Bank Regulations and Letter of Credit - Term Paper Example

?‘Banks deal with documents and not with goods, services or performance to which the documents may relate’ (UCP 600, Article 5). Critically Discuss in the Light of Relevant Case Law Introduction It is clear that international trade organizations have attempted to further develop the international trade system since the Bretton Woods Conference was convened in 1944.1 The reason for this is that international trade law regulates and covers a wide area of commercial transactions; for instance, commercial contracts, the sale of products, transportation of goods, insurance, finance and banking regulations. Bank regulations are examples of commercial laws that have received a considerable amount of attention in recent times.2 These regulations are often established to ensure transparency between banks and their individual clients. However, international sales can be affected by a number of risks, such as payment issues.3 In this risk, the seller wants to collect the money right after shipping the cargo; otherwise the buyer would wish to delay payment until the cargo arrives at its destination. Further risks are the economic climate in both the importing and exporting countries and the political stability of the countries, which affects the sale transaction and the degree of trust and confidence of each party in the other. As a result, banking regulations serve to lower or alleviate the risks that banks are exposed to and any disruptions and interruptions emanating from adverse economic and banking conditions. Additionally, banking regulations reduce the criminal risks to which banks are exposed, not to mention promoting and ensuring the confidentiality of banks.4 To reduce risks in international sales, in terms of the payment issue, the seller and buyer usually agree to settle through letters of credit. This essay seeks to explore Article 5 of the Uniform Customs and Practice for Documentary Credits (UCP 600) 2007, which reads as follows: “Banks deal with documents and not with goods, services or performance to which the documents may relate”. In fact, this Article is usually explored in regard to the letters of credit principles. Thereby, in the first part of this essay, the concept of letters of credit in the light of the UCP 600 will be revealed. Subsequently to that, the principles of letters of credit, which are autonomous and conform to strict compliance, will be discussed in the light of relevant cases. Finally, the way that fraud affects letters of credit will be examined in the light of relevant cases. 1. Letter of Credit and the UCP The importance of letters of credit to the current commercial society is evidenced by the many rules established to regulate and control its usage. These rules are called the Uniform Customs and Practice of Documentary Credits (UCP), which were created by the International Chamber of Commerce (ICC).5 Several commentators tend to accept this unification, such as Royston Goode, who describes it as “the most successful harmonizing measure in the history of international commerce”.6 In fact, the first version of these rules was drafted by the ICC in 1929. The rules were revised many times until the last version, UCP 600, was issued in 2007 and came into force on 1 July, 2007.7 Even though the UCP 600 regulates letters of credit, the legal status of these rules will not be considered binding until they are incorporated into the two parties’ contract, as it is mentioned in Article 1 of the UCP 600.8 Letters of credit, which are also known as documentary credit or banker’s commercial credit, is defined in Article 2 of the UCP 600 as “any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation”. According to this definition, a letter of credit has two characteristics. First, it is an irrevocable credit, which means that it cannot be amended or cancelled when it has already been communicated to the seller; under the previous UCP 500, credits could be either irrevocable or revocable.9 Second, it is a confirmed credit, which means that the seller also receives an undertaking from the confirming bank (in addition to that of the issuing bank) that he will be paid on presentation of the stipulated documents.10 It seems clear that documentary credit has some advantages to both the seller and buyer. For instance, when the buyer (applicant) instructs his bank (issuing bank) to open a letter of credit in favour of the seller (beneficiary), he has the right to put conditions or terms on the payment of the credit to guarantee the quality of the goods. On the other hand, the seller has extra security that he will be paid as soon as he presents the stipulated documents to his bank (advising or confirming bank). These documents are usually transport documents, invoices, insurance policies, certificate of quality and certificate of origin.11 Because of the popularity and importance of letters of credit in international commerce, several leading commercial judges in English courts have described them as the life-blood of international commerce.12 For instance, the judge Kerr, in The Harbottle v National Westminster Bank case, stated, “They are the life-blood of international commerce”.13 Also, the judge Donaldson, in The Intraco v Notis Shipping Corp case, said, “Irrevocable letters of credit have been said to be the life-blood of commerce”.14 It is highly likely that the essential feature of banks when they deal with letters of credit appears in Article 5 of the UCP 600. This Article was issued to state the main roles of the issuing bank and confirming bank when they deal with documentaries