Enjoining Payment of a Letter of Credit under Australian Law - Research Paper Example

Running head: ENJOINING PAYMENT OF A LETTER OF CREDIT UNDER AUSTRALIAN LAW ENJOINING PAYMENT OF A LETTER OF CREDIT UNDER AUSTRALIAN LAW [Writer’s name] [Institution’s name] Enjoining Payment of a Letter of Credit under Australian Law I. INTRODUCTION International trade consists of commercial transactions between buyers and sellers all over the world. A huge problem in international trade is selecting a method of payment that is suitable to both buyers as well as sellers. If a correct method is not selected then it may cause problems for both parities. Letters of credit is a safe and common method of payment in international business transactions The bill of exchange is a specialized type of negotiable instrument used to expedite payment in an international sale1. Furthermore is similar to a check in order to pay a sum of money. The other method is the letter of credit. Is a conditional undertaking by a bank, issued to or in favour of the beneficiary in accordance with the instructions of the account party, to accept or negotiate a draft, up to a certain sum of money? Analysis of letters of credit can be divided into eight sections. The first section reviews basic letter-of-credit characteristics keeping in mind the Australia system. The second section deal with how commercial letter of credit is used in Australia, the third section deals with how standby letter are used In Australia. The fourth section describes the essential accounting and reporting criteria for letters of credit In Australia. It also takes under consideration SFAS No. 105, SFAS No. 107 and SFAS No 115 and their implication for letter of credit as well as their accounting and disclosure requirements. The fifth section gives a review of Australian law regarding guarantor or issuer of letter of credit. The sixth section is based on a case i.e. Downs Investment Pty Ltd v Perwaja Steel SDN BHD [2000] QSC 421. The seventh section gives a clear understanding of fraud in the letter of credit. The eighth section is based on two cases Hortico (Aust) Pty Ltd v Energy Equipment Co (Aust) Pty Ltd and the Inflatable Toy Co Pty Ltd v State Bank of New South Wales. II. ANALYSIS Letters of credit have always been a vital part of international trade. This form of documentary credit represents the "classic instrument" for financing the purchase of foreign goods2. In recent years, a new type of documentary credit has arisen, the standby letter of credit. Standby letters can be used to guarantee a wide variety of financial obligations. In Australia letters of credit are becoming more and more commonplace; there is virtually no coverage of the topic in financial accounting textbooks. Therefore, our purpose in this article is to provide a synopsis of the topic (including a short case) that can be used to teach letters of credit in the accounting curriculum. In addition, covering this topic in class provides an excellent opportunity to address international trade and cultural issues. A.Characteristics of Letters of Credit In Australia Letters of credit are regulated by (a) Article 5 of the Uniform Commercial Code (b) provisions of the Uniform Customs and Practice for Documentary Credits (UCP) issued by the International Chamber of Commerce, and (c) the case law of state and federal courts3. In its basic form, a letter of credit is a document, usually issued by a bank, whereby the bank agrees to pay a third party on behalf of its customer. B. Commercial Letters of Credit Commercial letters of credit has been used for a long time in Australia to help businesses make payments in international trade transactions. The buyer (the account party) would ask its bank to issue a letter of credit to the seller (the beneficiary). In the letter, the bank would promise to pay the seller for the goods once the seller presents to the issuer specified documents indicating compliance with the requirements of the letter. According to the International Chamber of Commerce (ICC) Guide to Documentary Credit Operations (1978), commercial letters foster international trade In Australia by meeting the specific needs of both buyer and seller4. The seller wants assurance of prompt payment within the agreed-upon time limit and the convenience of receiving payment at its own bank or through a bank in its own country. The buyer wants assurance that payment is not necessary until the seller has fulfilled all of the terms of the sales contract. Both parties desire the convenience of using an intervening third party in who both have confidence to effect payment. A potential complication arises, however, when the beneficiary fails to comply with all of the requirements stipulated in the letter. For example, suppose the above importer wishes to stop payment on the transaction because it discovers that the wrong