The letter of credit is the most commonly used method of payment for goods in international trade. This thesis highlights the imbalance of the rights and duties of the parties in a letter of credit transaction by emphasising deficiencies in the letters of credit system. In addition, on those areas where there is lack of justice and equity and which make the system of the letters of credit vulnerable for fraudulent activities. After briefly discussing the structure of the letter of credit system, it discusses the rights and duties of parties to such transactions and how the risk of the innocent buyer has increased under UCP and very often the buyer is paying for the goods he had not contracted for. It further discusses the independence principle and the doctrine of documentary compliance, that overprotection of the “independence principle”, and the lack of “reasonable care” on the part of banks provide opportunities of fraud to the sellers to obtain payment without actually performing their duties to banks and buyers. It will also argues about the “fraud exception” to the independence principle, particularly the position of the fraud exception in England and the history of some decisions of English Courts. In the end it gives some suggestions to balance the rights and duties amongst parties in a letter of credit transaction.
Structure of a Letter of Credit Transaction
Commercial letters of credit have been used for the centuries as a most common method of payment, in international trade. Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits (UCP).
A commercial letter of credit is a contractual agreement between a bank (issuing bank), on behalf of one of its customers (buyer), authorizing another bank (advising or confirming bank), to make payment to the beneficiary (seller). The issuing bank, on the application of its customer (buyer), opens the letter of credit, and makes a commitment with the buyer to honour the credit on the presentation of the documents, conforming to the terms and conditions of the credit, by the beneficiary. Thus, the issuing bank replaces the bank’s customer as the payee.
Elements of a Letter of Credit
- A payment undertaking given by a bank (issuing bank)
- On behalf of a buyer (applicant)
- To pay a seller (beneficiary) for a given amount of money
- On presentation of specified documents representing the supply of goods
- Within specified time limits
- Documents must conform to terms and conditions set out in the letter of credit
- Documents to be presented at a specified place
Beneficiary Beneficiary is normally the provider of the goods or services and is entitled to payment as long as he can provide the conforming documents required by the letter of credit. The letter of credit is a distinct and separate transaction from the underlying contract (contract between seller and buyer). All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the buyer and seller. The issuing bank’s obligation to the buyer-applicant is to examine all documents to insure that they are in compliance with the terms and conditions of the credit. To get the payment it is for the beneficiary to provide all the required documents. If the seller-beneficiary conforms to the letter of credit, the seller must be paid by the bank.
The issuing bank’s duty to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is entitled to have a reasonable time after receipt of the documents to honour the draft. The issuing bank’s duty is to provide a guarantee to the seller that if complying documents are presented by the seller, then the bank will make the payment to the seller, and will only pay if these documents comply with the terms and conditions set out in the letter of credit. Typically the documents requested include a commercial invoice, bill of lading or airway bill and an insurance document; but there are many others. Letters of credit only concerns with the documents, not with the goods.
An advising bank is usually a foreign correspondent bank of the issuing bank which advises the seller-beneficiary. Generally, the beneficiary wants to use a local bank to insure that the letter of credit is valid. In addition, the advising bank is responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. Therefore, if the issuing bank does not pay the beneficiary, the advising bank is not obligated to pay.
At the request of the issuing bank, the correspondent bank may confirm the letter of credit for the seller-beneficiary and obligates itself to insure payment under the letter of credit. The confirming bank is usually the advising bank.
There are two main types of Letters of credit:
Revocable Letter of Credit
Revocable letter of credit is not a commonly used type of the letters of credit. This type of letter of credit can be revoked by the issuing bank at any time, without notification to the beneficiary, for any reason. Such type of letter of credit can not be confirmed by the correspondent bank and the bank will act as an advising bank only.
A revocable letter of credit can not be revoked after the presentation of the documents, if the documents are conforming to the terms and conditions of the letter of credit and the payment has been made.
Irrevocable Letter of Credit
Use of irrevocable letters of credit is very common in international trade. Irrevocable letter of credit can not be revoked or changed without the consent of the beneficiary. Issuing bank will make the payment to the seller, if the seller presents the documents complying with the terms of the credit, as agreed between seller and buyer. Such a letter of credit can only be changed with the permission of both buyer and seller. If it is not clear from the letter of credit that whether it is revocable or irrevocable, it automatically considers as irrevocable.
Irrevocable letters of credit are of two kinds:
In case of unconfirmed letter of credit, advising bank does not confirm the credit to the seller and the issuing bank is the only party responsible for payment to the beneficiary. Advising bank will only pay to the seller after getting payment from the issuing bank and there is no risk for the advising bank.
