The Lifeblood of International Commerce - Essay Example

?Letters of credit have been described '' as the lifeblood of international commerce'' (Kerr L J in R D Harbottle (Mercantile) Ltd v National Westminster Bank Ltd [1978] QB146, 155) Introduction International trade for supply of goods involves longer time gap between shipment and delivery than in domestic trade. In the absence of the possibility of simultaneous exchange of goods against payment, third parties enjoying the trust of importer and exporter step in to facilitate making and receiving payment without hassles. There are generally different forms of payment practices in the international trade depending on the bargaining powers of the respective parties to a sales contract, economic conditions and political stability of the countries from where the buyer and seller come from and the degree of mutual trust and confidence between the contracting parties. They are Open Account, Bill of Exchange, Documentary Bill and Letter of Credit.1 Open Account is a type of practice whereby contracting parties agree on payment of cash against order. This means the importer has to make advance payment along with his order. The risk for the importer is at a maximum. On the other hand, exporter assumes equal risk if he agrees to ship the goods and receive payment at a later date on or after delivery. Secondly, bill of exchange is an arrangement by which the exporter obtains an undertaking that the importer shall pay the value of goods received after a certain period from the date of supply, delivery or against despatch as the case may be. This is a negotiable instrument just as a cheque or promissory note and it is governed by the Bills of Exchange Act 1882. In case of default by the importer in payment, the exporter acquires legal rights to proceed against the importer. This arrangement is safer than an open account type of payments. The third type of payment Documentary bill refers to Bill of Exchange accompanied by the bill of lading which is document of title to goods. The Bill of exchange drawn by the exporter along with the bill of lading for the goods shipped is accepted by the importer for payment as per the negotiated terms as to whether it is payable at sight or after a period of say 30 to 90 days. These three types of payment do not guarantee payment or shipment (in case of advance payment by the importer) to the respective party. The last of the above said types is the letter of credit. This form of payment removes difficulties encountered by the parties in the first three types of payment. The letter of credit has therefore been regarded as life blood of business as rightly said by Kerr L.J.2 This type of payment wherein third parties step in to guarantee payment thus lubricating the wheels of commerce is however not without problems that would affect the interests of either party.3 This paper discusses the importance of letter of credit as the lifeblood of international commerce in the following pages. Letter of Credit The letter of credit opened by a bank on behalf of an importer guarantees payment to the exporter in a foreign country through his nominated bank. Thus, the importer’s bank after satisfying with the credentials of the importer who may be its long standing client and taking necessary precautions to collect payment from its client, sends an irrevocable letter of credit as per the terms and conditions agreed upon between the importer and the exporter to the exporter’s bank. The exporter’s bank in turn forwards the letter of credit to the exporter and intimates the fact to the importer’s bank. The exporter ensures the compliance of stipulated terms and conditions and ships the goods to the importer. The bill of lading which evidences the shipment of goods and becomes the document of title to goods, is submitted to the exporter’s bank along with other documents such as invoice, certificate of insurance, certificate of origin etc and the bank is instructed to collect payment for the goods shipped against delivery of the said documents to the importer’s bank. The importer’s bank ensures compliance of terms and conditions by the exporter and delivers the said documents to the importer on collection of payment immediately or on a letter date as per the terms of the letter of credit. The payment collected is then sent to the exporter’s bank which in turn credits the proceeds to the account of the exporter. Even in the absence of payment by the importer, the issuing bank must pay the exporter which is the spirit of the irrevocable nature of the letter of credit. This arrangement guarantees necessary performance by the respective parties to the sales contract.4 Letter of credit is therefore an important instrument and is subjected to uniform customs and practices in the international trade. Documents submitted by the exporters are subject to rejection by the importer’s bank even for the slightest variation or deviation from the terms and conditions of the letter of credit established by the importer. Banks act only as facilitators and will not risk accepting or rejecting the documents except when absolutely necessary and they are not parties to the underlying contract.5 The law and problems related to letter of credit will form part of the rest of this paper. Discrepancies in the documents As said above, discrepancies in the documents to be submitted in compliance with the terms and conditions of letter of credit need to be avoided at any cost as otherwise bankers are not obliged to honour the letter of credit. Banks are put to serious difficulties of taking a decision whether to accept or reject within a short duration in case of discrepancies in the documents or missing documents. Banks sometimes accept subject to certain terms and conditions without a commitment to the beneficiary at his own risk, for the importer may or may not approve of the shortcomings.6 It is surprising that in spite of the letter of credit practice being in vogue for more than hundred years and being the only common method of payment, discrepancies in the documents have been the norm. A research conducted by ‘The Simplification of International Trade Procedures Board’ (SITPRO) of the U.K. found that 49. 