The Importance of the Letter of Credit - Essay Example

Understanding The Importance of the Letter of Credit And Why It Is Considered the Lifeblood of International Trade I. Introduction International business transactions involve a lot of complex situations that may pose problems on the part of the sellers and buyers. Since parties in international transactions often do not see each other face to face, this situation can lead to confusions especially in terms of payments. As payments are very important in any commercial transaction, letters of credits for an important part of international transactions and is considered as the lifeblood of international trade. Compared to other types of payment systems, the letters of credit are relatively safe as it is course through banks. One of the most distinctive features of this means of payment is that the payment obligation attached to it is abstract and it is independent from the underlying contract of sale or the transaction. The obligation of the bank to honor or to pay the letters of credit is defined in the terms of credit alone and not on any other conditions that the seller and buyer may agree upon. According to the UCP 500 and the recent UCP 600, under the letters of credit, the banks deal with the documents only and they are not concerned with the goods or services that the seller is supposed to deliver to the buyer as part of the consideration. In other words, the letters of credit is considered as an autonomous document and the bank from which it is drawn is bound to act in accordance with the terms attached to the letters of credit. Since the bank is bound to the terms and conditions stipulated in the letters of credit, its must adhere to the strict compliance rule. Strict interpretation of the terms and conditions of the letters of credit means that whatever is not stipulated in the document is deemed excluded and whenever the beneficiary is able to meet the requirements set forth in the terms and conditions of the letters of credit, the bank is bound to pay the beneficiary (see Gian Singh v Banque de LIndochine1). Although the principles of autonomy and strict compliance as applied to letters of credit are important in safeguarding the entities involved in the international transactions, these principles may prove to be contentious in some instances. Note that since the bank is affected by rights and obligations of the buyer and the seller, there is always a chance that the bank will render payment even though the transaction did not fall through or is frustrated (see Gian Singh v Banque de LIndochine2). To give us a clearer picture of the effect of autonomy and strict compliance rules, let us discuss these principles one by one. II. The Principle of Autonomy Generally, there are two types of letters of credit that are widely used by merchants, namely revocable or irrevocable. Revocable letters of credit can be amended, modified and cancelled without the consent of the beneficiary while irrevocable letters of credit requires the consent of the parties namely, the issuing bank, the applicant and the beneficiary before it admits any amendments, modifications or cancellation (Goode R., 2004). Technically, irrevocable letters of credit bring with it an assurance that payments will be made as long as the terms and conditions attached to it are met. Since irrevocable letters of credit have more or less fixed terms and conditions, it is considered as transferable (van Houtte, H., 2002). When we say transferable, this means that the letters of the credit may be passed from one hand to another and still retains is legality and viability as a pre-export financing vehicle. To transfer the rights over the letters of credit, the exporter only need to contact the transferring bank and give a written instruction that the letters of credit be transferred to another party (Goode R., 2004). However, the irrevocable letters of credit may only be transferred in accordance with its original terms and conditions (van Houtte, H., 2002). In other words, whatever was originally agreed shall be the basis for the release of the payment for the drafts. In both revocable and irrevocable letters of credit, the issuing and the paying bank maintains autonomy from the other parties involved in the transaction. Autonomy is one of the features that attract merchants to use letters of credit. Note that unlike other forms of payments, the letters of credit can stand on its own and the bank need not rely on the perfection of the contract of sale or any other contract between the parties before it will honor the drafts presented to it (van Houtte, H., (2002). According to the court in the case of O’Meara (Maurice) Co v National Park Bank3, the bank has no obligation to personally examine and verify if the terms and conditions of the sales contract between the buyer and the seller have been fulfilled before it honors the letters of credit. The concerns of the bank are limited to what are stipulated in the terms and conditions of the letters of credit. Consequently, if the beneficiary presents the draft to the bank together with the requirements need for