credit. Besides this, it definitely confirms that a letter of credit is a separate commercial transaction from any other sale or contract with which it may be related. In other words, a bank’s duties are only to ensure that the documents presented, such as transport documents and invoices, appear to constitute a complying presentation. It is the role of a bank to check the veracity of the statements contained in the documents. In effect, Article 5 reflects the principles of letters of credit, which will be revealed in coming sections. As a matter of fact, no changes have occurred to the affirmation in Article 5, even with the many versions of the UCP that have been established so far. One thing in common with all these versions of the UCP is that a letter of credit is not a contract from which a third party can benefit.15 Therefore, a letter of credit is one of the many documents that banks deal with, and their role is to verify the legitimacy of documents and not to focus on the use or performances with which the documents relate. 2. Principles of Letter of Credit In order to understand the separation of a bank’s role, which is mentioned in Article 5 of the UCP 600, there are two fundamental principles of a letter of credit that need to be discussed carefully. In this part, the autonomy and doctrine of strict compliance of the letter of credit will be examined in the light of relevant case law.16 2.1 Principle of Autonomy One of the most outstanding principles of documentary credit transactions is that credit arrangements are separate from and independent of any underlying contracts. In other words, a bank’s obligation to execute payment is autonomous from any underlying contracts of sale, or any other transactions for that matter. Similarly, any disputes that may exist between a seller and buyer related to their contract or other contracts outside the credit terms do not affect the credit and the banks’ liabilities due to the fact that the obligations of banks are in respect of documents and not in respect of goods.17 The concept of the autonomy principle is asserted in Article 4(a) of the UCP 600.18 2.1.1 Cases on the Autonomy Principle The autonomy principle of letters of credit that secures payment of price against presented documents has been discussed in a large number of cases. Hamzeh Malas and Sons v British Imex Industries Ltd.19 The plaintiffs, a Jordanian firm, bought a large quantity of reinforced steel rods from the defendants, a British firm, and were to be delivered in two installments. The buyers opened two confirmed letters of credit in favour of the sellers with Midland Bank Ltd. in London. After fulfilling the first letter of credit, the plaintiffs alleged that the goods of the first instalment were defective. As such, they sought an injunction to bar the defendants from realizing the second letter of credit; however, Judge Donovan J refused to do so on the grounds that he had no jurisdiction. As a result, the plaintiffs appealed to the Court of Appeal against that refusal.20 Judge Jenkins LJ of the Court of Appeal said: It seems to be plain enough that the opening of a confirmed letter of credit constitutes a bargain between the banker and the vendor of the goods, which imposes upon the banker an absolute obligation to pay, irrespective of any dispute there may be between the parties as to whether the goods are up to contract or not. An elaborate commercial system has been built up on the footing that bankers' confirmed credits are of that character, and, in my judgment, it would be wrong for this court in the present case to interfere with that established practice.21 In my view, Judge Jenkins affirmed on the autonomy principle of the documentary credit by observing that the financial operations system in international sales would break down completely if courts interfered with disputes between the vendor and the purchaser in order to annul a letter of credit. Discount Records Ltd. v Barclays Bank Ltd.22 In this case, the plaintiffs bought a specific quantity of records and cassettes from a French company and gave signed instructions to the defendant bank for an irrevocable confirmed documentary credit in favour of the seller.23 When the cargo arrived, the plaintiffs discovered that some of the boxes were either empty or half empty, filled with rubbish or contained goods that were not ordered.24 The plaintiffs sought an injunction to stop the bank from paying the seller, but the court refused to do so. Consequently, Judge Megarry J stated that: I would be slow to interfere with bankers' irrevocable credits, and not least in the sphere of international banking, unless a sufficiently grave cause is shown; for interventions by the court that are too ready or too frequent might gravely impair the reliance which, quite properly, is placed on such credits…What I do say is that the present case falls far short of establishing any ground upon which it would be right for the court to intervene by granting the interlocutory injunction claimed, even in its revised form. The motion accordingly fails and will be dismissed.25 I believe that Judge Megarry’s approach was quite similar to the Hamzeh Malas case, owing to the fact that the judges in both cases confirmed that allowing courts to intervene between the issuing bank and the beneficiary in order to stop paying the documentary credit when the goods do not match the contract description would seriously affect the payment system in international trade. Power Curber International Ltd. v National Bank of Kuwait26 Power Curber, an American company, exported machinery to a firm in Kuwait. A letter