02. documentary credits

The question

A sale between a seller and a buyer in different countries raises a problem of trust that the local sale does not. The seller is reluctant to ship the goods before being paid, lest the distant buyer fail to pay; the buyer is reluctant to pay before receiving the goods, lest the distant seller fail to ship conforming goods. Neither can readily enforce against the other across a frontier, and each distrusts the other. This sub-unit examines the instrument by which commerce solves this problem, the documentary credit, asking what the problem is, how the instrument resolves it, and what legal principles govern it. The answer presents a clear instance of the pairing the orientation unit described, of a universal commercial concept, the use of a trusted intermediary's promise to bridge distrust between distant parties, with a specific instrument, the documentary credit governed by an international body of rules.

The problem of trust and the documentary credit

The problem the documentary credit solves is the problem of trust between distant trading parties, each unwilling to perform first and each unable to rely on the other across a frontier. The universal solution to this problem is to interpose a trusted intermediary whose promise both parties can rely on, and the specific instrument that embodies this solution in modern trade is the documentary credit, also called the letter of credit, an undertaking given by a bank, at the request of the buyer, to pay the seller a sum of money against the presentation of specified documents that evidence the shipment of the goods.

The documentary credit connects to the function of intermediation examined in the agency module and to the security of payment that this module addresses. By the credit, a bank, whose creditworthiness both parties trust, substitutes its own reliable promise to pay for the buyer's distrusted promise: the seller, instead of relying on the buyer to pay, relies on the bank's undertaking, which the bank must honour against conforming documents regardless of the buyer's willingness or ability to pay. The buyer, for its part, is protected because the bank pays only against the documents the credit specifies, documents that evidence that the seller has shipped the goods as required, so that the buyer is not called upon to pay until the seller has performed in the manner the documents record. The credit thus resolves the impasse: the seller ships in reliance on the bank's promise, and the buyer pays in reliance on the documents, the bank's intermediation supplying the trust that the parties lack in each other.

Consider a seller and a buyer in different countries, neither willing to perform first. The buyer arranges for its bank to issue a documentary credit in favour of the seller, undertaking to pay the seller against documents showing shipment of the goods. The seller, assured by the bank's promise, ships the goods and presents the required documents; the bank, finding the documents in order, pays the seller; and the buyer reimburses the bank and obtains the documents, which it needs to take delivery of the goods. The example shows the documentary credit resolving the problem of trust by interposing the bank's reliable promise between the distant parties.

The documentary credit is therefore a bank's undertaking, given at the buyer's request, to pay the seller against specified documents, an instrument that resolves the problem of trust between distant trading parties by substituting the bank's reliable promise for the buyer's distrusted one, so that the seller ships in reliance on the bank and the buyer pays only against documents evidencing the seller's performance.

The parties and the operation of the credit

The documentary credit involves several parties in a defined structure, and understanding the structure clarifies how the instrument operates. The buyer, who requests the credit, is the applicant; the bank that issues the credit at the buyer's request, undertaking to pay, is the issuing bank; and the seller, in whose favour the credit is issued and who is entitled to be paid against the documents, is the beneficiary. Frequently a second bank in the seller's country is involved, advising the seller of the credit and sometimes adding its own undertaking to that of the issuing bank, in which case it is a confirming bank, giving the seller a promise from a bank in its own country.

The operation of the credit connects the parties through a sequence of undertakings and documents. The buyer and seller agree, in their sale contract, that payment will be made by documentary credit; the buyer instructs the issuing bank to issue the credit in favour of the seller; the issuing bank issues the credit, undertaking to pay the seller against the specified documents, and the credit is advised, and perhaps confirmed, to the seller through a bank in the seller's country. The seller ships the goods and presents the required documents, which characteristically include a transport document such as a bill of lading, an invoice, and an insurance document, to the bank; the bank examines the documents and, if they conform to the terms of the credit, pays the seller; and the bank obtains reimbursement from the buyer and delivers the documents to the buyer, which uses them to take delivery of the goods. The documents are central, for the credit operates on documents, the bank dealing in the documents that represent the goods rather than in the goods themselves, a feature the governing principles develop.

Imagine the sequence in operation. The sale contract provides for payment by credit; the buyer's bank issues the credit to the seller; the seller ships and presents a bill of lading, an invoice, and an insurance document to the bank; the bank, finding the documents in order, pays the seller and is reimbursed by the buyer, to whom it delivers the documents so that the buyer may claim the goods from the carrier. Each party relies on the bank and on the documents rather than on the distant counterparty. The example shows the structured operation of the credit through the parties and the documents.

The parties to the documentary credit are therefore the applicant buyer, the issuing bank, the beneficiary seller, and frequently an advising or confirming bank, and the credit operates through a sequence in which the bank undertakes to pay and does pay the seller against conforming documents, dealing in the documents that represent the goods rather than in the goods themselves.

