DOCUMENTARY CREDITS AS A PAYMENT METHOD FOR GOODS

DOCUMENTARY CREDITS AS A PAYMENT METHOD FOR GOODS

Introduction

In the 21st century, international trade trasactions have a crucial role in the development of the economies of the respective countries. Moreover, to provide the trust, continuous and convenience in commercial relations, payment and the method of it are most important things about international trade transactions. . In this view, there are four different payment methods, with the documentary credits method being the most popular for a number of reasons.

However, it is also risky because it is open to abuse and sharp practice in some points. This essay will focus on the gaps and deficencies of the documentary credits method. In this perspective, all payment methods will be explained to increase the understanding of the reasons for the popularity of documentary credits. Therefore, the international trade transactions, Uniform Customs and Practice for Documentary Credits and all payment methods will be analysed but with particular focus on the payment method of documentary credits, documentary credits fraud, principles of documentary credits and exceptions of the principles.

International Trade Transactions

International trade is important fort he countries to reach the goods, materials, technology that they are not able to produce themselves. However, there can be some issues in the transaction process as well as other problems which can be caused by any variety of reasons such as problems on shipping, delivery, quality of goods or payment. Because of the geographical separation of the buyer and seler, international trade transactions may be hazardous.

In this perspective, sellers have to suggest charming payment solutions to the buyer to minimise the risk because many of the payment methods available are exteremely risky, particularly for the buyer. Therefore, the method should be chosen carefully because one of the most important issues about international trade transactions is payment. Obviously, according to the Article 53 of Vienna Convention, the most significant obligation for the buyer is making the payment of the goods in a determined place. The obligation starts after the items are checked by the buyer generally but the responsibilities of the buyer and the seller differ in the each types of payment. Therefore, each payment method will be explained to clarify the reasons behind the popularity of documentary credits.

It is certain that, exporters want to recieve the payment as soon as possible after the order is placed or before the delivery to secure their rights. However, before the goods are received, any payment can be called “donation” by importers. This is the main problem between sellers and buyers in international trade transactions, making a decision on a payment method and time.

Payment Methods

There are different types of payment methods which can be preferred by the parties of the conract in a international trade transaction and some of them are safer when they are compared with each other. Commonly, there are four methods of payment for international transactions and they are; cash-in-advance, letters of credit, documentary collection and open account. Each payment methods has various risk levels for exporters and importers and both of them will be examined. It should be emphasized that, the method of letters of credit (documentary credits) is the most-used one.

Actually, there should be a differentiation between the domestic and international sales while explaining the payment methods because payment methods and the security of them can be different in an international trade transaction from a domestic one. The best way of payment can be dissimilar in these two types of sales because risk levels and trust to the parties may not same.

For example, one possibility of the payment types which can be chosen by the parties is “open account” and this method is sam efor both international and domestic transactions. In this method, the seller sends an invoice and the goods and after a specific period of time, the buyer pays the value of goods. Even if the “immediately due and payable” note is written in that notice about that payment, the seller gives credit to the buyer. Indeed, it is certain that this way is not really safe for an exporter but it is one of the most favorable options to the buyer with regards to cash flow and cost.

The second type of the payment is cash in advance. In this method, the buyer makes the payment before the delivery. Wire transfers and credit cards payments can be given as an example to the cash in advance payment method. It is beneficial for the seller but it is the least attractive method fort he buyer. There is no guarantee of the delivery of the goods and it means that buyer gives a credit to the seller. Therefore, it is a risky method too.

Documentary Collection is another way of the payment in an international trade transaction. It is defined as “transaction whereby the exporter entrusts the collection of a payment to the exporter’s bank, which sends a document to the importer’s bank, along with instructions for payment.” It is the least expensive method and thats why it is suitable to choose. However, in this payment method, the banks’ role is limited. For example, they cannot do any investigations about the documents or they do not have the duty to verify. Moreover, they cannot give guarantee about the payment and that is why they do not take risk. The only thing that banks can do is control the flow of the documents.

After the explanation of the other payment methods, the last and the most important payment method “documentary credits”, will be clarified. However, there is an essential need for an information of the accepted banking customs “Uniform Customs and Practice for Documentary Credits” (UCP) before the explanation of the documentary credits because documentary credits are regulated basically with no legislative authority by this non-governmental organisation.