of credit was issued by the defendant bank in favour of the plaintiff. However, when the cargo arrived, the buyer raised a counterclaim against the seller and obtained a provisional attachment order from a court in Kuwait that restrained the bank from paying the amount of credit to the seller.27 Because the bank had a registered office in London, it was sued before the English court. Lord Denning MR concluded that: A letter of credit is like a bill of exchange given for the price of goods. It ranks as cash and must be honoured. No set off or counterclaim is allowed to detract from it. Whereas a bill of exchange is given by buyer to seller, a letter of credit is given by a bank to the seller with the very intention of avoiding anything in the nature of a set off or counterclaim. If the court of any of the countries should interfere with the obligations of one of its banks, by ordering it not to pay under a letter of credit, it would strike at the very heart of that country's international trade. No foreign seller would supply goods to that country on letters of credit because he could no longer be confident of being paid. No trader would accept a letter of credit issued by a bank of that country if it might be ordered by its courts not to pay. So it is part of the law of international trade that letters of credit should be honoured and not nullified by an attachment order at the suit of the buyer.28 In my view, the concept of Lord Denning about considering a letter of credit as a bill of exchange is actually quite misleading because a bill of exchange is treated as cash and is defined as an unconditional order to pay a sum certain money to a bearer, whereas a letter of credit is defined as a conditional undertaking by the issuing bank to honour a complying presentation. Otherwise, he agreed with the previous decisions in Hamzeh Malas and Discount Records cases about affecting the payment system in international trade if the courts annulled the documentary credit. Moreover, this case shows the power of documentary credit in the face of judicial decisions when the Court of Appeal held that the Kuwaiti Court order did not affect the bank’s obligation to pay the worth of the credit, as the bank is not concerned with any dispute arising from the contract sale.29 2.1.2 Discussion After examining these cases, there are two arguments to consider as public policy.30 The first argument is that letters of credit are the life-blood of international commerce and, as such, courts should not interfere to annul the credits. The reason for this is that if the courts interfere and stop the credits, then international sellers will lose confidence in the international sale system, and this will have a negative effect on international trade. On the other hand, some people argue that the autonomy principle favours the seller more than the buyer. In other words, supporters of this argument affirm that the risk is on the buyer because the applicant cannot involve the issuing bank to police the seller’s activities in the exporting country. As such, the autonomy principle places the buyer at the seller’s mercy.31 In my view, even though the autonomy principle of a letter of credit is crucial, there is no doubt that this principle serves sellers who usually are from developed countries or are capital exporters more so than buyers who often are from developing countries or are capital importers. Therefore, the developed countries’ courts, such as the English court, always refuse to annul the letter of credit because they do not want to affect the trade system in their countries. As Goode mentions, “unfortunately, English courts have become so beguiled by the autonomy principle that they decline to allow refusal of payment in favour of a beneficiary acting in good faith even where the documents are forged or otherwise fraudulent”.32 2.2 Principles of Strict Compliance The principle of strict compliance is the other basic principle of documentary credit. This means that the bank is entitled to reject documents that do not strictly comply with the terms and conditions of the credit.33 Despite the fact that strict compliance was embodied in Article 13(a) of the UCP 50034, it is mentioned in the UCP 600 in Article 14(e) and Article 18(c) according to the type of the documents.35 Hence, the aim of strict compliance is to protect the buyer by guaranteeing that he will have to pay only against documents that are specified in the letter of credit. 2.2.1 Cases on the Strict Compliance Principle The principle of strict compliance has been examined in many cases. Equitable Trust Company of New York v Dawson Partners Ltd. 36 In this case, the defendant bought prime quality Java vanilla beans from a seller in Batavia, which is now in Jakarta. The defendant arranged with the plaintiff to open a credit in favour of the seller and to make payment available on presentation of a complete set of shipping documents and a certificate of quality to be issued “by experts who are sworn brokers”.37 The issuing bank informed the advising bank in Batavia to advise the seller that the required certificate was to be issued “by expert who is sworn broker”. The shipment was made and payment was made to the seller by the bank based on the tendered documents, including one expert certification. Also, the shipment was mainly rubbish that contained less than one percent of the contracted goods. In the House of Lords, Viscount Sumner held that: There is no room for the documents which are almost the same, or which will do just as well. Business could not proceed securely on any other lines. The bank’s branch abroad, which