0 % of documents lodged during a randomly selected period were rejected in 1983. In 1986, the failure rate was 51.4 %. The rejections were not only due to discrepancies but also for reasons of expiry of credit period, delayed shipment and delayed presentation. The discrepancies in invoices were 20.9 %, transportation documents 23.7 %, insurance documents 6.8 % and others 25.1 % in 1986 as against 13.9 %, 18.8%, 7.2 % and 23.4 % respectively in 1983. This was the result of SITPRO’s research in the documents presented at Midland Bank. In a later survey in four other banks, the failure rate was within 50 % out of more than 10,000 presentations. While West German and the U.S. Banks had the same British pattern of rejection rates, Hong Kong had 85 % and Australia 90 % as per a 1970 survey. In Australia, they were rectified in the second presentations. This gains significance especially when the judges have described the letters of credits as the life blood of commerce, rejection rate should be so high.7 The letter of credit transactions per annum are estimated at the U.S. $ 1 trillion.8 Considering the annual turnover international transactions to be in the region of US $ 7 trillion, the cost of documentation is worth the U.S. $ 420 million i.e 6 % of the value of transactions. And a major portion of this cost is attributed to letter of credits. This high percentage is because of the rejection rates.9 The instances of rejections are stated below. Allowing of transhipment as per the printed transhipment clause as against the express prohibition of transhipment in the letter of credit. In this case, documents showed that goods were subject to transhipment which the L.C terms expressly prohibited though printed terms and conditions of the contract allowed transhipment. The court held that the printed clauses would be invalid due to the subsequently inserted prohibition clause and hence the bank can refuse to pay the letter of credit. Further, invoices also carry discrepancies though they may represent irrelevant variations. Yet, the bankers cannot be compelled to pay. Thus the invoice must have the same description of goods shipped as mentioned in the letter of credit and there must be a linkage to the particularity of description in the other accompanying documents concerning transport, insurance, inspection certificates etc. Literal agreement of description of goods in the credit and in the invoice may be wanting but it may be apparent that both are the same goods. For example, the credit may stipulate as ‘20 cm pipe-cutting machinery’ while invoice may state as ‘two 20 cm pipe-cutting machinery. This is considered as an insignificant irregularity and bank should not reject. On the other hand, if the credit states as two pipe cutting machines and the invoice states simply as pipe cutting machinery, bank is justified in refusing to pay since the mention of mere machinery may mean only one machinery.10 Banking Commission of the ICC has observed that bank should not act like robots and should be judicious enough analyse each case and come to a conclusion.11 At the same time banks cannot risk by taking too much liberty in interpretations.12 Banks are expected to be extra careful in cases of some impossible credit stipulations. In Gill & Duffus S A v Berger & Co. Inc (No 2),13 the contract was for sale of Argentine bolita beans on c.i.f basis. The payment term was agreed to be as ‘net cash against documents on first presentation through Banque de Paris et de Pays-Bas, Geneve.’ One of the terms of contract was that a certificate as to quality issued by an agency General Superintendence Co ltd (GSC) should be presented to the bank along with other documents. It was quite clear that a certificate to be given at a future date could not be included in the documents of a c.i.f contract. Hence,such a condition was an impossibility. This was not in a letter of credit transaction otherwise the bank would have been in a serious dilemma. Lord Diplock agreed with this view. If a banker is faced with such a situation, he should point out the contradiction to the importer at once without waiting for the actual transaction to take place and reject it.14 Sometimes courts can decide the irregularity as irrelevant. In Golodetz & Co. Inc v Czarnikow-Rionda Co Inc. The Galatia15, sugar was shipped from India to Iran on c and f Iran basis. While the goods were being loaded, a fire damaged a part of the cargo and hence a note to that effect was made in the Bill of Lading allowing a general average claim at the destination. The Chase Manhanttan Bank N.A that had issued and confirmed the credit refused to accept the bill of lading that contained a note not mentioned in the letter of credit holding it as a claused bill. The appeal court held it as a clean bill since goods were loaded in good condition and the fire broke out only later. The court took the legal view in preference to the commercial view that every bill containing a clause or notation should be treated as a claused bill. In yet another case Westpack Banking Corporation v South Carolina National Bank16, decided by the Privy Council in London on an appeal from the decision of the Court of Appeal in New South Wales, Australia, an Australian company The Commonwealth Steel Co ltd had sold railway components to the National Railway Utilisation Corporation of South Carolina. The South Carolina National Bank issued a letter of credit permitting only shipped bill of lading. The seller submitted a bill of lading that showed the cargo as ‘received for shipment’. It also contained a note as ‘Shipped on Board Freight Paid.’ The Westpack bank for the sellers did not object to it but the importer’s bank South Carolina which had issued the credit refused to accept on the ground that the notations were not signed and dated contrary to the Article 27 (b) of 1983 Revision UCP. The South Carolina bank argued in the Appeal Court and the Privy Council that the bill of lading consisted of contradictory statements of ‘received for shipment and shipped on board freight paid’ instead of their original contention that notation was not authenticated with signature and date. Although appeal court allowed the argument, Privy Council reversed it. This leading judgement of Lord Goff observed that there was no inconsistency as such in that the good had been indeed received on board for shipment and later shipped. The Westpack was therefore held to have rightly accepted the bill of lading and South Carolina was wrong in rejecting the claim. The conclusion based on these two cases should be that banks should be guided by the substance rather than the form. This is not necessarily confined to only bill of lading but also to all kinds of documents that should accompany the invoice.17 The author Schmitthoff argues that if the credit has been issued under Uniform Commercial Practices (UCP) provisions, date of authentication in such situations as in ‘received for shipment’ and ‘shipped on board freight paid’ is important as that is what constitutes date of shipment which should not be later than the date stipulated in the credit. Two other sources of confusion may arise in respect of telex messages and the freedom of negotiation of the L.C. by the beneficiary. Thus, a telex message issued by the Credit issuing bank can by itself serve as a mandate unless it shows that full details follow as per the Article 12 of the UCP. Further, where the beneficiary has received a letter of credit payable at say 180 days sight or from the date of bill of lading, he cannot encash or discount it with any other bank prior to despatch if there is a restriction for negotiation confined to only the bank named in the credit as held in European Asian Bank A.G. v Punjab & Sind Bank (no 2)18 Autonomy principle In a letter of credit transaction, three contracts come into operation. One, between the issuing bank and the accounting party, the buyer; two, between the accounting party, the buyer and the beneficiary (underlying contract); third, between the issuing bank and the beneficiary. The two contracts between the issuing bank and the beneficiary and the underlying contract are independent of each other. This independence is known as ‘autonomy principle’.19 This upholds the issuing bank’s freedom to honour the commitment to the beneficiary under the terms of credit if the beneficiary presents all the documents required or stipulated under the letter of credit even though the actual goods supplied does not conform to the terms of the underlying contract or there may be any dispute between the parties of the underlying contract. 20 The autonomy principle came into prominence at the time of Islamic revolution in Iran in 1978 “when, for political reasons, demands were being made under letters of credit and first demand bonds by Iranian beneficiaries. These demands were allegedly fraudulent, being made for reasons unrelated to default in the underlying contract.”21 This independence is what gives letters of credit their utility and efficacy in the international commerce.22 From the beneficiary’s view point, primary obligation rests with the issuing bank if the former complies with the terms of credit. Even if the buyer becomes bankrupt, the issuing bank must pay the beneficiary, the credit being irrevocable. No set-off claims, counter-claims or attachment orders can affect the payment to beneficiary under the credit. 23 The operation of letters of credit is governed by the regulations of the International Chamber of Commerce (ICC). The ICC has issued ‘The Uniform Customs and Practices for Commercial Documentary Credits ‘ (UCP) that are revised from time to time are a standard and guidance for bankers to follow in regards to issuance and acting up on commercial credits. 24 The UCP provisions are mentioned in all the letters of credits issued and all the parties to the letter of credit are bound by the these provisions as contractual terms if not as law themselves. These provisions reflect the autonomy principle.25 It was observed in Tukan Timber Ltd v Barclays Bank Plc 26 as “"The reputation of Barclays depends on strict compliance with its obligations ... the machinery of irrevocable obligations assumed by banks is essential to international commerce. Unless such commitments by banks can be honoured, trust in international commerce could be irreparably damaged" 27 The Fraud Exception The above independence is however subject to fraud exception principle. An issuing bank can excuse itself from honouring its commitment if fraud is detected or the accounting party, the buyer can restrain the issuing bank from making payment to the beneficiary. It however depends on the jurisdictions. The fraud exception was first recognised by the American courts as observed in Toy Company Pty Ltd v State Bank of New Southwales. 28 A leading case in this respect is Sztejn v J Henry Schroder Banking Corporation (‘Sztejn’)29 which involved shipment of worthless scrap and rubbish instead of the actual goods ordered. Shientag J observed that it should be presumed that the beneficiary deliberately failed to ship the goods actually ordered, so as to preserve the efficiency of letter of credit as a primary instrument of international trade. It was observed that if the fraud on the part of the seller is brought to the attention of the issuing bank before presentation of the documents, the principle of autonomy should not be extended to favour the unscrupulous beneficiary.30 English courts however have taken a different but fairly strict view of the fraud exception. The decision in United City Merchants (Investments) Ltd v Royal Bank of Canada 31by the House of Lords gives a frame work of fraud exception. This case involved shipment of cargo after the due date for shipment but the loading brokers not connected with beneficiary entered an earlier date to avoid rejection. Lord Diplock along with four other Law Lords confirmed that fraud exception would not apply if