Uniform Customs and Practice for Documentary Credits

International Chamber of Commerce Uniform Customs and Practice for Documentary Credits (UCP) regulates the documentary credits. Actually, UCP is not in the concept of international conventions or it is not a law. It is regulated by the ICC to provide the order in cross-border transactions. UCP is evaluated as “the most successful harmonising measure in the history of international commerce, which has removed a plethora of technical problems that would have undermined the smooth operation of letter and credit.”

It is regulated in the UCP 600 that, “A credit by its nature is a separate transaction from the sale or other contract on which it may be based...” . Moreover, in Article 5 it is also regulated that ‘Banks deal with documents and not with goods, services or performance to which the documents may relate’ . According to that regulations, it is seen that even if the goods are not delivered to the buyer, the seller can make a claim about the payment under credit. Therefore, it may cause to fraud from sellers and it is the main point of that issue. It will be clarified in this essay but it should be known that, this uncertainity, possibiltiy of the fraud is regulated in the UCP. Lastly, it should be said that UCP is not able to solve the problems which are caused by the principle of autonomy. (Principles of documentary credits will be explained critically)

Documentary Credits

In the cases Justice Kerr in R.D. Harbottle (Merchantile) Ltd v. National Westminster Bank Ltd. , Justice Griffiths in Power Curber International Ltd v. National Bank of Kuwait S.A.K. and Justice Stephenson and Justice Ackner in United City Merchants (Investment) Ltd v. Royal Bank of Canada , the jugdes have defined the letter of credits as “the life blood of international commerce”. Commercial letters of credits are called as “documentary credits” in common law countries, that is why only “documentary credits” term will be used. In this perspective, documentary credits can be defined as “traditional form of letter of credit created as a payment and financing mechanism for international sale of goods.”

It is assumed that, documentary credits method is the safest method when compared to the other methods. However, the applicability of this type is complicated. In this method, payment is made after the delivery of goods. There is no “verification process and limited recourse” if no payment is made and it is the biggest drawback of this method. It is certain that, buyer do not want to make payment until the goods come out for delivery and seller do not want to ship them until the payment is made.

This payment method is commonly prefered in crucial international transactions and buyer/seller relations because in this payment method there is also a third party which is trustworthy; the bank. When the buyer and seller choose the method of documentary credits and agree that, they invite that third party into their relationship. Therefore, the applicant (mostly buyer) applies for the letter of credit from a bank and this letter will probably reach to the seller through banking channels. The bank which gives the confirmation about the payment is called “issuing bank” and the applicant to the “issuing bank” is called “beneficiary”. Moreover, if issuing bank is not known in the seller’s country, another bank (correspondent bank) can confirm the documentary credit in the seller’s country as a solution to provide the trust. Thus, in addition to the buyer, another second bank is giving a kind of guarantee of the payment and normally it gives confidence to the seller. Correspondent bank easily check the amount of money in issuing bank because the mechanism of the banks is suitable for it. After that testification, the correspondent bank can give another confirmation to the seller safely. Therefore, it creates four different but interdependent relationships between buyer, seller, issuing bank and correspondent bank. In this relationship, if beneficiary force the correspondent bank to make the payment, correspondent bank has the right to request a reimbursement from the issuing bank. This relationship can be complicated in case of a fraud or any behaviour which caused by the malice of the parties.

The method of documentary credits is most preferred one when the usage of the other payment methods are compared to each other because of the advantages of it to both parties of the international trade transactions contracts. Three main advantages of documentary credits will be clafiried to express the popularity of it. Firstly, documentary credits are beneficial for the sellers because it is easy and trustworthy to control the information about buyers via the bank. As mentioned before, in international trade transactions there is an obvious buyer-seller trust problem. To solve this issue, “documentary credits” is an useful and trendy way. Secondly, until the bank’s obligation become unconditional, the buyer have to continue to make the payment to the seller and it gives confidence to the seller. Moreover, the last advantage may be about the currency because States are able to use their own currencies when they choose the letters of credit payment method.

However, although there are several advantages of documentary credits, there are also several risks with it and the number of cases about the implementation of documentary credits has increased rapidly. If the reasons of this increase is indicated, it can be said that the convenience of receiving payment ismotivating sellers to prepare devious documents. Therefore, this method inadvertently protects the fraudulent sellers. It means that, this system it is open to abuse and fraud. The International Chamber of Commerce (ICC) has identified one of the fraud type as documentary credits. The gap in that payment method should be filled by a legal protection to provide the continuous, popularity and security of usage of documentary credits method.

