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Balancing rights and duties of parties in a letter of credit transaction
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.
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.
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.
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.
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.
There are two main types of Letters of credit:
Revocable Letter of Credit
Revocable letter of credit is not a commonly used type of the letters of credit. This type of letter of credit can be revoked by the issuing bank at any time, without notification to the beneficiary, for any reason. Such type of letter of credit can not be confirmed by the correspondent bank and the bank will act as an advising bank only.
A revocable letter of credit can not be revoked after the presentation of the documents, if the documents are conforming to the terms and conditions of the letter of credit and the payment has been made.
Irrevocable Letter of Credit
Use of irrevocable letters of credit is very common in international trade. Irrevocable letter of credit can not be revoked or changed without the consent of the beneficiary. Issuing bank will make the payment to the seller, if the seller presents the documents complying with the terms of the credit, as agreed between seller and buyer. Such a letter of credit can only be changed with the permission of both buyer and seller. If it is not clear from the letter of credit that whether it is revocable or irrevocable, it automatically considers as irrevocable.
Irrevocable letters of credit are of two kinds:
In case of unconfirmed letter of credit, advising bank does not confirm the credit to the seller and the issuing bank is the only party responsible for payment to the beneficiary. Advising bank will only pay to the seller after getting payment from the issuing bank and there is no risk for the advising bank.
In this type of credit, advising bank confirms credit to the seller. When the advising bank confirms that the documents presented are conforming to the terms of the credit, it will make the payment to the seller, and after that advising bank will contact with the issuing bank to get the payment. This type of letter of credit is commonly used, when the seller is unfamiliar with the issuing bank. Such a type of letter of credit is quite expensive because the banks have some liability.
In international trade as the buyer and seller are in different countries so when the buyer and the seller of the goods agree to conduct business, than because of the gap of time between delivery of goods and the payment, usually the seller wants a letter of credit as a guarantee of payment from the buyer. Than the buyer makes a request to his bank called the issuing to open a credit in the favour of the seller. at the request of the buyer, issuing bank issues a letter of credit in favour of the seller and forwards it to the corresponding bank called the advising or conforming bank., which is usually located in the seller's country. Advising bank than either confirms the credit or not, depending upon the type of credit, and forward it to the seller. Seller than ships the goods and collects the documents required in order to meet the requirements of the letter of credit and finally to get the payment in time. Seller presents the required documents to the advising or confirming bank in order to get the payment in time. Advising or confirming bank examines the documents presented by the seller to check that whether they are conforming to the terms and conditions of the letter of credit. If the documents are in compliance, advising or confirming bank, in case of confirmed letter of credit, will make payment to the seller and will be reimbursed from the issuing bank and in case of unconfirmed letter of credit, advising or confirming bank will forward the documents to the issuing bank. Than the Issuing bank will, after examine of the documents, debit the buyer's account if the documents are in compliance to the terms of the letter of credit. In the end, Issuing bank forwards the documents to the buyer.
Most commonly used documents in a letter of credit transaction include:
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 the documents presented
A discrepancy is some defect in the documents presented by the seller, which show their non-compliance with the terms of the letter of credit. Issuing bank can not change the terms and conditions of the letter of credit with out t he permission of the buyer. Therefore to avoid any delay in getting payment. Beneficiary should be careful in preparing the required documents. Common defects in the documents presented by the seller include:
- If the description of the goods is not consistent.
- There is some error in the insurance documents.
- If the draft amount is not equal to invoice amount.
- Loading and destination ports are not same as provided by the letter of credit.
- Merchandise description is not same as in the credit.
- If any of the documents required by the credit is not presented.
- Documents are generally inconsistent such as quality, etc.
- If the names of the documents required are not correct, as mentioned in the credit.
- Invoice is not signed as provided in the letter of credit.
- If prior to the presentation of the draft, Letter of Credit has expired.
- If the date mention in the bill of lading is different from the date stated in the credit.
- If there are some changes in the invoice which are not authorized by 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
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?
Doctrine of strict compliance and independence principle
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. According to this principle, the issuer has no concern with the underlying contracts between buyer and seller. Its concern is with documents only, rather than the goods or any type of services. Obviously there are some doubts about this principle, i.e. to what extent this principle should be applied. Which some tome may cause injustice to the applicant under certain circumstances.
Generally, letter of credit is a contract between the issuer and the seller of the goods, which is independent of the underlying contract between the seller and the buyer. The independence principle is mentioned 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.
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?
Status of applicant under 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 the status of the applicant is doubtful, even it is not clear 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. Their importance is so clear that without their presentation and conformity, the performance of the letter of credit transaction is impossible. Article 13(a) of the UCP provides:
“Banks must examine all documents stipulated in the Credit with reasonable care to ascertain whether or not they appear, on their face, to be in compliance with the terms and conditions of the Credit. Compliance of the stipulated documents on their face with the terms and conditions of the Credit shall be determined by international standard banking practice as reflected in these Articles. Documents which appear on their face to be inconsistent with one another will be considered as not appearing on their face to be in compliance with the terms and conditions of the Credit.”
(b) Standard of “reasonable care”
Under this heading we will discuss that whether there is a any standard of reasonable care under the UCP or not and if there is a standard, toward whom, and in case of failure to exercise such care, what would be the consequences. Sub-Article 13(a) of the UCP, provides that the bank's duty is to examine the documents required by the applicant with “reasonable care” to ensure that such documents are complying with the terms and conditions of the letter of credit “on their face”.
To some extent, sub- Article 13(a) is ambiguous about its meaning. It is not clear that what exact standard should be exercised. UCP and even whole letter of credit system is quite about the standard of the duty of care imposed on the banks, towards whom bank should exercise such a duty of care, and what would be the consequences in case if the bank fails in exercising such a duty of care. Probably there is no answer to this question because of the fact that the rights of the applicant are not discussed under UCP.
