217 |
5â Introduction to letters of credit |
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bill in their possession is because of the activities … of the defendants thereafter in dishonouring the bill. The bankers have taken advantage of their rights of compulsory recovery against the plaintiffs to place the bill in the hands of the plaintiffs and debit the plaintiffs’ account. The plaintiffs stand in the shoes of the banks, each of which have the undoubted right not only to judgment but also to immediate payment against the defendants without the possibility of being met by any set off or counterclaim.5
The United Nations Convention on International Bills of Exchange and International Promissory Notes was adopted in 1988.6 The aim of the
Convention is to harmonise the approach taken to bills of exchange. Article 1(1) stipulates that the Convention will apply when the heading and text of the bill contain the words ‘International bill of exchange (UNCITRAL Convention)’. The Convention is not yet in force as actions taken by ten states are required for it to take effect. Accordingly, most transactions are governed by domestic laws.
Q1 Discuss payment options such as open accounts and bills of exchange. Is there an unfair advantage to one party in these transactions?
4â Documentary collections
A documentary collection is a method of payment where the seller’s bank takes collection of the payment on his behalf. The seller’s bank will send the documents relating to the goods and instructions for payment to the buyer’s bank. The bank will issue a draft upon which the buyer may pay either on sight of the documents or on a future date. The draft will stipulate the documents necessary for transfer of title of the goods. The banks therefore facilitate the exchange process of the payment and title of the goods. Although this process is somewhat similar to a letter of credit, it is much more straight-forward and less expensive. However, there are no verification mechanisms for the documents nor is there any security against non-payment.
The Uniform Rules for Collections (URC) is the internationally recognised codification of rules unifying banking practice regarding collection operations for drafts and for documentary collections. These rules have been developed and revised by the International Chamber of Commerce (ICC). The latest version of the rules was published in 1995.7
5â Introduction to letters of credit
Letters of credit are one of the most important mechanisms in international payments. We will examine the different types, functions and rules relating
5Ibid. 921.
6See www.uncitral.org/uncitral/en/uncitral_texts/payments/1988Convention_bills_status.html.
7ICC Brochure No. 522 (ICC, 1995).
218 Payment in international sales
to letters of credit. Historically, letters of credit or documentary credits have served a useful purpose in international trade and have been referred to as ‘the life blood of international commerce’.8 With a vast amount of trade being conducted by parties in different countries, in many cases where the buyer and seller are unknown to each other, letters of credit allow the parties an essential element of security in the payment of the contractual price. Letters of credit also serve a useful purpose when one party does not possess adequate financial history, assets or credit to support good faith credit terms.
(a)â Law governing letters of credit
There are no specific laws governing the letter of credit transaction in international trade. However, the rules developed by the ICC on the Uniform Customs and Practice of Documentary Credits (UCP) have been the closest step towards a unified approach on letters of credits. First issued in 1933 to deal with the problems encountered by conflicting laws in different countries, the UCP rules have met with limited success. Nevertheless, the latest revision of the rules, the UCP 600, which was approved by the ICC Banking Commission and came into effect in 2007, has met with widespread approval by many in the international banking community. The UCP rules are supplemented by the ICC International Standard Banking Practice (ISBP) for the Examination of Documents under Documentary Credits. The ISBP sets out various procedures for document checkers to consult when examining the documents presented under letters of credit; the latest version was published in 2007 to coincide with the UCP 600. The UCP 600, which consists of thirty-nine articles, offers significant improvements over its predecessor, the UCP 500.9 Whereas the UCP 500 was criticised as being too ambiguous, the new revised rules contain articles that provide interpretation and definitions of the terms used within.10
For example, article 2 of the UCP 500 defined the term ‘credit’ as ‘any arrangement however named or described, whereby the bank (the “Issuing Bank”) acts at the request and on the instructions of a customer (the “Applicant”) or on its own behalf’. The scope of this definition was very broad and covered all documentary promises to pay. In contrast, the UCP 600, article 2, defines ‘credit’ as ‘any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation’. Thus, the UCP 600 will only apply to irrevocable letters of credit. The UCP 500, in fact, offered only a definition of the meaning of the term ‘credit’ in its provisions, while the UCP 600 goes further to eliminate any confusion that was caused by its predecessor in providing definitions for terms such as ‘honor’, ‘negotiation’ and ‘presentation’. Article 3 of the UCP 600 provides an interpretative function in that it lends greater clarity to commonly
8 |
Per Kerr LJ in Hardbottle (RD) (Mercantile) Ltd v. National Westminster Bank Ltd [1978] QB 146, 155. |
9 |
Came into effect in 1994.â 10â UCP 600, arts. 2 and 3. |
219 5â Introduction to letters of credit
used terms which are often misconstrued. For example, it states ‘the expression “on or about” or similar will be interpreted as a stipulation that an event is to occur during a period of five calendar days before until five calendar days after the specified date, both start and end dates included’.11 The UCP 500 had no counterpart in its provisions.
