Letter of Credit - Lifeblood of International Commerce - Essay Example

? Letter of Credit, the “Lifeblood of International Commerce”   (Type of Paper) 4,081 words   The letter of credit was officially referred to as the “lifeblood of international commerce” since 1978 when Judge Kerr had it placed in history when he mentioned it in the case law Hardbottle v National.1 This comes as no surprise since letters of credits, otherwise known as documentary credits, are the most used type of payment for goods or services when trading internationally. The title was again reconfirmed in Intraco v Notis.2 To better understand what letters of credit are, how they are used and why it was called “the lifeblood of international commerce”, this paper will detail all pertinent information and know-how on the subject, from its origin to its present status in the international trade. 1. Brief Overview of Letter of Credit The letter of credit is about 180 years of age in the financing of trade exports. It has been one if not the most commonly used facilities for international trade payments. Today, its version is better known as the electronic letter of credit which with the use of the internet and computers, have become quite easy to use. The letter of credit comes in variety of forms, most common of which is the documentary credit,3 also referred to as just L/C, or credit or commercial in the UCP 600 or the ICC Uniform Customs and Practice for Documentary Credits 600 (UCP 600). The information contained in this paper is the standard type of documentary credit that is the common payment mechanism for international trade. There are other forms of letter of credit that may be mentioned but will not be dwelt upon are the standby letter of credit and the acceptable credit. Standby credit is not exactly related to the fundamental contract of shipment or sale of goods, unlike the documentary credit; therefore, it is not exactly applicable in payment condition and the investigation of shipping files and documents is not required. The standby credit’s primary role is the prevention of one party or both to attempt breaching a contract because o market changes or other reasons. The use of standby credit as collateral security and fidelity bonds in financing operations, and as performance bonds in the field of construction is increasing. In the transportation of oil, for example, particularly in short journeys such as transportation between countries in Europe, goods might be shipped to the discharge port within a day while the bills of lading are not yet delivered to the port of loading. Instead of documentary credits, the use of cash as the instrument for payment is more convenient and practical for the parties of sale contract in situations such as this. Then again, to increase the seller’s sense of security and confidence in doing business, a standby letter of credit can still be issued by the buyer as backup. From which it can be observed that a standby letter of credit is not exactly applicable in payment conditions. Even though the standby letter of credit has a significant role as a guarantee, it is not equivalent to a bank letter of guarantee by all means. Evidence of non-performance of the underlying transaction is required by the standby credit, instead of the sole requirement of the beneficiary’s documentary compliance. In addition, in standby credit, the proof of fraud is more difficult than in documentary credit. Simply put, proving that the breach of contract of the beneficiary is a fraud is very difficult. Just as Judge Kerr said, the case of Harbottle (Mercantile) Ltd. v. National Westminster Bank4 is not a case of established fraud at all. The seller may indeed be correct in arguing that a buyer has no contractual right to payment of any part of the guarantee, let alone the entire guarantee. However, all these rest on contractual disputes. They fall in a subject distant from fraud, particularly established fraud. 2. Defining the Letter of Credit Basically, the most common form of credit it documentary form is the Letter of Credit or simply L/C. It contains the agreement made between the buyer and the seller and the terms of their trade transaction. The definition of letter of credit according to Osborn’s Concise Law Dictionary5 is that it is an authority by an individual to another individual to withdraw bills of exchange or cheques (with or without an amount limit) upon him, with a responsibility of honouring the drafts on presentation. An ordinary letter of credit includes the name of the individual by whom the draft is to be cashed or negotiated; if the name is not included, it is referred to as an “open letter of credit”.6 The following documents are mandatory for majority of documentary credits: 1) A bill of lading. This functions as a receipt that acknowledges that goods have been delivered, and is issued to the seller by a common carrier. 2) A commercial invoice. This provides a description of the items sold together with the prices of such commercial items, and is prepared by the seller. 3) An inspection certificate. This certifies that the goods have undergone quality examination before being shipped. 