by Xiang Gao* and Ross P Buckley**
(2003) Oxford U Comparative L Forum 3 at ouclf.law.ox.ac.uk | How to cite this article
Table of contents
Introduction
National courts have required different standards of fraud to justify non-payment, or restraint of payment, under a letter of credit. The UNCITRAL Convention has adopted its own position. The issue is far from settled in any legal system. Based on an analysis of the law in the United States, United. Kingdom. Canada, Australia and under the UN Convention, this article proposes a standard that is a distinct improvement on the various standards applied around the world and suggests a means for its implementation.
The fraud rule allows the issuer of a letter of credit or a court to disrupt the payment of a letter of credit when fraud is involved. The raison d’etre of letters of credit is to provide an absolute assurance of payment to a seller, provided the seller presents documents that comply with the terms of the credit. The fraud rule thus goes to the very heart of the letter of credit obligation. The fraud rule is necessary to limit the activities of fraudsters, but its scope must be carefully circumscribed so as not to deny commercial utility to an instrument that exists to serve as an assurance of payment.1
This article explores the kind of fraud required to invoke the fraud rule or, in other words, what does fraud mean under the fraud rule in the law governing letters of credit?
This is a challenging question because fraud is an “inherently pliable concept”.2 Some argue that the fraud rule must be applied in a strict fashion, or in cases where only egregious fraud is involved. These commentators emphasise that the letter of credit is a unique commercial device that must be protected from simple contract disputes, which are often difficult to distinguish from certain fraud claims.3 Others favour a more flexible approach to the concept. 4
This article will investigate how this question has been answered in the United States, the United Kingdom, Canada, Australia and under the UNCITRAL Convention, i.e. the United Nations Convention on Independent Guarantees and Standby Letters of Credit (“UN Convention”).5
The Position in the United States
A large number of letter of credit fraud cases have been decided in the U.S. In addition, Article 5 of the Uniform Commercial Code contains state-of-the-art provisions with respect to the fraud rule. 6 Therefore, the US position deserves much attention. To facilitate the discussion, the US position will be examined in three categories: the pre-UCC position, the Prior UCC Article 5 position and the Revised UCC Article 5 position.
Pre-UCC Position
Pre-Sztejn Cases
The seminal case on the fraud rule in letter of credit law was Sztejn v. J. Henry Schroder Banking Corp.7 Before Sztejn was decided, a number of letter of credit cases in the US touched on the issue of fraud, but none considered the fraud rule in detail. Little discussion appeared in those cases about what kind of fraud might invoke the fraud rule. One of the few passages mentioning the issue was the dissenting judgment of Cardozo J in Maurice O’Meara Co v. National Park Bank8.
In Maurice O’Meara the underlying contract was for the sale of newsprint paper of a specified tensile strength. When the plaintiff presented facially regular documents and required payment against the letter of credit, the defendant bank, the issuer, refused to pay the drafts, claiming that “[t]here has arisen a reasonable doubt regarding the quality of the newsprint paper”.9 The plaintiff, the beneficiary, brought the action against the issuer for damages sustained by its assignor from the issuer’s dishonour. The issuer defended against the beneficiary’s action on the ground that the quality of the paper fell far short of that required. The majority judgment of the Court of Appeals of New York rejected the issuing bank’s claim and said:
The bank was concerned only in the drafts and the documents accompanying them. … If the drafts, when presented, were accompanied by the proper documents, then it was absolutely bound to make the payment under the letter of credit, irrespective of whether it knew, or had reason to believe, that the paper was not of the tensile strength contracted for ….10
However, Cardozo J disagreed with the majority judgment and observed:
We are to bear in mind that this controversy … arises between the bank and a seller who has misrepresented the security upon which advances are demanded. … I cannot accept the statement of the majority opinion that the bank was not concerned with any question as to the character of the paper. If that is so, the bales tendered might have been rags instead of paper, and still the bank would have been helpless, though it had knowledge of the truth, if the documents tendered by the seller were sufficient on their face.11
This paragraph shows that, in the view of Cardozo J, fraud under the fraud rule in the law governing letters of credit means misrepresentation. Reading the paragraph further, it appears that the respected judge, by stating “the bales tendered might have been rags instead of paper”, was suggesting that, to invoke the fraud rule, a misrepresentation might have to go as far as complete non-performance of the contract, a kind of gross misrepresentation. 12
However, some eminent commentators of the time seemed to take a different and more flexible view. In their view, the issuer should be allowed to dishonour a draft drawn under a letter of credit where the goods did not conform to the description of the superficially regular documents even if the misrepresentation was made innocently, because under such circumstances “the seller has failed as effectively as in the case of outright fraud to give the bank what the parties contemplated, that is, control over merchandise of a specific description”.13 Some went further and suggested that “the issuing bank may defend the action brought by the seller on the ground of inferiority of quality”.14 These suggestions have been classified as the “breach of warranty or innocent misrepresentation standard” and have been rejected by modern commentators.15
The Test of Sztejn
In Sztejn, Sztejn and Schwarz contracted to buy a quantity of bristles from Transea, and asked Schroder to issue a letter of credit naming Transea as the beneficiary. Transea placed fifty cases of material on board a steamship, procured the documents required by the letter of credit and drew a draft to the order of Chartered Bank, which presented the draft to Schroder for payment along with the required documents under the credit. Before payment had been made, Sztejn filed a suit for a judgment declaring the letter of credit and draft thereunder void, and for an injunctive relief to prevent the issuer from paying the draft, alleging that the beneficiary had in fact filled the fifty cases with “cowhair, other worthless material and rubbish with intent to simulate genuine merchandise and defraud the plaintiff and Schwarz”.16 The plaintiff also averred that the presenting bank was merely a collecting bank for Transea, not an innocent holder of the draft for value. The presenting bank moved to dismiss the complaint on the ground that it failed to state a cause of action.
