The particular legal aspects of documentary credit theory
Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. In addition, the performance of an existing duty under a contract cannot be a valid consideration for a new promise made by bank: the delivery of the goods is consideration for enforcing the underlying contract of sale and cannot be used, as it were, a second time to establish the enforceability of the bank – beneficiary relation.
Practitioners and lawyers as the prominent representatives of the legal environment of business have analyzed every possible theory from every legal angle and failed to satisfactorily reconcile the bank’s undertaking with any contractual analysis.
The theories include:
- the implied promise,
- assignment theory,
- the novation theory,
- the reliance theory,
- agency theories,
- estoppels and trust theories,
- anticipatory theory,
- and the guarantee theory.
These representatives as: Xiang Gao, J. F. Dolan, R. J. Lee, E. P. Ellinger, and others, have all accepted the view that documentary credits should be analyzed outside the legal framework of contractual principles, which require the presence of consideration. Accordingly, whether the documentary credit is referred to as a promise, an undertaking, a chose in action, an engagement or a contract, it is acceptable in European (also in English) jurisprudence to treat it as contractual in nature, despite the fact that is possesses distinctive features, which make it sui generis.
In this place it should be noted, however, that the fundamental concepts of the documentary regime including:
- the principle of autonomy,
- the doctrine of strict compliance, and
- the “fraud exception”.
Autonomous nature of the documentary credit
In accordance with this principle, the documentary credit is totally independent of the underlying contract. The autonomy of the letter of credit governs the rule that the paying bank, as the agent of the bank which issues the credit, will have to pay without conditions. This means that if the beneficiary (exporter) fulfils the documentary obligations, payment must be effected according to the terms of the credit, regardless of the disputes connected to the underlying sales and purchase contract between the exporter and importer.
It is essential that all parties remain confident that issuing or confirming banks will respect their payment commitments.
The payment obligation of an issuing bank is separate and autonomous from the underlying export contract. Thus, the exporter’s breach of contract condition (i.e., with respect to quantity, quality, delivery, date, etc.) is not sufficient to entitle the importer to instruct her bank to stop payment under the credit. The principle exception to this rule has committed by the beneficiary is not only entitled, but obliged, to withhold payment. However, banks are not required to investigate mere suspicions of fraud. Courts are quite reluctant to grant injunctions ordering a bank to withhold payment, so clear indications of fraud are generally necessary.
Since documentary credit practice has arisen to some extent to avoid risks related to the lack of knowledge or trust between the two trading partners, it is essential that both parties trust the banks. Letters of credit could not function if the parties lacked confidence that the banks would honour their obligations regardless of arguments submitted by the parties. Judges have referred to documentary credits as the “life blood” of international commerce.
If banks were allowed to refuse to pay letters of credit whenever trading parties had a dispute, the vital flow if international commerce would soon be blocked.
In some cases, the issuing bank officers may be obliged to resist pressure from the applicant to bend the principle of absolute neutrality and independence. However, it is unfortunately quite possible for an exporter to send bad merchandise (so long as this does not amount to a clear fraud) and yet present documents. That is one of the reasons that an inspection certificate is so frequently called for. If the importer learns that he may receive an inadequate or late shipment, he may sue for damages for breach of contract.
The autonomy of the letter of credit will be an advantage in international sales because it leads to successful agreed terms of goods delivery and price payment between the exporter and the importer, so that the seller will have to present documents of delivery in order to conform with the terms of the documentary credit, and the buyer will have to reimburse the bank upon the bank’s payment to the seller in compliance with the terms of the letter of credit1.
The doctrine of strict compliance
The second fundamental principle of documentary credit practice is the requirement that documents are strictly comply with the terms of credit. Generally speaking, the terms of the documentary credit must be strictly adhered to: this is known as the doctrine of strict compliance. The doctrine of strict compliance has governed the law of letters of credit since the beginning of the 20th century. It is echoed in one of the classical statements in point:
“It is elementary to say that a person who ships in reliance on a letter of credit must do so in exact compliance with it terms. It is also elementary to say that a bank is not bound or indeed entitled to honour drafts presented to it under a letter of credit unless those drafts with the accompanying documents are in strict accord with the credit as opened2.
What this means in everyday practice is that documents presented under the credit must conform very precisely with the terms of the credit. Documents are only compliant if they are complete, if they are of the kind described in credit and if they are without obvious defects.
The rationale behind this strict, uncompromising, doctrine is the notion that banks are financiers and not traders. They are not – and cannot be expected to be – familiar with the commercial elements of their customers’ business activities. Accordingly, banks should not be dragged into disputes respecting the conformity of goods supplies to the development of the other major (above mentioned) principle of the law of documentary credits, which is the autonomy doctrine3.