4) A document issued by the government or other legal document that confirms that the goods are ready to be exported (e.g. export license), and comply with the regulatory mandates of the importing country. 5) An insurance certificate. This shows that insurance has been obtained by the beneficiary for the shipment o the goods or, that such insurance has been obtained by the seller.7 3. Characteristics of the L/C Bank guarantees or irrevocable letters of credit, if taken in circumstances that they have become equivalent to letters of credit are also seen as the lifeblood of international commerce. Unless fraud is found in the transaction, thrombosis occurs and the court will meddle. This will result into the disturbance of the mercantile practice that has already been going on that L/C is already considered to be cash in hand.8 A feature found in all letters of credit regardless of type is the buyer’s action of arranging for bank payment of the seller upon his presentation of the required documents. This is the outcome of the agreement between buyer and seller that underlies in any L/C involving the sale of goods. The said required documents serve as proof that the goods being bought by the buyer have already been shipped and are already being transported by the seller to the buyer’s location and that all other necessary contractual and documentary conditions has already been performed. Upon showing of the pertinent documents signaling the shipping of the goods as set out in the letter of credit, the bank may now pay the seller the purchased priced agreed upon in the L/C. Payment may vary, i.e., by deferred or installment payment, sight payment, upon acceptance or via a bill of exchange that may have been negotiated upon by the parties as drawn by the seller. Letters of credit possess a documentary character that is used independent of the actual presence of the goods involved. It is the bill of lading that represents the goods. This document of title represents that the goods are indeed shipped. The bill f lading is thus used at times to finance transactions. The basic path taken with regards to international commerce commonly involves the production and raising of money to be indicated in the documents in order for those concerned to bridge the time spent between the shipment of goods to the time the payment is received by seller upon document presentation.9 Given the process involved in issuing a letter of credit, it is apparent that the L/C’s documentary character, as used in international commerce, cannot be over emphasized. The bank may proceed to pay the seller/exporter while it retains the documents as its security or collateral in case the need arises. The bank can use the documents to take recourse to the bank that issued the L/C, which in turn may go after the buyer. 4. Letter of Credit’s Function A letter of credit is an essential payment instrument, whose function in global transactions is becoming more and more important. The reason behind the popularity of a letter of credit is its aim of solving two problems that emerge in majority of overseas sales: the problem of raising credit, and the problem of providing security for the cost payment.10 In global transactions, the parties usually have not met personally or have not dealt with each other in the past, and have broadly different objectives and interests. For instance, the seller (beneficiary of letter of credit or the exporter) wants payment upon the manufacture and delivery of goods while the buyer (account party of letter of credit or the importer) does not want to pay before the delivery and wishes to pay only after the goods have been received and inspected. Furthermore, both parties may not have faith in the reputation of credit of each other, or doubt their chances to obtain compensation in each other’s court. A letter of credit is beneficial and necessary in such situation for reducing the risk of both parties and lowering the transaction costs. 5. Parties Involved in a Letter of Credit For example, when a seller in Canada wishes to sell goods to a buyer in Netherlands, the buyer must first open up a letter of credit in favour of the seller in a bank in Netherlands. In this situation, the seller is referred to as the beneficiary, the bank of the buyer is referred to as the issuing bank or opening bank, and the buyer is known as the account party. The bank will then send the letter of credit to the seller either directly or via an electronic transmission to the advising bank (a branch of the bank in Canada). The bank has the duty of paying as long as the documents that meet the requirements of the letter of credit are presented by the beneficiary. These documents basically include a bill of lading indicating that the possession of the goods has already been transferred by the seller to the bank. The buyer cannot be charged by the bank until the goods have been received by the buyer. Thus, both the seller and buyer feel secure and at ease to carry out the long-distance transaction, since the buyer is only required to pay upon receipt of the goods and the seller knows that it can get payment from the bank as long as it does the duty of sending the qualified goods. 