Assuming that all the allegations of the complaint were true, namely, “Transea was engaged in a scheme to defraud the plaintiff and Schwarz, that the merchandise shipped by Transea is worthless rubbish and that the Chartered Bank is not an innocent holder of the draft for value but is merely attempting to procure payment of the draft for Transea’s account”,17 Shientag J of the Supreme Court of New York County rejected the Chartered Bank’s motion and ruled for the plaintiff by saying:
This is not a controversy between the buyer and seller concerning a mere breach of warranty regarding the quality of the merchandise; on the present motion, it must be assumed that the seller has intentionally failed to ship any goods ordered by the buyer. In such a situation, where the seller’s fraud has been called to the bank’s attention before the drafts and documents have been presented for payment, the principle of the independence of the bank’s obligation under the letter of credit should not be extended to protect the unscrupulous seller.18
As can be seen, Sztejn applied the fraud rule where the dispute was not, in Shientag J’s words, “between the buyer and seller concerning a mere breach of warranty regarding the quality of the merchandise; [but where] the seller has intentionally failed to ship any goods ordered by the buyer”. 19
Despite the use of the word “intentionally”, divergent views have emerged among courts and commentators on the standard of fraud adopted in Sztejn. Some say Sztejn set forth a standard of “intentional fraud”.20 Some have read it more narrowly: “Sztejn on its facts exhibits an “egregious fraud’ standard”.21 But others would argue that the apparently severe standard in Sztejn arose out of its special procedural context — a motion to dismiss; if the case had been heard in the context of an equitable injunction, Sztejn would have set forth “a more flexible equitable standard of fraud”.22 Still others are of the view that the “judgment [in Sztejn] does not tell what degree of knowledge of fraud is necessary to justify the issuing bank in refusing to pay”.23
It has been suggested that one year later, in another letter of credit fraud case, Asbury Park & Ocean Grove Bank v. National City Bank,24 Shientag J himself provided some hint of what he had meant in Sztejn.25 In Asbury Park, Silverman Brothers entered into contracts to purchase clothing from the US Army. Payment was to be made by way of letters of credit. At the buyer’s request, the plaintiff itself issued letters of credit in favour of the sellers, but as the amount involved in the transaction was large, the seller required further letters of credit to be issued by other banks. The plaintiff accordingly applied to the defendant for it to issue letters of credit. Just prior to the expiration of the credits, the plaintiff requested the defendant not to honour any more drafts drawn under the credits, but the defendant made the payment in disregard of the plaintiff’s request because it found that the documents were in compliance with the terms of the credits.
The plaintiff sued the defendant for damages it sustained, alleging that the seller and the buyer were using the letters of credit to defraud the plaintiff, and the defendant knew it. The plaintiff claimed that, (1) when the seller shipped the goods to the buyer, it made out drafts on the defendant, but instead of presenting the drafts for payment, the seller held them as a sort of guaranty on its open account, and did not present them until it appeared that the buyer would be unable to pay the account; (2) such use of the credits had not been contemplated by its agreement with the buyer; and (3) the defendant knew that its credits were being used as guaranty even before the plaintiff requested the defendant to honour no more drafts. Shientag J rejected the plaintiff’s arguments and observed:
The authorities … agree that the letters of credit are contracts which are independent of the contract of purchase between the seller and the purchaser … unless there was such a fraud on the part of the seller that there were no goods shipped … .
It therefore follows that a notice given by the correspondent bank [the plaintiff] to the issuing bank [the defendant] to the effect that the former was defrauded by either the buyer, the seller or both, is ineffective to void or suspend the operation of the letter of credit. Any other rule would destroy the effectiveness of this valuable commercial device. The common-law fraud action is one of the most difficult to prove, and the issuing bank cannot be expected to evaluate the soundness of the correspondent bank’s claim. Thus, in the instant case it is not at all clear whether the plaintiff could prove a cause of action for fraud against the Army or Silverman Brothers or both. It would be improper to hold up the payment of drafts by the issuing bank pending the result of such litigation between the correspondent bank and the buyer or seller.26
If Asbury Park can lend assistance to the interpretation of Sztejn, it might have suggested that Shientag J would have applied the fraud rule only in such situations where “no goods” are shipped, “common-law fraud” is involved, or “the seller has intentionally failed to ship any goods ordered by the buyer”. It is therefore open to question whether Shientag J would apply the fraud rule if the beneficiary’s misconduct were less serious.
