Impacts on Documentary Credit Law

Regulation is an alternative to free market institutions in the process of allocating, producing and consuming resources. It can be impose based on external demand or selective implementation. The latter case tries to build a learning curve whereby it will allow regulatory failure to emerge as the financial industry matures naturally. Deregulation does not necessarily follow financial liberalization because performance monitoring under the current system would be impossible. Case studies in the lack of regulation include USA which failed to regulate corporate disclosure and agency relationship, Argentina which failed to stabilize and safeguard its financial system and Australia which failed to apply its experience of banking crisis in 1990s to avoid insurance crises in 2000 [1] .

Financial services regulation is opposed due to six arguments [2] . First, regulated markets are trailed by free markets in performance due to efficient pricing and promotion of quality. Second, regulation is inefficient as cause the rise in agency costs and distortion of agency relationships between managers and shareholders. Third, assuming that the strong form of efficient market hypothesis is in operation, stock markets can function without regulation. Fourth, regulation can hamper dispersion of financial service innovations triggering social costs. Fifth, regulatory failure is inevitable in the life cycle of FSR and both private and public entities have tendency to raise their own interest in developing and executing regulations. Lastly, regulation should be applied to individual professionals through appreciation of ethical standards.

Autonomy in Letters of Credit and Bank Guarantees

A letter of credit involves three persons such as the issuer, beneficiary and the applicant [3] . For a beneficiary to obtain the payment, terms and conditions in the credit must be met. The importance of letter of credit in international trade is so indispensable that it was termed the life blood of international trade.

It guarantees payment and ensures that obligations are performed. In essence, the letter of credit emulates currency system where the use of a bill and discounting happens. Banks, usually the issuer of payment, are bound to extend the credit for a specified period under any circumstances within the system. This issuer obligation is a crucial concept in letter of credit.

Letter of credit has two types; namely, commercial credit and standby letter of credit. The commercial credit is vital for global businesses as an efficient way to pay for product and services through an issuer.

It simplifies currency and legal system differences among countries. To have access to credit, the beneficiary who is usually a seller must submit documents to banks as a proof that their contractual obligation to the applicant who is usually the buyer has been fulfilled. On the other hand, a standby letter of credit occurs when the seller delivers a statement to the bank announcing that components of the original seller-buyer contract can only be fulfilled by a third party ’s performance.

Bank guarantees are initiated with the same purpose as letter of credit but with more straightforward payment awarding scheme [4] . The bank has more autonomy from the principal contract compared to letter of credit. This is substantially useful when one of the contract parties is in default. The issuing of credit is more independent from the original contract wherein the rights and obligations of applicant and beneficiary are of less concern to an issuer.

As long as the beneficiary presents documents to fulfill the credit requirements, the payment is performed and reimbursement against the applicant is applied. The main difference of guarantee to line of credit is that the former is not a collateral obligation arising from the principal claim and independent from the success or failure of the principal claim.

Autonomy of letter of credit and bank drafts is derived from the assumption that the contract that is entered by the parties is valid contracts [5] . Since the contract is binding in the first place, credit is issued once documents or statements have been presented. There is an element of good faith among the parties especially on how they create and fulfill the original contract. If a letter of contract or bank guarantee breach statutory or common law principle, then they cannot be imposed to contract parties. English law over the years put a keen eye on this issue simply because it can have negative impressions and lack of trust on the legal system.

Banks are not interested with goods but with documents [6] . This is why the documentary credit transaction is different from the contract being entered by the applicant and beneficiary. In effect, when the buyer is suspecting fraud against the seller for the sales contract, the bank can honor the documents and perform payment without being in error as the fraud in the original contract is separate from the credit document. The bank is required to perform the payment as it is part of the banking system where integrity of the process should uphold. Commerce especially global business system would be in trouble if traders cannot use documentary credit system to simplify international commerce procedures.

Fraud and Illegality Exceptions

At times when credit documents are not available, English courts place importance to the original contract as what Stocznia Gdanska SA v Latvian Shipping Co case [7] end up with. The case deals with the validity of restitution where a shipbuilder is unable to satisfy the contract demands of the client. A total failure of consideration is the main argument in the case which is posited two questions; namely, Had parties acted and funds spent? Did the shipbuilder acted for the contract such as designing, constructing and delivery of the order?

The English court decided that there was no total failure of consideration because the shipbuilder acted within its obligation of designing and building the ship. Breach of contract was not found because the client did not show intent to increase funding to support its desired design. In effect, the court concluded that for a balanced decision no party should be punished due to the inability of the other to fulfill its obligation.

The court studied the initiative of the shipbuilder and found that there was a consideration on their part which made total failure of consideration a weak declaration. Even when a contract is performed, it is unlikely that the court would change its decision as it protects certainty of contracts. However, when fraud and illegality are introduced into the contract the courts would not accept the letter of credit because it goes against equitable and statutory standards.