In this type of credit, advising bank confirms credit to the seller. When the advising bank confirms that the documents presented are conforming to the terms of the credit, it will make the payment to the seller, and after that advising bank will contact with the issuing bank to get the payment. This type of letter of credit is commonly used, when the seller is unfamiliar with the issuing bank. Such a type of letter of credit is quite expensive because the banks have some liability.
In international trade as the buyer and seller are in different countries so when the buyer and the seller of the goods agree to conduct business, than because of the gap of time between delivery of goods and the payment, usually the seller wants a letter of credit as a guarantee of payment from the buyer. Than the buyer makes a request to his bank called the issuing to open a credit in the favour of the seller. at the request of the buyer, issuing bank issues a letter of credit in favour of the seller and forwards it to the corresponding bank called the advising or conforming bank., which is usually located in the seller’s country. Advising bank than either confirms the credit or not, depending upon the type of credit, and forward it to the seller. Seller than ships the goods and collects the documents required in order to meet the requirements of the letter of credit and finally to get the payment in time. Seller presents the required documents to the advising or confirming bank in order to get the payment in time. Advising or confirming bank examines the documents presented by the seller to check that whether they are conforming to the terms and conditions of the letter of credit. If the documents are in compliance, advising or confirming bank, in case of confirmed letter of credit, will make payment to the seller and will be reimbursed from the issuing bank and in case of unconfirmed letter of credit, advising or confirming bank will forward the documents to the issuing bank. Than the Issuing bank will, after examine of the documents, debit the buyer’s account if the documents are in compliance to the terms of the letter of credit. In the end, Issuing bank forwards the documents to the buyer.
Most commonly used documents in a letter of credit transaction include:
It includes a description of merchandise, price, FOB origin, and name and address of buyer and seller. The buyer and seller information must correspond exactly to the description in the letter of credit.
Bill of Lading
It is a document which shows the receipt of goods for shipment by a freight carrier. It is an evidence of the control of the goods and also acts as an evidence of the carrier’s obligation to transport the goods to their proper destination.
Warranty of Title
A warranty given by a seller to a buyer of goods that states that the title being conveyed is good. It is generally issued to the purchaser.
Letter of Indemnity
It is a letter specifically indemnifies the purchaser against a certain stated circumstance. Indemnification is generally used to guarantee that shipping documents will be provided in good order when available.
Common Defects in the documents presented
A discrepancy is some defect in the documents presented by the seller, which show their non-compliance with the terms of the letter of credit. Issuing bank can not change the terms and conditions of the letter of credit with out t he permission of the buyer. Therefore to avoid any delay in getting payment. Beneficiary should be careful in preparing the required documents. Common defects in the documents presented by the seller include:
- If the description of the goods is not consistent.
- There is some error in the insurance documents.
- If the draft amount is not equal to invoice amount.
- Loading and destination ports are not same as provided by the letter of credit.
- Merchandise description is not same as in the credit.
- If any of the documents required by the credit is not presented.
- Documents are generally inconsistent such as quality, etc.
- If the names of the documents required are not correct, as mentioned in the credit.
- Invoice is not signed as provided in the letter of credit.
- If prior to the presentation of the draft, Letter of Credit has expired.
- If the date mention in the bill of lading is different from the date stated in the credit.
- If there are some changes in the invoice which are not authorized by the letter of credit.
In international sales, as the seller and the buyer are in different countries, there is a common problem of payment due to the difference of time between dispatch and delivery. Obviously, seller would like to receive payment for the goods when delivering them to the carrier and the buyer would prefer to delay the payment of the price until receipt of the goods. Therefore, a letter of credit solves this problem between the seller and the buyer.
Generally, there are three separate transactions in a letter of credit transaction. The first is between a seller and a buyer, called an underlying transaction, by which the seller provides contracted goods to the buyer. The second transaction is between the buyer-applicant and the bank (issuer of the letter of credit), in which the bank issues a letter of credit to the seller-beneficiary. Finally, the letter of credit itself creates a relationship between the issuer and the beneficiary, in which, the issuer makes payment for goods upon the beneficiary’s presentation of the required documents, in accordance with the terms and conditions of the letter of credit as agreed between seller and buyer. The bank’s performance of payment is conditional on the delivery of conforming documents by the beneficiary. The banks are called issuers and are usually the applicant’s bank. Normally the issuing bank opens a letter of credit in its own name and requests its correspondent bank to notify the seller about the letter of credit. Sometimes, the issuing bank instructs the correspondent bank not only to notify the seller of the issuing bank’s undertaking but also to add a confirmation. In this case, the credit is known as a confirmed credit and the correspondent bank as a confirming bank. The payment obligation of the issuing bank depends upon the beneficiary’s presentation of complying documents to the confirming bank or to any other nominated bank, in accordance with the terms and conditions of the credit. Under general practice, presenting “complying documents” means that they comply with the conditions of the credit “on their face”. From banking point of view, compliance “on their face” of the presented documents is sufficient. The “independence principle” (which will be discussed later) is the fundamental principle of the letter of credit system, which prohibits banks from looking beyond facial compliance of the documents, and therefore exclude whether or not there is actual performance by the seller-beneficiary.