Validity of documents
Article 15 of the UCP protects the banks by stating that “banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any documents...”.
Banks are authorised to make payment without having any concern whether the documents presented by the beneficiary actually represent goods, for which the applicant contracted for. As explained above that the letter of credit is a written undertaking by the bank to make payment only if the beneficiary presents original and genuine documents as agreed by the parties. Similarly buyer also knows very well that the amount will be paid only upon the delivery of the conforming documents according to the terms and conditions of the credit. Hence the documents play a key role in the performance of the letter of credit transaction. Conformity is the only condition for the payment of the amount. In practice, a bank very often takes security for the payment it makes under the letter of credit transaction. Such a security is provided by the documents of title from the seller. Bank gets the possession of these documents and hence keeps a control over the goods. Therefore, the documents are very important in this whole mechanism and if the goods appeared to be garbage than the security provided to the bank would be useless. Therefore it is clear that as the whole system of the Documentary Credits depends upon the integrity and the validity of the documents, bank should not make payment if there is lack of authenticity.
Lord Denning M.R., discussed the question of fraud in a case: “Documents ought to be correct and valid in respect of each parcel. If that condition is broken by forged or fraudulent documents being presented - in respect of any one parcel - the banks have a defence in point of law against being liable in respect of that parcel.”
In Old Colony Trust v Lawyer's Title and Trust Co., Justice Mayer held that:
“an issuer may refuse payment when the document of title presented by the seller is false in the sense that it does not represent any goods. Obviously, when the issuer of a letter of credit knows that a document, although correct in form, is, in point of fact, false or illegal, he cannot be called upon to recognise such a document as complying with the terms of a letter of credit…”
Hence, where the documents on their face seem to be correct but in fact proved to be illegal, are not the documents in compliance with the terms of the credit.
Standard of compliance
There are two ways in which courts deal with documentary compliance:
(1) strict compliance and (2) substantial compliance
(a) Strict compliance
Under common law
Strict compliance requires that all documents must comply with the requirements of the letter of credit i.e. all documents must be delivered, must me exactly same as agreed between the parties and the goods must be of sufficient description. When a beneficiary presents documents to the issuer and demands a payment of the credit, the issuer must examine the documents to determine whether they comply on their face with the requirements of the credit. If they do not comply, the issuer may dishonour the beneficiary's draft, and the beneficiary cannot complain. The advantage of the strict compliance rule to the applicant is most obvious in letters of credit transactions because the primary concern of the applicant-buyer is that the seller has shipped what was bargained for before the buyer becomes obligated to pay.
Article 37(e) of the UCP states:
“The description of the goods in the commercial invoice must correspond with the description in the credit. In all other documents, the goods may be described in general terms not inconsistent with the description of the goods in the credit.”
Such standard also appeared in some English cases.
In Midland Bank Ltd. v Seymour, Devlin J stated:
“… it is sufficient that the description should be contained in the set of documents as a whole and that the documents should each one be valid in itself and each be consistent with the other, and accordingly, it would not matter for this purpose whether the description in the bill of lading is or is not negatived by the clause in the bill of lading, since the description is sufficiently contained in the invoice, which is one of the documents.”
Under §5-108 of the UCC, banks owe a duty to examine documents with care, to ascertain that the documents appear on their face to be in compliance with the terms and conditions of the credit.
(b) Substantial compliance
However in very rare situations a question can arise that whether a beneficiary can be refused for payment, if he has, in good conscience, made substantial compliance, for example where there is a typing error in the document presented. There are two theories relating to this situation. One of them says that the strict rule can give harsh results sometime because as the seller is not the issuer of the documents and thus it would be difficult for it to comply with all the terms and conditions of the credit. Other one says that word by word compliance is the justification and necessity, which gives maximum security to the parties. Courts have also developed a “substantial compliance” rule, according to which a document should be accepted, despite discrepancies, if such discrepancies are not deceptive.
Strict and substantial compliance in practice
General rule is that if the typographical errors are not deceptive, will not affect the validity of the documents. Therefore most of the banks do not consider such discrepancies, e.g. replacement of “A” with “a”. Evidence tendered in Standard Chartered Bank v Pakistan National Shipping Corporation suggested that the practice of document checkers was far more liberal than this, to the extent of routinely ignoring late shipment dates on the basis of “speeding up trade flows”. Another challenge for the courts is that whether singular includes plural.
Under the strict compliance rule, if an applicant wants the opinion of two experts, it will be considered as a condition of the letter of credit .
In Equitable Trust Company of New York v Dawson Partners Ltd., the letter of credit required “a certificate of quality to be issued by experts who are sworn brokers.” But during the communication, the message had been altered by the bank's agent to the effect that a certificate issued by a single expert would satisfy the requirement. This was because of the agent's telegraphic code which used the same symbol for singular and plural words. The House of Lords held that the applicant was not obliged to reimburse the bank because the terms of the credit had not been complied with.
Beneficiary's obligation to present conforming documents
In order for the beneficiary to be entitled to claim upon the credit, the documents presented must conform to the terms of the credit. The question is, at what level must the documents conform? “Conformity” can be viewed on more than one level. At one level there is “facial conformity”, which considers whether the documents conform on their face to the requirements of the credit. Facial conformity may be satisfied even where there is fraud in relation to the documents. For instance, this was why the beneficiary in United City Merchants was entitled to payment. Although, fraudulently completed, the bill of lading reflected the required date of shipment and was therefore a facially conforming document. On a broader level, it has been argued that conformity is a question of whether the document is what is required under the credit. On this basis, a document that is a nullity, although potentially facially conforming, may not be sufficient to satisfy the broader requirement of conformity because it is not what is required under the credit.
