Essential Principles of Letter of Credit

The letter of credit is a specified documentation particularly required to enjoy the facility of credit for an international business transaction. These documents are tendered by the seller to the advising bank. These documents must agree strictly in accordance with the fundamental principle of strict compliance of the terms of the transaction. If the doctrine of strict compliance is fully observed then no issue arises. According the provisions of the UCP 600, the banks are only obliged to make payments on LCs if the documents presented completely comply with the terms and conditions of the credit [1] . If the strict compliance standard is not observed in the credit documents strictly, the banks need not to pay to the beneficiary on these ‘afflicted’ documents (UCP 600).

4.1.2. Affliction of Discrepancies in Documentation

Analysis show that British exporters receive 48 % letters of credit which are rejected by being either faulty or erratic [2] (70% as a whole in the world) [3]. This is the basic reason of failure of the payment in international trade and principal reason of rejection of tendered documentation when presented in ratio of one-half to two-third in these business transactions [4].

The suppliers expecting to receive their payment under a letter of credit may sadly face disappointment. Although, the letter of credit is believed one of the most secure and well established method of a prompt payment. But, the exporter, practically, can never control the process. The documentation is mainly prepared by other people, which does not meet the standards of the strict compliance as required. Sometimes, in some cases, bank has applied the principal, very narrowly, to deny the payment. The banks have been frequently upheld by the courts, in majority of the cases, on the issue of strict compliance, on the grounds that the exporter has not reached the required standard of strict compliance as in accordance with the terms of the letter of credit [5].

The strict compliance requires the relevant documentation must represent the complete compliance of the terms as laid down in the contract of credit. If it does comply completely, the bank is required to honour it (Article 15 of UCP 600) [6]. If the bank determines the presentation is discrepant, it may refuse to honour or negotiate (Article 16a of the UCP 600) [7]. A reflection of panoramic perfection is an essential to this rule.

In different parts of the world, the letters of credit are checked by people whose first language is not English. They are not fully aware of the complete terminology used in other countries of the world. In addition, it is not practically possible for the dealing workers at different banks in various countries, to be fully aware of the complete usage and understand the terminology used by every client. As a result, for example, in an export transaction, ‘coromandel groundnuts’ were called for but in the bill of lading ‘ machine shelled groundnuts kernels’ were referred, so the bank refused to pay against the documents. In the court, bank was upheld for refusal of payment. As everybody in the field is aware of both being the same thing so the bank is not required to know this term specifically [8]. Barclays bank was declared not entitled for the recovery of amount paid under credit. Where, in documents, ‘Chevrolet trucks’ in ‘new condition’ to ‘new goods trucks’ were referred [9]. The court held against the Barclays bank declaring that neither of the expressions completely complies with the strict and expressed terms of the credit.

The doctrine of strict compliance demands a flawless documentation. Terms used and goods described are required to be expressed in understandable terminology. The UCP has offered some solutions to likely erratic documentation. Now, to avoid these errors and discrepancies, it is preferable the preparation of the invoice by the seller or beneficiary of the credit. The beneficiary is considered to be much accurate in entering the description of the goods. And, in case of any mistake or error it is reasonably easy to be remedied by eradicating that error or slip up. The approach of the common law is more soft and lenient in this regard as compare to the UCP one, which is, comparatively strict one. According to the common law approach, if the description of the goods as described in the documents, read as a whole, understandably shows the compliance with descriptive details as set out in the credit documents, it is enough and sufficient for this purpose, unless, until the expressed terms of the credit suggest otherwise or it is clear that there are some grievous discrepancies in the documents [10].

The business organizations are divided into departments, especially the large companies. The documentation or preparation of LCs is handled in different departments or divisions. These departments do not hold the required information of handling the LCs. So, an updated and complete co-ordination is needed for an efficient and well knitted team work of the concerned departments. There is no denying of the fact that timely and accurate processing of the LCs is expertise of the staff dealing with it. The staff is required to have profound knowledge of the latest UCP and aware of terminology used at all the stages of LCs.

