Skip to content

Anchored in certainty – the importance of governing law clauses in letters of credit for beneficiaries

Briefing
23 January 2025
7 MIN READ
2 AUTHORS

As anyone involved in global trade will know, letters of credit (LCs) are often referred to as the “lifeblood of international commerce”. These vital trade instruments provide the trust and confidence to parties to conduct business across borders by moving the credit risk posed to them from dealing with a potentially unknown counterparty to a (reputable) financial institution.

In recent years, the international commodity supply chain has faced unprecedented stress and turmoil, arising from global events such as the COVID-19 pandemic and the conflicts taking place in the Middle East and Europe. Against this background, and a rising tide of commercial defaults and opportunistic fraudsters, industry participants have even greater reason to rely on the certainty and predictability that LCs provide.

This article considers the crucial role of governing law clauses in LCs, including the best choices for beneficiaries and the risks involved if an issuing bank refuses to include such a clause.

Why do I need a governing law clause in my LC?

A governing law clause identifies the legal framework pursuant to which the terms of the LC shall be interpreted and enforced.

Whilst the underlying contract to an LC will often provide for a governing law, LCs are subject to the autonomy principle, meaning they are independent from the underlying transaction for which they have been issued. That autonomy is what gives LCs their value, as it ensures that payment will be made if the terms of the LC are met, regardless of any underlying commercial dispute. However, it cuts both ways and also means that the courts will not rely on the governing law clause in the underlying transaction documents in the absence of such a clause in the corresponding LC.

If an LC does not specify a governing law, determining the applicable law could involve a protracted and complicated legal analysis of the conflict of laws position. This creates uncertainty and can lead to disputes and delays in payment. In some jurisdictions, such as the People’s Republic of China, the absence of a governing law clause often means that the local courts will simply apply local law, which may be more favourable to the issuing bank. Furthermore, many jurisdictions allow for broader defences against payment under an LC, increasing the risk of non-payment for the beneficiary.

Which governing law should a beneficiary choose?

Beneficiaries should opt for governing laws with a strong track record of upholding the autonomy principle. For example, known for its pro-beneficiary stance, the only defence to payment under English law is fraud, thus ensuring that absent fraud, an issuing bank must pay if the terms of the LC are otherwise met. Furthermore, English law provides a clear and predictable legal framework and its widespread use, with English courts generally well versed in dealing with commercial matters, make it a popular choice in international trade.

The laws of Singapore are also considered to be favourable to beneficiaries. However, whilst recognising the autonomy principle, Singapore’s legal framework allows for a slightly broader set of circumstances, including both fraud and unconscionability, under which an LC can be deemed unenforceable.

What if the issuing bank won’t agree to a governing law clause? Are there any mitigating steps a beneficiary can take?

Many beneficiaries face the commercial reality that issuing banks often insist on using their own standard template LC, which may well not include a governing law clause.

If an issuing bank refuses to include a governing law clause, the LC becomes subject to greater legal uncertainties. It creates the aforementioned risk that an unfavourable choice of law will be applied, which could result in issues with enforcement.

Whilst beneficiaries may seek to rely on the Uniform Customs and Practice for Documentary Credits (UCP 600) and its standardised rules for LCs for comfort, this offers a contractual framework for an LC but makes no reference to applicable law.

Including a confirming bank can mitigate some risks, particularly the credit risk of the issuing bank. However, it does not eliminate legal risks. If the LC itself is unenforceable, the confirming bank may also refuse to pay.

In such circumstances, beneficiaries should aim to negotiate a separate letter of confirmation with the confirming bank at the time the LC is confirmed, outside of the original LC framework and subject to a beneficiary-friendly governing law.

What other steps can a beneficiary take to protect its position?

To minimise the risk of the issuing bank refusing to pay, beneficiaries should ensure that all documents are clear, precise and strictly comply with the terms of the LC.

It is also prudent to choose a place of presentation that is convenient and reliable. This can help avoid delays and ensure that documents are presented within the required timeframe. Beneficiaries transacting in emerging markets should exercise particular caution in this regard.

Conclusion

The governing law clause is an essential component of a LC, should a beneficiary wish to ensure legal certainty and enforceability. Where commercial negotiations allow, beneficiaries should choose jurisdictions with pro-beneficiary laws.  They should also do everything possible to ensure the compliant presentation of documents, to avoid the risk of rejection by an issuing bank. If an issuing bank refuses to include a governing law clause, the beneficiary will be exposed to significant legal risks and while UCP 600 and the use of a confirming bank provide some protection, they are not substitutes for a clear governing law clause.

Research conducted by Zoe Fahmy, Trainee Solicitor.

Main Bulletin
Commodities bulletin, January 2025