The rapidly spreading conflict in the Middle East has already impacted oil prices with Brent Crude trading today close to USD 100 a barrel. With no sign that the conflict will have a rapid conclusion we seem to be headed for a period of increased price volatility.

With passage through the Strait of Hormuz effectively blocked, the impact will be felt across the market as traders seek new supplies away from the conflict area to fill the void.

A sign of how seriously traders are taking the risk of commodity volatility can be seen in Trafigura’s arrangement of a USD 3 billion “liquidity buffer” alongside the closing of its USD 5.8 billion European facility renewal.

Substantial volumes of oil being traded on secure payment terms involving documentary credits, ensuring that payment arrangements are future proofed for spikes in pricing, is a necessity in an unstable geopolitical climate.

While contractual pricing between buyers and sellers is typically linked to established industry indices which fix the price when oil is shipped on board (and parties typically take out hedging arrangements to mitigate price volatility), documentary credits will state a maximum drawing value which will have been calculated to allow for expected market price fluctuations when the documentary credit was issued (often before geopolitical upheaval was foreseen). That maximum sum will in turn be reflected in the reimbursement arrangements entered into by the applicant for the credit and the issuing bank. Applicants (buyers) generally do not want to underwrite maximum credit sums that have no immediate bearing on the expected market price as a bank will usually block a customer’s credit line with the maximum amount of a potential drawing.

One potential solution to this dilemma – as we have seen in previous periods of volatility – could be to insert a credit escalation clause in a documentary letter of credit. This is a topic that was much in focus during the oil price volatility of 2012 when geopolitical instability surrounding Iranian interference in the Strait of Hormuz as well as conflict in Yemen, Libya and Sudan caused prices to fly above what had become a stable USD 100 per barrel up to around USD 125 per barrel for a period of time.

How does a credit escalation clause work?

A properly drafted credit escalation clause will allow the credit to reflect those market fluctuations, allowing the beneficiary to draw down either a larger or smaller amount as the case may be. However, as always, drafting is key. Poor drafting can cause problems for all parties. Wording found in an oil documentary credit might, for example, read:

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

However, wording like this can exacerbate the price volatility issue because any provision in a credit which requires the bank to check an external pricing index or consider a provision of the underlying contract is likely to be held to be invalid. The bank checking the presentation under a credit must be able to verify data from the documents presented or from the credit itself but never an external source.

Is the credit escalation clause consistent with the other provisions of the credit?

While a credit price escalation provision appears to be the perfect solution to the problem of a fluctuating price, there is an additional legal issue that needs to be considered – namely whether the maximum value stated in the LC is in fact overridden by the presence in the credit of a credit escalation clause. A bank will not want to be in the position of signing a blank cheque unless they are certain of their customer’s ability to reimburse them.

If at crystallisation of the price on shipment (generally on issuance of the bill of lading), the price exceeds the maximum value stated in the credit, does the credit escalation clause remove the credit maximum value and turn the credit into a blank cheque? Also, if a credit escalation clause is intended to operate subject to the maximum value provision in a credit how can this be aligned 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 hyper inflate the specified maximum credit value?

The presence of both provisions (maximum credit value and credit escalation) give rise to conflicting outcomes. So how would a court or tribunal deal with this? To our knowledge there are no reported English law cases. However, in the Singapore High Court decision of Korea Exchange Bank v Standard Chartered Bank[i] the court held that the credit escalation clause did in fact operate to override the maximum value of the credit. So, what should the banks and buyers do to clarify their position ensuring that these clauses are interpreted correctly by tribunals and courts?

Under English Law, the court’s starting point for interpreting contractual provisions is that parties have a broad freedom to contract how they wish, i.e., commercial parties that are acting at arm’s length are in principle free to contract on whatever terms they want. Provided that the terms are sufficiently clear as to what they are, then the court will be slow to interfere. If there is uncertainty as to the meaning of the contract term then evidence of the parties’ intentions and of market practice could be put before the court.

The Uniform Customs and Practice on Documentary Credits (UCP 600) are incorporated into all documentary credits globally. UCP 600 (Article 14(a)) requires that the terms of a credit must be capable of interpretation by the bank examining the documents presented under the credit on their face with no external source of information to be available to a tribunal or court when examining conflicting provisions. The terms of the credit must be capable of being understood, read, and carried through by the examining bank when considering their plain meaning, having only examined the wording in the credit and the documents presented. When there are two conflicting provisions, where possible, the court will seek to give meaning to both provisions.

Parties to a contract where payment is agreed to be made by documentary credit therefore need to consider the possible effect of the credit escalation clause on the overall operation of the credit, and to the meaning of the credit. Failure to do so could lead to banks or buyers in the  position of having little or no control over how much the beneficiary can draw on the credit, or beneficiaries are unable to draw down the full sum due under the contract. Furthermore, uncertainty in the drafting of the clauses opens the opportunity for abuse – for example, beneficiaries attempting to draw down a larger sum under the credit despite the lack of actual price movement. What practices can the banks and buyers use to mitigate these risks?

Best Practice:

• Exercising extreme care when drafting the clauses to ensure that the credit escalation clauses work effectively. As mentioned above, the terms of a credit must be read and understood in isolation, without the need of the bank document checker designated to inspect the documents presented being required to refer to any documents not presented under the credit itself. While it is possible that some overseas courts may allow for the submission of additional information, such as a commonly used price index in current use in the market, the safer assumption is that an English court would not permit it. The badly drafted clause described above refers to the contractual price clause. However, if the full price clause from the underlying contract is not reproduced either in the text of the credit or in a document actually presented under the credit then it might be claimed that the clause is asking the document checker to look at the underlying contract rather than with the credit or presented documents. Under English Law (and the UCP 600) this could render the clause unenforceable – credits should never cross-refer to the underlying contract. Best practice would be to ensure that the credit stands alone by either incorporating the full price clause from the commercial contract or matching the escalated value of the credit to the one stated in the commercial invoice. However, there is also an obvious element of risk in the latter approach as it leaves the credit open to abuse by the beneficiary.
• An alternative approach would be to insert a provision that requires the price escalation clause to operate subject to the provision of a beneficiary statement as to the price on the relevant pricing index. Some credits may allow for the beneficiary to simply state and certify the accuracy of the price index in the commercial invoice. This 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 the applicant can easily verify against the relevant independent price index) the applicant may be able to challenge the statement as a fraud.
• If an issuing bank or buyer wants a “fluctuation clause” to be limited to a range in the percentage credit amount of tolerance, the credit could use express words to that effect such as: “the amount of this credit shall automatically fluctuate to cover any increase/decrease but not exceed 10% more or less than the credit amount, according to the price clause without further amendment to this credit”.

Parties to documentary credits generally want the payment mechanism to work but in times of price volatility it is crucial that applicants, issuing banks and beneficiaries pay close attention to any limitation that may exist under their oil and product letters of credit that might frustrate the payment flow.

This Client Alert is not intended as legal advice. If you would like to discuss any of the issues we describe above, please contact us.

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