In fact, letters of credit system has emphasised the independence principle to such an extent that banks are ignoring the performance of the underlying contract very confidently. As a result, all the risk is on the honest buyers, who are sometime paying for goods that they had not contracted for.
Importance of the research
The primary purpose of the letter of credit system is to facilitate international trade, rather than to provide an opportunity to the banks to make profit. As the fraud is very common in these days, but UCP is not designed to prevent fraud. The number of frauds relating to the letters of credit has increased over the years. Buyers are particularly vulnerable to such practices under the letter of credit system. This situation shows that there is some ambiguity in the letter of credit system and a lack of balance between the rights and duties of the parties to a letter of credit transaction, which is being exploited very easily by fraudsters.
Division of risk under a Letter of Credit Transaction
As we have discussed above, a letter of credit transaction consists of three linked but independent contracts. The first step is that the buyer makes a contract with the seller for the sale of goods, called the underlying contract. Subsequently the buyer signs an application form requesting the bank to open a credit, which is an arrangement between the buyer and the bank. The third step is that the issuing bank informs the seller, who is the beneficiary of the letter of credit, of the credit and promises to pay against the stipulated documents provided the terms and conditions of the credit are met.
The letter of credit allocates risk between the applicant and the beneficiary. By postulating a letter of credit, the beneficiary may greatly reduce the risk of not being paid and ultimately allowing the beneficiary of the letter to reallocate the risk of non-payment for delivered goods which do not conform to the underlying sale contract. Generally, banks are reluctant to dishonour a credit, since to do so may damage the bank’s reputation as a credit issuer. The cost of honour, however, falls on the honest applicant, not the bank. “If the beneficiary has breached the underlying transaction, payment under the credit to him will occasion loss, but that loss will not be the bank’s; it will be the applicant’s.”
Increase in the applicant’s risk and decrease in the bank’s risk under UCP
UCP is the governing law of the letters of credit, therefore there should be a balance regarding the rights and duties of the parties, but UCP contains rules that reduce bank risk. There is no provision asking for judicial intervention to compensate letter of credit parties in case of bank’s negligence. The provisions in favour of banks fall into two categories. The first provides sweeping immunity from liabilities that national legal systems may impose. Example of such a disclaimer is Article 15. Under Article 15, banks assume no liability for the genuineness, falsification or legal effect of any documents and therefore the issuer is immune from the liability for paying against forged documents, which on their face appear regular. Therefore, the payment by the issuing bank does not show that the buyer has received the goods, which he had contracted for. The security, which the beneficiary is getting under the letter of credit system is not the same with the security of the buyer. The second category of pro-bank provisions contains rules that set precise boundaries on what the banks must do, which reduces uncertainty about bank responsibility and provides clear guidance to bank employees. For example, the customer cannot stipulate non-documentary conditions of payment, and time limits on examination of documents are fixed rather than open-ended. In case of any loss, the buyer, which is the applicant for a credit, can take action against the seller for breach of contract or fraud, but has no right of action against the bank for bank’s negligence in examining the documents, which can be ineffectual for several reasons, such as insolvency of either the applicant or the beneficiary. Hence the burden of risk on the applicant is more than any party in a letter of credit transaction and in most of the cases, buyers are paying for the goods
UCP and letters of credit
Originally UCP has been drafted by the Banking Commission of the ICC, which was comprised of the representatives of the banking community, which shows the dominance of the banks and banking experts. Their dominance in UCP drafting hints that in drafting UCP. ICC was acting as a private legislature. It looks that the rules contain in the UCP are much beneficial for the banks than any other party, and giving a limited chance to the judiciaries to interfere to protect customers from any careless behaviour of the banks.
The authority to interpret the UCP rests in the ICC’s Commission on Banking Technique and Practice, which can apply these interpretations to solve the problems arising in any case. Because of wide publicity and distribution of commission’s answers, their interpretation can be considered as an official interpretation of the UCP. Commission can enhance, interpreting, and sometimes amend the provisions of the UCP. The banks which deal with the letters of credit, act upon these interpretations and any amendments. As in theory, commission is only answerable to ICC members, therefore the chances of any challenge to such interpretation is very low.