As mentioned above, even though the UCP rules have received widespread recognition for the useful function they serve in international trade, they are by no means considered part of the lex mercatoria or a customary trade usage. Parties have to agree to incorporate the rules into their contracts. UCP 600, Article 1 states that the rules will apply ‘when the text of the credit expressly indicates that it is subject to these rules’.
In the absence of parties failing to stipulate the UCP rules or any other laws to govern the letter of credit transaction, the English courts will determine the applicable law by referring to the EEC Convention on the Law Applicable to Contractual Obligations 1980 (‘Rome Convention’). The Convention was replaced by Regulation 593/2005 (‘Rome I’), which applies to contracts concluded after 17 December 2009. Under these provisions, the letter of credit transaction will be governed by the laws of the country to which it is most closely connected, specifically the country in which the party who is to carry out the performance that is essential to the contract is located. However identi fying this location in the letter of credit transaction is not entirely straightforward as there are at least four main parties involved in the transaction: the applicant, the beneficiary, the issuing bank and the advising bank, all of whom may be located in different countries. Thus, it would be prudent of the parties to nominate a set of rules in the event that a dispute should arise. It is important to note that the UCP rules do not address every contingency that may arise, so that issues such as fraud or insolvency in the letter of credit will be governed by the common law.
Q2 How has the UCP 600 improved the law on letters of credit in comparison with its predecessor?
(b)â Stages of a letter of credit
There are several stages involved in a letter of credit transaction. A typical documentary letter of credit will operate in the following way: once the buyer has concluded the contract of sale with the seller, the parties will agree that payment is to be made by the opening of a letter of credit. In some cases, the seller may request that the buyer open the letter of credit before the goods will be shipped. In Kronos Worldwide Ltd v. Sempra Oil Trading SARL,12 the buyer, for the supply of oil, was under an obligation to promptly open an irrevocable letter of credit. The issue that arose was whether the laytime for loading the goods should begin
11 Ibid. art. 3.â 12â [2003] 1 Lloyd’s Rep. 567.
220 Payment in international sales
to run after the opening of the letter of credit. It was stated in the judgment that the opening of the letter of credit could in some circumstances be viewed as a condition precedent to the seller’s obligation to load the cargo; however, this would depend on the wording of the contract.13
The next step in the process is that the buyer (the ‘applicant’) will request his bank (the ‘issuing bank’) to open a letter of credit in favour of the seller (the ‘beneficiary’). The buyer will stipulate the documents required; these can include invoices, insurance policies and transport documents. The UCP 600 makes provisions for a wide range of transport documents, such as multimodal transport,14 bills of lading,15 non-negotiable sea waybills16 and charterparty bills of lading.17
The issuing bank, in order to fulfil this request, sends the letter of credit details to the seller’s bank (the ‘advising bank’). The advising bank endorses the letter of credit and sends the beneficiary (seller) the details. The seller examines the details of the letter of credit to make sure that they are correct. If needed, the seller will contact the buyer and ask for the necessary amendments to be made. Once the seller is satisfied with the conditions of the letter of credit, the goods are shipped and the seller presents the documents to the advising bank. The advising bank examines the documents against the details on the letter of credit and, if applicable, the UCP 600 rules or any other governing laws. If the documents are in order, the advising bank will send them to the issuing bank for payment. If the details are not correct, the advising bank informs the seller and waits for the documents to be corrected. The issuing bank examines the documents from the advising bank and, if they are in order, pays the amount as promised. If the details are not correct, the issuing bank contacts the buyer for authorisation to pay or accept the documents. If acceptable, the issuing bank releases the documents to the buyer, and makes payment as agreed. The buyer receives the documents from the issuing bank and collects the goods. The seller receives the payment through the advising bank. The advising bank notifies the seller that payment has been made.
