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transnational law transnational law (lex mercatoria or international business law) and "Autonomy and strict compliance of letters of credit and bank guarantees" 2022-11-24 10:04:05

No. V.2.6 - Autonomy and strict compliance of letters of credit and bank guarantees

(a) A bank‘s obligation to honour a letter of credit (Principle V.2.5) is independent of the existence, non-existence, performance, or non-performance, of the contract or arrangement out of which the letter of credit directly or indirectly arises or on which it is based (principle of autonomy or independence).

(b) When calling on a letter of credit the documentary conditions specified therein must be strictly complied with by the beneficiary (principle of strict compliance).

(c) The bank must refuse to honour a letter or credit in cases of clear fraud by the beneficiary in relation to the documents presented or the underlying transaction which is sufficiently established to the knowledge of the bank.

(d) Subsections (a), (b) and (c) also apply to a guarantee, or similar abstract undertaking, however named or described, and whether issued by a bank or non-bank.

1 Letters of credit (also named „documentary credits“, „banker’s commercial credits“, „L/C“, see Principle V.2.5) issued by banks, and guarantees (also named „bonds“, „bank guarantees“ or „banker’s guarantees“) issued by banks or non-banks are essential for international business in general and cross-border trade financing in particular. Their main purpose is to provide the beneficiary with the equivalent of cash in hand.

2 In order to ensure that payment under these instruments is promptly and readily realizable by the beneficiary, the law of letters of credit and guarantees is built upon two key foundations: the principle of autonomy or independence and the principle of strict compliance. These two principles are indispensable for the proper functioning of of letters of credit and guarantees, and crucial factors for their success in international commerce.

3 However, these two principles do not apply if the relevant instrument is not meant to constitute an abstract, independent payment undertaking, but a secondary, accessory obligation like a suretyship or a similar form of security. Art. 3 of the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit provides indications when an undertaking is considered to be independent from the underlying transaction.

4 The principle of autonomy detaches the payment obligation under these instruments from the performance of the underlying contract, for example a construction, service or sales contract. It is universally accepted today that a beneficiary’s payment claim under a letter of credit or guarantee is abstract, i.e. independent of any entitlement and possible defences arising in connection with the contract between the applicant and the beneficiary. To safeguard this principle Art. 5 a) of the ICC‘s Uniform Rules for Demand Guarantees (URDG 758) specifies that „a reference in the guarantee to the underlying relationship for the purpose of identifying it does not change the independent nature of the guarantee“. A similar provision is contained in Art. 4 a) of the the ICC’s Uniform Customs and Practices for Documentary Credits (UCP 600).

5 The principle of strict compliance is a result of the autonomy principle. Art. 16 a) of the UCP 600 provides that a bank that determines that the presentation of documents under a letter of credit does not comply, may refuse to honour the payment demand by the beneficiary. Art. 24 a) of the URDG 758 contains a similar provision for guarantees. While the principle of autonomy protects the beneficiary, the principle of strict compliance aims at protecting the applicant and the bank.

6 The applicant is protected if and insofar as he has provided in the terms of the letter of credit or guarantee specific documents which the beneficiary must present and specific terminology he must use, - for example with respect to the written demand for payment -, in order to be eligible for payment under the instrument. The required documents usually record an event caused by the applicant (e.g. dispatch of goods sold in case of a letter of credit, non-performance in case of a performance guarantee) that is meant to trigger the payment obligation under the letter of credit or guarantee.

7 The bank is protected because in verifying the legitimacy of the beneficiary’s payment demand, it is not obliged to determine whether the relevant event has in fact occurred. The bank is also not concerned with potential disputes between the parties of the underlying transaction out of which the letter of credit or guarantee has arisen. Instead, the bank must only deal with the formal question of whether the beneficiary has complied with the documentary conditions laid down in the terms of the letter of credit or guarantee. Therefore, Art. 5 UCP and Art. 6 URDG provide that in handling payment claims under letters of credit or guarantees, banks or non-bank guarantors „deal with documents and not with goods, services or performance to which the documents may relate“. Art. 14 a) UCP further provides that a bank, in examining a payment request by the beneficiary, must determine, „on the basis of the documents alone, whether or not the documents appear on their face to constitute a complying presentation“.

8 It is likewise generally accepted that a bank or other issuing institution must disregard the autonomy principle and refuse to honour a payment demand in situations of clear fraud by the beneficiary, provided that the fraud is sufficiently established to the knowledge of the bank or non-bank which has issued the instrument. This exception to the autonomy principle and its narrow scope results from the balancing of two conflicting policy considerations. On the one hand, the application of the autonomy principle and the legal insulation from the underlying transaction which it entails must not serve to encourage or facilitate fraud in such transactions. On the other hand, the potential scope of the fraud exception must not create serious uncertainty and lack of confidence in the operation of letter of credit or guarantee transactions as instruments providing the beneficiary with the equivalent of cash in hand.

9 In case of clear fraud, the issuing bank is prohibited from honouring a letter of credit or guarantee even though the documents tendered by the beneficiary appear on their face to be regular and in conformity with the terms and conditions of the letter of credit or guarantee. In such a scenario, the applicant may request a court or arbitral tribunal to issue an interlocutory injunction to restrain the bank from honouring the letter of credit or guarantee. Absent cases of clear fraud, such injunctions are almost impossible to obtain, as they would jeopardize the value and functioning of letters of credit and guarantees in international trade finance as a substitute for cash in hand.

10 The case of clear fraud may relate to the underlying transaction or to the documents presented for payment under the letter of credit or guarantee, for example in case of clear forgery. While the fraud exception is globally well established, some jurisdictions go further than that. They allow exceptions to the autonomy principle also in cases of abuse of rights or similar situations. The legal development with respect to these other cases is still in a state of flux.

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