goods were shipped. From a legal point of view, in Australia the letter of credit is not at all dependent on the underlying transaction. According to Australian law it is the bank's duty to pay under the credit only if the required documents are submitted to the bank on time. These documents include invoices, shipping documents, etc. credit is not only given on the basis of customer satisfaction of the buyer regarding the transaction. The Uniform Commercial Code of Australia cannot deal with the documents that are submitted to attain payment, the business which requires the payment has to follow the conditions of the letter, and this matter has been the issue of considerable litigation. C. Standby Letters of Credit In Australia Standby letters work approximately the same way as commercial letters. Nevertheless, there are numerous significant distinctions between the 2 kinds of credit. First, as discussed above the commercial letter of credit is usually utilized to as mode of payment to purchase foreign goods5. A standby letter is usually used as guarantee that the issuer will payback the credit amount If a standby is to be secured, separate unpledged assets must be available for such use. That is, in the case of a standby letter, the issuer pays only if the account party defaults. Finally, the commercial credit may be revocable, whereas the standby is generally irrevocable. Standby letters of credit have been used In Australia to ensure completion of sales contracts (e.g., the acquisition of real estate, nuclear fuel, oil and gas), to secure performance (e.g., completion of construction projects, repayment of long-term promissory notes, and payment of insurance premiums), and have served as substitutes for security agreements, margin deposits, and escrow agreements . Standby credits have also been used In Australia to enhance the credit of municipal borrowers and corporate commercial paper issuers to cover claims through a self-insurance program, and to manage cash flow6 . In Australia There will not likely be as much litigation for standbys as there has been for commercial letters because standby letters are commonly used as performance guarantees. The beneficiary has more motivation to cooperate with the other party so that problems that may arise during the transaction can be solved. This is because the beneficiary's primary interest is in obtaining performance. D. Accounting and Reporting Requirements for Letters of Credit Many changes have taken place since 1986 in accounting and reporting requirements for letters of credit. The Financial Accounting Standards Board is responsible for these changes. The requirements for issuers in Australia have been the primary focal point of the changes7; financial institutions In Australia were not permitted by generally accepted accounting principles (GAAP) to disclose in their financial statements their possible liability under letters of credit. These and other such undisclosed contingencies are often referred to as "off-balance-sheet" risks. In 1986, the FASB initiated a project to develop "broad standards" to address existing and future financial accounting and reporting issues In Australia related to the use of financial instruments8. To date, three pronouncements have been issued. 1) SFAS No. 105 In 1990, the Board issued Statement of Financial Accounting Standards (SFAS) No. 105, Disclosure of Information about Financial Instruments with Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk. SFAS 105 In Australia requires improved disclosure for financial instruments possessing "off-balance-sheet risk"--the risk of accounting loss that is either greater than that reported in the balance sheet or is not reported in the balance sheet at all. In Australia Off-balance-sheet risk has three components: credit risk (the risk that a party will fail to perform according to the terms of a contract), market risk (the risk associated with future changes in market prices), and the risk of theft or physical loss9. Disclosure Required by SFAS 105 SFAS 105 in Australia permits entities to disclose the actual amount of their financial instruments. Disclosure should also contain the amount of accounting loss that can occur due to the credit and market risk related to such instruments. Disclosure in Australia may be made in the body of the financial statements or in the notes to the statements. However, the disclosure requirements go beyond quantitative disclosures. Management must also discuss the nature and terms of its financial instruments. The discussion should take into consideration for instance, the credit and market risk of the entity's financial instruments, any requirements which the instrument has regarding cash and management's policy about the accounting as well as reporting of such instruments10. Finally, an entity In Australia must disclose its concentrations of