Role of courts in a letter of credit transaction
In Discount Records Ltd. v. Barclay Bank Ltd., the judge was reluctant to “interfere with bankers’ irrevocable credit and not least in the sphere of international banking”. The position is same in many other cases. The apparent reason for the reluctance of the judges to interfere looks that they are afraid from the threats of the banking experts that their decisions would have an unfavourable affect on international trade. The difficulties of the courts to balance the rights and duties of all parties to a letter of credit transaction have increased.
In Mannesman Handel AG v. Kaunlaran Shipping Corporation, the Swiss bank argued that the bank was in rejecting the documents by the German company relying on the independence principle and the discrepancies appeared on the documents. The court was asked not to apply the good faith principle otherwise the court “would be calculated to undermine if not destroy the doctrine of strict compliance and to blur if not extinguish the distinction between transactions concerning goods and transactions concerning documents.” Normally the judicial decisions relating to the legal aspects of documentary credits base on either the express intentions of the parties or established business practice at the time, the parties entered in a contractual relationship. In cases where the UCP provisions are different from business practice, a court will apply the UCP if the UCP is incorporated in the contract of the parties. It shows that courts have assented to the entire documentary credit system being run by the banking industry and eventually abstaining the courts to intervene to balance the legal rights and duties amongst all the parties.
Should the UCP have the status of law?
Leading scholar Professor Ross Buckley says: “originally, the UCP was neither designed nor intended to be law. It was prepared as a set of standard terms to be incorporated by reference into letters of credit by those parties who chose to do so.” This has also been confirmed by the UCP in the preface of UCP 500, which states that the UCP is not legislation but a compilation of rules made by bankers for their own industry.
Therefore there is a dispute as to whether the UCP is a code of the law, or just customary practices, or some mutually consented regulations relating to letters of credit. However in fact, UCP is the governing law of the letters of credit.
Bank’s risk under UCP (exemption clauses)
Article 15 and 18 (b) of the UCP 500, limits the liability of the banks in a letter of credit transaction and which have almost made it a risk free transaction for the banks.
Article 15 says:
“Banks assume no liability to or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any document(s) or for the general and/or particular conditions stipulated in the document(s) or superimposed thereon, nor do they assume any liability or responsibility for the description, quantity, weight, quality, condition, packing, delivery, value or existence of the goods represented by any document(s) or for the good-faith or acts and/or omissions, solvency, performance or standing of the consignors, the carriers, the forwarders, the consignee or the insurers of the goods or any other person whomsoever.”
Article 18(b) further states:
“Banks assume no liability or responsibility should the instructions they submit not be carried out, even if they have themselves taken the initiative in the choice of such other bank(s).” The UCP 500 places the applicant-buyer in an absurdly vulnerable position through its disclaimer clauses. To some extent there is a lack of duties on the part of the bank to verify the authenticity of the documents. Hence it might not be wrong to say that albeit there is a waste increase in the use of letters of credit, does not signify that the UCP is fairly drafted.
Letters of credit and its users
It is also very important that whether all the parties to the letter of credit, particularly applicant-buyer are conscious about the presence of these exemptions, e.g. by providing a copy of these exemption clauses of the UCP or by giving a notice of these exemption clauses. It is a rule that to enforce an exemption clause, a reasonable notice should be given to the other party but in practice, buyers are assume to have the notice of the UCP and that they are familiar with the provisions of the UCP. Further, the application for the issuance of a letter of credit and the letter of credit document itself only contain a simple sentence: “Subject to UCP for Documentary Credits”, without any attachment of the provisions of the UCP or any notice of such exemption clauses. Hence it is debatable that why the courts do not look, while dealing with the cases relating to the letters of credit, that whether a reasonable notice has been given relating to the exemption clauses and do not interfere to balance the rights and duties of the parties to a letter of credit transaction?
Doctrine of strict compliance and independence principle
It is a basic rule of the letter of the credit transaction and which is widely recognised that the letters of credit are transactions independent of the underlying contracts on which they are based. According to this principle, the issuer has no concern with the underlying contracts between buyer and seller. Its concern is with documents only, rather than the goods or any type of services. Obviously there are some doubts about this principle, i.e. to what extent this principle should be applied. Which some tome may cause injustice to the applicant under certain circumstances.