The strict compliance doctrine is, reality, complementary to the autonomy of the credit. As long as the issuing bank adheres to it when it examines the documents tendered under the documentary credit it remains within the ambit of its contract with the applicant for the credit.
A rigid application of the doctrine of strict compliance is, obviously, bound to lead to results that would, on many occasions, be regarded as both unfair and unsound by the business world in general. Indeed, such is the trepidation invoked by the doctrine that, in certain trades, there has been a shift from the traditional forms of documentary or commercial letters of credit to standby credits. Although the doctrine of strict compliance applies even to such transactions it is, quite erroneously, believed that the simple nature of the documents to be tendered under standby credits renders compliance an easy task.
According to E. P. Ellinger, in respect of documentary or commercial credits, the courts and the business world developed five principles that are used to combat strict compliance.
The first principle is that, “in construing a letter of credit, the document has to be construed as a whole. Effectively, this means that specific terms of the letter of credit may be read together with, or elucidated, on the basis of others clauses4.
A second principle, “also developed by the courts, is to dismiss patent misprints a meaningless deviations as trivialities, to be distinguished from discrepancies. Originally, this principle was proclaimed in the United States5(…). The principle has been adopted in Singapore and by the English courts. In commercial terms, this principle gives effect to a view, held for a long time amongst bankers, according to which not <<every little discrepancy>> is a <<discrepancy>>. Coached in legal phraseology, the doctrine asserts that not every trivial departure in the documents from the wording of the letter of credit is a discrepancy justifying the rejection of the documents. Obviously, de minimis non curat lex has now been made applicable to letters of credit!6.
The third principle is to be found in article 13(a) of the UCP 500 (the second sentence) and actually in article 14(a) of the UCP 600:
- Article 13(a) of the UCP 500
“(…) Compliance of the stipulated documents on their face with the terms and conditions of the Credit shall be determined by international standard banking practice as reflected in these Articles”.
- Article 14(a) of the UCP 600
“A nominated bank acting on its nomination, a confirming bank, if any, and the issuing bank must examine a presentation to determine, on the basis of the documents alone, whether or not the documents appear on their face to constitute a complying presentation7.
It is clear these articles militate against any attempt to treat the compliance of a document as a mere exercise of proof reading, based on a mere comparison of its language with the words of the letter of credit.
The fourth principle, likewise developed in practice, is stated in article 13(c) of UCP 500 and in article 14(h) UCP 500:
- Article 13(c) of the UCP 500
“If a Credit contains conditions without stating the document(s) to be presented in compliance therewith, banks will deem such conditions as not stated and will disregard them”.
- Article 14(h) of the UCP 600
“If a credit contains a condition without stipulating the document to indicate compliance with the condition, banks will deem such condition as not stated and will disregard it.”
It should be noted, that these versions are both alike.
According to Ellinger, “whilst this provision does not combat the utilization of trivial deviations in the documents, it enables banks to ignore onerous conditions which, usually, seek to introduce into the letter of credit terms of the underlying contract of sale without specifying documents to be tendered in order to establish compliance therewith”8.
The last, five principle which seeks to soften the rigorous of strict compliance is based on an American doctrine, under which the bank is treated as waiving discrepancies not stated in the notice rejecting the documents9. “This principle, which was consistently rejected by the English courts”, was adopted with some modification in article 16 of the UCP 400 (1983 Revision) and is later set out in articles 13(b) and 14 of the UCP 500 (currently in articles 14(b) and 16 of the UCP 600).
According to article 14(e) of the UCP 500 that states as follows:
“If the Issuing Bank and/or Confirming Bank, if any, fails to act in accordance with the provisions of this Article and/or fails to hold the documents at the disposal of, or return the to the presenter, the Issuing Bank and/or Confirming Bank, if any, shall be precluded from claiming that the documents are not in compliance with the terms and conditions of the Credit”;
The effect of this provision is to estop the issuing bank from pleading discrepancies unless they have been stated in a notice of rejecting complying with the procedure laid down in the U.S. Uniform Commercial Code (Article 5 – Letters of Credit). To be effective, the notice must be given within a reasonable time not exceeding seven business day (according to UCP 500 article 13(b)) and a maximum of five banking days following the day of presentation (article 14(b) of the UCP 600), must be communicated without delay once the bank has reached its decision to reject (article 14(d)I of the UCP 500 and article 16(c) of the UCP 600), has to spell out all the discrepancies in respect of which the documents are rejected (article 14(d)II of the UCP 500 and article 16(c)II and 16(c)III a, b of UCP 600), and must, further state that whether the documents are being held at the “presenter’s” disposal or are being returned (article 14(d)II of the UCP 500 and article 16(c)III e of the UCP 600).
