Differences between the doctrine of strict compliance and autonomy principle in letters of credit; their development and interpretation by the courts.
Accordingly a letter of credit is a financial instrument, typically issued by a bank, in which the issuing institution commits to pay a draft presented by a third party in a specified format or meeting certain criteria. It is also defined as a document whereby a bank, at the request a customer, under takes to pay money to a third party (the beneficiary) on presentation of documents specified in the letter, (for example bills of lading and policies of insurance).The obligation of the bank to pay is independent of the under lying contract of sale and so is not affected by any defects in the goods supplied under the contract of sale. A contract of the sale of Goods may require a lawyer to open an irrevocable letter of credit in favour of the seller. This cannot be revoked by the issuing Bank or the purchaser of the goods before its expire date, without the consent of the beneficiary. A confirmed letter of credit is one in which the negotiating bank guarantees payment to the beneficiary should it not be honoured by the issuing bank.
Under Article 2 UCP 600, a letter of credit is any arrangement, however named or described, whereby a bank (the issuing bank) acts at the request and on the instructions of a customer (the buyer/applicant) to make a payment to a third party (the seller/beneficiary) against stipulated documents, provided that the terms and conditions of the credit are complied with. Once the buyer has concluded the contract with the seller in which a documentary credit clause has been incorporated, the buyer will request its bank (the issuing bank) to open a letter of credit in favour of the seller (the beneficiary). The buyer, as the applicant, will inform the issuing bank of the documentary requirements that it wishes to have inserted into the letter of credit. The issuing bank usually has its place of business in the buyer’s country, whereas the seller operates from another country. Therefore the issuing bank may request a bank in the seller’s country (which can be a branch office of the issuing bank) to take up the documents and make payment in its name (the advising or nominated bank — Article 6a UCP 600). The nominated bank then forwards the documents to the issuing bank against reimbursement.
Under Article 2 UCP 600, a letter of credit is any arrangement, however named or described, whereby a bank (the issuing bank) acts at the request and on the instructions of a customer (the buyer/applicant) to make a payment to a third party (the seller/beneficiary) against stipulated documents, provided that the terms and conditions of the credit are complied with. Once the buyer has concluded the contract with the seller in which a documentary credit clause has been incorporated, the buyer will request its bank (the issuing bank) to open a letter of credit in favour of the seller (the beneficiary). The buyer, as the applicant, will inform the issuing bank of the documentary requirements that it wishes to have inserted into the letter of credit. The issuing bank usually has its place of business in the buyer’s country, whereas the seller operates from another country. Therefore the issuing bank may request a bank in the seller’s country (which can be a branch office of the issuing bank) to take up the documents and make payment in its name (the advising or nominated bank — Article 6a UCP 600). The nominated bank then forwards the documents to the issuing bank against reimbursement.
International commercial contracts, such as international sales of goods, often involve large sums of money and large shipments of goods. Ever present and inherent to any commercial contract, but especially international transactions, is the threat of non-payment by the buyer or non-performance by the seller. Parties may not know much about each other, in particular about the financial stability and trustworthiness of their trading partner. The problem is compounded by uncertainty surrounding the applicable national law, where parties have not made an explicit choice of law in their contract. And even if a national law is chosen by the parties, at least one of the contracting parties will have to deal with a legal system that is not his own. The potential costs, inconvenience and delay involved in pursuing a recovery case against a buyer for non-payment or against a seller for non-delivery may well prove to outweigh what is to be gained from the contract in the first place.
Where parties have established a business relationship, the seller may extend credit to the buyer. In an international sale, however, this scenario is highly unlikely, as the risks inherent to such a transaction would be too great. In such situations, when suppliers or vendors are selling and purchasing goods to and from overseas customers with whom they have not established a business relationship, parties tend to search for additional means of securing performance and payment beyond the mere agreement in the contract. Such security may be achieved by means of, for instance, a letter of credit. The involvement of banks in international sales increases the costs of the transactions, but minimises the element of risk.
When contracting parties have agreed to effectuate payment by means of a letter of credit, the buyer’s bank takes upon itself the obligation to pay the purchase price when the seller tenders the documents that are stipulated in the letter of credit. The bank has no knowledge of the underlying contract or of the actual goods that are traded. The documents must therefore comply strictly with the terms of the credit. In most national legal systems there is no such thing as a letter of credit law. As such, the principle of strict compliance has evolved from international banking practice. Article 14 of the Uniform Customs and Practice for Documentary Credits (UCP 600) holds important provisions concerning the application of the principle of strict compliance to the tender of the documents by the seller. Although the UCP do not apply unless they are incorporated into the text of the letter of credit (Article 1 UCP 600), in international trade almost all documentary credits are expressed to be subject to the UCP.