English Courts also used proceedings of American Courts to arrive on a case decision. In United City Merchants v Royal Bank of Canada [8] , Lord Denning stated that the autonomy of letters of credit and bank guarantees apply only for cases where the parties involve can settle the dispute among themselves. However, when one of the parties such as the seller fraudulently submits documents that are false and misleading, American cases showed that courts should intervene. Two components must be present; namely, evidence of fraud and accrued benefits as a result of fraud. The legal custom demands standard for exception to be rather high where clear and unequivocal proof must also be considered.

There are three situations where English Courts may be called upon to administer letter of credit and bank guarantee disputes [9] . The first is when the applicant likes to defer the paying issuer to make payment because it is suspected that the beneficiary is in fraud. The second is when the beneficiary prefers to sue the issuer bank on the ground that the latter declines to make a payment due to suspicion of fraud. Finally, is when the issuer already completed the payment and the documents provided are fraud.

Sir Michael Kerr in the Harbottle case showed conservatism on how fraud exception can be used to override autonomy of credit documents [10] . He stated that only under special circumstances that a stop payment can be put on bank instruments. He argued that merchants know the risks undergoing in a trade contract especially international in nature. In effect, banks must perform payment when necessary documents are provided even without advice from the Court. If letter of credit and bank guarantees will be delayed because of Court proceedings, international commerce will be damaged.

Initial proceedings proved to be beneficial in creating a framework on when compliance to autonomy rule must be withheld. Not only the Hartbottle case contributed to this but also Edward Owen Engineering v Barclays Bank [11] where the role of the issuer or the bank is highlighted. Strict compliance on autonomy of these bank instruments is mitigated by fraud exception where there is a clear evidence of fraud, the bank notices the fraud, timeliness of being aware of the fraud and there should be balance of convenience. These elements should occur for English Court to intervene and lift autonomy restriction on bank instruments. The fourth element makes it suffice that the Court would have only to prioritize a grant or non-grant of injunction which may restrain payment. The bank must have mechanisms to prevent fraud exceptions from being escalated to English Courts.

English Court Decisions outside the Ten-Year Period

In Discount Records v Barclays Bank [12] , the plaintiff buyers did not receive injunction from the Court against the bank for paying a seller that delivered insufficient amount of products. The buyer contested that the seller did not follow the contract and was in fraud for the delivery. However, even if the credit document is not yet due, the bank had already paid the seller due to a draft discounting. Since the obligation had already been performed, what Courts can only do is to stop the bank from honoring future obligations.

In United City Merchants v Royal Bank of Canada [13] , the defendant is the issuer and the plaintiff is the seller. The bank refused to issue credit because the shipment performed by the seller is one-day late in reference to the credit document. The House of Lords came to support the bank even Lord Diplock admitted that disputes as to the delivery process in not a question to refuse payment. He quoted that fraud unravels all and that the Court will not permit somebody to be better-off due to dishonesty. It was proven that the seller presented false delivery date to the bank but the latter performed due diligence to protect the credit document and thus able to prevent payment with reasonable grounds.

English Courts, due to balance of convenience, resort to simplified decisions with convenient ends for the parties involved as basis of decision. In Tukan Timber v Barclay Bank [14] , the plaintiff requested injunction against its own bank to avoid future payments for a seller that was found to have forged two consecutive demand document. The restraint was declined not because the plaintiff did not have a valid claim but because of convenience thought by Justice Hirst if the stop payment be figured and administered through bank’s letter of credit procedures. This proved to be straightforward while the Court guaranteed the plaintiff that the bank would face a formidable claim from its client if the bank would pay the seller for a third attempt.

In Themehelp v West [15] , the first rare cases of injunction was observed. This rare occurrence happened because of two elements; namely, fraud is existent sufficient enough for pre-proceedings and the credit payment was not yet issued to beneficiary. Exceptional action was the description of most Courts to this event especially the plaintiff was able to request restraint before the claim was performed. Another case in level to the Themehelp is the Kvaerner John Brown Limited v Midland Bank pls. Justice Cresswell decided to put injunction to restrain credit payment against a beneficiary who submitted fraud documents to a bank even though it was not required to do so.

Two English Court decision in 1996 also made clearer examples of balance of convenience and the role of banks in letter of credit and bank guarantees. In Deutsche Ruckversicherung v Walbrook Insurance [16] , Lord Justice Staughton united the similarity of restraining the bank from paying and restraining the beneficiary from claiming the payment. This showed that plaintiff’s request pertaining to these scenarios can be approached to have singular purpose. Also, the Turkiye Is Bankasi v Bank of China (BOC) [17] showed that fraud exception can be found in the final trial. BOC failed to get inside the fraud exception which enabled Turkiye to demand counter-guarantee even if the latter recognized the seller’s fraud. Banks are not Courts. This case concluded that banks did not have responsibility to investigate against allegations to either side of the party or to study where the breach of contract may arise.