6. Legal Issues with the Letter of Credit 6.1 Domestic Laws All legal systems of the world recognize letters of credit. In the US, the law that governs letter of credit has been codified in the US Uniform Commercial Code (UCC) Article 5.11 Furthermore, case laws are also important laws that affect letter of credit, particularly those in the UK and US. 6.2 International Laws The most important ruling that affects letter of credit is the ACP, which is a set of guidelines privately formulated based on the customary practices and traditions of bankers and merchants.12 It has been developed by the Commission on Banking Technique and Practice of the International Chamber of Commerce (ICC). The most recent revision of the Uniform Customs and Practice (UCP) that regulate the letter of credit operation is UCP 600. UCP 600’s 39 articles are a practical and thorough and working aid to educators, transport executives, exporters, importers, lawyers, bankers, and everyone involved in transactions concerning letter of credit across the world. In addition, to consider the impact of electronic commerce, a supplement to the UCP has been issued by the ICC. This supplemented version was enforced on March 31, 2002, and was referred to as the eUCP. The eUCP is applicable where there exists at least one electronic presentation of documents in the letter of credit transaction.13 As regards the UCP’s legal status, there are varying views. The primary opinion is that the UCP is not a ruling which has the force of law; rather, it is a global practice that majority of countries recognize.14 It has been suggested by American law, for instance, that the UCP should not be interpreted strictly as how statutes are, but should be seen as a contractual document that businessmen prepared.15 In addition, it has been noticed in the UK that the Code does not have the force of law.16 7. Three Important Principles Involved in the Letter of Credit There are three vital principles involved in understanding the function and use of a letter of credit, i.e., the buyer and seller contract, the doctrine of strict compliance and autonomy. 7.1 The Buyer and Seller Contract Since a letter of credit is a contract made between the seller and the buyer, legally, the law of contract applies. The contract of sale would include the terms that will also be found in the letter of credit. The most important data that should be found in the letter of credit are the name of the issuing bank which is the buyer’s bank, the name of the Beneficiary or the seller, the name of the Applicant for the L/C which is the buyer, the opening date of the L/C, the L/Cs expiration date, the name the confirming or advising bank, the type of credit to be used in the L/C and the pertinent terms and conditions. It is also necessary to have the attached documents described in the L/C. These documents are those to be tendered for payment, e.g., insurance certificate, commercial invoice, standard certificates of quality, origin, cleanliness of ship’s hold, condition and the evidence of shipment such as the bill of lading. In a contract law, the construction rules apply. However, in the matter of international trade, the jurisdiction and governing laws become more complicated. Jurisdiction is vital since rules of construction vary depending on it. For instance, under the CISG rules of interpretation, a contract may be interpreted by making use of common law depending on the jurisdiction. If so, then it would be clear what information and circumstances will be taken into consideration or what rule should be used, e.g., parole evidence. A condition that has to be performed before the effectively of the contract is the opening of the letter of credit. The failure to do so will be regarded as the absence of any contract, or any transaction for that matter. When this happens, the seller is not obliged to deliver the goods.17 More rules on the seller and buyer obligations as well as the payment rules are provided by the CIGS. 7.2 Doctrine of strict compliance The documents involved in the international transaction are dictated upon by the terms of the letter of credit. What is indicated in said documents are also set out by the L/C. These documents, as already mentioned, should first be available before the bank is authorized to pay the letter of credit. The bank therefore serves only as the buyer’s agent and has no discretion on the transaction or has any authority to pay based on documents that failed to meet requirements as received by them. Likewise, documents that are almost mirror image or almost alike is not allowed.18 The issuing bank chosen by the beneficiary should inspect and consider if the letter of credit is in accordance with the requirements and be able to honor and pay it or refuse it based only on the documents presented to it. If the same issuing bank chosen by the buyer decided not to accept the documents, it should claim that there is failure on the documents to adhere to the letter of credit’s terms and conditions.19 The doctrine of strict compliance can be clearly seen in the following