Generally, letter of credit is a contract between the issuer and the seller of the goods, which is independent of the underlying contract between the seller and the buyer. The independence principle is mentioned in Article 3 and Article 4 of the UCP. Article 3 states: “Credits, by their nature, are separated transactions from the sales or other contract(s), even if any reference whatsoever to such contract(s) is included in the Credit.”
Article 4 further says:
“In credit operations all parties concerned deal with documents and not with goods, services and/or other performances to which the documents may relate.”
From the very beginning independence principle governs letter of credit transactions and very clearly states that the credits are completely separate from their underlying transactions and the issuer makes payment depending on the conformity of the documents presented according to the terms and conditions of the credit without considering the performance of the underlying contract by the beneficiary. Under this principle, bank is only under a duty to accept the conforming documents and should not get involved in the performance of the contract between seller and buyer. Further it has no concern about any debt obligations and other claims between the seller and the buyer.
May commentators accept that for the workability of the letter of credit system, the strictest observance of this principle is indispensable. In this chapter we will discuss that how the banks deal with documents and about relationship between bank and other parties in a letter of credit transaction. As Lord Justice Jenkins stated in Malas (Hamzeh) & Sons v British Imex Industries Ltd:
“It seems to me plain that the opening of a confirmed letter of credit constitutes a bargain between the banker and the vendor of the goods, which imposes upon the banker an absolute obligation to pay, irrespective of any dispute there may be between the parties on the question whether the goods are up to contract or not.…”
The issuing bank does not have any concern with the shipping of the goods or whether the goods are conforming or not whether the documents actually represent those goods which the buyer contracted for. This is because of the reason that the obligations of the banks in a letter of credit transaction are very limited.
In this situation it is also debateable that whether under a letter of credit transaction, it would be fair to say that banks are not allowed to look beyond the presenting documents, while making payments?
Status of applicant under UCP
Article 1 of the UCP explains that the UCP binds all parties to the letter of credit unless otherwise provided but it is quite as who such parties are. Therefore the status of the applicant is doubtful, even it is not clear as to whether an applicant is a party to the UCP or not, and this is also to some extent obvious due to the absence of any provision in the UCP stating about the duties owed by the issuing bank toward the applicant. However courts have indicated on occasions that the contract between the bank and the applicant is similar to a contract of agency.
Doctrine of strict compliance
(a) Duty to pay only for conforming documents
In a letter of credit transaction a bank is only bound to make payment if the beneficiary delivers the required documents. Simultaneously buyer knows that the amount will be released only if the documents are conforming according to the terms and conditions of the letter of credit. It is very much clear that the documents play a very important role in the letter of credit transaction. Their importance is so clear that without their presentation and conformity, the performance of the letter of credit transaction is impossible. Article 13(a) of the UCP provides:
“Banks must examine all documents stipulated in the Credit with reasonable care to ascertain whether or not they appear, on their face, to be in compliance with the terms and conditions of the Credit. Compliance of the stipulated documents on their face with the terms and conditions of the Credit shall be determined by international standard banking practice as reflected in these Articles. Documents which appear on their face to be inconsistent with one another will be considered as not appearing on their face to be in compliance with the terms and conditions of the Credit.”
(b) Standard of “reasonable care”
Under this heading we will discuss that whether there is a any standard of reasonable care under the UCP or not and if there is a standard, toward whom, and in case of failure to exercise such care, what would be the consequences. Sub-Article 13(a) of the UCP, provides that the bank’s duty is to examine the documents required by the applicant with “reasonable care” to ensure that such documents are complying with the terms and conditions of the letter of credit “on their face”.
To some extent, sub- Article 13(a) is ambiguous about its meaning. It is not clear that what exact standard should be exercised. UCP and even whole letter of credit system is quite about the standard of the duty of care imposed on the banks, towards whom bank should exercise such a duty of care, and what would be the consequences in case if the bank fails in exercising such a duty of care. Probably there is no answer to this question because of the fact that the rights of the applicant are not discussed under UCP.
Validity of documents
Article 15 of the UCP protects the banks by stating that “banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any documents…”.
Banks are authorised to make payment without having any concern whether the documents presented by the beneficiary actually represent goods, for which the applicant contracted for. As explained above that the letter of credit is a written undertaking by the bank to make payment only if the beneficiary presents original and genuine documents as agreed by the parties. Similarly buyer also knows very well that the amount will be paid only upon the delivery of the conforming documents according to the terms and conditions of the credit. Hence the documents play a key role in the performance of the letter of credit transaction. Conformity is the only condition for the payment of the amount. In practice, a bank very often takes security for the payment it makes under the letter of credit transaction. Such a security is provided by the documents of title f