Is The L/C Really An Independent Undertaking?
By Shahriar Masum[Republished from DC Insight with the kind consent of the author.]
"Letter of credit is an independent undertaking"1
"A letter of credit is separate from the underlying sales contract"2
"Banks deal with documents and not with goods"3
"Banks examine documents on their face"4
These are some of the fundamental assumptions of letter of credit transactions. In fact, these are the assumptions that make the L/C what it is, namely:
a. a secured payment guarantee for the seller;
b. a secured and convenient guarantee product for the banks; and
c. a convenient payment mode for the buyer who does not need to pay in advance.
It's a win-win situation for all, and this is possible because of the independent nature of the L/C.
Autonomy at risk
But there are some scenarios in which the parties try to dilute this "Principle of Autonomy". The most common example occurs when a buyer tries to obtain an injunction5 prohibiting the L/C payment when the goods are not as per the sales contract. In this and other circumstances, it's perfectly valid to ask the question: "Is the letter of credit truly independent?" In an L/C, there are three related contracts:
1. a contract between the buyer and seller (i.e., sales contract);
2. a contract between the buyer and the issuing bank (i.e., L/C application); and
3. a contract between the issuing bank and the seller (i.e., letter of credit).
If parties 1 or 2 restrict the execution of the contract 3, the autonomy of the letter of credit is at stake. As noted above, the autonomy of the L/C is most commonly threatened by the opportunistic attitude of the buyer. If the buyer believes the seller has shipped defective goods, he may seek an injunction to stop payment under the L/C. Although in many cases courts will refrain from granting an injunction, there are exceptions. One is the so-called "fraud exception". In a historic court case6, Lord Denning, M.R. commented:
"A bank guarantee is very much like a letter of credit. The Courts will do their utmost to enforce it according to its terms. They will not, in the ordinary course of things, interfere by way of injunction to prevent its due implementation. Thus they refused in Malass v. British Imex Industries, Ltd., [1957] 2 Lloyd's Rep. 549. But that is not an absolute rule. Circumstances may arise such as to warrant interference by injunction [emphasis added]."
Seller's and beneficiary's fraud
One instance where an injunction is most likely involves a fraud by the seller. Justice Shientag7 put it this way:
"Where the seller's fraud has been called to the bank's attention before the drafts and documents have been presented for payment, the principle of the independence of the bank's obligation under the letter of credit should not be extended to protect the unscrupulous seller [emphasis added]."
By contrast, when we speak of beneficiary's fraud, there are two possible scenarios:
1. the beneficiary has not performed under the sales contract on which the L/C is based;
2. the beneficiary has performed under the sales contract, but has prepared some documents including false statements to meet the L/C requirements.
A difficulty arising from the comment of Justice Shientag is that it's unclear whether the case he referred to was one involving false documents or one of fraud in the underlying transaction. If the case is about the fraud in required documents under the L/C, then the principle of autonomy remains intact. But if it concerns the underlying transaction, the principle of autonomy of the L/C may be at issue.
While US courts have tended to extend the fraud exception to underlying transactions, UK courts are somewhat divided on the issue and often give great importance to the principle of autonomy. But there are contrasting decisions as well. In Edward Owen Engineering Ltd v. Barclays Bank International Ltd [1978], the fraud exception was characterized by Lord Denning as follows: "... the bank ought not to pay under the credit if it knows that the documents are forged or that the request for payment is made fraudulently in circumstances where there is no right to payment [emphasis added]." The italicized language in Lord Denning's formulation is broad enough to encompass the concept of fraud in the underlying transaction.
Establishing fraud
It must be remembered, however, that to obtain an injunction, a mere allegation of fraud is not sufficient; the buyer must have a claim for established fraud. In Discount Records Ltd v. Barclays Bank Ltd [1974], Justice Megarry refused to grant an injunction commenting: "In the present case there is, of course, no established fraud, but merely an allegation of fraud."