example case laws: In Bank Melli v Barclays,20 the need for strict adherence to the mandate of the L/C in terms of payment against documents was given focus. Strict care should be given it its carrying out; In Westminster v Arlington,21 what is involved is the payment of credit wherein there was a failure to do as mandated; For cases wherein the bill of lading is the involved document, several factors may be reason for problems, i.e., failure of bill of lading to comply with the letter of credit’s terms,22 for date altered23 and for ambiguous bank instructions.24 For cases involving the letter of credit, the factors that may be taken into consideration are rejection of documents, discrepancies in the documents, on the quality certificate, mistakes in authorization of payments by banks, substitution of ship, failure to follow exact wordings in the required documents and mistake in the origin of goods as described in the documents. Examples of the cases involving these problems with the documents are English , Scottish v Bank of S. Africa,25 Seaconsar v Bank Markazi,26 Eigthed v National Bank,27 Mannesman v Kaunlaran,28 Bankers Trust v State Bank29 and JH Rayner v Hambros.30 Should the bank which issued the letter of credit fail to perform in accordance to the doctrine of strict compliance, it will be penalized via the loss of its right to get reimbursement from the buyer.31 However, banks involved in the letter of credit have the obligation of checking if the documents are authentic.32 7.3 Autonomy As already referred to in the preceding chapters, the L/C or documentary credit has an autonomous character that serves as a binding and legal contract between the beneficiary and the issuing bank. It is independent from other transactions or relationships the buyer or seller may have in their trade. Generally and by nature, credits are transactions considered to be separate from other contracts or sales transactions from which they are based. Banks are therefore not in any way bounded by such other contracts or are even concerned of their existence. This is despite the fact that some of these contracts are incorporated or indicated in the letter of credit.33 Under the operations of credit, the parties involved are transacting or dealing only with regard to the documents concerning it, not the services or goods being purchased in the letter of credit or whatever related performances.34 The bank that issued the letter of credit as chosen by the buyer is without any authority to perform its own discretion with regard to the documents. Likewise, it is without power to refuse the performance of its obligations as set upon on the irrevocable L/C based on the reason that seller sent goods that are below standard, defective or are not according to what is specified in the L/C. Any dispute or legal issues that may come up as a result of the transaction must be resolved outside the L/C transaction. To cite a case law to illustrate the matter, buyers from Jordan bought a big quantity of reinforced steel for delivery in 2 installments. Payment is with two letters of credit, both confirmed and one for each installment. A letter of credit is therefore opened and the first shipment paid upon delivery of the goods. However, the buyers, upon close inspection of the delivered steel complained that those were defective. They thus wanted an injunction for the prevention of payment of the second ordered shipment under the second L/C. The injunction was not allowed and the case went on appeal. However, the Court of Appeals held the decision citing that the confirmed letter of credit, in consistence with its character, is a bargain made between the seller of goods and the banker, which is bound by law by an absolute obligation to make payment regardless of any problem or legal dispute that might arise between the buyer and the seller. The condition of the goods has nothing to do with the effectivity of the letter of credit.35 7.3.1 Exceptions to the Rule There are two exceptions to this rule, i.e., fraud and illegality. Fraud In England, should the bank learn about the tendered documents being fraudulent, the following case laws may be referred to: American Accord.36 Legally however, fraud should be proven without doubt and conclusively. Alleging fraudulent transactions or documents will not suffice.37 In the United States, the case laws that are pertinent, to cite a few, are Ashbury Park v National38 and Werner v Grootemaat.39 Illegality For transactions using a letter of credit was illegality underlies, the case laws that may be referred to are Mahonia v JP Morgan Chase40 and The American Accord.41 In cases where the bill of lading is used for the transport of papers, the bank would require the sending of all original bills and pertinent documents. Failure to do so would allow the shipper who committed fraud to still be paid based on the letter of credit from one of the 3 sets of original bills. 