the release of the money, then the bank is bound to honor the drafts and pay the beneficiary even if the bank has a reason to believe that the contract of sale has been frustrated or the terms of the contract of sales have not been met. Although transactions involving letters of credit are generally autonomous, the autonomy of the letters of credit and the bank involved is not absolute. According to the court in the case of United City Merchants (Investments) Ltd v Royal Bank of Canada4, there is one exception to the general principle of autonomy in letters of credit, that is, fraud. According to Lord Diplock in this case, “where the seller, for the purpose of drawing on the credit, fraudulently presents to the confirming bank documents that contain, expressly or by implication, material representations of fact that to his knowledge are untrue” then the autonomy of principle of autonomy no longer applies. We have to understand that once fraud is present in a transaction, it creates an inequity between the parties involved. Once this happens, the court will now have the obligation to allow remedies for recovery of money. The decision of the court in this case followed the exception established by the American case, Sztein v J Henry Schroeder Banking Corpn5. Technically, the decision of the American case became the cornerstone for the establishment of English common law on regarding letters of credit fraud. Yet, despite the fact that English law frowns upon fraud and it recognizes the remedies available to the parties in case of fraudulent transactions involving letters of credit, the courts have not been quick in stepping in and interfere in transactions involving letters of credit. Again, we can attribute this hesitation on the part of the court to the fact that letters of credit enjoys autonomy or independence (see Gian Singh v Banque de LIndochine6. In the words of Jenkins LJ of the Court of Appeals in the case of Hamzeh Malas & Sons v British Imex Industriers Ltd7, the “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.” Jenkins LJ stressed that since this system of transferring funds through letters of credit is already well established, the constant interference of the court in these transactions will result to a complete breakdown of the system. Since the English courts have adopted a non-interference approach when it comes to letters of credits, parties who want to go to court for redress of grievances regarding their letters of credit transactions must be able to meet the standards of proof for the existence of fraud. Unfortunately, the English courts have set very high standards of proof in this case that it is quite difficult for parties to recover payments made by the banks to the beneficiary. According to the court in the case of R D Harbottle (Mercantile) Ltd v Nat Westminister Bank Ltd8, except in clear cases of fraud, the court will not interfere with the transaction. This means that in most cases, the merchants will have to settle their disputes in other ways than seeking to nullify the letters of credit especially when the drafts hereof have been presented and paid by the paying bank. Unfortunately, the non-interference policy of the courts in this case can have some negative impacts on the transaction. Note that in the case of Discount Records Ltd v Barclays Bank Ltd9, even though the goods involved were opened in the presence of a third party and were found to be defective, the court said that the complaint was based on “mere allegation of fraud” and not fraud in itself, thus, the paying bank was still under obligation to honor the drafts. Under English law, for fraud to be considered as a ground to render the letters of credit unenforceable, the beneficiary must be involved or have personal knowledge of the fraud (see United City Merchants (Investments) Ltd v Royal Bank of Canada10; Montrod Ltd v Grundkotter Fleischvertriebs GmbH11). According to the decision of the House of Lords as penned by Lord Diplock, in case of United City Merchants (Investments) Ltd v Royal Bank of Canada12, a valid transfer of the bill of lading from one party to another binds the bank to honor the drafts upon presentation and fulfillment of the requirements attached to it. Since the beneficiary has no knowledge of the forgery committed by the third party in this case, the fraud committed by a third party does not nullify the obligation of the bank to honor the same. III. The Rule of Strict Compliance The rule of strict compliance is another feature that makes letters of credit more appealing to merchants. Technically, the rule of strict compliance is structured about the principle of independence or autonomy of the letters of credit from the underlying contract of sale or another other contracts between the parties. Both the revocable and the irrevocable letters of credit enjoy strict interpretation thus; the parties involved are well protected. Note that under the strict compliance rule, the paying bank cannot divert from what is written in the terms and conditions stipulated under the letters of credit. For instance, where the presentation of a transport document is