beneficiary was not involved as a party to the fraud. Although in principle, fraud unravels all, the fraud here in is related to the documentation and not to the underlying transaction. Such a stricter interpretation of the fraud exception view only reinforces the banks’ autonomy principle.32 This view has been reaffirmed in Montrod Ltd v Grundkotter Fleischvertriebs GmBH33 Lord Pollock’s view was in quite contrast with the earlier view of Lord Denning MR in Edward Owen Engineering Ltd v Barclays Bank International Ltd 34 . He had observed that bank must not pay knowingly that documents had been forged or payment was demanded fraudulently. However, in some jurisdictions such as Australia, there is no clear view as to the applicability of fraud exception to underlying transaction alone or documentation also.35 Hence, focus should be as to how to improve the existing system of letter of credit transactions. The ideal characteristics of a letter of credit are reliability, trust, lasting, negotiable, collateral, international, distance, third-party, irrevocable, transferable, conditional, flexible, legal and structural. With these characteristics the letter of credit seems to be irreplaceable in the international trade practices.36 A new system of payment that governs the contractual relationship from the importer to exporter encompassing all the intermediaries, can therefore arise only from the concept of letter of credit for which ICC has brought out guidelines in the form of UCP serving as almost as a secondary legislation for the parties involved. It is no exaggeration to say that UCP is almost a Bible for the bankers. The UCP 500 has been already updated taking into consideration of the practical difficulties and new version UCP 600 has been brought out in 2007 to be enforced from 2007 and it is too premature to comment upon its functioning. Bergami37 says that letter of credit continues to remain an acceptable instrument of finance although in the U.K. ? 113 million per annum are incurred to rectify discrepant documents.38. The UCP 500 had 49 articles whereas UCP 600 has only 39 articles which is a pointer to the simplification of the guidelines. Article 13 of UCP 500 had required bankers to verify the documents presented by the exporter as per the International standard banking practice. Actually there was no such standard until ICC itself (the author of UCP) brought out International Standard Banking Practice (ISBP) in 2003 and it was not made mandatory but voluntary. The article 13 of UCP 500 has been replaced by article 14 of UCP 600 in which the “doctrine of strict compliance” is still in place. As such even a spelling error between two documents not relevant to the fields of the letter of credit is not tolerated. Rather a regime of ‘inventing discrepancies’ has been established over the years as a result of the doctrine. Article 16 of UCP 600 (ex article 14) stipulates action to be taken on the discrepant documents. While under UCP 500, the issuing bank can approach the importer for waiver and even in the case of waiver, the issuing bank is under no obligation to accept it in view of the other contractual considerations in the letter of credit mechanism, the UCP 600 provides that the exporter can consult with the bank prior to its request for the waiver. Article 14 of the UCP 600 (ex article 37) dilutes strict compliance in respect of product description on the invoice.39 Conclusion In spite of the error-laden letter of credit system of trade financing, it is still preferred for the banks’ role played between the applicant and the beneficiary. This is more of personalised nature at the respective party’s level which is a confidence building measure. The international trade litigation is abounding with cases of documents not in conformity with the stipulations in the letter of credit established between parties. The seemingly trivial nature of discrepancies such as invoices or packing slips not being original and even though they are in fact original not having been stamped as such are not taken lightly by the collecting banks. They promptly return the documents and refuse to honour the commitment in the letter of credit since the buyer can always litigate on such matters and hold the bankers liable. It is understandable if the Bill of lading is not in original form since original alone is considered a negotiable instrument. If the original with blank endorsement goes to wrong hands, it can always be used to clear the shipment from the harbour before the importer comes to know of it. So also, insurance policy should be in original since insurer will not entertain a claim without production of the original. But anyone else making a fraudulent claim is a remote possibility unless the insured sleeps over any loss incurred by him. Even though original versions of invoices and packing materials are not going to present immediate problems in accessing the goods, difficulties will arise in inland transit if cleared goods are not accompanied by the original and at the time of tax assessment when the tax authorities would disallow deductions without the original invoices in the records of the importer. The tax assessment will be held sometime later when it may not be possible for the importer to claim it from the exporter. He may have as well lost it and obviously cannot create another original. He can only give a certified true copy of the original and not the original itself. Hence it is quite understandable to insist on the documents to be strictly as stipulated by the letter of credit to avoid future complications. This robustness of the letter of credit obviously makes it a lifeblood of the international commerce. 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(2004) Australian Business Law Review 32 (6) 1-30 , 5 Bergami Roberto, 2007 ‘Will the UCP 600 Provide Solutions to Letter of Credit Transactions?’ International Review of Business Research Papers, .3 (2) June, Pp. 41 - 53 Periodicals D. Clarke ‘ Wire News :Unclogging International Trade’. Wired July 8 1999 Read More