Prior UCC Article 5 Position
Sztejn or the fraud rule manifested by it has been codified in Article 5 of the UCC, In Prior UCC Article 5, the fraud rule was embodied in s 5-114(2), which read:
(2) Unless otherwise agreed when documents appear on their face to comply with the terms of the credit but a required document … is forged or fraudulent or there is fraud in the transaction:
(a) the issuer must honour the draft or demand for payment if honour is demanded by a negotiating bank or other holder of the draft or demand which has taken the draft or demand under the credit and under circumstances which would make it a holder in due course (Section 3-302) and in an appropriate case would make it a person to whom a document of title has been duly negotiated (Section 7-502 ) or a bona fide purchaser of certificated security (Section 8-302); and
2. in all other cases as against its customer, an issuer acting in good faith may honour the draft or demand for payment despite notification from the customer of fraud, forgery or other defect not apparent on the face of the documents but a court of appropriate jurisdiction may enjoin such honour. 27
Although the fraud provision in Prior UCC Article 5, it disappointed in that “[n]either the Code nor its comments give any hint as to what type of fraud gives the bank an option to pay or not to pay under this section”.28 As a result, a number of standards of fraud were suggested in the cases applying Prior UCC Article 5.
Egregious Fraud
The term “egregious” is not commonly used by courts in connection with letter of credit fraud29 but is a standard advocated by some commentators.30 The elements of egregious fraud are not entirely clear, but the term has been used to denote very serious misconduct in the context of letter of credit transactions. One suggestion is that egregious fraud means “a flagrant violation of the beneficiary’s obligation under the letter of credit”.31 Another is that egregious fraud is a kind of “outrageous conduct which shocks the conscience of the court”.32 Some commentators have used “gross fraud” interchangeably with “egregious fraud”.33 In sum, under the standard of egregious fraud “simple intent to deceive is not sufficient; it is the extreme or outrageous nature of the fraud” that matters.34
One oft-mentioned case for the standard of egregious fraud is Intraworld Industries Inc v. Girard Trust Bank.35 Intraworld involved a contract under which a luxury Swiss hotel was leased. The applicant, the lessee, obtained a standby letter of credit in favour of the beneficiary, the lessor, to guarantee rental payment in advance. Under the letter of credit, the issuer promised to pay a draft accompanied by the beneficiary’s signed statement to the effect that the applicant had not paid an instalment of rent due under the lease.
When a dispute arose and the beneficiary presented a draft accompanied by a statement conforming to the terms of the letter of credit, the applicant attempted to enjoin the bank from paying the beneficiary, alleging that although the beneficiary’s supporting documents on their face conformed to the credit they were false and fraudulent on the following grounds: (1) no rent was due because the beneficiary had terminated the lease, which the beneficiary’s statement failed to disclose; and (2) the beneficiary was not seeking rent at all but rather seeking the stipulated penalty.
After a hearing, the Supreme Court of Pennsylvania found the facts were not as the applicant had claimed. Conversely, the Court found that correspondence had been exchanged between the parties’ lawyers when dispute arose and that one of the letters from the applicant’s counsel to the beneficiary’s stated that “[i]f the transfer of the rent … should not be made in timely fashion, your client … is at liberty to obtain payment by way of the guarantee contract [the letter of credit]”.36 The Court also found that the underlying contract provided that if the applicant should fail to pay the rent, the beneficiary could not only draw under the letter of credit, but also terminate the lease immediately without further notice. Accordingly, the Court rejected the applicant’s claim for an injunction against payment of the letter of credit, reasoning:
In light of the basic rule of the independence of the issuer’s engagement and the importance of this rule to the effectuation of the purposes of the letter of credit, we think that the circumstances which will justify an injunction against honor must be narrowly limited to situations of fraud in which the wrongdoing of the beneficiary has so vitiated the entire transaction that the legitimate purposes of the independence of the issuer’s obligation would no longer be served. A court of equity has limited duty of “guaranteeing that [the beneficiary] not be allowed to take unconscientious advantage of the situation and run off with plaintiff’s money on a pro forma declaration which has absolutely no basis in fact”.37
One case having mentioned the term “egregious fraud” is N Y Life Insurance Co v. Hartford National Bank & Trust Co.38 Here the plaintiff and a real estate developer entered into a mortgage loan agreement under which the developer committed to borrow from the plaintiff a large sum of money. The defendant issued a standby letter of credit in favour of the plaintiff to satisfy one of the terms of the agreement — that the developer would have to pay the plaintiff a sum as liquidated damages if it failed to take up the loan. The sole condition for payment of the letter of credit was that the drafts were to be accompanied by a signed statement of the plaintiff that the liquidated damages were due. When the developer failed to take up the loan, the plaintiff presented to the defendant the draft accompanied by the required document, but it was dishonoured.