Where sufficient notice of fraud in the documents or nullity is brought to the attention of the bank, despite the documents being facially conforming, the bank should not be permitted to accept and pay on such documents. To do so would be contrary to its mandate from the applicant to pay against genuine documents. Therefore, the view that genuine documents must be presented which are conforming with the terms and conditions of the letter of credit is clearly one that is well established and supported.
The idea that banks are not required to look beyond what appears on the surface of the documents is clearly summarised by Potter L.J. in Montrod:
“… [N]either as a matter of general principle, nor under the UCP 500 is an issuing bank obliged to question or investigate the genuineness of documents which appear on their face to be documents the nature and content of which comply with the requirements of the credit.”
Thus it can be seen that, on the one hand, banks are said to have an obligation to pay on presentation of genuine documents, while, on the other hand, they are not required to question or investigate the genuineness of the documents presented. This appears quite contradictory and leaves banks in a dilemma. Will a bank be entitled to reimbursement from an applicant where it accepts and pays on a document which, on its face, appears true and genuine even though further investigation into the genuineness of the document may reveal that was not in fact the case? In accordance with the UCP and the decision in Gian Singh & Co Ltd v Banque de l'Indochine, it is suggested that a bank would be entitled to reimbursement in such circumstances. The situation might be different, however, where the bank has knowledge that the genuineness of the document was being called into question, even though on its face the document appears true and genuine.
The bank's mandate from the applicant
In the Court of Appeal in United City Merchants, Ackner L.J. stated that the bank's authority or mandate from the applicant is to pay against genuine documents. The bank's mandate derives from the instructions of the applicant and the bank has no authority to depart from those instructions in any way. Accordingly, a bank that breaches its mandate and pays out on apparently conforming documents which it knows are not genuine should not be able to claim reimbursement from the applicant.
The view that the bank has a limited mandate has been described as “attractive”. It is simple common sense. In no circumstances would an applicant be willing to authorise a bank to pay out on documents which it knew to be null and void. It is the applicant who would ultimately bear the loss from the bank paying out on such documents. It is obvious that in such a situation the applicant would desire that the bank withhold payment.
Investigating abnormalities in the documents
The system postulates from the banks to fulfil their duty to check documents properly that whether they are in compliance to the requirements of the letter of credit, and gives permission to the banks to rely only on the apparent compliance of the documents irrespective of the underlying contract between seller and buyer. Therefore banks bear no risk in respect of the non-performance of the underlying contract between seller and buyer. Despite the fact that under Article 15 of the UCP, bank's liability is very limited in dealing with the documents and the banks are only limited to their facial compliance, under this heading we will discuss that the banks should not ignore any abnormalities in the documents.
Under Article 13 of the UCP, while examining the documents, banks should adopt “international standard banking practice” as the standard, which looks very odd if someone is setting up a self made standard for judging his own duty of care, hence a question of neutrality can arise. It is very difficult to acknowledge “good faith” under general banking practice because of the two reasons: (a) lack of a significant requirement of reasonable care and (b) lack of a clear standard of such duty of care. For example, no such duty has been imposed on banks, both under the UCC and the UCP to investigate such abnormalities which can raise a suspicion of fraud in the documents or in the underlying contract between buyer and seller. Therefore, the banks have the excuse of not highlighting such suspicions of fraud and ultimately all the burden of the risk of fraud shifts to the applicant. It has furthermore been admitted by banks that “banks are not concerned with the bona fides of the beneficiary”.
The situation has now changed to the extent that the English courts are now reluctant to uphold banks payment just because of facial compliance. Therefore, banks could be in a difficulty if the buyer proves before the court that there was a fraud and if the court apply the rule of “fraud unravels all”, the only remedy for the banks is to sue the beneficiary who has acted in bad faith.
Fraud and Letters of Credit
In order to achieve more equitable results , courts tried to introduce a fraud exception to the independence principle if the transaction is contaminated with fraud. The court in Bank of Nova Scotia v. Angelica-Whitewear Ltd. expressed the significance of this exception in the following terms: “An exception to the general rule has been recognized for the case of fraud by the beneficiary of the credit which has been sufficiently brought to the knowledge of the bank before payment of the draft or demonstrated to a court called on by the customer of the bank to issue an interlocutory injunction to restrain the bank from honouring the draft.”
The ICC Banking Commission has also made it clear that irrespective of the independence principle specified in Articles 3 and 4 of the UCP, and the bank's right of reimbursement in sub- Article 10(d) and 14(a), ”there is an exception to these provisions in many jurisdictions, namely abuse of right, or fraud”.
It is for the courts working in different jurisdictions to deal with the cases of fraud to protect the interests of all parties concerned. The court in the Canadian case of Angelica- Whitewear, summarized various questions relating to the fraud exception and independence principle: (1) whether the fraud exception should only be confined to cases of forged or false documents or should extend to fraud in the underlying transaction; (2) the sufficiency of proof or demonstration of fraud which is required to relieve an issuing bank of its obligation to honour a draft or to warrant the issue of an interlocutory injunction to enjoin the honour; (3) whether the fraud exception is “opposable” (i.e. sustainable) against a holder in due course of a draft; and (4) whether the fraud exception should be limited to the fraud by the beneficiary of the credit, or it should extend to fraud by a third party when the beneficiary is innocent.
What is fraud?
This question is typically arises in the context of a false statement made in a document. It is not necessary that the maker of the statement should be dishonest in the sense used in the criminal law; it suffices that it constitute the tort of deceit in that it is made knowingly and with intent that it should be acted upon by the person to whom it is addressed. So where the conforming bank sent a letter to the issuing bank falsely stating that the document had been presented within the period limited by the credit and the statement was known to the conforming bank checkers to be false and was intended by them to acted upon by the issuing bank, this constituted fraud entitling the issuing bank to refuse payment and exposing the conforming bank to liability even though the checkers were not dishonest or fraudulent in the criminal law sense.