required for the payment of the letters of credit, once the transport document is tendered and found to be compliant with the provisions of the letter of credit, the bank has no other choice but to honor the letter of credit and pay to beneficiary (see Montrod Ltd v Grundkotter Fleischvertriebs GmbH13). In case of negotiated or transferred letters of credit, the bank is even oblige to pay the beneficiary even if there is fraud as long as the beneficiary thereof has no involvement or has no knowledge of the fraud (see United City Merchants (Investments) Ltd v Royal Bank of Canada14). Despite the fact the strict compliance rule is generally favorable to the parties involved in the transactions, there are instances when strict compliance can cause problems. We have to understand that like the principle of autonomy, the strict interpretation of the letters of credit is a double edge sword and it cuts both ways. This situation is evident in the case of J.H. Rayner and company ldt. V. Hambro´s Bank ltd15, the bank did not honor the letter of credit presented to it simply because the description of the goods in the bill of lading did not use exactly the same terms as what was stipulated in the letter of credit. According to the court in this case, it does not matter if the words used to the describe the good are more or less the same, the fact that the bill of lading used different terms to describe the goods is a ground for the bank not to honor the letter of credit. Clearly, the literal interpretation and compliance of the bank to the terms and conditions of the letter of credit can have some adverse effects on the seller and the buyer. Moreover, the fact that banks are obliged to honor the letters of credit upon presentation of proper documents can have some adverse effects especially in cases of fraud (see Rafsanjan Pistachio Producers v Bank Leumi16; Mahonia v J.P. Morgan Chase17). According to the court in the case of United City Merchants (Investments) Ltd v Royal Bank of Canada18, it is not the job of the bank to personally verify if the transaction was indeed consummated so even if the transaction between the buyer and the seller was frustrated, the bank still has to follow the instructions embodied in the letters of credit. Technically, this situation can lead to the payment of substandard or even non-existent goods. IV. Conclusion The use of letters of credit in international transactions has both advantages and disadvantages. The principles of autonomy and strict compliance may be beneficial to the parties involved but in some instances, it can be a source of dispute. Since the English courts are not quick to interfere in transactions involving the use of letters of credit, it is therefore up to the buyers and the sellers to institute safeguards to protect themselves in case problems that may arise in the transaction. BIBLIOGRAPHY Books 1. Goode R., Commercial Law (London, UK, Penguin Books Ltd., 2004) 2. Moss, G. C., International Commercial Arbitration: Party Autonomy and Mandatory Rules (Oslo, Tano Aschehoug, 1999) 3. van Houtte, H., (2002) The Law of International Trade (London, UK, Sweet and Maxwell Ltd.,) Table of Cases 1. American Steel Co. v. Irving National Bank 258 US 617 (1922) 2. Equitable Trust Co. of New York v. Dawson Partners Ltd. (1927) Ll. Rep. 49 3. J. H. Rayner & Co. Ltd. v. Hambros Bank Ltd. [1943] KB 37 4. J. Zeevi & Sons Ltd. v. Grindlay’s Bank (Uganda) 371 NYS.2d 892 (Ct.App. 1975) 5. United City Merchants (Investments) Ltd & Others v. Royal Bank of Canada & Others [1982] 2 All ER 720 6. Hamzeh Malas v British Imex [1958] 2 Q.B. 127; UCP600, §§ 4, 5 7. United City Merchants v RBC, The American Accord [1983] A.C. 168 8. Mahonia v J.P. Morgan Chase [2003] 2 Lloyds Rep. 911 9. Montrod v Grundkotter [2002] 3 All E.R. 697 10. Balfour Beatty Civil Engineering and another v Technical & General Guarantee Co (1999) 68 ConLR 180 11. Sirius International Insurance v FAI General Insurance Co [2003] 1 All E.R. (Comm) 865 12. Solo Industries UK Ltd v. Canara Bank [2001] 1 W.L.R. 1800 13. Comdel Commodities v Siporex [1997] 1 Lloyds Rep 424 14. Gian Singh v Banque de LIndochine [1974] 1 W.L.R. 1234 15. Rafsanjan Pistachio Producers v Bank Leumi [1992] 1 Lloyds Rep. 513 16. Lloyds of London v CIBC [1993] 2 Lloyds Rep. 579 17. R D Harbottle (Mercantile) Ltd v Nat Westminister Bank Ltd [1977] 2 All ER 862 Articles 1. Ellinger P., (1989) The Law of Letters of Credit in The Law of International Trade Finance 203 (Horn N., ed., Deventer, Kluwer Law & Taxation, 1989) 2. Dolan J. F. (1999), Letters of Credit: A Comparison of UCP 500 and the New US Article 5 JBL 521 Internet 1. Moss, G. C., Lectures on International Commercial Law (3rd November 2003) retrieved February 2, 2010 http://www.dundee.ac.uk:80/cepmlp/journal/html/Vol14/article14_3.html 2. UCP 600 retrieved February 2, 2010 http://www.ibp.org.pk/DC-UCP-600.pdf Private Codifications 1. International Chamber of Commerce, (Paris 1994) ICC Uniform Customs and Practice for Documentary Credits 500 2. International Chamber of Commerce, (Paris 2007) ICC Uniform Customs and Practice for Documentary Credits 600 Read More