The plaintiff sued for wrongful dishonour. The defendant asserted several defences, but none of them alleged that the plaintiff had practised fraud. The Supreme Court of Connecticut made its decision for the plaintiff on the basis that no fraud was involved in the case, stating:
Only in rare situations of egregious fraud would … [Prior UCC Article 5, s 5 -114] have justified the issuer, on the facts presented here, in going behind apparently regular, conforming documents; such fraud “must be narrowly limited to situations of fraud in which the wrongdoing of the beneficiary has so vitiated the entire transaction that the legitimate purposes of the independence of the issuer’s obligation would no longer be served.” … There is no such evidence in the record of this case, and the [lower] court correctly found that the documentation presented by New York Life complied fully with the terms of the letter of credit.39
The court of N Y Life Insurance followed the reasoning of Intraworld. Taking both cases together, under the standard of “egregious fraud” the fraud rule might be applied only in situations where “the wrongdoing of the beneficiary has so vitiated the entire transaction that the legitimate purposes of the independence of the issuer’s obligation would no longer be served”, or the letter of credit was called upon with “absolutely no basis in fact”.
In practice the fraud rule has rarely been activated when the standard of egregious fraud has been applied. Ironically, the standard of egregious fraud has normally been cited in cases where no fraud would have been found to have been involved whatever standard of fraud is applied. For example, in Intraworld, the court properly denied the request for an injunction because the letter of credit was used for precisely the purpose for which it was generated — to guarantee payment of the advance rent as liquidated damages. In N Y Life Insurance, as fraud was not even mentioned as a defence, the statements of the court relating to the standard of fraud were mere dicta. Therefore, it can be seen that the standard of egregious fraud has in fact become the term used by those courts and commentators who regard a letter of credit “as something akin to a claim check redeemable at a bank’s cash vault”40 — courts and commentators who have to recognise the rationale for the existence of the fraud rule but are very reluctant to see the payment of a letter of credit interfered with due to the application of the fraud rule.
Intentional Fraud
The idea that intentional fraud can invoke the fraud rule was articulated in the case of NMC Enterprises Inc v. Columbia Broadcasting System Inc,41 where the underlying contract was for the purchase of stereo receivers. A commercial letter of credit was issued in favour of the defendant to finance the purchase. The plaintiff, the buyer, sought a preliminary injunction restraining the defendant from presenting for payment or negotiating any drafts under the letter of credit.
The affidavit of the plaintiff’s president averred that the technical performance specifications for the receivers were substantially below that specified in brochures that formed the basis of the bargain. These allegations were confirmed by a testing laboratory. One critical element of the case was an allegation that one of the beneficiary’s officers had admitted the seller was aware of such non-conformity prior to the execution of the contract.
The New York Supreme Court, while acknowledging that questions as to quality or condition of the goods could not form the basis of the request for an injunction, nevertheless, granted the requested injunction and stated:
Where no innocent third parties are involved and where the documents or the underlying transaction are tainted with intentional fraud, the draft need not be honoured by the bank, even though documents conform on their face … and the court may grant injunctive relief restraining such honor.42
Another oft-mentioned case applying the standard of intentional fraud is American Bell International v. Islamic Republic of Iran,43 where American Bell International (Bell) contracted with the Ministry of War of the Imperial Government of Iran (the Imperial Government) to provide the latter with consulting services and telecommunications equipment. A down payment was involved, and Bell’s liability to return the down payment would be reduced in proportion to the work completed. In order to protect the down payment, the Imperial Government required Bell to establish a bank guarantee issued by Bank Iranshahr. The bank guarantee was counter-guaranteed by a standby letter of credit from Manufacturers Hanover Trust Company. The payment under the letter of credit would be triggered by a statement from Bank Iranshahr to the effect that it had received a call for payment under the guarantee from the Imperial Government.
Subsequently, the Imperial Government in Iran was replaced by the Islamic Republic and Bank Iranshahr made demands under the standby letter of credit for payment of the remaining balance of the down payment. Bell filed an action for a preliminary injunction against honouring the demand in the Supreme Court, New York County, claiming inter alia that the demand was fraudulent because the old and new Iranian governments had repudiated the underlying contract, but the new Islamic Republic nevertheless caused Bank Iranshahr to demand payment under the letter of credit, thus asserting rights in a transaction it had otherwise repudiated. Rejecting Bell’sargument, Judge MacMahon said:
Even if we accept the proposition that the evidence does show repudiation, plaintiff is still far from demonstrating the kind of evil intent necessary to support a claim of fraud. Surely, plaintiff cannot contend that every party who breaches or repudiates his contract is for that reason culpable of fraud. … [T]he evidence is ambivalent as whether the purported repudiation results from non-fraudulent economic calculation or from fraudulent intent to mulct Bell. … On the evidence before us, fraud is no more inferable than an economically rational decision by the government to recoup its down payment, …44
It seems that the standard of intentional fraud requires a misrepresentation made knowingly or recklessly with the intention of inducing another to rely thereon. It is thus similar to common law fraud, requiring: (1) a false presentation of the fact; (2) knowledge or belief on the part of the defrauder; and (3) an intention to induce the other party to act or to refrain from action in reliance upon the misrepresentation.45 If cases of common law fraud are treated as equivalent to cases of intentional fraud, the number of cases supporting the standard of intentional fraud are significant.46
The critical requirement for the application of the standard of intentional/common law fraud (treating the two as one) is to prove the fraudster’s intention or state of mind to defraud, which is “notoriously difficult”.47 This is especially so in a standby letter of credit scenario where few documents are required to effect a call on a letter of credit. However, if the fraudster’s intention can be proven, the standard of intentional fraud does not seem to be as high as that of egregious fraud. So, in NMC Enterprises the fraud rule was applied because the court was satisfied the buyer had proven that the seller knew of the inferior quality of the goods yet had induced the purchaser into the contract and drawn on the letter of credit.48
Given that the purpose of the fraud rule is to stop dishonest beneficiaries from abusing the letter of credit system, the standard of intentional fraud seems to be an appropriate one, even though the term is a general one and does not specifically reflect the characteristics of letters of credit.