Does the fraud in the underlying transaction suffice?
Apparently there is no reason in principle why the fraud exception should be confined to fraud in relation to the issue of the letter of credit. Indeed, in Themehelp Ltd v West the Court of Appeal held, in a majority decision, that it was equally available in the case of fraud in the underlying transaction, as where it was seriously arguable that the seller-beneficiary had been guilty of fraudulent misrepresentation. However the decision is open to the objection that, as pointed out by Evans LJ in his dissenting judgment, the primary remedy sought by the buyers in respect of the alleged misrepresentation was not rescission but damages, leaving the contract on foot and the buyers still liable for the price, and there was equally no basis upon which the fraud exception could be made available to the bank if payment were demanded under the guarantee.
What is the standard of proof?
Standard of the proof of fraud depends upon the stage of the proceedings before the court. In proceeding relating to an interlocutory injunction, the mere allegation of fraud is not sufficient, nor is it enough that the bank has an ‘arguable case'. What does suffice, courts would have to struggle to set a standard which is high enough to safeguard the autonomy principle but not so high as be unattainable.
Whose fraud is relevant?
In cases, where the documents are conforming on their face to the terms and conditions of the letter of credit, the bank's right to withhold the payment on the grounds of the fraud is limited to cases where the fraud is that of the beneficiary himself or his agent. In The American Accord the House of Lords, reversing the decision of the Court of Appealand restoring that of the trial judge on this point, held that the beneficiary who tendered a bill of lading in which a false date of shipment had been inserted by an employ of the ship's broker was entitled to be paid, since the beneficiary had been acted in good faith and the broker was not his agent.
Who is immune from the effects of beneficiary's fraud?
The fraud exception is not available against a bank which in conformity with an authorization from the issuing bank, has conformed or negotiated the credit prior to becoming aware of the fraud or against a bona fide transferee of a transferable credit or a holder in due course of a draft.
Position of Fraud exception in England
Disputes arise if a bank makes payment where a fraud is alleged in connection with the underlying contract between seller and buyer. Such disputes come before the Courts in three different situations:
- When the buyer wants to stop payment from the issue, on the basis of fraud on the part of seller.
- When the seller is suing the issuer on the grounds that the issuer has refused to make payment on the basis of fraud.
- When the issuer has already paid and a recovery is sought on the basis of fraud.
Under this heading, we will consider the approach of the English Courts in relation to fraud exception, in the context of the UCP, and also to look at the outcome and any lessons for the banks in the decisions of English Courts.
The view of the English Courts is that banks should make payment in a letter of credit transaction, depending:
(1) Autonomy of the letter of credit, i.e. the letter of credit transaction is completely independent from the underlying contract between seller and the buyer. Banks are concerned only with the documents presented by the beneficiary and not with the goods or services. Thus if buyer alleges that the seller has committed a fraud in relation to the underlying contract between seller and buyer, bank can claim that its duty is to make payment on the presentation of the complying documents by the beneficiary and it has no concern with the underlying contract between buyer and seller.
(2) Trust upon the integrity of the banking system, i.e. international trade, would suffer loss, if no one would rely upon the integrity of the banking system and the duties of the banks to pay in a letter of credit transaction.
To balance the principle of the autonomy of the letter of credit, bank are authorised to refuse the payment, if the documents are not conforming on their face with the terms of the credit, but if the documents are conforming on their face, banks are obliged to pay.
However, there is an exception to the doctrine of documentary compliance, which is called the “fraud exception”. This exception says that even if the documents are in compliance on their face with the terms of the credit, a bank is authorise to refuse to pay where:
- there is clear evidence of fraud on the part of the seller in an underlying contract, and
- the bank has been informed about this fraud, and
- the bank has been informed in time.
Some decided cases of English courts relating to fraud exception
The development of English case law in relation to the fraud exception is based on an American case: Sztejn v. Henry Schroder Banking Corporation, this was a decision of Judge Shientag. In this case the applicant of the letter of credit sought an injunction against the issuing bank to stop the bank from paying on documents, presented by the seller. The beneficiary was a merchant in India. Applicant's allegation was that the shipped goods were not the goods he had contracted for.
In the New York Court of Appeal, Judge Shientag stated that a Letter of Credit is “independent of the primary contract of sale between a buyer and a seller. The issuing bank agrees to pay upon presentation of documents not goods. This rule is necessary to preserve the efficiency of the Letter of Credit as an instrument for the financing of trade”.
But the Judge further said that due to the facts of the case the situation is different because: “on the present motion, it must be assumed that the seller has intentionally failed to ship any goods ordered by the buyer. In such a situation, where the seller's fraud has been called to the bank's attention before the drafts and documents have been presented for payment, the principal of the independence of the bank's obligation under a Letter of Credit should not be extended to protect the unscrupulous seller.”
This decision of an American Court had been given about sixty years ago but has been quoted many time in the English Courts. Indeed, Lord Diplock in the United City Merchants case referred to Sztejn as “the landmark American case”.
Discount Records v Barclays Bank 
In this case, buyers claimed that the cartons shipped by the sellers contained only a small amount of the goods, which the buyers had contracted for ordered, and the remaining cartons were filled with rubbish. The buyers sought an injunction against the bank to stop the payment to the sellers, under letters of credit. It was held that the fraud had been alleged but was not yet proved, so an injunction would not be granted, as in such circumstances, the grant of an injunction would prevent the bank from performing its obligations.