knows nothing officially of the details of the transaction thus financed, cannot take upon itself to decide what will do well enough and what will not. If it does as it is told, it is safe; if it declines to do anything else, it is safe; if it departs from the conditions laid down, it acts at its own risk. In my view, there are three points that need to be illustrated in this case. First, in the law, the presentation documents have to be absolutely right. This means that documents that are similar to the terms of the credit are not acceptable according to the principle of strict compliance.38 Second, a bank is not expected to be involved in sale contracts or trade practices, because its expertise is in finance and not trade. Thereby, the bank deals with documents and not goods, as it is mentioned in Article 5 of the UCP 600.39 Finally, the bank has to reject the presentation documents if they do not conform to the terms of the credit, unless the bank loses its right of reimbursement and forfeits remuneration from the applicant.40 JH Rayner and Company Ltd. v Bank Ltd. 41 In this case, the defendant received instructions from the seller to open a confirmed credit in favour of the plaintiffs that covered a cargo of "Coromandel groundnuts". The bank opened the credit and notified the plaintiffs that it was available against the invoice and bills of lading for "Coromandel groundnuts". The plaintiffs presented bills of lading for "machine shelled groundnut kernels", which was accompanied by an invoice for "Coromandel groundnuts".42 The bank refused payment and was thus sued by the plaintiffs. At the Court of Appeal, Judge Mackinnon J said that: The words in that bill of lading clearly are not the same as those required by the letter of credit. The whole case of the plaintiffs is, in the words of Lord Sumner, that ‘they are almost the same, or they will do just as well.’ The bank, if they had accepted that proposition, would have done so at their own risk. I think on pure principle that the bank were entitled to refuse to accept this sight draft on the ground that the documents tendered, the bill of lading in particular, did not comply precisely with the terms of the letter of credit which they had issued.43 Eventually, I think that Judge Mackinnon’s approach in this case was quite similar to the one in the Equitable Trust Company of New York case. This is because he insisted on rejecting documents that were similar to the conditions of the credit. Moreover, he mentioned that the bank would have taken a risk if it had accepted the documents, because even though the issue was trivial, the bank was not entitled to deal in goods or services. Judge Mackinnon concluded, “It is quite impossible to suggest that a banker is to be affected with knowledge of the customs and customary terms of every one of the thousands of trades for whose dealings he may issue letters of credit”.44 3. Fraud Exception The bank’s obligation to pay the value of the documentary credit against the presentation documents can be curtailed in the event of fraud. Fraud occurs when the documents appear to be compliant on their face, but that they are tainted by fraud.45 Fraud is the only exception to the autonomy principle and it is not provided for in the UCP.46 As a consequence, in individual jurisdictions it is part of domestic law, as it is in the UK and other Commonwealth countries. However, in the U.S., it is provided for under the Uniform Commercial Code (UCC).47 3.1 Cases on the Fraud Exception The main issue that may arise in relation to fraud is whether the bank or the buyer is able to identify the fraud and then prove it. This issue will be discussed in the following section in light of the cases. United City Merchants Ltd. v Royal Bank of Canada 48 In this case, the plaintiff had arranged a contract for the sale of a plant for the manufacture of glass fibres to a Peruvian buyer, who arranged a letter of credit to be issued in favour of the seller in London.49 Under the contract terms, shipment was to take place by 15 December, 1976; however, the cargo was shipped on 16 December, 1976, and the bill of lading was backdated by the loading brokers. The seller was unaware of the loading broker’s fraud. The defendant discovered the fraud and refused to pay the seller.50 At the House of Lords, Lord Diplock held that: To this general statement of principle as to the contractual obligations of the confirming bank to 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. 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 fraud.51 In my view, in this case Lord Diplock illustrated the circumstances in which the fraud exception could be successfully raised, because he indicated four key conditions that must be satisfied for the defence to be operative.52 First, it must be the seller or his agent who has committed the fraud. Second, there must be a material misrepresentation of fact. Third, the fraud must be in the documents presented to the bank. Fourth, the seller must know that the documents contain a misrepresentation. According to the first and the fourth conditions, and because the seller was unaware of the loading broker’s fraud, Lord Diplock concluded: “The instant case, however, does not fall within the fraud exception”.53 Therefore, I think that although this narrow approach of the fraud exception was used to maintain the payment system in international trade, the current attitude is in favour of the seller more than the buyer, as the burden to prove the fraud is cast on the buyer who often alleges fraud.54 Bolivinter Oil v Chase Manhattan Bank and Others 55 The plaintiff agreed to