4.1.3. UCP Standards for Strict Compliance

It was observed in Banker Trust Co v Bank of India [11] that in London, almost half of the documentary presentations made under credit terms are afflicted with discrepancies. During the proceedings, in order to capability of meeting the strict compliance standards, a very important question regarding the workability of present documentary system arose. [12]

It has been observed that, the international banks having branches in other countries have not much knowledge about the credit details of the transaction. Thus the credit issued, does not make them able to make decision. If branch acts just as directed or refuses to act otherwise, it is secure and safe. But, if it deviates from the instructions it is likely to be risk. In a case, the court of appeal held the test of inconsistency as fundamental in the transaction ( Glencore International AC v Bank of China ) [13]. In this case, the invoice had possessed the detail description of information but was not exactly the same, but, additional information was included. It was declared consistent with the terms of the credit.

In United States, an ‘appropriate standard’ is held for the compliance of strict standard in a vast majority of cases [14]. In a series of cases, however, the principle of ‘lesser standard of substantial compliance’ [15] has been applied. In case of Far Eastern Textile Ltd v City National Bank and Trust [16] , the court declared the action of the applicant against his bank is based upon his agreement of credit with his bank. It was held that letter of credit which in itself holds independence between the beneficiary and the bank which has been entered into for the purpose of the credit agreement [17]. And this action against bank is not based upon this letter of credit itself basically;

“ The credit agreement did not specifically described the certain language precisely, of the concerned documents, which would trigger the payment and it is held that as the customer had left that step upon the bank, it could not make any complain if the documents presented substantially complied with the requirements as laid down by the bank” [18].

This case identified two-way compliance standard by an unlikely and novel approach for the identity of the plaintiff [19]. The court differentiated between letter of credit itself and an agreement of credit in pursuit of the credit. In a large number of cases, where preference was given to the substantial compliance rather than to the strict compliance, application of lesser standard was preferred. Despite all these judicial excursions in pursuit of leniency of the rule or in quest of a liberal rule, strict compliance standard still goes on as a test for igniting the payment.

The points where lesser standard of compliance is adopted do not fall under this area of law. Essential of the rule is the strict compliance. Basically, seller holds the responsibility of streamlining of documents strictly in accordance with descriptions of the credit. An easy mode of compliance leaves no space for any excuse of non compliance. The UCP 600 provides fundamental guidelines to take the reasonable care while examining of the documents (Article 14 of UCP 600) and to make the documents strictly consistent with the terms and conditions as laid down in the agreement of the credit [20].

4.1.4. The Autonomy of the Letters of Credit

The principle of autonomy stands fundamental among the laws pertaining to the Letters of Credit [21] . This principle is also known as the ‘independence principle’ [22]. This determines the separation and independence of the letters of credit from the underlying contract for the credit in respect of which the letter of credit is issued. This means that those claims made or defense taken under the contract cannot specifically affect the payment undertaking of the banks [23]. The doctrine of autonomy is considered lying at the heart of the documentary credits [24].

4.1.5. Exception of Fraud

The principle of autonomy has rendered LC an authentic position in international trade [25] . Due to this principle the LCs has gained a unique attraction as a tool of financing in international business. However, still there is one exception to the principle which the courts yet have to refine with regard to the scope of this principle [26]. Although, the Unified Customs and Practices do not contain any provision in connection with fraud exception [27], yet in various jurisdictions it is recognized. The banks are not obliged to make any payment under the credit when it comes to knowledge that the presented document is false, contains wrong statements being in knowledge of the beneficiary or the presence of the false signatures is found on the face of the document or any form of the alteration which is subject to fraudulent. The fraud cases are very common in day to day business but it is very rare for such cases to reach to the courts as bankers usually prefer to resolve these issues privately instead of publicly [28]

In English jurisdiction the fraud exception was first detected in the case of Discount Records Ltd v. Barclays Bank Ltd [29] and again it was articulated by Kerr J in Harbottle v. National Westminster Bank [30]. Where it was held that the risk taken by the merchants on commitments and mechanism of the banks is considered on a different level. They should must be permitted to be honored and without any interference on part of the courts. Otherwise, an irreparable damage to the trust in the international trade would be obvious [31].