It is perhaps most helpful to view the letter of credit process as three separate obligations. The first obligation is found in the contract for the sale of goods, which sets out the responsibilities of the buyer and seller. The second obligation is between the buyer (applicant) and his chosen bank (issuing bank), whereby the bank agrees to ensure the creditworthiness of the buyer. The final obligation is found in the letter of credit itself, in which the issuing bank promises to pay the seller the contractual sum upon tendering of documents.
(c)â Characteristics of letters of credit
There are two main characteristics that define letters of credit: first, the principle of autonomy, and secondly the doctrine of strict compliance.
13 |
Ibid. 568.â 14â UCP 600, art. 19. |
15 |
Ibid. art. 20.â 16â Ibid. art. 21.â 17â Ibid. art. 22. |
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5â Introduction to letters of credit |
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(i)â Principle of autonomy
One of the doctrines upon which letters of credit are built is the principle of autonomy. This means that the responsibility on the part of the issuing bank to pay the seller under the terms and conditions of the letter of credit is a separate obligation and is entirely severed from the contract of sale between the buyer and seller. Therefore, the issuing bank must honour the payment under the letter of credit irrespective of any problems or disputes that arise under the contractual transaction for the sale of goods, the only exception to this rule being where fraud can be proven.18 This principle is embodied in articles 4 and 5 of the UCP 600, which emphasise that the banks are in no way concerned or bound by the underlying sales contract.19 An example of this principle can be seen in Hamzeh Malas & Sons v. British Imex Industries Ltd,20 where it was stated:
We have been referred to a number of authorities, and it seems to be plain enough 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 as to whether the goods are up to contract or not.21
It is often the case that buyers will try to halt the payment from the issuing bank once they are aware that the goods do not conform to the contract; this is usually in the form of an injunction. However, the courts are reluctant to grant such injunctions as this would undermine the function of the letter of credit in international trade. In Discount Records Ltd v. Barclays Bank Ltd,22 the plaintiffs were purchasers of a consignment of records and cassettes. Although the documents tendered were in conformity with the contract, some of the boxes delivered were empty or only partially filled, while others were filled only with rubbish. The buyers’ attempt to restrain the bank from paying the seller by asking for an injunction was refused by the courts. Megarry J stated that:
I would be slow to interfere with bankers’ irrevocable credits, and not least in the sphere of international banking, unless a sufficiently grave cause is shown;
18David C. Howard, ‘The Application of Compulsory Joinder, Intervention, Impleader and Attachment to Letter of Credit Litigation’ (1984) 52 Fordham Law Review 957.
19Article 4: ‘Credits v. Contracts: (a) A credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the credit. Consequently, the undertaking of a bank to honour, to negotiate or to fulfil any other obligation under the credit is not subject to claims or defences by the applicant resulting from its relationships with the issuing bank or the beneficiary. A beneficiary can in no case avail itself of the contractual relationships existing between banks or between the applicant and the issuing bank. (b) An
issuing bank should discourage any attempt by the applicant to include, as an integral part of the credit, copies of the underlying contract, proforma invoice and the like.’ Article 5: ‘Documents v. Goods/Services/Performances. Banks deal with documents and not with goods, services or performance to which the documents may relate.’
20 |
[1958] |
2 QB 127.â 21â Ibid. 129. |
22 |
[1975] |
1 Lloyd’s Rep. 444. |
222 |
Payment in international sales |
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for interventions by the Court that are too ready or too frequent might gravely impair the reliance which, quite properly, is placed on such credits.23
Q3 Explain why the courts are reluctant to interfere with the letter of credit mechanism. Does this leave the innocent party without a remedy?
(ii)â Principle of strict compliance
The second principle that the letter of credit system is based on, and arguably the most important, is the principle of strict compliance. The rules governing this principle state that if the seller wishes to be paid under the letter of credit transaction, then documents that comply with the letter of credit must be tendered. Similar to the principle of autonomy as presented above, once documents which on their face conform to the terms and conditions of the letter of credit are tendered then the issuing bank must honour their obligation to pay. This rule is strict in the sense that presentation of documents which almost conform will not be sufficient to justify payment. If the issuing bank chooses to pay under these circumstances, it does so at its own risk and may not be reimbursed by the buyer.
