Credit Escalation Clauses in Letters of Credit

by Reed Smith

It is increasingly common to have a ‘credit escalation clause’ in a documentary letter of credit (“LC”) relating to the sale and purchase of crude oil and petroleum products. This alert, which follows alert 13-215 Letters of Credit and Commodities Contracts – Best Practices Revisited/Optional Confirmation of 9 August 2013, will consider the effect of such clauses on the value and operation of the credit and outline some suggested best practices for buyers and banks.

What is a credit escalation clause?

A credit escalation clause is, as the name suggests, intended to deal with a specific problem that can occur in relation to crude oil and petroleum products where the contract price will be based on a formula comprising a daily price quoted on a recognized trade index such as Platts plus a margin – so the price payable can rise or fall, whereas the LC will state a maximum value. If the fluctuating price were to exceed the stated maximum value of the LC then without a credit escalation clause, the beneficiary could find itself unable to recover the full sale price. Properly drafted, the credit escalation clause within the LC will allow a beneficiary to draw down either a smaller or larger amount to reflect those market fluctuations. However, poor drafting can potentially cause problems for all the parties. For example wording often found in an oil LC might read:

“The amount of this LC shall automatically fluctuate to cover any increase/decrease according to the contractual price clause without further amendment to this credit.”

Credit escalation clauses are generally found in LCs with a short tenor, where the bank issuing the LC can take a reasonably confident short term view as to price movement risk and therefore price the LC (and ensure it is covered by the applicant) accordingly. This means that, in relation to a LC with an expiry date three to four months after issue, absent a significant market changing event, the issuing bank might consider it unlikely for the price to move such that the amount claimed via the credit escalation clause, proved to be in the order of 10, 20 or 30 times the face value of the LC though the price might well exceed the usual 10% tolerance that might typically be included in the LC terms.

However, as we explain below, clauses such as the above in a LC which appear to require the bank inspecting a presentation of documents to check an external pricing index or interpret a formula in a contractual document the bank has never seen, are at risk of being held invalid. We make some suggestions below as to how these might be improved.

Is a credit escalation clause inconsistent with other provisions of the LC?

One issue on which we have been asked to advise recently is whether the maximum value stated in the LC (usually in Field 47A) is superseded by a credit escalation clause. In other words, if the price, when crystallised (typically on the day of shipment), exceeds the maximum stated value in the LC, does the credit escalation clause oust the maximum value and turn the LC, effectively, into what could (from a buyers’ perspective) be a blank cheque? Alternatively, will a seller find himself unable to draw sufficient funds on the LC due to the maximum value provision, notwithstanding the presence of a credit escalation clause? By a similar token, if a credit escalation clause is intended to operate subject to the maximum value provision in a LC, how can this be reconciled with a quantity tolerance provision permitting a seller to deliver +/- 10% of the contract value of goods which, if subject to market price increases, may also operate to ‘blow the top’ of the specified maximum credit value1?

It is fair to say that the two provisions (maximum value and credit escalation) are potentially conflicting. So how would this apparent conflict be dealt with by a court or tribunal?

While there are to our knowledge no reported English law cases on point, the various Singapore cases and Docdex decisions relating to this issue tend to suggest that the credit escalation clause may operate to override the maximum value of the LC - which may be good news for sellers, but a potentially worrying development for buyers and banks. So what can banks and buyers do to clarify the position and ensure that these clauses are interpreted correctly by a court or tribunal?

As a matter of English law the starting position for interpreting contractual provisions is that parties have freedom of contract, i.e. that sophisticated commercial parties acting at arm’s length are free to contract on whatever terms they wish, provided it is sufficiently clear as to what those terms are. If a contract term is not clear on its face then a court or tribunal may, ordinarily, entertain evidence of intent and market practice as to what the parties might objectively be said to have intended.

However, since under Article 14(a) of UCP 600 the terms of a LC must be capable of being interpreted by the examining bank on their face, no such external aid to interpretation would be available to a court or tribunal in examining and interpreting these apparently conflicting provisions. Rather, the terms of the LC must be capable of being read and understood and carried through by the examining bank by considering their plain meaning, having examined only the LC and the documents presented. Where possible, a court or tribunal will seek to give meaning to two potentially conflicting provisions - for instance in a previous Singaporean case the Singaporean courts have given effect to both a credit escalation clause and a tolerance clause within the same LC.

Thought will therefore need to be given to the possible effect of the credit escalation clause on the operation of the LC as a whole, and care must be taken to make the meaning of the LC clear, so as to preclude banks or buyers finding themselves in the unsatisfactory position of having less or no control over how much money the seller can draw on the LC, or sellers finding themselves unable to draw down the full contract value at the relevant time.

Furthermore, there is very real cause for concern that without sufficient certainty in the drafting of the relevant provisions, credit escalation clauses may be open to purported abuse – for example by sellers attempting to draw down a larger sum under the LC despite the fact that no actual market movement has occurred. How then can banks and buyers protect themselves in this situation?

Best practice pointers

  • Care should be taken at the drafting stage to ensure that the credit escalation clause works. As stated above, the terms of a LC must be capable of being read and understood on their plain meaning and without the bank officer tasked with inspecting the presentation of documents being required to refer to anything other than the LC itself or a document called for under the LC. While decisions in some overseas courts might suggest that a bank can take notice of extraneous information (such as a well known published price index) the safer assumption is that an English court would not permit it. The sample escalation clause set down above refers to a contractual price clause – however if the full price clause from the underlying contract is not faithfully reproduced in the LC or a document presented under the LC (and the LC does not point the examining banker to that wording/document to see the evidence of the increased price) then an argument could be raised that the clause requires the examining bank to look to the underlying contract rather than within the LC or presented documents. If this were the case, the clause may well prove to be unenforceable. We would suggest therefore exercising caution to ensure that the LC stands alone either by incorporating the full price clause from the contract, or by matching the escalated value of the LC to that stated in the commercial invoice.
  • We would also recommend inserting a complimentary provision to ensure that the price escalation clause operates subject to the provision of a beneficiary’s declaration as to the price on the relevant index (eg Platts). In some cases the LC simply allows the beneficiary to state and certify the accuracy of the index price in the commercial invoice. The advantage of such a provision is that it avoids reference by the bank to a non-documentary source of information and at the same time means that if the beneficiary mis-states the price (which is an independently verifiable index price) the applicant will be in a position to challenge the veracity of that statement.
  • Furthermore, should a buyer or issuing bank intend that a "fluctuation clause" be limited to a range within the percentage credit amount of tolerance in field 39A, then the L/C should clearly qualify that by express words to that effect, such as, but not limited to: "The amount of this LC shall automatically fluctuate to cover any increase/decrease, but not to exceed 10% more or less of the credit amount, according to the price clause without further amendment to this credit", or similar.
  • Credit escalation clauses should be distinguished from credit tolerance clauses, which are often intended to respond to a movement in the volume of product shipped and to be paid for (usually mirroring the amount of tolerance in volume specified in the underlying sale contract). Care should be taken when drafting the relevant terms of a LC to ensure that the clauses interact adequately with each other and with the applicable tolerance/price escalation provisions in the underlying sale and purchase contract, to avoid disputes arising.

1. In this regard see Singapore decision Suit No.162 of 2004 (REGISTRAR'S APPEAL No. 307 of 2004) [Singapore] which while not binding is indicative. In that case it was held that these clauses should be construed together, and that the credit escalation clause and tolerance clause would operate together such that the maximum stated value of the credit would be exceeded.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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