Letter of Credit Fraud
The concept of “letter of credit fraud” was fashioned in Emery-Waterhouse Co v. Rhode Island Hospital Trust National Bank,49 where a back-to-back letter of credit was involved. In Emery-Waterhouse, Hospital Trust National Bank (HTNB) financed the business of a stove importer, Franklin. As security for the financing, Franklin gave HTNB rights to its accounts receivable, which were backed by letters of credit issued by banks of Franklin’s customers. Emery, a Franklin customer, arranged with its own bank, First National Bank of Boston (FNBB), to provide Franklin with a standby letter of credit guaranteeing Emery’s purchases. The credit stated that to draw upon it Franklin must present FNBB with a signed statement that “the amount of your draft represents funds due you as a result of the failure of the Emery company to pay invoices with its terms, that demand for payment has been made, and that payment has not been received by you”.50
When Franklin became insolvent, HTNB took it over and asked a Donnelly to call upon letters of credit that named Franklin as a beneficiary. Donnelly presented three drafts to FNBB with documents apparently complying with the terms of the credit. FNBB honoured two of them immediately, held up the third and notified Emery. Emery told both HTNB and Franklin that it did not owe the money. Franklin’s CEO told HTNB that Emery did not owe the money. HTNB’s own investigation found the same result. Donnelly told HTNB that it was wrong to draw the drafts on Emery in such circumstances. HTNB nonetheless continued to press for payment and refused to return any of the money obtained.
Emery brought the action to recover the money paid, claiming that it owed nothing to Franklin and that HTNB’s call was fraudulent. The trial court agreed and awarded the plaintiff punitive damages. HTNB appealed. Affirming the judgment of the trial court, the United States Court of Appeals for the First Circuit observed:
Hospital Trust Bank argues that, even if the record contains facts showing a “fraudulent” document or “fraud in the transaction,” we must pretend that it does not because the jury refused to find Hospital Trust Bank liable on Emery’s separate charge of common law fraud. The elements of “common law fraud” as charged by Emery, however, are significantly different from the elements of fraud in the statutory letter-of-credit exception. Even if we assumed that both required some showing of a “false” statement, common law fraud as charged by Emery also requires a showing that Emery “justifiably relied” upon the false statement.51
This is one of the most important cases with respect to the development of the notion of fraud under the fraud rule . It is clear that the beneficiary called on the letter of credit with “absolutely no basis in fact”, but the court did not use “egregious fraud” or similar terms that arguably reflect an overly rigid attitude towards the fraud rule. Nor did the court use the term “intentional fraud”, although the beneficiary knowingly called on the letter of credit without a legitimate basis. It chose to use the phrase “statutory letter of credit exception”, an expression proper and responsive to the special characteristics of letters of credit. This can be branded as a new page in the development of the standard of fraud in the fraud rule.
Flexible Standard
The term “flexible standard” was used in the case of United Bank Ltd v. Cambridge Sporting Goods Corp,52 where Cambridge contracted to buy boxing gloves from Duke. Duke arranged with United Bank and another Pakistani bank to finance the sale. Cambridge was asked by the financing banks to cover the payment of the purchase price by opening an irrevocable letter of credit with its bank, Manufacturers Hanover Trust Company. Manufacturers Hanover issued the letter of credit. When the shipments arrived, inspection revealed Duke had shipped “old, unpadded, ripped and mildewed gloves rather than the new gloves” required.53 Cambridge commenced an action against Duke, joining Manufacturers as a party, obtained a preliminary injunction prohibiting the issuer from paying the drafts, and subsequently levied on the funds subject to the credit.