Another interesting case was that of Urquhart Lindsay & Co Ltd v Eastern Bank Ltd. [1922] in which Mr Rowlatt J ruled:
"the position of the bank under an irrevocable credit is in law the same as that of a person who has contracted to buy the shipping documents representing goods shipped, or to be shipped, under the contract between the beneficiary and the person at whose instance the credit has been issued [emphasis added]."
If indeed, banks purchase only the shipping documents and are in no way concerned with any other transaction, the Principle of Autonomy should still work, even taking account of the seller's fraudulent action, as long as the seller submits credit-complying documents. However, since the L/C is a conditional payment mechanism, created to facilitate trade transactions, the Principal of Autonomy will not work here. The courts have said that this is understandable and necessary to protect innocent parties. In fact, if a bank, with knowledge of established fraud, honours a fraudulent document, it may find itself a part of the seller's fraud8. In short, the L/C is not "fully independent" and depends, at least to some extent, on the actual performance of the seller under the sales contract.
Other cases
Interestingly, it's not always the buyer who wants to resist payment. There are cases where the buyer/applicant wants to waive discrepancies and wishes to pay, but the issuing bank refuses to accept the waiver and, due to discrepancies, does not make payment. Under UCP 600 subarticle 16 (c) (iii) (b), this is possible9. However, the UCP does not make clear the circumstances under which the issuing bank may refuse to accept a waiver from the applicant. Nevertheless, if the L/C is truly independent, this should be possible in all circumstances, since the L/C contract is only between the issuing bank and the seller. This was not the decision, however, in the case of Bombay Industries, Inc. V. Bank of New York [1995].
In this case, Bombay Industries Inc. (the L/C beneficiary) shipped goods to Collection Clothing Corporation (the L/C applicant) under a letter of credit issued by the Bank of New York (BNY). The presented documents were discrepant and were eventually refused by the bank. Later, the discrepancies were waived by the applicant, but the bank refused to accept the waiver as the applicant's credit line with the bank was cancelled. The court judged that BNY wrongfully dishonoured the presentation, since it considered matters outside the L/C transaction (i.e., the credit line of the applicant) when refusing the waiver.
Another bizarre case, International Dairy Queen, Inc. V. Bank of Wadley [1976], involved a bank that refused to pay because to honour the claim under the L/C, the issuer would have had to create a loan exceeding its capital adequacy ratio. In summary, the autonomy of the letter of credit does not always work, as courts tend to protect innocent parties. Applicants, banks and L/C beneficiaries, therefore, should not always consider the L/C to be the ultimate payment security. One also has to attach some not inconsiderable importance to the construction of the related contracts as well. Consider the words of Sir John Mcgaw in Bankers Trust Co. v. State Bank of India [1991]:
"The metaphor 'autonomous' means only that one does not read into any one of the four contracts the terms of any of the other three contracts. But the genesis and the aim of the transaction (Lord Wilberforce's words in another authority) are not to be ignored where they may be relevant to assist in the interpretation of the terms of the contract."
1. In an independent undertaking, the party giving an undertaking conditions its promise on timely presentation of documents containing the required data.
2. Article 4 of UCP 600.
3. Article 5 of UCP 600.
4. Article 14 of UCP 600.
5. ICC has always upheld the independence principle of the L/C before the courts. In official Opinion TA 689 it said: "The issuing bank should now reconsider its position vis-Ã -vis the status of the presentation and approach the court for the order to be removed, thereby upholding the principles of the letter of credit product and the UCP, in particular article 5 and sub-articles 14 (a) and (h)."
6. Elian and Rabbath (trading as Elian & Rabbath) v. Matsas and Matsas; J.D. McLaren & Co. Ltd. And Midland Bank Ltd. [1966].
7. Sztejn v. J.Henry Schroeder Banking Corporation et al. [1941].
8. " ... a bank with knowledge of the beneficiary's fraud would itself be complicit were it to pay against them and require reimbursement from the applicant. Otherwise the autonomy principle prevails." Mr Paul Todd, "Bill of Lading and Banker's Documentary Credit@."
9. As per UCP 600 sub-article 16 (c) (iii) (b), the issuing bank may not agree with the waiver given by the applicant.