transport a cargo of crude oil for a third-party defendant, the General Company of Homs Refinery, from Iran to Syria. The plaintiff also agreed to furnish the third defendant with a bank guarantee for $1 million; the plaintiff requested that the first defendant arrange the guarantee. In consequence, the second defendant, the Commercial Bank of Syria, gave a guarantee of $1 million to the third defendant, and the first defendant opened an irrevocable letter of credit in favour of the second defendant. Disputes over the performance of the contract arose between the plaintiff and the third-party defendant.56 Sir Donaldson commented: The wholly exceptional case where an injunction may be granted is where it is proved that the bank knows that any demand for payment already made or which may thereafter be made will clearly be fraudulent. But, the evidence must be clear, both as to the fact of fraud and as to the bank's knowledge. It would certainly not normally be sufficient that this rests upon the uncorroborated statement of the customer, for irreparable damage can be done to a bank's credit in the relatively brief time which must elapse between the granting of such an injunction and an application by the bank to have it discharged. The appeal will be dismissed.57 I think that the discussion in this case is quite similar to the United City Merchants case because Sir Donaldson adopted the narrow ambit of the fraud exception. Furthermore, he affirmed that mere allegation of fraud would not be enough because the evidence must be clear for the fact of fraud and the bank's knowledge. Conclusion Surveys have indicated that approximately 60 to 70 percent of all letters of credit are rejected by the issuing banks at the initial presentation of the relevant documents. These worrying trends have caused some concerns and anxiety at domestic and international commercial levels. While some of these rejections could be based on genuine discrepancies in the presentation documents and other requirements of the letters of credit, other rejections are related to personal opinions, typographical errors and varying degrees of expertise among practitioners. These findings hint at the need for far reaching reforms, as the identified rejections hinder and slow down local and international commerce not to mention litigation. The first to be reformed should be the courts, which should be competent enough to identify the discrepancies that constitute substantive grounds for the rejection of a letter of credit. In fact, there are certain minor discrepancies for which letters of credit should not be dishonoured. The central and vital role played by the letter of credit in the facilitation of domestic and international commerce makes it necessary that transactions dealing with letters of credit are undertaken as flawlessly and expeditiously as possible. Thus, all laws targeting letters of credit should evolve as the world becomes more globalised, accompanied by changes in demands and conditions in marketplaces. There is a need for the establishment of more effective authoritative and legislative bodies to ensure the practical and commercial viability and usability of letters of credit in regard to its main principles of autonomy and compliance. (4441 words) Bibliography Books JE Byrne, The Comparison of UCP 600 and UCP 500 (Institute of International Banking Law and Practice 2007) I Carr, International Trade Law (4th edn, Routledge Cavendish 2010) P Ellinger and D Neo, The Law and Practice of Documentary Letters of Credit (Hart Publishing 2010) R Goode, Commercial Law (4th edn, Lexis Nexis 2010) A Grath, The Handbook of International Trade and Finance: The Complete Guide to Risk Management, International Payments and Currency Management, Bonds and Guarantees, Credit Insurance and Trade Finance (2nd edn, Kogan Page 2012). HC Gutteridge and M Megrah, Law of Bankers’ Commercial Credits (8th edn, Richard King 2001) D Horowitz, Letters of Credit and Demand Guarantees Defences to Payment (OUP 2010) V Lowe, International Law (OUP 2007) A Mugasha, The Law of Letters and Bank Guarantees (The Federation Press 2003) CM Schmitthoff, Select Essays on International Trade Law (Martinus Nijhoff 1988) Journal Articles Buddy Baker, ‘Understanding the UCP 600’ [2011] Q Finance Howard Bennett, ‘Performance Bonds and the Principle of Autonomy’ [1994] JBL Charles Chatterjee, ‘The Concept of the Natural Forum and the Governing Law of a Transnational Letter of Credit Contract’ [1995] 10 JIBL Yeliz Demir-Araz, ‘International Trade, Maritime Fraud and Documentary Credits’ [2002] 8 ITLR John Head, ‘How Letters of Credit Operate in the International Commercial Transactions: An Introduction to the UCP’ [2008] 77JKSBA Gao Xiang and Ross Buckley, ‘The Unique Jurisprudence of Letters of Credit: Its Origin and Sources’ [2003] 4 SANDILJ Cases Bolivinter Oil v Chase Manhattan Bank and Others [1984] 1 WLR 392 Discount Records Ltd. v Barclays Bank Ltd. [1975] 1 WLR 315 Equitable Trust Company of New York v Dawson Partners Ltd. [1927] 27 LIL Rep 49 Hamzeh Malas and Sons v British Imex Industries Ltd. [1958] 2 QB 127 Intraco Ltd. v Notis Shipping Corp [1981] 2 Lloyd's Rep 256 JH Rayner and Company Ltd. v Bank Ltd. [1943] 1 KB 37 Power Curber International Ltd. v National Bank of Kuwait [1981] 1 WLR 1233 RD Harbottle Mercantile Ltd. v National Westminster Bank Ltd. [1978] 1 QB 146 United City Merchants Ltd. v Royal Bank of Canada [1983] 1 AC 168 Authorities Uniform Customs and Practice for Documentary Credits UCP 500 (1994) Uniform Customs and Practice for Documentary Credits UCP 600, Entered into force on 1 July, 2007 Read More