The Pakistani financing banks instituted proceedings to vacate the levy and to obtain payment of the drafts, claiming they were holders in due course of the drafts and hence were entitled to the proceeds thereof irrespective of any defences against the beneficiary. In refusing the petitioners’ request, the Court of Appeals of New York observed:
It should be noted that the drafters of section 5-114, in their attempt to codify the Sztejn case and in utilizing the term “fraud in the transaction”, have eschewed a dogmatic approach and adopted a flexible standard to be applied as the circumstances of a particular situation mandate. It can be difficult to draw a precise line between cases involving breach of warranty (or a difference of opinion as to the quality of goods) and outright fraudulent practice on the part of the seller. To the extent, however, that Cambridge established that Duke was guilty of fraud in shipping, not merely nonconforming merchandise, but worthless fragments of boxing gloves, this case is similar to Sztejn.54
Factually, as mentioned by the court, this case resembles Sztejn. It might be argued that the court in Cambridge Sporting Goods itself takes a “dogmatic approach” towards the issue of fraud in advocating a “flexible standard” of fraud under the fraud rule. Nevertheless, it does set out the range of the flexibility: the degree of fraud is somewhere between “breach of warranty … and outright fraudulent practice”.55 At the extremes, if only a warranty is breached, the fraud rule will not be brought to play; on the other hand, if “outright fraudulent practice” is established, the fraud rule will certainly apply. Under these guidelines, the relevant standard of fraud requires of the beneficiary’s misconduct something which is more serious than mere breach of warranty.
This decision is laudable and the standard of fraud adopted is a good one if it can be implemented because it exactly matches the purpose of the fraud rule: the stopping of fraud in letter of credit transactions without becoming enmeshed in simple contract disputes. However, because the standard is labelled “flexible”, it may be susceptible to misinterpretation and might be misapplied in practice in unanticipated “flexible” ways.56
Constructive Fraud
The standard of constructive fraud was suggested in Dynamics Corp of America v. Citizens & Southern National Bank,57 where Dynamics, the plaintiff, and the Indian government entered into a contract whereby the former agreed to sell to the latter defence-related equipment. The plaintiff agreed further to have the defendant bank issue standby letters of credit by which the issuer promised to pay drafts drawn by the Indian government, and accompanied by the Indian government’s certification in quite general terms that Dynamics had failed to carry out certain of its obligations under the underlying contract.
While part of the contract remained unperformed, war broke out between India and Pakistan. The US government announced an embargo on military supplies to the region, thereby making further delivery of the equipment impossible. The Indian government thereafter refused to pay for some of the supplies previously delivered and presented a draft accompanied by a certificate purporting to comply with the terms of the letter of credit. The plaintiff filed a complaint seeking an injunction to prevent the issuer from honouring the draft, alleging that the certificate provided by the Indian government was fraudulent in that the plaintiff had actually performed its obligations under the contract. The United States District Court of Georgia granted the injunction and stated:
The law of “fraud” is not static and the courts have, over the years, adapted it to the changing nature of commercial transactions in our society … [I]n a suit for equitable relief — such as this one — it is not necessary that plaintiff establish the elements of actionable fraud required in a suit for monetary damages. “[F] raud has a broader meaning in equity and an intention to defraud or to misrepresent is not a necessary element. Fraud, indeed, in the sense of a court of equity properly includes all acts, omissions and concealments which involve a breach of legal or equitable duty, trust, or confidence, justly reposed, and are injurious to another, or by which an undue and unconscious advantage is taken of another.”58
In accordance with this judgment, any conduct of the beneficiary that breaks even an equitable duty may lead to the application of the fraud rule. Such a standard of fraud is unquestionably too low, for it neglects the nature of a letter of credit transaction, normally a commercial transaction between sophisticated parties who can and should look after their own interests.
If the standard of fraud for the application of the fraud rule is set too low, as in the instant case, it may lead to the abuse of the rule by the applicant. Temptation to abuse always exists: “[f]raud is, in practice, virtually the only defence available when one seeks to escape payment”.59 In the commercial world there are almost limitless ways in which an applicant’s bargain with a beneficiary may go sour. When this happens, the applicant will be tempted to use every means to escape from its original bargain. Exploitation of the fraud rule may be one of its choices. Not only is the risk of such abuse inherent, but the signs of abuse have already appeared. As put by Bertrams:
Through the years, a huge volume of case law concerning the issue of fraud has grown up…. It is only natural for the account party, when the risk of a call has materialized, to claim that the demand for payment in his case is indeed fraudulent. He may, therefore, initiate proceedings in order to attempt to prevent payment and, of course, it hardly matters whether he believes honestly or with little conviction, that the demand is totally unjustified.60
If the standard of fraud is set too low so that the fraud rule is abused and payment of letters of credit repeatedly disrupted, the inherent commercial functions of the letter of credit instrument such as prompt payment, allocation of risks and shifting of the forum will disappear. In turn this will ultimately vitiate the reliability and commercial utility of letters of credit. Accordingly the standard of constructive fraud should be avoided.
Summary
As has been seen, Prior UCC Article 5 cases did not provide a consistent answer to the question of notion or standard of fraud. As Prior UCC Article 5 was silent over what kind of fraud could invoke the fraud rule, almost every Prior UCC Article 5 case involving letter of credit fraud cited Sztejn as authority and, in no surprise, the standards of fraud adopted by the courts in those cases were as divergent as the views already considered regarding the position expressed in Sztejn. Some courts stuck to a strict and restrictive approach and adopted an egregious standard of fraud, while others were ready to take a much different approach adopting a constructive standard of fraud. Still others fell somewhere between the two extremes.
