The Independence Principle is the foundation of the Letter of Credit transaction.1 In theory, its primary function is to completely separate an underlying contract for the sale of goods from the contract for payment to the beneficiary.2 Because of the Independence Principle, letters of credit have become an integral part of international transactions involving the importing and exporting of goods.3
In its recent holding in Mid-America Tire, Inc. v. PTZ Trading Ltd.,4the Ohio Supreme Court was called upon to determine whether an injunction to stop payment on a commercial letter of credit is an appropriate remedy for a claim of fraud existing solely in the underlying sale of goods transaction.5 In its 5-2 decision finding that a permanent injunction was proper, the court chose to look behind the letter of credit in contradiction of the independence principle.6 This decision to protect an Ohio corporation claiming to be the victim of an underlying fraud as to the quality of goods purchased weakens the credibility of the independence principle by eroding its efficient use in international documentary sales transactions.
This Note will begin with a brief discussion of the basic purpose and function of the letter of credit and its independence principal, followed by an in-depth look at its historic interpretation concerning issues of fraud and the appropriateness of a remedial injunction. The Note will examine both the statutorily-created and judicially-mandated standards of practice and contrast them with Mid-America Tire's holding. In addition, this Note will Page 1098 address the potentially negative effects this holding will have on future letter of credit jurisprudence. Finally, this Note will explore the numerous protections already embedded in the letter of credit transaction that a buyer has available to prevent a fraud in the underlying contract for the sale of goods.
The commercial letter of credit is a payment mechanism employed in a sale of goods transaction which "substitutes the payment obligation and creditworthiness of a more solvent party (usually but not necessarily a bank) for the payment obligation . . . of a less solvent party (a buyer, debtor or obligor)."7 An important benefit of the letter of credit is that it introduces a third-party payor into the exchange, which eliminates the commercial arm wrestling between the seller who refuses to ship goods until payment is obtained and the buyer who refuses to pay until the goods are received.8 Similarly, it is used to prevent the problem of the buyer who uses the excuse of nonconforming goods as a reason not to pay a seller.9The entire transaction, which gives rise to the letter of credit, typically involves three parties and three separate and independent contracts.10 The initial contract consists of the underlying sale of goods transaction between the buyer and the seller.11 This first contract typically deals with such terms as the quantity and quality of the goods and sets forth the terms for payment and shipment of the goods.12 One frequently-used provision of this contract will also obligate the buyer to procure a letter of credit from a bank or other issuing third party, who in turn agrees to pay for the goods upon the presentation of the letter by the seller.13 This obligation of the buyer to procure the letter compels the creation of the second contract, giving rise to the issuance of the letter of credit.14
The second contract is comprised of an agreement between the buyer, also called the applicant, and a third party issuer, usually a bank, to issue a Page 1099 letter of credit in favor of the seller (now called a "beneficiary").15 The buyer agrees to reimburse the bank for all payments made on the letter of credit, and, as collateral, the bank usually receives a security interest in the documents of title or goods involved in the underlying transaction.16 The buyer details the conditions and criteria that are required of the seller for a proper demand for payment to be made upon the issuing bank.17
The third contract consists of the letter of credit itself. This contract consists of the irrevocable promise from the issuing bank or any intermediary confirming bank to honor a draft or other proper demand for payment presented by a seller/beneficiary with the letter.18 The proper demand for payment is "documentary in nature" and requires the presentation of "specified shipping documents," such as a commercial invoice and a bill of lading before the expiration date of the letter of credit.19 These documents demonstrate that the goods have been shipped according to the underlying contract.20
By definition, the letter of credit guarantees that the bank/issuer will pay upon the letter of credit once a proper demand has been made.21 This guarantee is based on a rudimentary function of the letter of credit supported by the "independence principle." The independence principle derives its name from the theory that the relationships and three contracts between the buyer and seller, the buyer and the issuer, and the issuer and the beneficiary are separate and independent.22 The promise of payment upon proper presentment is absolute irrespective of whether the underlying agreement between the customer and the beneficiary has been satisfied as to all of its terms.23 The underlying contract for the sale of goods is considered a completely distinct agreement and wholly independent from the contract creating the letter of credit. This is so the issuing bank, in deciding whether payment of the letter is proper, need only concern itself with the document compliance.24 The issuing bank is relieved of any obligation to act as an umpire regarding the conformity of the purchased Page 1100 goods stemming from the underlying sale of goods contract between the buyer and the seller.25
The Uniform Customs and Practices for Documentary Credits (UCP) was created as a direct result of the prevalence of letters of credits in international dealings. The UCP, in its purest form, represents a compromise among numerous international industry sectors, articulating current practices in letter of credit transactions.26 Banks located in over 145 nations use the UCP.27 Even though it is not legislative in nature because it is not derived from any particular country's lawmaking body, the UCP is often given the force of law.28 Since the UCP in and of itself is not law, its applicability to a letter of credit transaction must come from incorporation by the parties of the transaction.29 The letter of credit, by its own terms, must explicitly identify the UCP as its guiding principle.30 The UCP is thus considered a "reliable supernational code" whose legitimacy is derived from the voluntary undertaking to a letter of credit by the parties.31The latest edition of the UCP is the 1993 revision, also known as ICC publication No. 500.32 Article 1 of the 1993 UCP enumerates the scope of applicability to both documentary credits and parties to the transaction, as Page 1101 well as the requirement of a textual incorporation into the letter of credit.33Once incorporated, the UCP will provide guidance over "such questions as the liabilities and responsibilities of bank issuers, transfer of the credit and the character of the documents presented."34
The independence principle was not overlooked by the authors of the UCP and is clearly embodied in Articles 3 and 4 of the UCP. Article 3 specifically and unequivocally recognizes the proposition that letters of credit by their nature are separate transactions from the sales or other contracts on which they may be based.35 As if this was not clear enough, the Article further declares that banks are neither "concerned with" nor "bound by" the underlying contracts, regardless of whether there is any "reference whatsoever to such contract[s]" in the letter of credit.36 Thus, the bank's obligation to pay on a letter made subject to the UCP is not subordinate to any claims or defenses by the buyer emanating from his relationship with the beneficiary. Article 4 further supports the embodiment of the independence principle through its recognition of the importance of "documents, and not with goods, services, and/or other performances to which the documents relate."37
A significant catalyst of UCP litigation arises from its silence concerning a course of action addressing allegations of fraud. The UCP contains neither a specific provision addressing fraud nor remedies for a potentially wronged buyer.38 There is nothing in the UCP which would permit a buyer to enjoin the bank's payment on the letter of credit based on the receipt of nonconforming goods. This is largely a result of the magnitude of the independence principle.39 Since the issuing bank is only concerned with the conformity of the documents, as long as a beneficiary presents the required documents, the...