credit risk. For example, suppose a bank with expertise in the automotive industry issues most of its standby letters of credit to firms in that industry. This practice exposes the bank to considerable risk because a downturn in the industry might force the bank to make a significant payout of its resources to settle its obligations under the letters. Implications for Letters of Credit A primary type of risk In Australia associated with letters of credit is credit risk to the issuer. For commercial letters, the credit risk may be minimal because the letter is often secured by the goods being purchased. In the case of a standby letter, the risk In Australia is essentially similar to that associated with extending a loan. How much credit risk can be disclosed in such a situation might be hard to estimate as it is affected by the length of time which it has taken, the value of the collateral, and the costs needed to collect and end collateral. Theoretically, In Australia there is no credit risk to the holder of the letter, the beneficiary, because the holder will receive payment in either case, whether from the account party or from the issuer. Likewise, there is no credit risk to the account party In Australia because payment is required only when the beneficiary fully complies with the requirements of the letter. 2) SFAS 107 In 1991, the FASB issued SFAS 107, Disclosures about Fair Value of Financial Instruments11. In Australia This standard represents the Board's initial response to regulators (such as the Securities and Exchange Commission [SEC]) and other groups who supported market value accounting requirements for certain financial instruments in light of the recent crisis in the thrift industry12. Though SFAS 107 did not require any changes in accounting practices, it did continue the Board's effort to improve the information disclosed about financial instruments. Disclosure Required by SFAS 107 SFAS 107 requires that an entity disclose the fair value of its financial instruments. If it is not practicable to estimate an instrument's fair value, the entity must disclose the instrument's carrying amount, effective interest rate, maturity, and reasons why an estimate could not be made. In Australia management has to disclose the methods they use along with any underlying statement made in estimating the fair values of its financial instruments13. Although SFAS 107 does make a few exceptions, most financial instruments are covered by the standard. Implications for Letters of Credit Often commercial letters are issued In Australia to facilitate the purchase of foreign goods are executed in just a matter of days or weeks. Therefore, the face amount of such credits most likely approximates their fair value. Standby letters often involve longer periods of time between origination and realization. Furthermore, payment under the letters under Australian law may be required at varying stages of the completion of the activities for which the letters were issued. In Australia the financial accounting standards board wants an estimate of fair value be based on the present cost charged for similar agreements or on the expected price to end the agreements or make a settlement on the obligations with the counterparties at the reporting date14. 3) SFAS 115 The FASB issued the latest work in its financial instruments project. According to Australian law SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, entail financial institutions to implement market value accounting practices for particular investment securities. Though the SEC and a number of organizations within the accounting profession In Australia support fair value accounting for financial instruments, financial institutions (particularly banks) waged an intense campaign against the new standard15. Accounting and Disclosure Requirements of SFAS 115 SFAS 115 requires entities to classify their debt and equity securities into three categories. In Australia securities are kept till maturity, it also consists of those debt securities which the entity has the positive intention and capability to hold to maturity. Holding gains or losses are the net changes in fair value of a security exclusive of dividends declared or interest earned but not yet received and exclusive of any write-downs for permanent impairment. In Australia The second category, trading securities, includes those debt and equity securities which are sold later on. SFAS 115 requires that entities report trading securities on the balance sheet at fair value. In addition, entities must recognize unrealized holding gains and losses in earnings. In Australia, the third category, securities available for sale, includes those debt and equity securities do not come under the category of being held till maturity or trading securities.16 Securities available for sale must also be reported on the balance