The authors have tried to place the mentioned standards of fraud “on a continuum where the suggested standard ranges from, at the one extreme, where fraud must be egregious, to the other extreme, a broader constructive fraud approach, where an intention to defraud is not a necessary element.” 61 However, this is not an easy task. It may be easy to tell the difference of the level of fraud between the two extreme standards — the standard of egregious fraud and the standard of constructive fraud, and people may also say that the flexible standard of fraud is higher than the standard of constructive fraud because the breach of warranty is excluded under the former, but it is not easy to tell the difference between the standard of intentional fraud and that of letter of credit fraud. If there is any difference, it may be that the former looks more to the state of mind of the fraudster while the latter emphasizes the severity of the effect of fraud on the transaction.
Iranian Cases
The Iranian Revolution of 1979 gave rise to considerable litigation in the United States over standby letters of credit. These cases are known as the Iranian cases. The Iranian cases raised novel legal questions and prompted heated discussion upon a range of issues, especially the standard of fraud of the fraud rule, not only at that time but also thereafter. 62
The Iranian cases can be divided into two groups: pre-hostage cases and post-hostage cases. The pre-hostage cases were decided before hostages were taken at the US Embassy in Teheran in November 1979. The post-hostages cases were decided after that date. The post-hostages cases are extreme examples of how the fraud rule, if the standard or concept of fraud is not clearly defined, can be misused by the parties and misapplied by the courts.
The facts of the Iranian cases were similar one to another. Prior to the Iranian Revolution, the Imperial Government of Iran spent billions of dollars modernising the country. Many US companies poured into Iran on this “gold rush”63 and were awarded lucrative contracts by the Imperial Government. At the same time, they were required to procure independent guarantees, counter-guaranteed by standby letters of credit, to secure the good performance of those contracts or the return of advance payments. All transactions involved four parties — a US company, an Iranian government agency, an Iranian bank, and a US Bank. The US company contracted with the Iranian government agency to provide goods or services in Iran. The contract required the US company to provide for the Iranian agency independent guarantees as above. The independent guarantees were issued by the Iranian bank and counter-guaranteed by standby letters of credit issued by the US bank in favour of the Iranian Bank at the request of the US company. In the event of a dispute the Iranian government agency would demand payment under the guarantee from the Iranian bank, the Iranian bank would demand payment under the standby letter of credit from the US bank, and the US bank would in turn look to the US company for reimbursement.
In the wake of the Iranian Revolution US companies, fearing that the new Iranian regime would arbitrarily demand payment under the letters of credit, flocked to US courts, in most of the cases on the ground of fraud, to prevent the letters of credit from being paid and their accounts from being charged. They had “only marginal success in the courts”64 in the pre-hostage cases. There were only two reported pre-hostage cases in which US companies were granted preliminary injunctions, and they were soon vacated.65 In other pre-hostage cases, injunction motions were either denied or only “notice injunctions” were granted.66 For example, in American Bell International v. Islamic Republic of Iran,67 a paradigm pre-hostage case which “typifies the Iranian cases with regard to the facts, relief sought, arguments raised, and results”,68 the court rejected the applicant’s claim of fraud because it failed to meet the test of intentional fraud by showing the beneficiary had “evil intent” or “fraudulent intent to mulct” the applicant.69 In the post-hostage cases, in striking contrast with the pre-hostage cases, US courts changed their attitudes dramatically. They issued preliminary, and in some cases permanent, injunctions when US companies came back to them after the hostage crisis. Payment of letters of credit in many cases was enjoined without an opinion. According to one commentator, out of fourteen injunction motions made in federal district courts, twelve were granted, and only two were denied. Of those twelve enjoined cases, only three were issued with written opinions, eight were decided without an opinion, and the remaining one was decided without a formal written judgment. No-opinion judgments were not limited to federal courts; a similar approach was taken by some of the state courts.
In those cases where an opinion was given, the reasons provided were hardly convincing to letter of credit specialists. For example, in Touche Ross & Co v. Manufacturers Hanover Trust Co,70 Touche had entered into a contract with the Ministry of War of the Imperial Government to audit, examine and review the financial aspects of military contracts that various American contractors were performing for the Government. To assure performance, Touche was required to provide by Bank Saderat in the amount of 10% of the contract price a performance guarantee, which was counter-guaranteed by a standby letter of credit issued by Manufacturers Hanover Trust (Manufacturers). The letter of credit was payable upon presentation of a sight draft together with documents consisting of either Bank Saderat’s statement signed by one of its officers or its tested telex that Bank Saderat had made payment to the Ministry of War pursuant to the guarantee.
