What is a Letter of Credit in International Trade Law - Research Paper Example

Enjoinment of Letter of Credit in Australian Law Introduction Throughout history, enterprising individuals have sought a way of moving goods from one place to another for the purpose of trade. While in simpler times, the use of cash or payments in kind might have been suitable, the vast amounts of trade conducted around the world, and the uncertainties that attend them, including the possible delivery of shoddy goods, loss of goods in transit, or even the prospect of non-delivery, have prompted parties in the mercantile trade to come up with instruments that remove some of the uncertainties attending these complex interactions of people and companies and the movement of goods. The letter of credit is one such instrument that helps smooth the relationship between buyer and seller especially when they are separated geographically. Business, to some extent, is based on good faith and honour among the parties. But having some rules, regulations, and conventions, do help in providing the kind of transparency and peace of mind that the parties need when they are involved in dozens or even hundreds of transactions spanning the globe and involving people that they do not personally know or can vouch for. This paper focuses on what the purpose of a letter of credit is, and considers some cases in which the letter of credit may be enjoined, doing so in consideration of Australian law in particular and the international regulations and conventions that surround letter of credit transactions. What is a Letter of Credit? A letter of credit provides a measure of security in settling a financial obligation, such as between a buyer and seller. The parties to the transaction agree on the terms of their business dealings and they may be in different countries and have to worry about different currencies. Cash does not exchange hands immediately after the terms of the transaction have been agreed upon. This may be because “the buyer does not wish to give up cash before shipment, and the seller does not wish to ship without cash.”1 This is because the person or institution designated as the beneficiary of the letter of credit gets the required payment by “presenting all of the documents required by the letter of credit to the letter of credit issuer.”2 The issuer of the letter of credit may be a bank but the bank may have been instructed to create the letter of credit by a merchant or some other entity involved in trade transactions with the beneficiary. It is often used “in international trade and other business transactions, such as in the export and import of goods and services. A letter of credit could also be used as a security for a party’s performance of its obligations.”3 It is important to note that three parties are involved in the letter of credit transaction and this also means that three independent contracts are involved, the first of which is the contract or “agreement for which the letter of credit is to be the means of payment or collateral security.”4 As noted above, this may be a contract of purchase or one that ensures that purchased products are delivered as promised. The second contract involves the initiator of the agreement, that is the entity or trading company that seeks to make payment to a third party. Such an entity, the applicant, makes an agreement with the bank. As such, “The issuer agrees to issue a letter of credit, and the letter of credit applicant/account party agrees to reimburse the issuer for payments made to the beneficiary upon the presentation of all the documents required by the letter of credit.”5 The applicant, as part of the agreement, is required to pay all commissions and fees that accrue as a result of the issuance of the letter of credit. In some cases, the bank may require the applicant to put up a form of collateral. In other cases, the applicant may be a depositor with the bank and having enough funds in the account may be enough of an assurance for the bank to agree to carry out the transaction. Another important principle is the so-called fraud exception to the autonomy principle, which sets out the parameters within which banks might consider not honouring the letter of credit. “This exception deals with circumstances in which it may be appropriate for payment under a credit to be enjoined.”6 The third contract “is the letter of credit itself. The beneficiary must timely present (prior to the expiration of the letter of credit) all of the documents required under the letter of credit in order to obtain payment from the issuer.”7 It can be seen from these multi-layered contracts that there are many possibilities for error that might affect the integrity of the letter of credit. Of course, if all parties are handling their part of the agreement in good faith and diligence then it is unlikely that there would be much cause for concern at any stage of the issue and payment of the letter of credit. The so-called independence principle governs letter of credits and means that if the beneficiary of the letter of credit is able to present all the necessary documents, the issuer is obliged to make the requisite payment. It also means that each of the contracts stands independent of the others. For example, when a letter of credit has been issued for payment or as a collateral for a sales transaction, should the seller who is the beneficiary be able to present the necessary documents, “the issuer must pay on the letter of credit regardless of disputes between the seller and the buyer in the sale transaction and/or the buyer’s financial inability to reimburse the issuer for payments and charges under the letter of credit.”8 By the same token, the applicant is obliged to pay the issuer for the costs incurred in issuing the letter of credit even if there is a dispute regarding the integrity of the transaction for which the letter of credit was issued. There are two main types of letter of credit. The commercial or documentary letter of credit relies on the bank issuing the letter of credit rather than the debtor or