English Court Decisions inside the Ten-Year Period

There is apparent conflict between fraud rule and autonomy principle under English Law. In the 1990s, the fraud exception was relaxed in English Courts. Developments to the exception of autonomy rule had recently happened. There are two other exceptions that are not developed as fraud rule; namely, illegality exception and nullity exception. In Staughton LJ in Group Josi Re v Walbrook Insurance Co Ltd [18] , Colman J cited that the lack of legislation stating that arms contract is illegal is not a reason to permit unlawful ancillary dealings and support the transaction with letter of credit. He also stated that Courts must not be called to decide on a letter of credit case for enforceable illegal contracts.

Nullity exception extended the fraud rule in such a manner that beneficiary’s participation in fraud is not pre-requisite to avail letter of credit exception. The exception enables bank to decline the payment if there is an indication that the beneficiary and the null document are related. Its inception into court decision was observed in Lambias (Importers and Exporters) Co Pte Ltd v Hong Kong and Shanghai Banking Corpn [19] . It was when the Court confirmed the appropriateness of bank’s refusal to documents presented by a seller that had discrepancy. In effect, the inspection certificate presented was nullified.

In Montrod Limited c Grundkotter Fleischvertriebs GMBH and Standard Chartered Bank [20] , the applicant (Montrod) wanted to avoid reimbursement to issuer (Standard Chartered) because it found that documents presented by the beneficiary (GF) is tampered by a third party contractor. The issuer already paid GF because documents showed the applicant’s stamp. The issuer identified nullity exception against the principle of autonomy as the documents are null while emphasizing that the beneficiary acted in good faith over the fraud signed documents made by a third party. At the end, the Court rejected the applicant’s argument.

Still, beyond the ten-year period brought reasons to why Courts undermined arguments from plaintiffs. Still, even with the development of other exception and improvement in investigation services of banks, autonomy of letter of credits is the cornerstone of Court decisions. Even at this more recent proceeding, the English Court argued that banks are not responsible to investigate allegations of fraud. Also, the applicant believed fraud documents were presented too late as it was after the payment was already been made. Nullity exception, which is recently developed, cannot be placed on bank’s shoulders this early because banks are not competent to perform rigid investigations.

Conclusion

The arguments in the free trade and regulation are deficient in applying systems theory which connotes several important considerations. Without regulation, systematic risk of financial markets can rise tremendously and lead to crisis. This is especially true as technological advancements allow financial systems to integrate globally and transact business in a non-stop manner. As an illustration, the banking sector is regulated for the purpose of assuring that deposits made by the public are kept, distributed and invested with moderate risks.

In theory, regulation is necessary due to presence of hidden actions and information which entails risks on morals and selection respectively. The performance of regulation is also dependent on confidence and convenience factors while the propensity of a current regulation to change is based on the levels of innovation and contestability. When confidence factor is low, institutions such as banks are practicing ineffective risk monitoring that contributes to distressed financial industry. When convenience factor is low, the cost and quality of financial services are disruptive to user satisfaction.

Within the ten-year period, English Courts continued practicality and simplicity in applying exceptions to fundamental principles of letter of credit and bank guarantees. The issuer is not obliged to protect the sales contract nor be held liable for not determining fraud for documents that become relevant in the post-payment performance. The pre-21st century cases implied that English Courts will only make applicant not liable to bank’s reimbursement if the former find fraud before demonstration the payment. Pre-ten year and within-ten year period are in accord when it comes to Court’s tendency of simplifying proceedings and support to balance of convenience. Still, merchants and banking system are treated in the context of commerce.

Perhaps, one of the biggest roles of recent judgments for letter of credit and bank guarantee proceedings is to make it clear that there is a contractual relationship between the issuer and the beneficiary. It gives bank a valid and popular reason to decline a payment especially when forgery and fraud is noticed before payment. Nullity exception can be used to support the bank’s decision and sustain the security interest it has on the contract. Bank freedom is reinforced because of the cases within the ten-year period which reflects the historical respect English Courts are giving to banking system and efficiency international commerce.

Developments to exceptions for letter of credit and bank guarantees are focused on concretizing the practicality of dealing with conflicts arising from them. English Courts continued to distance itself from direct regulation of merchant and banking relationship and dealings. The historical and recent evidence suggest that the Courts are continuously adhering to free market rule and deregulation which makes international commerce vibrant. Less restriction and passing risks to merchants and banks is a way to make life easier and legal system more inclined in preserving rather than complicating justice and normality.

Advantages from this custom of English Courts abound. It can focus on criminal and civil cases rather than spending time in solving letter of credit and bank guarantee complications. It contributes to the well-being of financial system which can create harmony within institutions. Finally, international commerce is not restricted by legal factors from other countries especially English countries which have positive economic impact as well.