sheet at fair value. Every thing has to be mentioned under SFAS 115. For instance, an entity has to disclose the total fair value, gross unrealized holding gains also losses, amortized cost basis, and contractual maturities, as suitable, for securities involved in the held-to-maturity and available-for-sale categories17. The entity has to disclose the realized gains along with losses which take place due to sale of securities, the gains and gross losses included in earnings from transfers of securities amongst investment categories, and the alteration in net unrealized holding gain or loss reported as an amendment to stockholders' equity or included in earnings. Implications for Letters of Credit Letters of credit, per se, are not addressed in SFAS 115. Although In Australia beneficiaries have a guarantee of payment or performance, the guarantee does not meet the definition of an asset. According to Statement of Financial Accounting Concepts No. 3, an asset doesn't yet exist if the event giving rise to the holder's right to future economic benefits (i.e., the default of the account party) has not yet occurred18. SFAS 115's impact on letters of credit will come from changes in business practices that the standard may produce. Much of the opposition to fair value accounting for investment securities relates to the potential impact such requirements will have on banks' earnings and capital levels. In Australia Bankers are concerned that reporting unrealized holding gains and losses in earnings or as adjustments to stockholders' equity will lead to confusing, misleading, and fluctuating financial statements. An additional factor is the extensive amount of regulation tied to a bank's capital levels19. For example, the Prompt Corrective Action (PCA) rule for financial institutions uses capital levels to determine when an institution should be closed. The rule also specifies the supervisory actions regulators may take against banks as their capital levels fall to specified levels. Because of the potential financial statement impact, market value opponents fear that banks will attempt to manage their earnings by switching from long-term to short-term investment strategies. In Australia such a shift may lead to significant changes in lending practices as banks demand fewer fixed-rate mortgage-backed securities. It would make it difficult and expensive for firms to finance their long-term growth and expansion plans. If banks increase their capital levels to avoid the possibility of being closed under the PCA rules of Australia the current credit crunch may be further exacerbated. In Australia As credit becomes more costly and hard to attain, firms might increasingly use letters of credit as financial strategies. If issuers do not pay attention their letter-of-credit requests as if they were loan applications, there is liable to be a major raise in risk exposure from such instruments20. From the other perspective, if the increased demand for letters of credit causes a significant increase in letter-of-credit fees, customers may find such letters less attractive. E. According To Australian Law Regarding Guarantor or Issuer of Letter Of Credit An insurer has a guarantee or letter of credit regarding the reinsurance recoverables due from a reinsurer who is not authorized, the Investment Capital Factor to be utilized may be implemented on the issuer of the letter of credit. The following cases is where this can be applied 0 (a) the guarantor or issuer of the letter of credit is an authorised deposit-taking institution; 1 (b) the guarantee or letter of credit is explicit, unconditional and irrevocable 2 (c) the guarantor or issuer of the letter of credit is obliged to pay the insurer in Australia; and 3 (d) The obligation of the guarantor or issuer of the letter of credit to pay the insurer is specifically linked to performance of the reinsurance contract or contracts under which the reinsurance recoverables arise.21 A guarantee or letter of credit provided to an insurer by its own parent or a related entity is not eligible for this treatment. The collateral, which is present in referred to in para 23 and 26 have to be in use for the likely period for payment of claims underneath the reinsurance contract underneath which the reinsurance recoverables occur. If this is unfeasible, the collateral must be in use a period of for at least 2 years however be renegotiable every year to permit at least a year to discover alternative arrangements if cannot be renegotiated. F. Downs Investment Pty Ltd v Perwaja Steel SDN BHD [2000] QSC 421 This case involved two parties in which one was an Australian seller of scrap metal and the other party was a Malaysian buyer. The buyer did not to follow the contract and opened the letter of credit in a different manner. Due to this Ambrose J stated that the party had filed the requirement to pay