The Principle of autonomy or independency
In transactions involving a letter of credit, the bank is not party to the underlying contract. As such, letters of credit have an abstract character. This implies that the bank is not concerned with the specifics and the actual performance of the underlying contract. The conditions of the bank’s duty to pay are to be found exclusively in the terms of the letter of credit and do not in any way depend on the performance of the seller’s obligations under the contract of sale. Article 4(a) UCP 600 stipulates that: ‘credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such a contract, even if any reference whatsoever to it is included in the credit…’
Accordingly, when deciding whether to make payment under the credit in favour of a beneficiary, the bank may only look at the terms of the credit itself. The bank may not raise any defences that are available to the applicant in respect of the underlying agreement of sale. The seller will thus always receive payment from the bank if he submits documents that comply with the credit, regardless of any developments in the underlying sales agreement. The bank should not be forced into the position in which it has to resolve disputes between the seller and buyer, because this would lead to extensive delays in payment and would make the letter of credit unattractive as a commercial service. If the doctrine of independence is not scrupulously observed, the continuance of the letter of credit system as the primary means of payment in international trade would be in danger.
The only exception to the principle of autonomy is fraud committed by the beneficiary when tendering the documents. As De Rooy has stated: ‘No system can be effective if it is blind to something which is manifestly unreasonable.’ If the bank discovers fraud in the documents that were tendered by the beneficiary, it is entitled to refuse payment even though the documents appear to be in conformity with the terms of the letter of credit. This entails that the beneficiary, if he had been truthful in his representations, would have tendered documents that did not strictly comply with the terms of the letter of credit. The fraud, however, must be clear and evident to the bank, without the need for additional proof or having to investigate the actual circumstances surrounding the underlying contract. A mere suspicion of fraud is not sufficient to set aside the independence principle. Thus, even if a bank suspects fraud, it is obliged to pay under the letter of credit if the beneficiary has tendered documents that are in conformity with the letter of credit.
The Principle of Strict Compliance
The second principle governing letter of credit transactions is closely linked to the principle of independence. If the seller wishes to be paid under the letter of credit transaction, documents which strictly comply with the terms of the letter of credit must be tendered. The doctrine of strict compliance demands that the bank’s verification of the documents upon presentation is both literal and exact. When applying the principle of strict compliance in its strictest sense, even the most trivial discrepancy allows a bank to reject the documents for non-conformity with the letter of credit This was first formulated in a 1927 decision handed down by an English court, in which Lord Sumner stated that:
‘There is no room for documents which are almost the same, or which will do just as well … the bank which knows nothing officially of the details of the transactions financed cannot take upon itself to decide what will do well enough, and what will not. If it does as it is told it is safe; if it declines to do anything else, it is safe; if it departs from the conditions laid down, it acts at its own risk.’
This decision has laid the groundwork for a long line of court rulings all over the world especially in the United Kingdom and the United States defining, refining and redefining the principle of strict compliance.
The UCP are fairly general in providing for a standard of documentary compliance and make no mention of the principle of strict compliance as such. However, Article 14(a) UCP 600 requires documents to ‘appear on their face to be in accordance with the terms and conditions of the credit’. In tune with the doctrine of independence, Article 14(a) of the UCP 600 further provides that banks must make their checks ‘on the basis of the documents alone’. In this respect, the principle of strict compliance is linked to the independence principle. Banks act on behalf of the buyer within the limits delineated in the letter of credit alone. Whenever they go beyond these limits, the buyer can reject the bank’s actions. The safest course for banks, and thus for the party tendering the documents (the seller), is obviously to follow the wording of the credit precisely. However, Article 14(d) UCP 600 has added to the requirement of strict compliance that the documents do not need to be identical, but must not be in conflict with each other:
‘Data in a document, when read in context with the credit, the document itself and international standard banking practice, need not be identical to, but must not be in conflict with data in that document, any other stipulated document or the credit.’
Thus, subject to the UCP, banks cannot reject every document containing a misspelling or typographical error. In fact, banks are obliged to examine whether the documents that are tendered in a letter of credit transaction are in conformity with the credit not by determining merely whether they comply exactly to the terms of the credit, but whether they are consistent with each other, and a simple misspelling usually will not affect such consistency. Article 18(c) UCP 600 specifically stipulates that only the commercial invoice must contain a description of the goods that strictly conforms to the description in the letter of credit, whereas the other documents may contain a more general description, as long as this description is not inconsistent with the credit and the other documents (see Article 14(e) UCP 600).