Harbottle v National Westminster Bank 
In this case, English plaintiffs entered into contracts for sale with Egyptian buyers, provided that the plaintiffs would provide a guarantee confirmed by a bank and the guarantees covered five percent of the purchase price in favour of the buyers. The plaintiffs claimed that the buyer's demand of guarantees was without any justification. Mr Justice Kerr stated in his judgement that it was only in “exceptional cases” that courts would interfere with the irrevocable obligations assumed by banks.
Edward Owen Engineering v Barclays Bank 
In this case, Court of Appeal approved the decision of Sir Michael Kerr in the Harbottle case. Lord Denning described the fraud exception the following words:
“that case (the Sztejn case) shows that there is this exception to the strict rule: the bank ought not to pay under the credit if it knows that the documents are forged, or that the request for payment is made fraudulently in circumstances where there is no right to payment” (page 982).
In the same case, Lord Justice Brown, said about the fraud exception:
“that exception is that where the documents under the credit are presented by the beneficiary himself and the bank knows when the documents are presented that they are forged or fraudulent, the bank is entitled to refuse payment”(page 984).
Lord Justice Geoffrey Lane also said at page 986:
“the only circumstances which would justify the bank not complying with the demand ……..is this, if it had been clear and obvious to the bank that the buyer had been guilty of fraud”.
United City Merchants v Royal Bank of Canada 
In this case, documents presented to the confirming bank, contained a misstatement, i.e. the bill of lading showed the shipment date as 15th December 1976 which was the last date for payment, while in fact shipment was on 16th December. So the Defendant bank refused to pay.
In the House of Lords, Lord Diplock described the autonomous nature of the letters of credit, that the goods are irrelevant to the seller's right to payment from the bank. However, he said:
“to this general statement of principle as to the contractual obligations of the confirming bank and the seller, there is one established exception: that is, 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.”
Lord Diplock further referred to the Sztejn case and said:
“the exception for fraud on the part of the beneficiary seeking to avail himself of the credit is a clear application of the maxim ex turpi causa non oritur actio or, if plain English is to be preferred, ‘fraud unravels all'. The Courts will not allow their process to be used by a dishonest person to carry out a fraud.”
Deutsche Ruckversicherung v. Walbrook Insurance 
In this case, Lord Justice Staughton emphasised on the distinction between preventing a seller from getting payment from the issuer or preventing a bank from making a payment under a letter of credit transaction. He said:
“the effect on the lifeblood of commerce would be precisely the same whether the bank is restrained from paying or the beneficiary is restrained from asking for payment.”
Standard Chartered Bank v. Pakistan National Shipping Corporation 
This is an important case in relation to the liability of a bank in case of contributory negligence, where false documents are delivered by the beneficiary in support of an application to get payment under a letter of credit.
In the proceedings before the English Court, Standard Chartered Bank had established a good cause of action against the defendant, Pakistan National Shipping Corporation. Pakistan Shipping Corporation issued a Bill of lading which to its knowledge contained a false shipment date. The Bill of Lading was presented to Standard Chartered Bank under a letter of credit which was issued by Incobank of Vietnam and was confirmed by the Standard Chartered Bank. In fact the shipping documents were presented to Standard Chartered Bank late. However Standard Chartered Bank made the payment without the authority of Incobank, and hence claimed reimbursement on the basis of a false statement that the documents had been presented on time. Incobank refused to make payment because of discrepancies. Pakistan Shipping Corporation argued that the damages caused due to Standard Chartered Bank's negligence in failing to find out the discrepancies in the documents presented before the bank, and the Court should reduce the amount payable under the provisions of Section 1 of the Law Reform (Contributory Negligence) Act 1945.
The Court of Appeal held that under section 4 of the 1945 Act, for a defence of contributory negligence, negligence should be actionable. In this case Pakistan Shipping Corporation's claim for reduction of the damages payable depends upon its establishing that the act of Standard Chartered Bank has given rise to an action for contributory negligence. However, it was unbelievable that the deceitful conduct of Standard Chartered Bank would have afforded Pakistan Shipping a defence, as in any event, a Defendant, liable in a deceit could not establish a defence based upon the contributory fault of a Claimant. Therefore, there were no grounds for reducing the damages recoverable on the basis of contributory negligence.
The Court of Appeal criticised the role played by Standard Chartered Bank in this case. Lord Justice Ward referred to Standard Chartered Bank, “scandalous attempts to deceive the issuing bank on the basis of a false statement that the documents were presented to them in time.” (page 948). Later he referred to his “…..distaste for the bank's conduct. They have brought dishonour upon themselves and upon the City. It is quite another question whether the dishonest ship owners can benefit from the attempted fraud”. (page 958).
Fraud exception and UCP
The fraud exception does not originate from the UCP, it is a Common Law practice. In fact there is nothing about fraud or fraudulent documents in the text of UCP 500. Under UCP 500, the bank's only duty is to examine the documents with reasonable care to see if they, on their face, comply with the terms and conditions of the credit. If so, then the bank is entitled and should pay against them. UCP also provides that banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any documents. UCP, having given the principle of autonomy, does not mention any exception to this principle. The reason for this gap is suggested to be the difference and uncertainty of the position in municipal laws and that every court should give its decision according to the related municipal law.
ICC Banking Commission when asked to comment on the liability of a negotiating bank which had paid against a forged bill of lading, gave the following reply:
“The commission expressed its opinion that the negotiating bank passing forward what proved to be a forged bill of lading was protected by Article 9 unless it was itself a party to the fraud, or it had knowledge of the fraud prior to presentation of the documents, or unless it had failed to exercise reasonable care, e.g., if the forgery were apparent ‘on the face' of the document.”
With this interpretation, ICC Banking Commission has approved the existence of fraud exception.