While the rules of strict compliance are not explicitly mentioned in the UCP 600,24 the principle has for many years been embodied in judicial decisions, both in the English courts and in the United States. This is illustrated, for example, in cases such as Equitable Trust v. Dawson Partners,25 where Lord Sumner stated that, ‘there is no room for documents which are almost the same or which will do just as well’. This was supported by the decision in Fidelity National Bank v. Dade County,26 in which it was held that ‘[c]ompliance with the terms of a letter of credit is not like pitching horseshoes. No points are awarded for being close.’
The UCP 600 provides in article 14(a) that:
A nominated bank acting on its nomination, a confirming bank, if any, and the issuing bank must examine a presentation to determine, on the basis of the documents alone, whether or not the documents appear on their face to constitute a complying presentation.
In Seaconsar Far East v. Bank Markazi Jomhouri Islami Iran,27 it was held that the bank was correct in rejecting the non-conforming documents even though the discrepancy in question was trivial. The reasoning behind this strict approach is evident, as banks do not have expertise in the goods, rather they are concerned with the aspect of finance.28 In J.H. Rayner and Co. Ltd v. Hambros Bank Ltd,29 the description of the goods in the letter of credit stated
23 |
Ibid. 448.â 24â UCP 600, art. 14(b). |
||
25 |
(1927) |
27 L1. L Rep. 49, 52.â |
26â 371 So. 2d 545, 546 (1979). |
27 |
[1993] 1 Lloyd’s Rep. 236.â |
28â This is supported by UCP 600, art. 5. |
|
29 |
[1943] |
1 KB 37. |
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223 |
5â Introduction to letters of credit |
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‘Coromandel groundnuts’, whereas the bill of lading referred to the goods as ‘machine-shelled kernels’. Although the two terms have the same meaning in the trade, the bank rejected the documents as being non-conforming. In his judgment Mackinnon LJ stated:
The words in that bill of lading clearly are not the same as those required by the letter of credit … The bank, if they had accepted that proposition, would have done so at their own risk. I think on pure principle that the bank were entitled to refuse this sight draft on the ground that the documents tendered, the bill of lading in particular, did not comply precisely with the terms of the letter of credit which they have issued.30
However, this does not mean the document will be deemed non-conform- ing if it fails to dot every ‘i’ or cross every ‘t’ or contains obvious typographical errors. This can be seen in Hing Yip Fat Co. v. Diawa Bank Ltd,31 where it was held that the use of the word ‘industrial’ rather than ‘industries’ on a letter of credit application was an obvious typographical error. Also, in New Braunfels National Bank v. Odiorne,32 it was held that strict compliance can mean something other than absolute or perfect compliance. Therefore, the courts will have to decide whether the typographical error in question has the potential to have severe repercussions for the transaction.
The letter of credit process is very technical and there are many things that can potentially go wrong. Indeed, in commercial reality the letter of credit process can be revised many times before it is deemed to be in conformity with the documents identifying the contractual terms. In a study undertaken in the United Kingdom by the Midland Bank and SITPRO33 in the mid 1980s, the amount of letter of credit transactions that failed upon first presentation of documents was staggering.34 Out of 1,143 presentations, 51.4 per cent failed to meet the strict compliance standard, however most were accepted upon retender.35 Furthermore, 23.7 per cent of those that failed were due to discrepancies in transport documentation. In other studies carried out in countries such as Hong Kong and Australia, the failure rate was as high as 90 per cent in some cases.36 These numbers have not decreased; in a more recent study undertaken it was found that documents did not conform to the letter of credit 73 per cent of the time.37 Some experts have asserted that courts should apply a legal test rather than a commercial one when examining non-conforming documents; specifically they should inquire whether there is a substantial, and more to the point a real discrepancy.38 The strictness of this rule has been somewhat
30 Ibid. 40.â 31â [1991] 2 HKLR 35.â 32â 780 SW 2d 313 (1989).
33The Simplification of International Trade Procedures Board.
34Clive M. Schmitthoff ‘Discrepancy of documents in letter of credit transactions’ in Chia-Jui Cheng (ed.), Select Essays on International Trade Law (Kluwer, The Hague, 1988) 431–49.
35Ibid.â 36â Ibid.
37Ronald J. Mann, ‘The role of letters of credit in payment transactions’ (2000) 98 Michigan Law Review 2495.
38Schmitthoff, above n. 34, at 437.
