A documentary credit or a letter of credit is usually used to finance international trade. Judges have referred to documentary credits as the “life blood” of international commerce. Most documentary credits in international transactions are governed by the International Chamber of Commerce (ICC) Uniform Custom and Practice for Documentary Credit 500 and 600. In the United Arab Emirates (UAE), documentary credits are governed by Federal Law No. 18 of 1993, the Commercial Transactions Law. The provisions relating to documentary credit are contained in section 4 of chapter 3 of the Federal Law number 18 of 1993 Commercial Transactions Law and are not mandatory rules but rather complementary to the parties’ intentions. As per the Court parties to a documentary credit are free to choose the ICC Uniform Rules and Practices for documentary credits instead of the Commercial Transactions Law rules.
Before understanding the legal obligations of the parties involved in documentary credit transactions it is better to comprehend the terminologies associated with the transaction. A documentary credits is a contract whereby the bank (the Issuing Bank) undertakes to open a credit at the request of one of its customer (the applicant/buyer), for a certain amount and for a specified period, in favor of another person (the beneficiary/seller), secured by documents which represent the goods that is shipped or being prepared for shipment (Article 428).
Usually four parties are involved in the context of documentary credits transactions, namely: the buyer-applicant, the Issuing Bank, the seller-beneficiary, and the Correspondent Bank (confirming / advising and / or negotiating the Letter of Credit) (the Correspondent Bank). The credit must be in compliance with the sales contract signed between the buyer and seller prior to the opening of the documentary credit, otherwise the seller may be entitled to reject it.
After opening the credit, the Issuing Bank informs the beneficiary directly or through a Correspondent Bank in the country of the beneficiary. The Issuing Bank may ask the Correspondent Bank to either advise the beneficiary (in this case correspondent bank may not be obliged to make any payment to the beneficiary) (Advising bank); or advise and add its confirmation to it (in this case the correspondent bank can be held responsible for making payment to the beneficiary and called Confirming bank). Once the advising bank has confirmed the documentary credit, it will refuse to accept any instructions to the contrary from the buyer. In Hamzeh Malas and Sons v. British Imex Industries Ltd 1958 2Q.B. 127, the buyer sought an injunction against the seller to restrain the later from withdrawing the purchase price on a confirmed letter of credit. The English Court of Appeal held that “a vendor of goods selling against a confirmed letter of credit is selling under the assurance that nothing will prevent him from receiving the price”.
The documentary credits are of several types bearing different legal implications, however, in this article we will address the types specifically mentioned in Commercial Transactions law i.e. revocable or irrevocable.
In revocable documentary credit, the bank can, at any time, amend or cancel the documentary credit on its own initiative or at the request of the buyer and shall not involve any liability by the bank towards the beneficiary (Article 431 (2)). In absence of any clear indication, the documentary credit would be irrevocable (Article 431). Thus the assumption of irrevocable documentary credit in UAE is in contrast to the applicable laws in the Gulf and internationally which expressly state the stipulating type as revocable in absence of any express mention about irrevocability.
It is worth mentioning that Article 431 (2) may be disadvantageous to the buyer and the banks in the UAE as the bank is responsible to pay the beneficiary-seller even if the fraud is committed by the seller on buyer as the parties under letter of credit do not physically verify the contents of goods and have no such right thereby relying completely on documentary transactions. The obligation of bank under the irrevocable documentary credit is elaborated below. Moreover, if the documentary credit is confirmed by the bank in the country of the beneficiary, it will enable the beneficiary to deal exclusively with a local bank, known to the beneficiary. It is therefore recommended to amend the law and bring it in line with the applicable laws in the Gulf and other international trade laws.
An irrevocable documentary credit constitutes a definite undertaking by the bank which is conclusive and direct towards the beneficiary, provided the conditions therein are complied with (Article 433 (1)). As per Article 434 (1), the liability of the bank shall continue notwithstanding the instructions by the buyer to cancel the documentary credit. The bank therefore cannot amend and withdraw the irrevocable documentary credit under any circumstances (Article 433 (2)). It thus represents a direct relationship between the beneficiary and the bank and the right of the beneficiary against the bank is not harmed by any dispute between the buyer and seller to the contract of sale. Irrevocable documentary credit is therefore more advantageous to the seller as it gives more security in terms of payment.