applicant, for payment. So the beneficiary prepares documents showing that the goods ordered have been paid such as invoices, shipping documents or insurance papers.9 A standby letter of credit is meant for security purposes and is designed in such a way that the creditor or beneficiary relies, not on the issuing bank, but on the debtor or applicant, for the payment. “If the debtor defaults on its obligations to the creditor, the creditor can obtain payment by presenting all of the documents required under the letter of credit. If a standby letter of credit is properly drafted, the only documents that should be presented are a draft (demand for payment) and a statement of default.”10 The standby letter of credit is often used for “complex, ongoing enterprises abroad, for example, project financings, and in effect amounts to a performance bond.”11 In other words, whereas commercial credits “involve the payment of money under a contract of sale…In the standby case, the credit is payable upon certification of a party’s nonperformance of the agreement.”12 Also, while the party that issues a commercial credit expects to make payment, those that issue standby credits hope that conditions would be such that they are able to perform the expected task and thus not have to pay. In effect, “the presentation of drafts or demands under a standby credit is an indication that something has gone wrong.”13 Uniform Customs and Practices for Documentary Credits The letter of credit is used mostly in international transactions and has therefore been influenced by a set of rules issued by the International Chamber of Commerce. These rulings have come to be known as the Uniform Customs and Practices for Documentary Credits (UCP); they are “adhered to by banks in 165 countries.”14 Also, the Uniform Commercial Code (UCC) of the United States is often referred to by international parties as is the Convention on Independent Guarantees and Stand-by Letters of Credit (UNCITRAL Convention) put out by the United Nations Commission on International Trade Law.15 Key Considerations for Honouring a Letter of Credit The primary concern is to figure out if the beneficiary has all the right documents that match or comply with the terms stated for that particular letter of credit. The issuer examines the documents presented by the beneficiary and makes the determination to pay on that basis. “If the documents comply with the letter of credit, the issuer must pay the beneficiary; if the documents do not comply, the issuer cannot make payment unless the applicant agrees otherwise.”16 Potential Problems The forms used in the creation of a letter of credit follow an international standard and usually include a short description of the goods involved, along with the list of documents required for payment to be made. Among the problems that can arise with the issuance of a letter of credit are the following: Problems with the letter of credit Documents required by the credit are missing Documents required to be signed are not signed The credit amount is exceeded The credit has expired or the documents are presented late Shipment was short or late17 Problems with the bill of lading The bill of lading is “unclean” (it includes comments relating to damage, or other deficiencies in the goods). A marine bill of lading is required, but the bill does not state that the goods were shipped on board a named vessel. The bill of lading shows that the goods were shipped on deck. This is normally forbidden unless the credit explicitly allows it. The bill of lading offers no evidence that freight was paid by the exporter (if this was required) There is no endorsement (if endorsement is necessary).18 Problems with insurance The insurance document is different from what is specified in the credit (eg a certificate of insurance is produced while the credit calls for a policy) The insurance risks are not those specified in the credit. Insurance cover is expressed in a currency other than that of the credit. This is forbidden, unless the credit explicitly allows it. The sum insured is below the figure required. Insurance cover does not begin on or before the date of the transport document.19 Inconsistencies among documents Descriptions of the goods on the invoice and in the credit are different. Weights differ between two documents. Marks and numbers differ between two documents. Exporters should remember that it is vital to check the letter of credit when they receive it and to ask the buyer to amend the credit if they think they will have any difficulty in complying with its terms before shipment.20 Though the letter of credit is a standard form, it is clear from the above, the potentially large number of problems that can arise, either from carelessness or a deliberate attempt at deception. With the above in mind, we may now turn to Australian law and to consider what the law has to say about enjoinment of a letter of credit. It must also be noted that international norms and regulations have played a role in the use of the letter of credit though national laws continue to influence its use and honour. Australian Law In recent years, the courts have not been so passive when cases have been brought to their attention. One of the key factors that can allow the issuer of a letter of credit or a court to stop payment is evidence of fraud. This is simply because one of the reasons for the creation and use of the letter of credit is “to provide an absolute assurance of payment to a seller, provided the seller presents documents that comply with the terms of the credit. The fraud rule thus goes to the very heart of the letter of credit obligation.”21 While the fraud rule is meant to prevent fraudsters from taking unfair advantage of the instrument, there are usually provisions to ensure that the fraud rule will not be used to unfairly deprive a legitimate bearer of the letter of credit to the required payment. “According to the rule, payment under the letter of credit may be dishonoured by the issuer or enjoined by a court if fraud is found in the transaction, provided that the party