The fraud issue is raised against the party involved in committing it. The courts have held that holder of the bill under credit cannot enjoy the enforcement of that documentary credit only for the reason of fraud committed by the seller. This point was raised in the case of Sztejn v J H Henry Schroder Banking Corp [32] and again by Megarrry J in the case of Discount Records Ltd v Barclays Bank Ltd [33] . In case where the fraud is committed by a third party i.e. sub contractor or, as in accordance with the American Accord [34] by any of the shipping agent [35], an injunction to stop the beneficiary to claim the payment would be refused. The English courts, on finding of strong suspicion of fraud by any party are not in practice of issuing the restraining orders. English courts have not yet adopted the practice of granting the temporary restraint order, such as American courts, on the basis of fraud suspicion.

In Anglo Australian Jurisdiction, however, only one reported fraud case is found [36] . This is the case of Contronic Distributors Pvt Ltd v Bank of New South Wales [37] . In this case of an established fraud in the documents, Helsham J, issued the injunction giving the reason;

In my view the law is perhaps now settled and in any event would establish that the seller can be restrained from presenting a LC for payment or having made payment against it in the event that the documents which are needed to require payment to be made are false to the knowledge of the seller. [38]

It is viewed that two basic points still seeking clarification. First, in an exceptional and very rare matter of fraud in the contracts, it is difficult to predict that the English case law will develop in such a way to restrict purely to the issues of fraud in the documents or will it allow the consideration of fraud in relation to the underlying contracts of credit’ [39].

The second unresolved issue which is more significant, is the nature, degree and a notice of fraud which requires the unveiling of the ’spirit’ working behind the credit. In a case of Hortico private Ltd v Energy Equipment Company private Ltd [40], Young J determined;

‘ obiter that a very little short of common law fraud would be justifying the restriction of making the payment ‘though it may be in some cases that the unconscionable conduct may be so grave as to lead to trigger the exercise of the discretionary power’. [41]

In English law, a fraud committed by third party without the knowledge of the beneficiary, does not fall within the exception of fraud. The House of Lords has held in a famous case, generally known as ‘American Accord’ [42] , that the documentary fraud in a credit justifies its dishonor only if the beneficiary is included as a party to the fraud exception. In the case of ‘American Accord’ fraud was committed by falsifying the date in the bill of lading without being brought in the knowledge of the beneficiary of the credit, as he was kept unaware and complete ignorant of that falsified change of the date [43] . This judgment raised a substantial concern in the banking circles as it made banks obligatory to make the payment on representing the documents of credit. This is the duty of the banks to take care of the transaction and look into the document containing statements which have been falsified or made fraudulently and this fraud is within the knowledge of the beneficiary or the beneficiary is a party to this fraudulent transaction. [44]

It is viewed that the banks should undertake their own responsibility to look after the documentary credit transaction with utmost care strictly in accordance with the provisions of the UCP (as guided in Article 14 of the UCP 600). The banks should keep on chasing and anticipate the actions of the beneficiary. The documentary credit is purely a documentary transaction. The banks, in these documentary credit transactions should not be required to make payments on documents particularly falsified or containing statement made fraudulently [45] . The point of notice provokes an important and practical query which is also needed to be resolved by the courts, such as how much notice of fraud a bank requires in a fraudulent transaction. Secondly, how much production of evidence is required to justify a payment dishonor. [46]

It is submitted that the injunction should be granted to restrain a bank for its performance of undertaking in LC transaction, particularly in the circumstances where a fraud is alleged in the transaction and prima facie, strongly suggestive evidence is available and is produced in its support. As Megarry J said that;

I would be slow to interfere with banker’s irrevocable, and not least in the sphere of international banking, unless a sufficiently grave cause is shown. [47]

In an application for an injunction to restrain the bank to make a payment, the Court of Appeal declared that the English courts have not yet adopted the principle as being practiced in the American courts [48] , of granting a temporary restraint orders on the basis of suspicion of fraud in the transaction of credit. It is not in the best interest of the international trade or of the banking business that such a useful and important mechanism should be used for the purpose of fraud. [49]