Of course, it is of great importance that the description of the goods is clearly identifiable as the description in the credit and that it is kept simple. This remains the best method to avoid complications in the examination of the documents and to achieve the main goal of the letter of credit transaction and its strict compliance principle: to provide a secure payment mechanism.
It cannot go without notice that one cannot talk about these two (autonomay principle and the doctrine of strict compliance), in isolation of each other. The strict compliance doctrine was formulated in 1927 decision and also Article 14 ‘Data in a document, when read in context with the credit, the document itself and international standard banking practice, need not be identical to, but must not be in conflict with data in that document, any other stipulated document or the credit.’ The description of the goods must be catered for. In Midland Bank Ltd v Seymour Delvin J stated that
It is sufficient that the description should be contained in the set of documents as a whole and that the documents should each one be valid in itself and each be consistent with each other, and accordingly it would not matter for this purpose whether the description in the bill of lading is or is not negative by the clause in the bill of lading since the description is sufficiently contained in the invoice which is one of the documents.
Autonomy principle gradually being left out and the issuer’s independent commitment is a sui generis however since its birth, it’s been held in a more respectable position by different courts and different jurisdictions. The principle notwithstanding if the issuing bank has knowledge of a breach in an underlying transaction, if the documents appear to be correct the issuer is bound to pay the credit. This is a clear indication on how the strict compliance doctrine slightly concurs with the autonomy principle.
Generally speaking, the above shows the difference between the doctrine of strict compliance and autonomy principle and how it has developed over years with its application in the courts of law.
Where parties have established a business relationship, the seller may extend credit to the buyer. In an international sale, however, this scenario is highly unlikely, as the risks inherent to such a transaction would be too great. In such situations, when suppliers or vendors are selling and purchasing goods to and from overseas customers with whom they have not established a business relationship, parties tend to search for additional means of securing performance and payment beyond the mere agreement in the contract. Such security may be achieved by means of, for instance, a letter of credit. The involvement of banks in international sales increases the costs of the transactions, but minimises the element of risk.
When contracting parties have agreed to effectuate payment by means of a letter of credit, the buyer’s bank takes upon itself the obligation to pay the purchase price when the seller tenders the documents that are stipulated in the letter of credit. The bank has no knowledge of the underlying contract or of the actual goods that are traded. The documents must therefore comply strictly with the terms of the credit. In most national legal systems there is no such thing as a letter of credit law. As such, the principle of strict compliance has evolved from international banking practice. Article 14 of the Uniform Customs and Practice for Documentary Credits (UCP 600) holds important provisions concerning the application of the principle of strict compliance to the tender of the documents by the seller. Although the UCP do not apply unless they are incorporated into the text of the letter of credit (Article 1 UCP 600), in international trade almost all documentary credits are expressed to be subject to the UCP.
The Principle of autonomy or independency
In transactions involving a letter of credit, the bank is not party to the underlying contract. As such, letters of credit have an abstract character. This implies that the bank is not concerned with the specifics and the actual performance of the underlying contract. The conditions of the bank’s duty to pay are to be found exclusively in the terms of the letter of credit and do not in any way depend on the performance of the seller’s obligations under the contract of sale. Article 4(a) UCP 600 stipulates that: ‘credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such a contract, even if any reference whatsoever to it is included in the credit…’
Accordingly, when deciding whether to make payment under the credit in favour of a beneficiary, the bank may only look at the terms of the credit itself. The bank may not raise any defences that are available to the applicant in respect of the underlying agreement of sale. The seller will thus always receive payment from the bank if he submits documents that comply with the credit, regardless of any developments in the underlying sales agreement. The bank should not be forced into the position in which it has to resolve disputes between the seller and buyer, because this would lead to extensive delays in payment and would make the letter of credit unattractive as a commercial service. If the doctrine of independence is not scrupulously observed, the continuance of the letter of credit system as the primary means of payment in international trade would be in danger.