seeking payment does not belong to a specified class of protected persons.”22 When the beneficiary is caught in a fraud, that is a very straightforward matter. But even when the beneficiary is not the perpetrator of the fraud, “the fraud rule will still apply if the beneficiary knows of, or has participated in, the fraud.”23 Two main elements of fraud have been used as a standard in Australia for enjoining a letter of credit. One is Intentional Fraud and the other is Gross Equitable Fraud. In one of the major cases relating to intentional fraud, Contronic Distributors Pty Ltd. V Bank of New South Wales, Presiding Justice Helsham noted that the case could be decided on the simple grounds of fraud.24 In effect, if it is possible to prove that a person or company has intentionally sought, on the basis of fraudulent documents, or some other element of deceit, to try to obtain money for which the fraudulent parties are not entitled. One of the leading cases having to do with Gross Equitable Fraud was Hortico (Australia) Pty. Ltd. v. Energy Equip. Co. (Australia) Pty. Ltd.. In this case, Energy Australia contracted with Hortico for not only the design but also the supply and installation of a boiler. Hortico undertook an arrangement where a bank guarantee would be presented to Energy Australia should there be a claim for damages regarding the job contracted for. “Hortico brought the action to enjoin the payment under the guarantee, alleging, inter alia, that the guarantee was contemplated only to be security for the performance of the contract by the plaintiff and not also for damages, as the defendant claimed.”25 Judge Young did not accept the arguments of the plaintiffs, noting that the courts prefer a hands off approach and that the courts would intervene only if there was an indication of “unconscionable conduct may be so gross as to lead to exercise of the discretionary power.26 In effect, the court did not have any reason to believe that Energy Equip Co (Australia) had attempted to engage in fraud. In a later judgment, Inflatable Toy Co. v. State Bank of New S. Whales, the plaintiff made an order for the purchase of inflatable plastic toys that were meant to be delivered in installments. The payments were to be made by letters of credit. In one of the installments, it was found that there were discrepancies between the paperwork and the facts. The discrepancies were accepted by the buyer when it was explained, by the seller but the buyer later decided not to accept the explanation and sought the assistance of the court to prevent the issuer of the letter of credit from making the payment to the seller. The buyer claimed that “the seller was guilty of fraud in presenting documents, which it knew to be untrue. Judge Young rejected the buyer’s claim.”27 It seems that in this the case the judge rejected the claim because the buyer’s action seemed calculated to escape responsibility for payment. It must be noted that the seller’s mistake seems to have been an innocent one which, upon explanation, the buyer accepted, only to reject it later and to try to wiggle out of the responsibility to make payment. In the case of Olex Focas Pty. Ltd. v. Skodaexport Co., the matter of fraud was cited by the plaintiffs but the Judge did not consider it applicable under the facts presented. In this case, Olex Focas signed a contract with Skodaexport for the supply and installation of equipment used for telecommunications, telesupervisory and instrumentation systems. These were in connection with an oil pipeline being constructed in India. Olex was in the position of a subcontractor to Skodaexport, which was in the position of head contractor. The agreement between the two parties called for Skodaexport to pay advances for mobilization and procurement in the amount of 15% of the contract costs. Olex, for its part, was required to provide security for possible repayment of the amounts in the form of performance guarantees that amounted to 10% of the contract costs in order to “secure the good performance of its obligations under the underlying contract.”28 As part of the agreement between the two parties: “All the guarantees were payable “at sight forthwith on first demand . . . without protest or demur or proof.”29 When the two parties had a conflict relating to the contracts, Skodaexport informed Olex that it was going to demand the full amount of the guarantees if Olex did not accept the terms that Skodaexport preferred for the settlement of the dispute. “By this time, the advances secured by the mobilization guarantees had largely been repaid. The plaintiffs also claimed that collectively 95 percent of the equipment had been supplied and 78 percent of the design, construction, integration and commissioning services had been provided.”30 On this base, Olex applied to the court for an interlocutory injunction that would enjoin the payment of the independent guarantees on the basis that a) Skodaexport’s threats to demand payment on the guarantees were fraudulent since Skodaexport was aware that it was not in a good position to make such claims, and b) that Skodaexport’s threats also amounted to unconscionable conduct within the meaning of “Section 51AA of the Trade Practices Act 1974 (Cth).”31 The Presiding Judge, Batt, noted that a high level of proof was required when it came to accusations of fraud. The reference to “unconscionable” in the Focas claim posed a bit of a challenge to Justice Batt who noted that the word “unconscionable” is not defined in the Trade Practices Act. The Oxford English Dictionary, to which Justice Batt turned, provided that unconscionable meant not in accord with conscience or reason. Still, Justice Batt stated: Now in Victoria, as in England, the law is clear. The principle is clearly established that payment by a bank and a demand therefore by a beneficiary under an unconditional performance bond or guarantee, as under a confirmed irrevocable letter of credit, will not be restrained except in a clear case of fraud, of which the bank is clearly aware at the time of, probably, the proposed payment, or in the