The principles of autonomy and strict compliance

Two legal principles govern the documentary credit and give it its character, and they are the key to understanding how the instrument achieves its purpose. The first is the autonomy principle, the principle that the credit is an undertaking independent of the underlying sale contract between buyer and seller, so that the bank's obligation to pay against conforming documents is separate from, and unaffected by, disputes arising out of the sale. The bank must pay the seller against conforming documents even if the buyer alleges that the seller has breached the sale contract, for the credit is autonomous of that contract, and the buyer's remedy for any breach lies against the seller under the sale, not against the bank under the credit.

The autonomy principle connects to the security of payment that the credit is designed to provide, for the seller's assurance of payment would be worthless if the bank could withhold payment whenever the buyer raised a dispute about the goods; the autonomy of the credit gives the seller a reliable right to payment against documents, insulated from the buyer's complaints about the underlying transaction. The second principle, complementary to the first, is the principle of strict compliance, the principle that the bank is entitled and bound to pay only against documents that strictly conform to the terms of the credit, so that the seller must present documents exactly matching the credit's requirements, and the bank may, and must, reject documents that do not conform. Strict compliance protects the buyer and the bank: because the bank deals only in documents and not in the goods, the only protection the buyer has is that the documents conform exactly to what the credit required, and the bank, which cannot judge the goods, can judge only whether the documents conform. The two principles together define the credit: it is autonomous of the sale, so the bank pays against documents regardless of disputes about the goods, and it is governed by strict compliance, so the bank pays only against documents that exactly conform. There is a narrow and exceptional qualification to autonomy where the seller's demand is fraudulent, recognised in the developed systems, but the principle of autonomy otherwise holds firmly.

Suppose a buyer, dissatisfied with goods it claims are defective, instructs the issuing bank not to pay the seller, who has presented conforming documents. By the autonomy principle, the bank must nonetheless pay, for the credit is independent of the sale, and the buyer's complaint about the goods is a matter between buyer and seller. Suppose instead the seller presents documents that depart from the credit's requirements; by the principle of strict compliance, the bank must reject them, for it may pay only against strictly conforming documents. The example shows autonomy compelling payment despite a dispute about the goods and strict compliance requiring exact conformity of the documents.

The principles of autonomy and strict compliance are therefore the twin pillars of the documentary credit: autonomy makes the bank's undertaking independent of the underlying sale, so that the bank pays against documents regardless of disputes about the goods, and strict compliance confines the bank to paying only against documents that exactly conform to the credit, the two together giving the seller a secure right to payment and the buyer the protection of conforming documents.

The UCP and the governance of credits in practice

The documentary credit, though built upon the general law of contract and undertaking, is governed in practice by a specific body of rules, and identifying that body completes the pairing of universal concept and specific instrument that this sub-unit illustrates. The rules are the UCP, the Uniform Customs and Practice for Documentary Credits, a set of rules issued by the International Chamber of Commerce, the current version being the UCP 600, which codifies the practice of documentary credits and which parties incorporate into their credits by reference, so that the UCP governs the great majority of documentary credits in international trade.

The UCP connects to the harmonisation of commercial law examined in Course 1, for it is a leading example of harmonisation achieved not by treaty but by a body of standardised rules issued by a private international organisation and adopted by the parties' agreement. The UCP is not a treaty and does not bind of its own force; it governs a credit because the parties have incorporated it, an expression of the party autonomy examined in the orientation unit. Yet because banks throughout the world issue credits subject to the UCP, it operates in practice as a uniform law of documentary credits, supplying the detailed rules, on the examination of documents, the time for examination, the treatment of discrepancies, and much else, that the autonomy and strict-compliance principles require in their application. The UCP thus exemplifies a distinctive mode of harmonisation, by private codification of commercial practice adopted through party autonomy, and it stands alongside the treaty-based CISG and the standardised Incoterms, examined elsewhere in this course, as one of the principal instruments through which the law of international trade has been made uniform. The reader who has understood the documentary credit and the UCP has understood both the instrument and the mode of harmonisation it represents.

Consider banks and traders across many countries dealing in documentary credits. Each credit incorporates the UCP, so that the same detailed rules govern the examination of documents and the treatment of discrepancies wherever the credit is issued or paid, giving the instrument a uniformity that no single national law could provide. The traders rely on this uniformity, transacting on a common and known basis. The example shows the UCP operating as a uniform body of rules for documentary credits, adopted through the parties' incorporation of it.

The UCP is therefore the body of rules, issued by the International Chamber of Commerce and incorporated by the parties into their credits, that governs documentary credits in practice, a leading example of harmonisation by private codification adopted through party autonomy, which supplies the detailed rules giving effect to the principles of autonomy and strict compliance and completes the pairing of the universal concept with its specific instrument.