8. Conclusion Clearly, the letter of credit is the most convenient, the safest, most secure and widely acceptable means of payment for international trade and commercial transactions. The advantages are numerous and all the parties involved in the contract, including the banks, enjoy the benefits. With the distance between the buyer and the seller, the existence of a letter of credit is truly a valuable gift. To sellers, the L/C meets their needs of being assured payment by an international bank. This gives them confidence and a peace of mind when shipping out expensive goods. Likewise, the exact date of payment will be known to them allowing them to make a timely shipping of goods. In case of oversight, the bank will be responsible and the seller will still be paid. Risks and losses are greatly reduced due to the letter of credit. On the other hand, the buyer is also provided a safer way to pay for goods that will be coming from abroad. Through the letter of credit, the bank secures their money and ensures them that they will pay only when they receive the products they paid for. The L/C can be created in such a manner that the buyer is secured by including terms that would be to his advantage, e.g., setting of the delivery and production time, quality and inspection of goods, etc. Moreover, cash is not tied up with the L/C because there is no need to pay cash up front. Between all these transactions, the bank plays a middleman and at the same time earns from the transactions. Not only are safety and security provided for the two parties, but business and commerce is also alive. With all the information discussed in this paper about the letter of credit, it is clear and agreeable why it was given the title “the lifeblood of international commerce”. As was shown by all the definitions, functions, characteristics, benefits, processes involved, etc. of an L/C, it is easy to digest how extensively it is used in the international trade. Today, technology and innovation has made its use even faster and simpler. With the speed by which technology changes however, it is not impossible for the letter of credit to evolve and have new forms. It the long run, other ways and methods of payment may come up but at present, it still serves its purpose. By the ease and familiarity by which international traders use letters of credits in their transactions, it appears that it is here to stay. Bibliography E. P. Ellinger, “Letter of Credit” in Norbert Horn and Clive M. Schmitthoff (eds.) The Transactional Law of International Commercial Transactions (The Hague: Kluwer Law and Taxation Publishers, 1982). Rumu Sarkar, Transnational Business Law: A Development Law Perspective (The Hague: Kluwer Law International, 2003). Richard Schaffer, Filiberto Agusti and Beverly Earle, International Business Law and its Environment (7th edn. Mason: South-Western, 2005). KCDM Wilde (eds.), International Transactions (Law Book Co 1993). Donggen Xu, Law and Practice of Letter of Credit (Beijing: Peking University Press, 2005) Law Journal Xiuwen Zhao. “The Role of Soft Law in International Commercial Transactions” [1999] 2 Int’l. Economic Law Essays 121. Table of Cases Ashbury Park & Ocean Grove Bank v National City Bank of New York [1942] 35 NYS (2d) 985. Bank Melli Iran v Barclays Bank [1951] 2 Lloyd’s Rep 367. Bankers Trust Co v State Bank of India (QB Com Ct) [1991] 1 Lloyd’s Rep 587(CA) [1991] 2 Lloyd’s Rep 443. Bhoja Trader [1981] 2 Lloyd’s Rep 256 per Donaldson LJ and Ackner LJ at 257. Edward Owen Engineering Ltd v Barclays Bank International Ltd [1978] QB 159 (CA). Eigthved & Co v National Bank of Scotland 25 Ll L Rep 99. English, Scottish & Australian Bank Ltd v Bank of South Africa 13 Ll L Rep 31. Equitable Trust Co of New York v Dawson Partners [1926] 27 Ll L Rep 49. Hamzeh Malas v British Imex Industries [1958] 2 QB 127. Harbottle (Mercantile) Ltd. v. National Westminster Bank, [1978] 1 Q.B. 146. Intraco Ltd v Notis Shipping Corporation of Liberia. JH Rayner & Co Ltd & The Oilseeds Trading Co Ltd v Hambros Bank Ltd 73 Ll L Rep 32. Mahonia Ltd v JP Morgan Chase Bank & Anor [2003] 2 Lloyd’s L Rep 911. Mannesman Handel AG v Kaunlaran Shipping Corp & Ors [1993] 1 Lloyd’s Rep 89. Marine Midland Grace Trust Co. v. Banco del Pais, SA [1996] 261 F. Supp. 844 (S.D.N.Y.). Midland Bank Ltd v Seymour [1955] 2 Lloyd’s Rep 147. Seaconsar Far East Ltd v Bank Markazi JomHouri Islami Iran [1993] 1 Lloyd’s Rep 236 (CA). TD Bailey, Son & Co v Ross T Smyth & Co Ltd [1940] 56 LTR 825 per Lord Wright at 828. The American Accord (HL) [1982] 2 Lloyd’s Rep 1. United City Merchants Ltd and Glass Fibres and Equipments Ltd v Royal Bank of Canada & Ors. [1981] 3 W.L.R. 242 (CA). Werner v AL Grootemaat & Sons Inc [1977] 259 NW (2d) 310 at 315. Westminster Bank Ltd v Arlington Overseas Trading Co [1952] 1 Lloyd’s Rep 211. Westpac Banking Corp and Commonwealth Steel Co Ltd v South Carolina National Bank (PC) [1986] 1 Lloyd’s Rep 311. Table of Authorities International Chamber of Commerce 1993, Uniform Customs and Practice for Documentary Credits, (ICC Publishing, S.A., Paris, 1993). Uniform Commercial Code 5 (U.C.C. §5) (Adopted in 1952, enacted 1 July 2001). Uniform Customs and Practice (UCP 600 2007) (Adopted in 1933, Enacted 1 July 2007) Secondary Materials: Dictionaries Osborn’s Concise Law Dictionary, 10th ed., s.v. “letter of credit”. Read More