the required amount , which according to in article 25 was a fundamental breach, thus allowing the seller to state that he contract did not follow article 64(1)22. The buyer‘s management had change but that was no reason to breach the above mentioned articles. Ambrose J filed for damages accruing to article 74 and 75. Reselling the scrap in 2 months was also considered as an alternate transaction for the reason of filling for damages, as it was done in a ‘reasonable time’ as mentioned under art 75.206 Article 72 on anticipatory breach was taken into consideration as well. The Court of Appeal in came to the conclusion that no discrimination had been made, not due to the similarities amongst the provisions, although in light of the way in which proceedings were carried out. Court also considered the arguments made at trial and throughout the leave application made it quite clear that the seller’s case was not only based on Sale of Goods Act. G. Fraud and Letter Of Credit Both Letters of credit as well as performance bonds are considered as good securities. The fraud exception helps in putting restrictions on the issuer's undertaking. Assurance given by issuing bank cannot be considered as pay on demand, however to pay claims which are non-fraudulent on demand23. However if this helps in paying for a claim that may be considered as being fraudulent, then no reimbursement is given by the account party as it has acted more then what it’s authority was . Thus the above mentioned condition makes the bank stuck in bad situation. The bank is usually supposed to pay immediately as soon as the demand for reimbursement is filed24. There no time for inquiry and the bank is not equipped well enough to come to a decision regarding the validity of claims of fraud. The position is bearable as the courts require extremely valid evidence for fraud cases. The above discussed situation can be seen in Olex Focas Pty Ltd v Skodaexport Co Ltd. [[1996] 70 ALJR 1983] in this case a Czech company is the defendant, he had been given the responsibility of being a head contractor for the construction of an oil pipeline in India25. An Australian company was the claimant; they designed provision of communications systems. The defendant was in contract with the plaintiff to provide them communications systems which they required the price stated in the contract was almost US$22 million. In the contract the defendant had also agreed to reimburse the plaintiff. The advances were to be given divided into two with a total of fifteen present of the total contract price. The plaintiff was supposed to first ask for bank guarantees so that the reimbursement of the mobilisation advances could be guaranteed. 6 guarantees totalled to about A$7 million. The account party wanted injunctions for suspected fraud and, thus filing for the bonds would be 'unconscionable' under article s51AA of the Trade Practices Act 1974. Batt J thought that there were no reasons for granting the injunction at common law. The judge came to a decision that the documentary credit would be restrained only under 3 conditions. These are (1) When the bank knows that there is a case of fraud at the time of payment; (2) Where the documents are counterfeited; and (3) When the original contract is illegal. Batt J stated that the doctrines of restraining performance bonds were exactly like the principal of letters of credit, and thus it was concluded that principles of forged documents cannot be applied to the performance bond H. Cases Dealing With Fraud 1. Hortico (Aust) Pty Ltd v Energy Equipment Co (Aust) Pty Ltd In this case Energy Australia had signed a contract with Hortico for the plan, supplying, as well as installation of a boiler. Hortico made arrangements for the issuance of a bank guarantee for Energy Australia. Afterward both the parties terminated the contract and Energy Australia filed for a guarantee regarding the damages26. Hortico also wanted the payment to be made under this guarantee, claim, inter alia, that the guarantee was considered only to be security till the contract was not terminated by the claimant and not also for damages, which the defendant had filed for . Judge Young who was appointed as the judge of this case did not entrain the plaintiff. He stated that however: with means of the commercial transactions like the one currently made the courts have always preferred a “hands off” approach, and it does not appear to me that something this short of actual fraud be sever in enough for the court to interfere although it might be in a few cases the un- conduct might considered as serious fraud. 