case of forgery of documents (which is probably applicable only to letters of credit) or, perhaps, in the case of illegality of the underlying contract.32 The conclusion of the judge was that on the basis of both English and Australian law, mere accusations of fraud were not enough to make it so and that a high level of proof was required for the court to recognize fraud and to issue an enjoinment. The plaintiff’s claim was thus rejected. Referring to the Hortico case, Judge Batt noted: In my view his Honour was speaking in very guarded terms, prefacing his mention of that concept by reference to the general “hands–off” approach taken by courts with respect to commercial transactions. . . . I would not with respect, having regard to all the other cases I have cited, treat gross unconscionability falling short of actual fraud as a ground for an injunction.33 The two kinds of misconduct that can trigger an enjoinment of a letter of credit both relate to fraud, but of the two, only intentional fraud has been applied. Though gross equitable fraud has been noted twice by the same judge in the Supreme Court of New South Wales, it has not been applied. “Moreover, it has been rejected by the Supreme Court of Victoria. Whether the standard of gross equitable fraud can become a real ground for the application of the fraud rule in Australia remains to be seen.”34 The element of “unconscionability” has continued to pose a problem for Australian courts and there have been continued efforts to ensure that there is an adequate definition. In trade guidelines released by the Trade Practices Commission in 1993 it was suggested that unconscionability should apply in cases where “the stronger party must have known of a ‘special disability’ and have taken advantage of it before the provision would apply.”35 And special disability was to encompass reasonableness in handling terms of the relationship, the special commercial needs of a particular business or trade, and “the setting, purpose, and effect of the contract.”36 Even with these suggestions the Trade Practices Commission could not help but note that “competition is a ruthless and difficult process in which competitors may be hurt, and that unconscionable conduct will always be harder to prove in commercial settings than in consumer transactions because hard bargaining is a characteristic of commerce.”37 In yet another Australian case, Contronic Distributors Pty Ltd v Bank of New South Wales, the seller of the goods connived with the buyer and presented to the bank documents that the seller was clearly aware were not proper. The buyer owed money to the seller for merchandise that had been supplied in the past. In order for the buyer to get more supplies, the seller and the buyer came to an agreement that provided that the buyer instruct a bank to issue a letter of credit in an amount that covered not only the previous indebtedness but also the current one, meant for the new supply of goods that the buyer wanted. The buyer instructed its financier, which was other than the issuing bank, to make arrangements for such a line of credit. The beneficiary of the letter of credit, namely, the seller, knew that the goods that would be delivered would not match the amount of money stated on the letter of credit and which it planned to present to the bank for collection of the money involved. When the financier got to know about the shady nature of the transaction, he notified the bank before the seller had had the chance to present the letter of credit for payment. He also sought an enjoinment. Helsham J canvassed two grounds for enjoining payment. First was fraud, which would be established by the use of documents it knew to be false and which were brought into existence with its connivance. Secondly, the court restrained payment, because of false documents, to the knowledge of the beneficiary, were to be used to be used to obtain payment.38 Conclusion Letters of credit are considered instruments of great importance in international trade. Australian courts, like those of other countries such as the United States and the United Kingdom, would have preferred not to have to interfere in business transactions. But they recognize, nevertheless, that “The rules on fraud in letters of credit were developed by the courts to balance two policy principles, both of which favour the practice of letters of credit. On the one hand, a demand on a letter of credit should be promptly honoured. On the other hand, the perpetrator of fraud should not be paid.”39 The law is not static. While unique cases will likely stretch the creativity of Justices in Australia, in the foreseeable future, it is unlikely that those who deliberately try to perpetrate fraud using letters of credit can go scot-free, and that is a good thing for the integrity of business and international trade. Bibliography Browne, Jeffrey J., ‘The Fraud Exception to Standby Letters of Credit in Australia: Does it Embrace Statutory Unconscionability? 11.1, (1999) Bond Law Review. http://epublications.bond.edu.au/blr/vol11/iss1/6 ‘Efficiencies Grow in Letters of Credit’, (Jan 1981) 73.1 ABA Banking Journal. ‘Letters of Credit: Tips for Smooth Sailing’, (1999) 3.99 International Trade For, p.24. Lipton, Jacqueline D, ‘Documentary Credit Law and Practice in the Global Information Age,’ 22 (5) Fordham International Law Journal (1999), 1972-1990. Mugasha, Agasha, The Law of Letters of Credit and Bank Guarantees, (2003), Australia: Federation Press. Nathan, Bruce, ‘Letter of Credit Issuer Not entitled to Payment for Surplus Funds Drawn by Beneficiary’, (Mar 2003) 105.3 Business Credit 33. Gao Xiang, ‘The Identity of the Fraudulent Party Under the Fraud Rule in the Law of Letters of Credit.’ 24.1 (2001), University of New South Wales Law Journal, p. 119. Xiang, Gao & Buckley, Ross P. A Comparative Analysis of the Standard of Fraud, Rule in Letter of Credit, Duke Journal of Comparative and International Law, 13.293, (2003), p 293-336 [Global Trade and Finance, Bond University, Australia, law.duke.edu/shell/cite.][Retrieved on September 3, 2009] Read More