Narrowness of fraud exception
As there are strict requirements for a fraud exception to be applied, therefore are only few cases, which have been successful in establishing fraud and acquiring injunctions. The fact that courts do not want to interfere with banks' business and that they are reluctant to grant injunctions makes this exception almost useless. Even where a bank knows that payment demand is fraudulent but cannot establish this, it has to pay. This is another big advantage for fraudsters who want to misuse the documentary credit system.
Banks and the Fraud Exception
English cases clearly exhibit that in case fraud exception, banks are authorised to refuse the make payment and also have a defence if they are sued by the beneficiary or other party presenting the documents under a letter of credit transaction. On the grounds of fraud exception Courts will not permit fraudsters to perform fraudulent activities.
Do the banks learn any lesson from the decisions of the English Courts?
Generally, banks in England can feel quite safe. Albeit the Courts will not permit their processes in any case to be used by the fraudsters for their fraudulent activities, however, except in some exceptional circumstances, the integrity of the banking system is upheld by the English courts. As many of the fraud cases come before Court at a pre-trial stage, therefore the banks have the benefit that the “balance of convenience” is likely to be in favour of the banks. The English Courts decided in a case that, where fraud is alleged, it is not for a bank to investigate such allegations, which makes the position of the banks safer. Even in some cases as in Standard Chartered Bank v National Shipping Corporation of Pakistan, where a bank has itself been guilty of making a false claim against another bank, apportionment of loss will not be made by way of contributory negligence in circumstances where false documentation is delivered by the beneficiary in support of an application for payment.
Comparing bank's duty to applicant with bank's duty to beneficiary
In the House of Lords in United City Merchants, Lord Diplock put forward the argument that it would be strange from a commercial point of view:
“… if the contractual duty owed by the confirming and issuing banks to the buyer to honour the credit on presentation of apparently conforming documents despite the fact that they contain inaccuracies or are even forged, were not matched by a corresponding contractual liability of the confirming bank to the seller/beneficiary (in the absence, of course, of any fraud on his part) to pay the sum stipulated in the credit on presentation of apparently conforming documents.”
In fact, this was one of the reasons upon which the House of Lords relied in deciding that the seller/beneficiary should be paid despite the fraud in the documents. Such an argument also weighs against a nullity exception, as it implies that the bank has a duty to pay against documents which apparently conform to the credit, but which might nonetheless be forged and a nullity.
However, this argument is similarly not without objection. It has been observed that, “the notion that a bank owes its own customer a duty to allow him to be defrauded by forged documents is surely bizarre”. The first part of the House of Lords' argument is problematic. Neither the UCP nor the common law imposes a duty on the bank to the applicant to pay upon conforming documents. The common law and UCP are directed at the duty of the applicant to reimburse the issuing bank if the bank has, despite having exercised all due care, mistakenly paid the beneficiary upon apparently conforming documents which were inaccurate or forged. The focus is on the bank's entitlement to reimbursement, rather than on any duty it owes to the applicant to honour apparently conforming documents.
The second part of the House of Lords argument is similarly questionable. Under Art.9 of the UCP 500, the issuing bank undertakes to pay out sums under the credit provided that the stipulated documents are presented and the terms and conditions of the credit are complied with. Article 9 does not state that conformity on the face of a document is sufficient. It is a rule for the protection of banks, entitling them to pay against documents which, on a reasonable examination, appear to conform to the credit, but it certainly does not oblige them to do so if they know the true facts.
Further, the stated condition of the beneficiary's right to payment is presentation of documents which in fact conform to the credit, not those which merely appear to do so. Accordingly, based on this statement surely banks can argue that when a document that is a nullity is presented there has in fact been no presentation at all? A document that is a nullity has no legal existence. Such an argument should arguably be available to banks even if they realise after presentation that the document was a nullity. Normally, in accordance with Art.13 of the Uniform Customs and Practices for Documentary Credits (1993 revision), ICC Publication No.500, a bank will have:
“… a reasonable time, not to exceed seven banking days following receipt of the documents, to examine the documents and determine whether to take up or to refuse the documents and inform the party from which it received the documents accordingly.”
In other words, once the period of seven banking days for examination of the documents has passed, the bank is estopped from objecting to, or raising, any discrepancies or defects in the documents presented. However a document that is a nullity has no legal existence so it should be open to a bank to argue that there has been no presentation and therefore no time from which the period for reasonable examination can begin.
It follows, therefore, that Lord Diplock's argument that the bank owes a matching contractual duty to the beneficiary to pay on presentation of apparently conforming documents, cannot be regarded as persuasive. It is inconsistent with both the common law and the UCP. Even if it is valid, such an argument could, at best, only be described as a weak argument against recognising a nullity exception.
Every year, maritime fraud victims lose millions of pounds. Traders, bankers, and international organisations, although aware of this serious problem, are far from taking effective precautions.
Making money by means of maritime fraud is a big opportunity for the unscrupulous. It promises high profit and entails little risk. In particular, some features of documentary credits, which are an essential instrument for the quick and smooth running of international trade, make it even more attractive for fraudsters to commit fraud. While fraudsters vanish with millions of pounds in their pockets, banks and/or their customers, remain legally and practically without any remedy.
According to the Article 4: “in credit operations all parties concerned deal with documents, and not with goods, services and/or other performances to which the documents relate.” That means banks are obliged to pay against documents, strictly complying with the credit terms. Banks cannot investigate the factual background of documents. Their duty is just to see whether the documents comply with the terms and conditions of the credit and if they comply pay the amount, stipulated in the credit. The fact that banks are concerned only with documents and not with goods makes it easier for the unscrupulous to abuse this system. A fraudster can easily fabricate documents required by the letter of credit, discount them in a bank and then vanish. In another scenario, he can ship containerised, valueless goods instead of contract goods, safe in the knowledge that the goods will arrive after he obtains payment. Even after shipping goods different from contractual quality, he can make alterations in necessary shipping documents and demand payment from the bank with these documents.