The present articles 14(b) and 16 of the UCP 600 seek to combat the highly formal doctrine of strict compliance by lying down an equally formal doctrine governing the rejection of a faulty tender. An issuing bank that fails to follow the precepts of the latter relinquishes the right to rely on the former.
The state of the law, following the promulgation of the former UCP 500 and present UCP 600, and the general body of case law, was that the doctrine of strict compliance, according to E.P. Ellinger view, remained sacrosanct. “True, the five exceptions just discussed introduced some counter measures. All the same, if the issuing bank was able to identify just one “discrepancy” – other than a mere misprint or patent triviality – it was entitled to reject the documents”10. Provided it complied with the precepts of the rejection procedure, laid down in articles 13(b) and 14 of the UCP 500 (14(b) and 16 of the UCP 600), it could ignore the protests of the negotiating bank and the beneficiary.
The fraud exception
The autonomous nature of the documentary credit is limited by the exception of fraud. The scope of the concept of fraud and especially the actual application of the juridical patterns which have evolved over time to actual cases remains, however, uncertain and controversial.
The fraud is a persistent thorn in the side of international commerce but legal writing on this topic is no less voluminous. The issue of fraud arises if a defence against payment is made which is founded on grounds derived from the underlying transaction.
The fraud exception describes circumstances where, due to the operation of fraud, the autonomy principle must yield. The documentary credit system is the life-blood of international trade. In order to maintain the integrity of this system, documentary credit transactions are considered to be separate and district from underlying sale transactions. Documents presented under letters of credit for payment are considered only on the basis of letters of credit and documents, and without reference to underlying transactions or any other extraneous facts.
In this article, the fraud exception, as applying to letters of credit, will only be examined relatively briefly in order to provide the framework to consider whether this exception has application in relation to bank guarantees and unconditional performance bands or documentary credits.
The fraud exception may operate to enable an issuing bank to elect to not make payment under a documentary letter of credit or alternatively may enable an account party to seek to restrain the issuing bank making payment or to restrain the beneficiary from seeking payment. The actual scope and availability of the fraud exception in practice turns on several questions and appears to be very much dependent upon the relevant jurisdiction11.
The impact of fraud in relation to documentary credit is seen in one specific context:
“a dispute as to whether a bank is obliged to pay a documentary credit in circumstances where fraud is alleged in connection with the underlying contract.”12.
Such disputes are likely to come before the courts in three situations:
- where the applicant/buyer (importer) wishes to stop the paying bank making payment on the grounds that the beneficiary/seller (exporter) has been guilty of fraud;
- where the beneficiary/seller (exporter) is suing the bank on the basis that the bank has refused to make payment on the ground of fraud;
- where the paying bank has already made payment and recovery is sought on the ground of fraud in relation to the documentation presented in support of payment13.
Proceeding on to a general conceptualization of the documentary credit, it refers to any arrangement whereby a bank (the issuing bank), acting at the request and on the instructions of a customer (the applicant for the credit):
- undertakes to make a payment to, or to the order of a third party (the beneficiary), or is to pay or accept bills of exchange (drafts) drawn by the beneficiary, or
- authorizes another bank to effect such payment, or to pay, accept, or negotiate such bills of exchange14.
The strict obligation of banks under the concept of the autonomy of the credit – banks must pay – is to some extent counter-balanced by the rights of banks to refuse payment where the documentation tendered in support of an application for payment under a credit is not strictly in compliance with the requirements of the credit15.
But provided the documents are, on their face in conformity, the bank has an obligation to pay:
However, there is an exception to the doctrine of strict compliance with the terms of credit, payment can be refused under “the fraud exception” where:
- there is clear evidence of fraud, and,
- the bank has clear notice of this evidence of fraud, and,
- the bank’s awareness of the fraud was “timely”
Bearing in mind that, where fraud is alleged, the procedural machinery likely to be used is the injunction, there is a fourth element involved where what is sought is a pre-trial injunction, the balance of convenience16.
For the purposes of this article it is assumes that a payment obligation is triggered by a simple demand by the beneficiary. As such these unconditional documents are commonly used and represent an instrument which is “readily, promptly and assuredly realizable”.
