Letter of Credit

Balancing rights and duties of parties in a letter of credit transaction

Introduction to Letter of Credit

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.

Chapter 1

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.

Issuing 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.

Advising Bank

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.

Confirming Bank

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.

Letters of credit may be either revocable or irrevocable.

Revocable Letter of Credit

A revocable letter of credit may be revoked or modified by the issuing bank, for any reason at any time, without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction involving a revocable letter of credit, it serves as the advising bank.

A letter of credit can not be revoked, once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honoured. The revocable letter of credit is not a commonly used instrument.

Irrevocable Letter of Credit

This is the most common form of credit used in international trade. The irrevocable letter of credit may not be revoked or amended without the consent of the issuing bank, the confirming bank, and the beneficiary. The buyer’s issuing bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the letter of credit. Changes in the credit must be approved by both the buyer and the seller. If the documentary letter of credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable.

There are two forms of irrevocable credits:

Unconfirmed credit

In an unconfirmed credit, the buyer’s bank issuing the credit is the only party responsible for payment to the seller. The seller’s advising bank pays only after receiving payment from the issuing bank. The seller’s advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk.

Confirmed credit

In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer’s issuing bank. Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the seller. The advising bank will then look to the issuing bank for payment. Confirmed Irrevocable letters of credit are used when trading in a high-risk area where war or social, political, or financial instability are real threats. Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order. A confirmed credit is more expensive because the bank has added liability.

Sight and Time Drafts

All letters of credit require the beneficiary to present a draft and required documents in order to receive payment. A draft is a written order by which the party creating it, orders another party to pay money to a third party. A draft is also called a bill of exchange. There are two types of drafts: sight and time. A sight draft is payable as soon as it is presented for payment. The bank is allowed a reasonable time to review the documents before making payment.

A time draft is not payable until the lapse of a particular time period stated on the draft. The bank is required to accept the draft as soon as the documents comply with credit terms. The issuing bank has a reasonable time to examine those documents. The issuing bank is obligated to accept drafts and pay them at maturity.

Step-by-step process

• • Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment.

• • Buyer applies to his bank for a letter of credit in favour of the seller.

• • Buyer’s bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming). The correspondent bank is usually located in the same geographical location as the seller (beneficiary).

• • Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary).

• • Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a particular company.

• • Seller presents the required documents to the advising or confirming bank to be processed for payment.

• • Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit.

• • If the documents are correct, the advising or confirming bank will claim the funds by:

• • Debiting the account of the issuing bank.

• • Waiting until the issuing bank remits, after receiving the documents.

• • Reimburse on another bank as required in the credit.

• • Advising or confirming bank will forward the documents to the issuing bank.

• • Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer’s account.

• • Issuing bank then forwards the documents to the buyer.

The most common documents include:

Commercial Invoice

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 Documentation

About half of the documents presented contain discrepancies. A discrepancy is an irregularity in the documents that causes them to be in non-compliance with the terms of the letter of credit. Requirements mentioned in the letter of credit cannot be altered by the issuing bank without the express consent of the buyer-applicant. The beneficiary should prepare all documents carefully before presentation to the issuer to avoid any delay in receipt of payment. Commonly found discrepancies include:

• • Letter of Credit has expired prior to presentation of draft.

• • Bill of Lading evidences delivery prior to or after the date range stated in the credit.

• • Stale dated documents.

• • Changes included in the invoice not authorized in the credit.

• • Inconsistent description of goods.

• • Insurance document errors.

• • Invoice amount not equal to draft amount.

• • Ports of loading and destination not as specified in the credit.

• • Description of merchandise is not as stated in credit.

• • A document required by the credit is not presented.

• • Documents are inconsistent as to general information such as volume, quality, etc.

• • Names of documents not exact as described in the credit. Beneficiary information must be exact.

• • Invoice or statement is not signed as stipulated in 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

Chapter 2

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?

Chapter 3

Independence Principle and the Doctrine of Documentary Compliance

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. Under this principle, the issuer is not concerned with or bound by underlying contracts. It deals exclusively in documents and not in goods or services to which the documents may relate. Obviously there are some doubts as to the extent to which this principle should be applied and which may cause injustice to the applicant under certain circumstances.

The Independence Principle

Generally, letter of credit is a contract between the issuer and the beneficiary independent of the underlying contract between the applicant and the beneficiary. The rule relating to the independence principle is incorporated 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.

This separation of documents and goods has been considered essential to the continued utility of the letter of credit and is the basis upon which the banks enter into these transactions. 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?

Is the applicant a party to the 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 it is doubtful 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.