Key principles governing documentary transactions

Key principles governing documentary transactions

By Amit Ronald Charan and Sounak Chakraborty, SNG & Partners
3 April 2019

A letter of credit (LoC) is a common documentary credit instrument in settling trade between nations. The documentary credit transaction process involves the applicant for the credit (buyer) and the beneficiary (seller) entering into a contract recording their commercial terms. The buyer then applies to the bank issuing the credit (issuing bank) to issue an LoC promising to pay the amount to the seller on the fulfillment of the terms and conditions mentioned in the contract.

The issuing bank provides the LoC to the bank which makes the payment (intermediary bank), which forwards it to the seller. The seller then confirms that the terms of the LoC match the commercial understanding between the buyer and the seller and the seller ships the goods to the buyer.

Amit Ronald Charan
Principal associate
SNG & Partners

The seller then produces the documents before the intermediary bank, which will forward the LoC along with any other document from the seller to the issuing bank. The issuing bank again would review the compliance to the terms of the LoC then send the money to the intermediary bank. The intermediary bank would then pay the amount to the seller.

The Uniform Customs and Practice for Documentary Credits (UCP 600) came into effect on 1 July 2007, replacing UCP 500. UCP 600 is a set of rules prepared by the International Chamber of Commerce, which applies to any documentary credit that expressly indicates that it is subject to the rules.

Further, the rules under UCP 600 are binding on all parties to the documentary credit unless expressly excluded. UCP 600 consists of 39 articles on issuing and using LoCs, and applies to 175 countries around the world.

Key Principles

Sounak Chakraborty
SNG & Partners

The cornerstone of documentary transactions is the independence principle, which lays down that the credit recorded under the LoC or other documents of such nature is independent and separate from the underlying contract between the buyer and the seller and also from the agreement between the buyer and the issuing bank. This principle has been cited numerous times by courts across the world to uphold the sanctity of an LoC including the US Supreme Court in the case of Sztejn v J. Henry Schroder Banking Corporation, in which the court stated that “…a letter of credit is independent of the primary contract of sale between the buyer and the seller. The issuing bank agrees to pay upon presentation of documents, not goods”.

Another important principle which governs documentary letters of credit is the principle of strict compliance. The principle of strict compliance can be invoked by the issuing bank or intermediary bank regarding compliance with the terms of the LoC by the seller. The England and Wales High Court (EWHC) in the matter of Bankers Trust Co v State Bank of India (1991) observed that in the UK, a majority of documentary credit was subject to discrepancies resulting in the failure of the transactions.

It is the seller who holds the responsibility of ensuring that all documents are in conformity as stipulated by the issuing bank or intermediary bank. Article 14 of the UCP 600 only strengthens the principle of strict compliance by setting a standard for examination of documents. Fraud is also a common occurrence in documentary transactions, usually committed by the seller by presenting forged or fake documents with no underlying performance resulting in the buyer not receiving the goods. Although international courts have largely held that the obligation of the banks to honour the documentary LoC remains but in case of a fraud being committed the transaction may be temporarily or permanently stopped.

In the case of Harbottle v National Westminster Bank (1978), the EWHC held that “only in exceptional circumstances the courts will interfere with the machinery of irrevocable obligations assumed by banks…They must be allowed to be honoured, free from interference by the courts. Otherwise, trust in international commerce could be irreparably damaged”.

UCP 600 lays down clearly the duties to be performed by each party involved in such a transaction. However, there is no obligation on parties entering into a documentary LoC transaction to be bound by UCP 600 if they opt out. The issuing bank may exercise the right of not applying the rules of UCP 600 in a transaction and in such a case there could be substantial confusion in case a dispute arises. Thus, there seems to be the need to ensure that all documentary LoC transactions are governed by a single set of rules in the interest of the parties involved in international trade.

SNG & Partners has offices in New Delhi, Mumbai and Singapore. Amit Ronald Charan is a principal associate and Sounak Chakraborty is an associate.