The only exception to the principle of autonomy is fraud committed by the beneficiary when tendering the documents. As De Rooy has stated: ‘No system can be effective if it is blind to something which is manifestly unreasonable.’ If the bank discovers fraud in the documents that were tendered by the beneficiary, it is entitled to refuse payment even though the documents appear to be in conformity with the terms of the letter of credit. This entails that the beneficiary, if he had been truthful in his representations, would have tendered documents that did not strictly comply with the terms of the letter of credit. The fraud, however, must be clear and evident to the bank, without the need for additional proof or having to investigate the actual circumstances surrounding the underlying contract. A mere suspicion of fraud is not sufficient to set aside the independence principle. Thus, even if a bank suspects fraud, it is obliged to pay under the letter of credit if the beneficiary has tendered documents that are in conformity with the letter of credit.
The Principle of Strict Compliance
The second principle governing letter of credit transactions is closely linked to the principle of independence. If the seller wishes to be paid under the letter of credit transaction, documents which strictly comply with the terms of the letter of credit must be tendered. The doctrine of strict compliance demands that the bank’s verification of the documents upon presentation is both literal and exact. When applying the principle of strict compliance in its strictest sense, even the most trivial discrepancy allows a bank to reject the documents for non-conformity with the letter of credit This was first formulated in a 1927 decision handed down by an English court, in which Lord Sumner stated that:
‘There is no room for documents which are almost the same, or which will do just as well … the bank which knows nothing officially of the details of the transactions financed cannot take upon itself to decide what will do well enough, and what will not. If it does as it is told it is safe; if it declines to do anything else, it is safe; if it departs from the conditions laid down, it acts at its own risk.’
This decision has laid the groundwork for a long line of court rulings all over the world especially in the United Kingdom and the United States defining, refining and redefining the principle of strict compliance.
The UCP are fairly general in providing for a standard of documentary compliance and make no mention of the principle of strict compliance as such. However, Article 14(a) UCP 600 requires documents to ‘appear on their face to be in accordance with the terms and conditions of the credit’. In tune with the doctrine of independence, Article 14(a) of the UCP 600 further provides that banks must make their checks ‘on the basis of the documents alone’. In this respect, the principle of strict compliance is linked to the independence principle. Banks act on behalf of the buyer within the limits delineated in the letter of credit alone. Whenever they go beyond these limits, the buyer can reject the bank’s actions. The safest course for banks, and thus for the party tendering the documents (the seller), is obviously to follow the wording of the credit precisely. However, Article 14(d) UCP 600 has added to the requirement of strict compliance that the documents do not need to be identical, but must not be in conflict with each other:
‘Data in a document, when read in context with the credit, the document itself and international standard banking practice, need not be identical to, but must not be in conflict with data in that document, any other stipulated document or the credit.’
Thus, subject to the UCP, banks cannot reject every document containing a misspelling or typographical error. In fact, banks are obliged to examine whether the documents that are tendered in a letter of credit transaction are in conformity with the credit not by determining merely whether they comply exactly to the terms of the credit, but whether they are consistent with each other, and a simple misspelling usually will not affect such consistency. Article 18(c) UCP 600 specifically stipulates that only the commercial invoice must contain a description of the goods that strictly conforms to the description in the letter of credit, whereas the other documents may contain a more general description, as long as this description is not inconsistent with the credit and the other documents (see Article 14(e) UCP 600).
Of course, it is of great importance that the description of the goods is clearly identifiable as the description in the credit and that it is kept simple. This remains the best method to avoid complications in the examination of the documents and to achieve the main goal of the letter of credit transaction and its strict compliance principle: to provide a secure payment mechanism.
It cannot go without notice that one cannot talk about these two (autonomay principle and the doctrine of strict compliance), in isolation of each other. The strict compliance doctrine was formulated in 1927 decision and also Article 14 ‘Data in a document, when read in context with the credit, the document itself and international standard banking practice, need not be identical to, but must not be in conflict with data in that document, any other stipulated document or the credit.’ The description of the goods must be catered for. In Midland Bank Ltd v Seymour Delvin J stated that
It is sufficient that the description should be contained in the set of documents as a whole and that the documents should each one be valid in itself and each be consistent with each other, and accordingly it would not matter for this purpose whether the description in the bill of lading is or is not negative by the clause in the bill of lading since the description is sufficiently contained in the invoice which is one of the documents.
Autonomy principle gradually being left out and the issuer’s independent commitment is a sui generis however since its birth, it’s been held in a more respectable position by different courts and different jurisdictions. The principle notwithstanding if the issuing bank has knowledge of a breach in an underlying transaction, if the documents appear to be correct the issuer is bound to pay the credit. This is a clear indication on how the strict compliance doctrine slightly concurs with the autonomy principle.
Generally speaking, the above shows the difference between the doctrine of strict compliance and autonomy principle and how it has developed over years with its application in the courts of law.
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