The utilization and purpose of these documents is very similar to the utilization and purpose of documentary letter of credit as previously discussed. These documents are commonly used for trade and project finance, in building or construction contracts, in property transactions (in lieu deposits) and as security for service contracts. Some of the advantages of these documents were identified. In the considerable case law treatment of the letters of credit. Although each individual instrument must be separately considered to decide, the observation is commonly, the observation is the “List of Supervised”17.
- F. Monteiro, W. Harle, “Documentary Credits: the Autonomy Principle and the Fraud Exception – A Comparative analysis of common law approaches and suggestions for New Zealand”, Auckland University Law Review, 2007, Vol. 13, pp. 144-147;
J. S. Wood, “Drafting Letters of Credit: Basic Issues Under Article 5 of the Uniform Commercial Code, UCP 600 and ISP 98”, The Banking Law Journal, February 2008, p. 105;
R. F. Dole Jr, “Warranties by beneficiaries of letter of credit under Revised Article 5 of the UCC: the truth and nothing but the truth”, Houston Law Review, Vol. 39, 2002, p.380;
Zhang, Jingbo, “Principle of autonomy in documentary credits”, in: Shipping and Trade Law, 2012, Vol. 12, No. 4, p. 6-7.
R. L. Frias Garcia, “The Autonomy Principle of Letters of Credit”, Mexican Law Review, Vol. III, No. 1 (July-December 2010), pp.74-76.
- E. P. Ellinger, “The Doctrine of Strict Compliance: Its Development and Current Construction, 2001 Annual Survey of Letter of Credit Law & Practice”, Montgomery Village, MD, USA, 2001, , p.64.
- J. K. Lewit, “Bottom-up lawmaking through a pluralist lens: the ICC Banking Commission and the transnational regulation of letters of credit”, Emory Law Review, Vol. 57, No. 5, 2008, pp 1178-1179
- E. P. Ellinger, “The Doctrine of Strict Compliance”, op. cit., p. 67
- Ibid, p.67-68
- See „Commentary on UCP 600. Article–by–Article Analysis by the UCP 600 Drafting Group”, ICC Publication No. 680, International Chamber of Commerce (ICC), Paris 2007, pp. 59-62.
- E. P. Ellinger, “The Doctrine of Strict Compliance”, op. cit., p. 68.
- Ibid, p. 69; see D. M. Kolko, “Strict Compliance Applies to Letter of Credit Issuers Too”, The Secured Lender, September/October 2007, pp. 44, 46-47.
- J. F. Dolan, “The strict – compliance rule: documentary compliance in a recession”, Documentary Credit Insight, Vol. 15, No. 4/2009;
R. J. Lee, “Strict Compliance and the Fraud Exception: Balancing the Interests of Mercantile Traders in the Modern Law of Documentary Credits”, Macquarie Journal of Business Law, 2009, Vol. 5, pp. 154-158.
- X. Gao, “The Fraud Rule in the Law of Letters of Credit”, Kluwer Law International, Hague 2002, pp. 29-35;
H. Y. Low, “Confusion and difficulties surrounding the fraud rule in letters of credit: an Englisch perspective”, The Journal of International Maritime Law, 2011, Vol. 17, pp. 462-464 & 479-480.
J. F. Dolan “The Law of Letter of Credit: Commercial and Standby Credits”, Warren, A.S. Pratt&Sons, Detroit, 2001 Edition, App. A (pp.16-17);
A. Mugasha, “The Law of Letters of Credit and Bank Guarantees”, Federation Press, April 2003, pp. 136-143;
D. Horowitz, “Letters of Credit and Demand Guarantees: Defences to Payment”, Oxford University Press, Oxford 2010, pp. 15-18.
- P. Lowe, “Fraud and the Documentary Credit”, Report of the ICC International Maritime Bureau, ICC Publications, Paris, 1994, p. 7;
G. A. Fellinger “Letters of Credit: The Autonomy Principle and the Fraud Exception”, Journal of Banking and Finance Law and Practice, 1990, No. 1, pp. 4-17.
- S. H. Van Houten “Letters of Credit and Fraud: A Revisionist View”, Canadian Business Review, Vol. 62, 1984, pp. 373-374.
- G. W. L. Smith “Irrevocable Letters of Credit and the Party Fraud”, Virginia Journal of International Law, Vol. 24, 1983, pp. 55-57.
- G. Fohler “Fraud in the Letter of Credit Transaction and its Possible Arbitration”, Institute of Comparative Law, McGill University, Montreal, Quebec, 1999, pp. 59-60.
- E. P. Ellinger “The Doctrine of Strict Compliance”, op. cit., p. 72.
- H. Hartfield “Enjoying Letter of Credit Transactions”, Banking Law Journal, Vol. 95, 1978, pp. 599-601.