UCP protects the banks by providing that banks assume no liability, or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any document(s). This means that when a bank pays against forged or fraudulent documents, it will still be entitled to reimbursement unless the documents do not comply with the terms and conditions of the credit on its face and the bank had not applied reasonable care in determining this fact. It could be said that this puts the applicant of a letter of credit under a very heavy and unjustified burden. The acceptance of a fraud exception under common law can be said to equalise the burden between banks and customers, but when the difficulty of establishing fraud and court's reluctant behaviour in ordering injunctions is considered, it will be seen that this exception obviously did not make much of a difference in the position of applicants.
How to avoid the rise in fraud?
Wide use of independent inspectors
In international sales, according to the way of payment, one party has to rely on the other one more and accept some risks. Documentary credit payments put this risk on the buyer, because payment will be made against documents usually originating from the seller. Even a master's signature under a bill of lading would confirm the apparent good order and condition of goods and nothing else. What a buyer can do to provide a level of security is to stipulate independent opinions in the documentary credit. Extensive use of independent survey firms in determining the quality and quantity of goods and even in determining whether the goods have been loaded at all or not would avoid the risk of fraud to a great degree.
Checking capacity and location of the contract vessel
Most of the time, the sale contract contains the name of the ship to be used and the time of shipment. In fact, this is advantageous for the buyer because this gives him an opportunity to check the availability of the ship. A quick reference to standard Lloyd's information will show whether the ship is capable of taking the contractual type and quantity of goods. Again, a reference to Lloyd's Shipping Intelligence would determine the current location of the ship, and consequently, the possibility of this ship's arrival to port of loading can be calculated. Sometimes, such a reference would even show that such a ship does not exist at all. There is no need to mention the benefits of such an easy precaution.
Checking credibility of the seller
If a buyer is involved in a trade with a seller unknown to him, the buyer should try to get information on the credibility of the seller. It cannot be very difficult for the buyer to learn the current conduct and history of the seller's business. In addition to this, learning the opinions of local banks can be of great benefit for the buyer to anticipate a possibility of fraud.
Usage of performance bonds
In fact this is the best way for the buyer to secure his contract with the seller. With a performance bond issued in favour of the buyer, the seller gives a guarantee to perform his obligations under the sale contract and a contrary behaviour would oblige the issuing bank of this performance band to pay to the buyer the sum stipulated for in the bond, without any further requirements than a demand itself. Such a strong guarantee by a seller supported by a bank's unconditional undertaking would leave the possibility of fraud at the lowest level.
Re-consideration of fraud exception
The narrowness of the fraud exception under common law has been mentioned before. The fraud exception exists under common law almost like a theoretical concept rather than a practical one. There are not many cases where this exception has been successfully applied in favour of the applicant. Although they knew that the documents were presented fraudulently, the strict requirements of establishing fraud have many times left the banks without any other solution than paying.
It is difficult to find any reason why this exception is not applied the way it is applied by American courts. American judges, where there is suspicion of fraud, do not hesitate to give temporary injunctions in order to stop payment and provide time for the buyer to establish his allegation. Lord Justice Ackner declared this practice in United Trading Corporation v. Allied Arab Bank Ltd with these words:
“It is interesting to observe that in America, where concern to avoid irreparable damage to international commerce is hardly likely to be lacking, interlocutory relief appears to be more easily obtainable. A temporary restraining order is made essentially on the basis of suspicion of fraud, followed some months later by a further hearing, during which time the applicant has an opportunity of adding to the material which he first put before the court. Moreover, their conception of fraud is far wider than ours and would appear to include ordinary breach of contract….”
English Law appears to be unfair for the buyer, who most probably will be the victim of such a fraud. It is something like a person watching someone taking his money from his hands and doing nothing. He knows that the seller is fraudulent and he alleges so, but the requirements of establishing the case are so high that he cannot do anything but watch. It seems, therefore, imperative that the fraud exception should be reconsidered.
Usage of International Chamber of Commerce Services
Commercial Crime Services, which is a division of ICC, offers a service to banks. This service is fee-free for members. A bank can always send the documents against which it will pay to CCS and check the authenticity of these documents and the transaction. Indeed, the Commercial Crime Bureau has a database supplied by information from various different sources in all parts of the world. Apart from this database, members of CCB have a good overall picture of the market and their experience is very helpful in determining whether a document is a genuine or fraudulent one. This service also satisfies the requirement of swiftness in international trade. Any application to CCB will be answered, according to the source of information, either in hours or at the latest in two days.
Extending banks' responsibilities
Banks always use the same phrase: “under UCP we deal only in documents and not in goods.” This is certainly a correct argument. The problem is that this fact makes fraud easier. Shiao-Lin Kuo makes the following criticism:
“International Commerce has changed so much and bankers must change. You can't simply go on saying “we only deal with documents”. You can get a machine or people without any kind of professional training to deal with documents. The only way you can progress as an industry is to make changes. You cannot ignore that fraud exists in our day-to-day lives and it happens all the time in banking and in trade. I believe that some consideration has to be given to changing UCP to take this in to account.”
Obviously, the banks' only responsibility is to check the documents on their face in order to determine whether they comply with the requirements of credit. What can be done in order to extend their responsibility? Of course a change in UCP would be the best possible solution as S. Lin Kuo suggests. But since a change in UCP is not planned until 2003, a prompt precaution against fraud can be taken by banks themselves. Banks could offer a new service of making a deeper examination of documents than that suggested by UCP, in return for additional commission. This would assist both the bank and the client and moreover would be useful in avoiding fraud cases.