2. The Inflatable Toy Co Pty Ltd v State Bank of New South Wales. Ten years after the case of Hortico (Aust) Pty Ltd v Energy Equipment Co (Aust) Pty Ltd the believe that gross equitable fraud may consist of the fraud rule was again clarified by judge young27. in this case, the buyer, gave an order for some inflammable toys, it was agreed by both parties that the toys could be delivered on instalments and payments would be made by letter of credit. However in one for one instalment, there was deviation between the facts and the contract. The buyer forgave the seller for this deviation, but then he filed a claim for fraud on the buyer .Judge Young in this case gave careful consideration to the case and rejected the claim III. CONCLUSION By the above given analysis it is save to say that the letter of credit plays an vital role in international trade. However it can also be the cause of fraud. The cases given in this assignment give clear understating of how this document has been misused in the past. The types and characteristics given in the assignment make it easy to understand how this document works. However the fact that in Australia it is used a lot in business transactions even though an insurer has a guarantee or letter of credit regarding the reinsurance recoverables due from a reinsurer who is not authorized, the Investment Capital Factor to be utilized may be implemented on the issuer of the letter of credit. It is safe to conclude that this document has made export easier and has helped a lot of business men to recover their payment thus reducing chances of fraud. References Journal Article Bergami, Roberto; 'eUCP: A Revolution in International Trade?' The Vindobona Journal of International Trade Law and Arbitration, vol. 8, no. 1, 2004 Buckley Ross Reprinted in Byrne (ed), The 1998 Annual Survey of Letter of Credit Law & Practice, Institute of International Banking Law & Practice, 1998, 49-84. Buckley Ross “Potential Pitfalls with Letters of Credit ", 70 Australian Law Journal 1996 pp217-238 Ellinger Peter “Assignment of the Proceeds of Letters of Credit” Annual Survey of Letter of Credit Law and Practice 2003 Fellinger.A .Greg “Letters of Credit: The Autonomy Principle and the Fraud Exception”, vol. 1, (1990) Journal of Business & Finance Law and Practice p6 Ian Sharpe & Tayfun Tuzun; Standby Letters of Credit and Bank Default Risk Australian Economic Papers 2002 Volume 37 Issue 2, James. D. Murphy, “Documentary Credits and Rejected Documents”, 1992, vol.1, Lloyd’s Maritime and Commercial Law Quarterly 26. James G. Barnes & James E. Byrne, “Letters of Credit”, August 1993, vol. 48, The Business Lawyer Metha, Ravi, 'Export letters of credit - eight steps to error free compliance', International Trade Forum, no. 4, 1999 pp. 12-5. Peter Lowe, “Fraud and the Documentary Credit”, Report of the ICC International Maritime Bureau, ICC Publications; Paris: 1994. Pottengal Mukundan, “Trade Finance Fraud: When Buyers and Sellers Collude”, vol. 9, no. 1, Jan-March 2003 Documentary Credits Insight Schlesinger, V 'The beleguered letter of credit', Journal of Commerce, vol. 4, no. 2, 2003, pp. 26-7. Weissman, Ira, 'Letters of credit - doing business in a global market', CPA Journal, vol. 66, no. 1996 EL Rubin, “Types of Contracts, Interventions of Law”, Winter 2000, 45 Wayne L. Rev. Books Buckley Ross The International Financial System: Policy & Regulation, Kluwer Law International, London, 2008. Burnett, Robin; Law of international business transactions, 3rd edn, The Federation Press, Sydney 2004 John F. Dolan, The Law of Letters of Credit: Commercial and Standby Credits, Warren, A.S. Pratt & Sons; Warren: 2001. Agasha Mugasha; The law of letter of credit and bank guarantees, The Federation Press, Sydney, NSW. 2003, Gregory Burton, Australian Financial Transactions Law, Butterworths; Sydney: 1991. Ronald J. Mann, “Symposium Empirical Research in Commercial Transactions: II”, op. cit., 2494, at 2524-2530. Websites Cutter Karen. & Curley Steve; Collateralisation of non-apraregulated Reinsurance recoveries – has the industry’s Passion subsided? 2009 VOL. 32 no. 02 retrieved on September 9 2009 from www.finity.com.au/file.php?f=Collateralisation+Iss+2+09.pdf Cases Downs Investment Pty Ltd v Perwaja Steel SDN BHD [2000] QSC 421 retrieved on 9th September 2009 from Law of International Business in Australasia by Robin Burnett and Vivienne Bath 2009 Federation Pr; 4 edition p33 Hortico (Australia) Pty Ltd v Energy Equipment Co (Australia) Pty Ltd (1985) 1 NSWLR 545 retrieved on 9th September 2009 from The Fraud Rule In The Law Of Letters Of Credit: A Comparative Study By Xiang Gao, Xiang Gao (L.L.M.) 2003 p93 Inflatable Toy Company Pty Ltd. v. State Bank of New South Wales Ltd. (1994) 34 NSWLR 243 (Sup. Ct, NSW) retrieved on 9th September 2009 from Gutteridge and Megrah's law Of Bankers' Commercial Credits By King Richard 2001 Europa Publications; 8 edition p168 Olex Focas Pty Ltd v. Skodaexport Co Ltd [1996] 134 FLR 331 retrieved on 9th September 2009 from the Fraud Rule in the Law of Letters Of Credit: A Comparative Study by Xiang Gao, Xiang Gao (L.L.M.) 2003 p94 Read More