224 Payment in international sales
alleviated by the UCP 600 rules. For example, although article 18(c) states that ‘the description of the goods, services or performance in a commercial invoice must correspond with that appearing in the credit’, article 14(e) permits that in ‘documents other than the commercial invoice, the description of the goods, services or performance, if stated, may be in general terms not conflicting with their description in the credit’. Also, article 30 allows for some tolerance in credit amount, quantity and unit prices. For example, in relation to quantity of the goods, in the absence of the letter of credit stating the quantity by a stipulated number, a tolerance of not more or less than 5 per cent will be permitted.39
(d)â Fraud exception
As mentioned above, the only exception to the bank’s obligation to pay against conforming documents is where fraud is present. However, it is not sufficient that fraud be alleged, rather it must be proven.40 In United City Merchants (Investments) Ltd v. Royal Bank of Canada,41 which concerned a confirmed irrevocable letter of credit, the loading brokers had falsely backdated a bill of lading to reflect an earlier ‘shipped on’ date. The sellers were unaware of this fraud; however, the bank, on becoming aware of the discrepancy, refused to pay the seller. The court held that if the seller had no knowledge of the fraud he cannot be deprived of payment. Although the aim of public policy is to limit or control instances of fraud, the courts tend to construe the fraud exception narrowly to protect the utility of the letter of credit transaction. The UCP 600 does not expressly deal with the issue of fraud and such matters are left to be determined by the applicable laws of the forum state. However, UCP 600, article 34 states that:
A bank assumes no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any document, or for the general or particular conditions stipulated in a document or superimposed thereon
Thus, the risk of payment for devalued or even worthless documents will remain on the buyer.
Q4 ‘The UCP 600 fails to provide adequate protection in cases of fraud.’ Critically analyse this statement with reference to the case law.
(e)â Types of letters of credit
(i)â Documentary letters of credit and standby letters of credit
There are two main types of letters of credit, documentary letters of credit and standby letters of credit. Documentary letters of credit are the most common,
39UCP 600, art. 30(b).
40Discount Records Ltd v. Barclays Bank Ltd [1975] 1 Lloyd’s Rep. 444.
41[1983] 1 AC 168.
225 5â Introduction to letters of credit
and are used on an individual transaction, order or invoice basis. They generally have specific conditions applied to them, such as being irrevocable by the buyer and confirmed by the bank. Standby letters of credit are used as a back-up should the buyer fail to pay the contract price as agreed upon. Thus, a standby letter of credit allows the buyer to ensure the security of the transaction with the seller by showing that it can uphold its promise to pay the price. Standby letters of credit are covered by the UCP 600, as well as by the ISP98 International Standby Practices.
(ii)â Revocable letters of credit and irrevocable letters of credit
The UCP 600 defines the term ‘credit’ as being only that which is irrevocable.42 This means that it cannot be altered or withdrawn without the consent of the parties to the letter of credit transaction. Therefore, once all the terms are complied with the issuing bank gives its assurance to the seller that payment will be made. Unlike the revised rules, the UCP 500 allowed for credit terms to be negotiated as revocable, meaning credit could be withdrawn at any time by the bank without notice to the seller.43 In Cape Asbestos Co. Ltd v. Lloyds Bank Ltd,44 it was held that in the case of revocable letters of credit, the risk of not being paid will remain on the seller as the banks have no duty to notify that credit has been withdrawn.
(iii)â Confirmed and unconfirmed letters of credit
A letter of credit may also be confirmed or unconfirmed by the advising bank, which is usually located in the beneficiary’s country. If the letter of credit is unconfirmed, this means that the advising bank has not given its undertaking to the seller that it will make payment in the event that the buyer or its bank should default on payment, rather it has simply verified that the letter of credit is in conformity with the requirements requested. In contrast, with a confirmed letter of credit, the advising bank gives an undertaking that if the documents are conforming then payment will be made. This undertaking will prevail if the buyer or the issuing bank fails to make payment. This type of credit is commonly used where the buyer is situated in a country that may be politically or economically unstable, however the cost of opening such a letter of credit will increase with the risk involved.
(iv)â Revolving letters of credit
In cases where the buyer and seller regularly conduct transactions, a revolving letter of credit may be used. This helps to avoid the time and cost of opening a new letter of credit for each transaction. A revolving credit operates either on the basis of ‘time’ or ‘value’. If it is on the basis of time, then once this is used up it will continue to be renewed until it is revoked. If the credit is made on a value basis then once the amount has been paid, it will be re-instated.
42 UCP 600, art. 2.â 43â UCP 500, art. 8(a).â 44â (1921) WN 274.