Educating banks' staff Sometimes banks' staffs involve their banks in fraud because they don't take very simple precautions and they do not know what to look for in a document. A short training period with appropriate education would be very helpful in avoiding these kinds of absurd mistakes.
Use of Deferred Letters of Credits
A deferred letter of credit is one which provides for maturity, i.e. the due date for payment, to be at a stipulated date some time after the documents have been presented and the conditions of the letter of credit have been complied with rather than at the time of presentation of the documents.
Normally in a deferred letter of credit, beneficiary will present the requisite documents at the counters of the confirming bank. The confirming bank then checks these documents and, providing they appear on their face to be in order, accepts them and sends them on to the issuing bank. In accordance with its undertaking the confirming bank then pays out the amount of the letter of credit on maturity and obtains reimbursement from the issuing bank pursuant to its own undertaking to the confirming bank. Once the documents are presented and accepted the confirming bank has a fixed obligation to pay the beneficiary; the issuing bank has an obligation to reimburse the confirming bank. Both obligations are to be satisfied on maturity. Failure by the confirming bank to pay will give the beneficiary a right to claim against the bank and failure of the issuing bank to reimburse the confirming bank gives the latter the right to claim.
The time between presentation of documents and payment enables the buyer in most cases to take possession of the goods, inspect them, resell them and, if required, put the opening bank in funds before the credit matures. This sequence of events makes it more possible or likely that any non-performance or fraud by the beneficiary will be discovered before payment is due. Applying the general principles, stated above, if, after the documents have been accepted but before the due date for payment, it is proved to the confirming bank that the beneficiary has failed to perform under the underlying contract this is not itself sufficient to extinguish the bank's obligation to pay. However, if the bank discovers or is notified before maturity that the beneficiary had acted fraudulently, it would then be entitled not to pay and should it do so despite this knowledge, it would not be entitled to reimbursement from the issuing bank.
Applicants can be advised to choose deferred payment credit rather than the other forms of letters of credit. Santander demonstrated that where the letter of credit in question is a deferred letter of credit, use of the deferred payment letter of credit provides the applicant with certain safeguards. Under a deferred payment letter of credit, the issuing bank is not to pay out on the credit until the maturity date. In the interim, the confirming bank may pay out the beneficiary, and discount the credit at its own risk. In a deferred payment credit, applicant has enough time to gather evidence in case of any fraud on the part of the seller because of the period of time between issuing the credit and its payment and to show this evidence to the issuer to stop the payment prior to the maturity date. The method of using the deferred payment credits and also requiring confirming banks to enter into recourse arrangements with sellers can help in shifting the risk, to some extent, under the letters of credit transaction from the applicant to the confirming bank and seller, for the purpose of balancing the risk between the parties.
Originally the letter of credit instrument was governed by the law merchant but from the mid-twentieth century, it has been increasingly governed by the UCP. The drafting and interpretation of the UCP is dominated by banking interests, which leaves a very little opportunity for judiciaries to intervene to protect the customer from the careless behaviour of the banks. There is an imbalance regarding the rights and duties of the parties in a letter of credit transaction and there is no security provided under the UCP and in many cases buyer is paying for the goods he had not contracted for. Courts believe that the buyer chose the UCP under the principle of autonomy. Yet the process clearly shows that the buyer's autonomy has been denied. These factors shows that the way the letter of credit system operates, applicant bears a disproportionate portion risk due to the negligence of the bank and the risk of intentional wrongdoing in respect of the documents and the underlying transaction.
The contractual relationship between the applicant and the issuing bank has never been given enough attention by the UCP or the courts. Therefore, there is a clear lack of balance of rights and duties of the parties as if they were only the rights and duties of the banks and the sellers. Due to such deficiency in the letter of credit system, a situation has raised, where banks do not exercise true reasonable care towards the buyers, and sellers deliver discrepant and even non-genuine documents and get payment. There should be a clear standard for the banks to exercise “reasonable care” towards buyers. The importance of the seller's duty of providing conforming and genuine documents should also be clarified by placing all parties under the obligation to exercise “good faith” in the discharge of their respective responsibilities under the letter of credit transaction.
This thesis demonstrated the deficiencies of the UCP in its role to balance the rights and obligations of the parties participating in the credit, and the system's failure to properly solve the fundamental issues of justice and equity. It further highlighted the need for reform in the system and also set out some ways in which such reforms can be brought. By making such improvements in the UCP so that it represents the interests of all parties, the integrity, efficiency and the reliability of the system can be increased.
There is no doubt that documentary credits are the most common way of payment for international sales. English judges have referred to documentary credits as “the life blood of international trade”. This interpretation well establishes the importance of documentary credit for international trade. It seems that documentary credits will preserve their popularity until a better system is developed.
The fact that it is the most common way of payment does not mean that documentary credits are based on a perfect system. Indeed, the documentary credit system has some points that should be improved and adjusted according to new technology and new commercial concepts. Revisions of UCP have been very useful in achieving this idea. However there has been no improvement, in respect of one, maybe the most important problem: fraud. UCP 500 is silent on this issue. Case law has considered the issue but has not provided a precise manner to follow or a proper solution to apply.
Undoubtedly, fraud is inevitable for the documentary credit system, in particular because banks deal with documents only. Nevertheless there are simple precautions to be taken in order to avoid the rise in number of fraud cases. A reconsideration of fraud in the English courts or the insertion of a relevant article in a new version of UCP seems to be the best solution. Until this is done, banks and buyers, who are the usual victims of documentary credit frauds can take very simple precautions and protect themselves from the consequences of possible fraud.
If fraud is left as a gap in order to preserve the attraction of documentary credits due to its autonomous character, the rise in fraud will continue and losses will reach irreparable sums. Ultimately, risk of fraud will diminish the attractiveness of documentary credits.
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