Documentary Credits Fraud

Fraud has started to become a crucial issue that threatens the trust of the system because of the contradictions in documentary credits and has described as “a cancer in international trade” in the case of Standard Chartered Bank v Pakistan National Shipping . It is nonplusing that documentary credits is the most popular payment method and it is most preferred one in the international trade transactions. However, the possibility of fraud or abuse in international trade transactions is considerable. If parties do not fulfil their obligations such as delivering the goods or making payment, fraud in documentary credits occurs and it may cause to financial losses. In this perspective, it is beneficiary to mention about the fraudulent party that can be “the beneficiary, the applicant, both of them in co-operation, or a third party issuing a document.”

As mentioned before, the greatest fraud possibility in documentary credits method is that the seller can receive the money from the issuing bank but delivery of the goods may not be made to the buyer. If there is a certain fraud which is made by the seller, issuing bank has no obligation anymore to make the payment to the seller. It means that, if the buyer can discover the fraud ,which has been committed by the seller, and prove any sufficient evidence of his fraud, the bank may be prevented from making the payment to the seller. However, if buyer cannot convince the bank with the valid evidence, the issuing bank has the discretion to make payments. In this phase, the buyer can obtain a precautionary measure from the court to prevent the seller from withdrawing money from the buyer’s account.

This may be more complicated and difficult for the issuing bank in two different ways in terms of taking the necessary precautions or the attitude of the bank in case of fraud. Firstly, the buyer may finish the dealings with the bank if the money is transferred to the seller and it is a loss of a client for the bank. On the other hand, there should be a relevant document as proof of the fraud, which is claimed in the trial as an injunction by the buyer, because if the buyer cannot obtain an injunction and at the same time the issuing bank can choose not to make the payment to seller, it can cause damage to the international reputation of the bank.

It is seen that evidence of the fraud is very essential. For example in the case in RD Harbottle (Mercantile) Ltd v National Westminster Bank Ltd , all of the payment is fraudulently guaranteed by the seller and the buyer took an action against the seller. However, English courts generally do not impose an interim injunction and the claims of the buyer were rejected. According to these situations, international commerce can damage and failure of the system is also possible because the rights of the buyer were not protected but it is also clear that, there is need for strong evidence to make a claim.
Principles of Documentary Credits

Principle of Strict Compliance

Principle of strict compliance is one of the principles which governs the documentary credits. It can be defined as “the legal principle that entitles the bank to reject documents which did not strictly comply with the terms of letter of credits”. The main purpose of the principle of strict compliance is protecting the buyer who has no chance to examine or supervise the shipping process of the goods because of the geopraphical distance. It is seen that, the only security of the rights of the buyer is the documents because documents prove the delivery of goods. Moreover, if there is a fraud but the bank cannot prove it, then the principle of strict compliance is best way to abstain from making payment.

On the other hand, the principle of strict compliance is also beneficial for the seller because it provides the fast payment system. In this view, if bank documents about the delivery reach to the buyer, the seller does not have to wait the shipping time, the seller has the opportunity to receive the payment. Therefore, it is seen that all of the parties of the international trade transaction contract benefit from the principle of strict compliance in documentary credits. The issuing bank is protected also interms of any possibility of fraud.

Principle of Independence

The other principle of documentary credits is the “Principle of Independence”. According to that, the issuing bank is not included if any dispute has arisen between the seller and the buyer. As is mentioned before, because of the UCP 600, Autonomy Principle creates an unfairness and it is a possibility that “Fraud Exception Rule” can reduce that unfairness. However, neither the issuing bank nor the buyer is able to withhold the payment with the reasons which are not related with the delivery such as quality of delivered goods or other issues. Therefore, it means that if delivery has been made, the money should be transferred to the seller’s account. After that there is an opportunity to sue the seller for the breach of contract. It is clear that, the logic of “pay first, argue later” is supported by the Autonomy Principle which is against to the buyer and the issuing bank. However, it causes a gap in the system which is open to abuse. The exceptions of principle of independence are ‘the illegality exception’ and ‘fraud exception’. These exceptions will be clarified respectively.