PRINCIPLE OF AUTONOMY
Documentary credit is considered a separate contract than the underlying sales contract under the principle of Autonomy. It is the key principle governing documentary credits thereby assuring commercial utility of documentary credits since centuries. Accordingly, documentary credit is considered as an independent transaction from the contract for which it is opened and the bank shall remain independent of such contract (Article 428). The Issuing Bank undertakes the liability of the buyer towards beneficiary without involving itself in the underlying transaction between the buyer and the seller. The Issuing Bank will pay to the benficiary without condition if the beneficiary fulfils the documentary obligations based on terms mentioned under the documentary credit, regardless of the disputes, if any, connected to the underlying contract between the buyer and seller. The specific claim under the underlying sale contract is considered separately. The seller’s breach of the terms and condition (i.e., with respect to quantity, quality, delivery, date, etc.) of sale contract does not entitle the buyer to instruct the Issuing Bank to stop payment under the credit or does not grant authority to issuer and / or Correspondent Bank (the paying bank) to withold payment.
Courts are quite reluctant to grant injunctions ordering a bank to withhold payment, unless there is a clear indication of fraud, it was held that documentary credit was aimed at providing security to both the seller and buyer in international business transactions. The bank therefore cannot cancel the credit without taking into consideration the parties’ interests.
The autonomy of the documentary credit can therefore be considered as an advantage in international sales as it serves as a commercial assurance to parties in international trade based in different countries. If banks were allowed to refuse to pay under a documentary credit, whenever trading parties had a dispute, the vital flow of international trade would have been blocked.
THE DOCTRINE OF STRICT COMPLIANCE
The second fundamental principle of documentary credit practice is the requirement that documents are strictly complied with the terms and condictions of the documentary credit (Article 430). Documents are considered compliant to the terms if they are complete as described in credit and are devoid of obvious defects.
The obligation of the seller or beneficiary is to tender the stipulated documents in accordance with the terms of the documentary credit usually to the issuing/Correspondent Bank. These documents are evidence of the fact that the goods have been shipped and dispatched. As per Article 433, the Issuing Bank assumes liability to pay at the time the seller delivers the documents to the bank before the expiry of the documentary credit. The documents submitted after the expiry period grants the bank authority to reject them unless the buyer requests his or her acceptance and the bank approves such request (Article 435).
Once the documents are tendered, as per Article 435, the bank is under an obligation to insure that the required documents are exactly in accordance with the terms and conditions of the documentary credit, and that they correspond with each other. Once the bank is assured, it shall make the payment (Article 430 (2)).
If the documents do not comply with the documentary credit, the Issuing Bank shall reject them. It may also send them to the buyer for approval as soon as possible. Otherwise, the issuing/Correspondent Bank (referred to as Paying Bank, wherever applicable) will be deemed to have accepted the documents and will be liable to pay. Further, the Paying Bank will not be able to recover the amount paid to the beneficiary towards the documentary credit. The Paying Bank will be responsible to the buyer for deductions from the buyer’s account and entitle for damages. Once the bank accepts the documents, it shall urgently transfer them to the buyer and pay to the beneficiary; and if the bank rejects them, it shall immediately notify the beneficiary and the buyer. The bank must provide reasons for such rejection (Article 437).
However, banks are not under any obligation to check whether such documents represent the goods in question. The bank’s obligation is restricted to examining that the presented documents are the exact documents required under the documentary credit. 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 supplied. As long as the Paying Bank adheres to strict compliance principle when it examines the documents tendered under the documentary credit, it remains within the ambit of its contract with the applicant for the credit.
However, the seller may send defective goods (so long as this does not amount to a clear fraud) and yet present conforming documents. A rigid application of the doctrine of strict compliance may therefore lead to results that would, on many occasions, be regarded as both unfair and unsound by the business world in general.
The buyer’s obligation is to refund to the bank the amount paid to the beneficiary within the limits of the opened credit along with the expenses, which the Issuing Bank has incurred in this respect. If the buyer fails to pay the value of the documentary credit to the bank within one (1) month from the date of being notified of the arrival of such documents, the bank has the right to have a lien on the goods represented by the documents and can sell the goods. If the goods are destroyed or become damaged, the right of mortgage/lien shall pass to the insurance amount (Article 439).
In view of the above, documentary credit transactions demand trust towards banks by both the buyer and seller to remain confident that Issuing or Correspondent Banks will respect their payment commitments. Documentary credit could not function if the buyer and seller lacked confidence that the banks would honour their obligations irrespective of their instructions thereby making prinicple of autonomy the most significant practice serving as lifeblood for international trade and to some extent brigding the gap of trust and knowledge between the two trading partners unknown to each other at initial risk taking phase.