In international trade, especially when trust is yet to be firmly established between transacting parties, sellers often insist on payment through documentary credit. This financial instrument is a letter issued by a bank to the seller, guaranteeing that if specific documents stipulated in the letter of credit are presented to the buyer, signifying the delivery of goods (such as a bill of lading and a commercial invoice), the bank will, in turn, release the payment to the seller. This mechanism offers assurances to both parties: the seller secures payment, and the buyer ensures that funds are disbursed only when proper documentation confirming the delivery of goods is provided.
With substantial sums often at stake in these transactions, various parties may attempt to exploit the system, sometimes testing the boundaries of legality. Here are a few illustrative scenarios:
- Seller’s Strategies: Sellers might attempt to deceive buyers by presenting genuine documents to the bank but shipping subpar or irrelevant goods. This deceptive practice jeopardizes the integrity of the transaction.
- Buyer’s Dilemmas: Buyers may seek to delay the utilization of the letter of credit by claiming discrepancies between the delivered goods and their initial order. In some cases, they may discover alternative, cheaper sources for similar goods and wish to postpone the credit’s execution.
- Third-Party Interference: Creditors of the seller may aim to temporarily freeze the letter of credit in order to recover outstanding debts owed by the seller.
Therefore, the key question is: What situations can cause delays in realizing a documentary credit?
Crucial Principles: Compatibility and Independence:
A documentary credit transaction is rooted in two fundamental principles: compatibility and independence.
The compatibility principle safeguards the buyer’s interests. It necessitates that the documents presented by the seller to the bank align with those specified in the letter of credit. While some documents, such as the commercial invoice, require exact compliance, others, like the bill of lading, necessitate substantial alignment. Failure to meet these requirements means the bank won’t release the payment to the seller unless the buyer grants approval. This principle empowers the buyer to withhold payment if the goods do not match the documents. An intriguing question here is whether the seller can legally challenge the buyer’s refusal to approve any discrepancies.
The principle of independence, conversely, protects the seller’s interests. It asserts that the credit transaction is entirely separate from the primary goods transaction, and any disputes or breaches in the latter cannot impede the realization of the credit. The letter of credit and the goods sale are partitioned by an impenetrable barrier. This independence principle is critical for the functionality of documentary credits, as it ensures the credit’s effectiveness remains intact. Nonetheless, an exception exists: fraud.
Fraud Exception:
The principle of independence does have a crucial exception: fraud. Suppose it is proven that the seller exhibited gross fraud and did not uphold their obligations in accordance with the sales contract in any way. In that case, legal action can be taken, requesting a court order instructing the bank not to transfer the credit amount to the seller. The courts will grant such an order only in cases of severe fraud that negates the credit’s original purpose and would allow the perpetrator to unfairly profit at the expense of the buyer. Consequently, buyers can employ the fraud exception when they receive goods that blatantly deviate from what was promised (e.g., waste instead of valuable products) but not when they encounter less critical discrepancies in the goods ordered (e.g., slightly smaller screens than initially ordered). Likewise, the seller’s behavior and willingness to rectify the situation play pivotal roles in assessing the presence of fraud. A seller who acknowledges an error and offers to make amends will be evaluated differently from a seller who ignores the buyer’s messages and severs communication.
Illustrative Cases:
2235-11-08: Tomer vs. M. Russo – In this case, Tomer, a food products marketing company, engaged in a contract with M. Russo, an importer of food products. Tomer paid M. Russo an advance of $100,000 and issued a documentary credit amounting to $320,000 in favor of M. Russo. However, some shipments failed to reach Israel, leading M. Russo to request the release of the documentary credit funds.
Tomer alleged fraud, asserting that the promised goods were never delivered, arguing that this justified the withholding of the documentary credit funds. In response, M. Russo explained the delay due to customs issues in India, citing a labeling discrepancy. M. Russo also claimed that the bill of lading submitted to the bank was authentic. Therefore, by issuing the bill of lading, responsibility for the goods was transferred to the buyer. Tomer countered that the bills of lading were fraudulent, citing non-existent container numbers.
The court ruled in favor of Tomer, determining that there was evidence of fraudulent documents. It also rejected M. Russo’s argument regarding the transfer of responsibility upon issuing the bill of lading to the buyer. The court emphasized that accepting M. Russo’s argument would mean no liability could be attributed to them, even if the bill of lading was fraudulent. Because ownership of the goods had already been transferred to Tomer. Who would still be obligated to make the payment?
In another case, 13853-05 Nayer Brothers Industries, an importer, entered into an agreement to purchase pest protection nets from a Chinese supplier for NIS 1,500,000. Opening a documentary credit in favor of the supplier’s bank. The initial shipments proceeded smoothly. However, some of the subsequent deliveries lacked the required UVA component needed for sun protection, making the nets potentially unusable. The importer alleged that the Chinese supplier had knowingly delivered subpar goods.
The importer’s request to prevent the release of the documentary credit was rejected. The court found no evidence of fraud. Notably, among others, the importer was able to sell the imported goods in Israel, which factored into the decision that fraud hadn’t been established.
Third-Party Involvement:
The granting of a temporary garnishment order on a letter of credit by a third party, typically a seller’s creditor, is in accordance with Israeli legal precedent contingent upon several key conditions:
Sole available collateral: The court will consider such an order only when it deems that the garnishment of the funds associated with the documentary credit serves as the sole available collateral within the context of the matter at hand.
Substantial Evidence: The creditor must provide compelling and substantial evidence to support their claim. This stringent requirement ensures that any garnishment is based on a solid legal foundation, preventing unwarranted interference in the letter of credit.
Jurisdictional Suitability: The Israeli court must also evaluate whether it is the appropriate venue for the legal proceedings. Even if the court has jurisdiction according to Israeli law, it must be a fitting forum for litigation. This evaluation aims to prevent foreign suppliers from becoming embroiled in legal disputes within the State of Israel simply because they engaged in a separate transaction with another Israeli party who opened a letter of credit on their behalf.
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The content in this communication is provided for informational purposes only and is not intended to be comprehensive. It does not serve to replace professional legal advice required on a case by case basis. The firm does not undertake to update the information in this communication or its recipients about any normative, legal or other changes that may impact the subject matter of this communication.
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For any questions or clarifications on the issues listed in this memorandum, you can contact your contacts at our office or:
Gill Nadel, Co-Head of Tax Department –
