obliged nor allowed to enter into controversies between the contracting parties regarding the primary contract.³² In this case the parties accepted that the letter of credit was governed by the UCP (1983 version). Sinclair J had cause to refer to articles of the UCP when interpreting the provisions of the letter of credit, in order to determine whether (as the defendant claimed) there was any restriction on the bank through which the letter of credit could be negotiated.³³

38 As the independence principle is generally invoked to prevent an injunction being granted against a bank paying out on an undertaking, account parties have attempted instead to seek injunctions against a beneficiary claiming payment.³⁴ However the argument that the independence principle and strict fraud exception could be modified as between the contracting parties was rejected in Fortex Group Ltd (in rec & liq) v New Zealand Meat Producers Board.³⁵ Doogue J concluded that, in the absence of reason to the contrary, he should follow cited decisions not to grant injunctive relief unless the plaintiff established a seriously arguable case that the defendant had acted fraudulently. It was not sufficient that the plaintiff had established a seriously arguable case that the defendant did not have a good claim under the underlying contract.³⁶

39 When determining whether to allow payment, a court must balance two competing policy arguments: maintaining business confidence in the guarantee or letter of credit as an effective payment mechanism, and upholding the interests of the business community in detecting fraud. Zohrab observes that the English courts have leant in favour of the former, and that New Zealand courts are now likely to follow a similar approach in light of the decision in Fortex.³⁷

IMPACT OF ADOPTION ON NEW ZEALAND PARTIES

40 If adopted by New Zealand, this Convention would automatically apply where the place of business of the guarantor/issuer at which the undertaking was issued was in a Contracting State, or if the rules of private international law led to the application of the law of a Contracting State.³⁸ As already noted, however, parties could avoid the Convention by expressly excluding it in the undertaking. As the Convention only applies to international undertakings, domestic transactions involving these guarantees and letters of credit would not be affected.

RECOMMENDATION

41 The Commission’s view is that there is no reason to accede to this Convention on Independent Guarantees and Stand-by Letters of Credit at this time. The first consideration in support of this view is that the United States is the only one of New Zealand’s major trading partners to have signed the text, and has yet to bind itself by ratification. Secondly, parties are free to subject their undertakings to the Convention’s provisions, simply by expressly incorporating the Convention into the text of the guarantee or letter of credit. This has been the practice with the other international guidelines such as the UCP which have been expressly incorporated, and indeed have been applied by the courts, without any recognition in New Zealand’s domestic law. Thirdly, because the Convention largely codifies the basic legal principles recognised internationally as applicable to guarantees and letters of credit, New Zealand parties need not formally adopt the Convention to benefit from its provisions. The decisions of the High Court in both Cruickshank v Westpac Banking Corporation and Fortex Group Ltd (in rec & liq) v New Zealand Meat Producers Board support this final reason against the adoption of the Convention as part of New Zealand domestic law.