Exceptions

The Illegality Exception in Documentary Credits

If the transaction or some aspect of it is prohibited by law , it can be called “illegality in transactions”. If there is an illegal issue in a documentary credit, it can be easily said that the documentary credit itself is illegal. The options are; the regulation or the usage of the documentary credits may be against or prohibited by the law or the enforcement of the documentary credits is prohibited by the law. If there is an illegality in an international trade transaction contract and because of that illegality, the enforcement of documentary credits is to be affected, it means that the principle of autonomy would be destroyed as is the case when the second exception which is fraud exception, is applied.

There are conditions for applying the illegality exception in documentary credits under current English Law. According to that, the illegal fact should be clearly established. The participation of the beneficiary from the illegality is the second condition of applying. If the content or purpose of the documentary credit is illegal or there is a hidden illegal purpose in the contract and it is known by a party, there is an opportunity to make an application to illegality exception. Therefore, the enforcement of the documentary credits can be prevented.

Fraud Exception in Documentary Credits

The solution of the fraud issues was originated by an American court which is known as “Fraud Exception” and is the exception of the Autonomy Principle. It is mentioned in the ‘illegality exception’ that the illegality can be in the documents or in the contract itself. Moreover, it is same in the fraud exception that; it can be in the documents, in the contract or in the credit itself. In this perspective, the beneficiary of the fraud, has to be aware of the falsity of the representation. Moreover, the fraud should be proved to the bank to block the payment.

If there is a fraud, it is possible for the issuer or a court to indicate the evidences behind the implementation of the documents and suspension of the payment of letter of credit. Moreover, the issuer bank can take the due precautions. For example, in the case of Etablissement Esefka International Anstalt v. Central Bank of Nigeria , consignment notes were counterfeited and there was convincing evidence to prove it. Furthermore, there was another doubt that a part of the delivery was not made. Therefore, the bank rejected to make further payments to the seller. The plaintiffs sued the issuing bank and the bank counterclaimed, applied for security of costs. According to the decision of the court, it is clear that the obligation of payment is overriden if it is known that fraud is made from the bank.

In another case of Sztejn v. Henry Schroder Banking Corporation two points were emphasised that the buyer has the authority to prevent the sellers from drawing the credit or to restrain the payment from banks to sellers. Lord Diplock has commented that this case was a cornerstone because after that under English Law there was an opportunity to implementation of the fraud exception. Therefore, it is seen that the case of Sztejn has established the “Fraud Rule”. The aim of the fraud rule is similar to the illegality exception. It is, providing the stability and safety in the documentary credits method.

The application of fraud rule is difficult because of three high standards. Firstly, the fraud has to be established clearly. Secondly, someone in that relation has to benefit from that fraud. It means that, there should be a beneficiary. However, this beneficiary cannot be a third party. For example, in the famous case of United City Merchants v. Royal Bank of Canada , third party fraud was rejected. Lastly, in the case of Gian Singh & Co. Ltd. v. Banque de L'Indochine it was emphasised that the fraudulent facts have to be known at the time of payment.

Conclusion

To sum up, it is necessary to emphasise the facilities provided by the documentary credits to clear up the reasons of the popularity of it. As mentioned above; it is easy to use and it is trustworthy. Moreover, while countries are making payments, they can use their own currencies and that is advantageous for them. However, this system is open to abuse and sharp practice interms of fraud and illegality. In this perspective, to increase the intelligibility of that issue, regulations on documentary credits and all payment methods of documentary credits, the term of fraud and documentary credits fraud, principle of strict compliance and independence principle, the illegality exception and fraud exception in documentary credits have been explained critically. It is seen that “ease of obtaining payment” in documentary credits can be the weak point but also the reason of the popularity of documentary credits. It has been defined as the weak point and drawback because this virtue of that payment method makes this system open to fraud or illegality. In addition, if there is a fraud, it is not always easy to prove that. Therefore, the buyer and issuing bank may be forced into a difficult situation because this process can be long and complicated.

As explained above, although there are many advantages of the documentary credits payment method, the Autonomy Principle and the nature of the method show there are some gaps in the system and these points have evaluated in this essay. Lastly, it is clear that documentary credits is currently the safest and most popular option but it does not still give a impeccable security to the parties. Payment is the keystone of the commercial transactions and there is a need for either a potential new payment method or new regulations on documentary credits to make it more dependable to protect also the buyer and issuing bank further.