There was in the contract a force majeure clause, under which the contract could be cancelled if events of force majeure occurred. The contract also provided that the bank guarantee would be released in the event the contract was cancelled due to force majeure. After the hostages were taken in Teheran, Touche invoked the force majeure clause and cancelled the contract unilaterally. Nevertheless, Touche was advised that Bank Saderat had made a demand on Manufacturers for payment of the letter of credit.71
Touche moved for a preliminary injunction pendente lite enjoining Manufacturers from making any payment under the letter of credit, but it is not clear from the report when Touche made the move, whether before or after the demand for payment was made, and on what basis, whether fraud or something else.72 The Supreme Court of New York granted the plaintiff’s motion, and said:
As a result [of the cancellation of the contract], the guaranty has been released, and no legitimate call could be made on the guaranty or the letter of credit. …
As all financial institutions in Iran, including Bank Saderat, have been nationalized, Bank Saderat is owned by the Islamic Republic of Iran. Bank Saderat could not have legitimately paid on the guaranty, as Bank Saderat would be simply paying itself. Therefore, any call on the letter of credit would be fraudulent.73
The court in Touche cited two grounds for its application of the fraud rule. The first was the effect of the invocation of the force majeure clause by the applicant. However, the soundness of this ground is questionable on two fronts:
1. It seems that the parties were in dispute over whether events such as the Iranian Revolution were within the force majeure clause, for one party invoked the clause and claimed that the independent guarantee had been released while the other party called on the independent guarantee in ignorance of it. This raises the question of whether the case ought not to have been decided on the basis of simple contract rather than fraud.
2. Even if the independent guarantee were released under the force majeure clause in the contract, it is doubtful whether that release would automatically release the issuer’s obligation under the letter of credit, because there was no provision for that in the letter of credit and the two were independent under the law of letters of credit.74
What has struck commentators most is the second ground for the judgment: that nationalisation of the Iranian institutions meant that “any call” by the Iranian bank on the letter of credit would be fraudulent because any payment made by the bank under the independent guarantee would not be legitimate. According to the logic of this statement, the fraud rule may be applied by looking into the identity of the beneficiary, not at what the beneficiary has done. This seems to take the fraud rule a very long way indeed from its purpose.75
While the Iranian cases were extreme cases arising from extreme circumstances, the sudden change of attitude by the US courts shocked the letter of credit world and prompted commentators to ask whether the post-hostage decisions were really “influenced by the widespread sentiment that Iran should be punished”.76 Whatever the answer, the Iranian cases made abundantly plain that the fraud rule needed urgent improvement by the provision of a proper definition or standard of fraud.
Revised UCC Article 5 Position
Observations and Recommendations of the Task Force
Before the revision of UCC Article 5 was commenced, a Task Force was formed to study the previous case law and make recommendations for the revision. With respect to the standard of fraud implemented in the US courts when applying the fraud rule, the Task Force made the following observations:
1. The reported cases indicate general agreement that the defense of fraud in the transaction must be based on serious conduct that “has so vitiated the entire transaction that the legitimate purposes of the independence of the issuer’s obligations would no longer be served.”77
2. The reported cases differ, in rhetoric if not result, as to whether fraud in transaction refers to “egregious fraud” or “intentional fraud” or involves application of a flexible fraud standard … Most of the cases favoring a flexible standard have nonetheless been supported by a showing of serious misconduct equivalent to the shipment of rubbish.78
3. The “fraud-in-the-transaction” defense has generally been construed to require proof of an active intent and proof of no colorable or plausible basis under the underlying contract for the beneficiary to call the credit.79
The Task Force further observed that “[n]ot every instance of misconduct by the beneficiary should interrupt or excuse honor of a letter of credit. Ordinary contracts disputes must be settled by the beneficiary and applicant between themselves and entirely apart from the credit obligation”.80 It agreed with the position taken by the court of Emery-Waterhouse: “letter of credit fraud — i.e., conduct warranting judicial interference — is not the same as common law fraud.”81 However, the Task Force stated that “[h]ow to formulate the requisite fraud standard is not easy”,82 because there is a “grey area of misconduct which is wrongful but not so serious as to justify interruption”83 of the normal operation of the letter of credit. The Task Force pointed out:
Because of the serious possibility of confusion of letter of credit fraud with common law fraud and other types of fraud as well as the critical importance of a narrowly gauged standard, the Task Force believes that an attempt must be made to alert parties and courts that not just any fraud will suffice.84
The Task Force finally recommended that a different standard should apply for commercial letters of credit as opposed to standbys. 85 For commercial letters of credit, the focus should be whether “the purpose of the underlying transaction must be rendered virtually without value”.86 For standby letters of credit, the question should be “whether the drawing has occurred with no colorable basis whatsoever”.87
The Position in the Statute
The Drafting Committee, after deliberating upon the Task Force’s recommendations and holding extensive discussion and consultation, set forth a standard of fraud in the law of letters of credit in Revised UCC Article 5. Revised UCC Article 5, s 5-109, reads:
1. If … a required document is forged or materially fraudulent, or honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant: … the issuer, acting in good faith, may honor or dishonor the presentation….
2. If an applicant claims that a required document is forged or materially fraudulent or that honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant, a court of competent jurisdiction may temporarily or permanently enjoin the issuer from honoring a presentation or grant similar relief against the issuer or other persons.88
Revised UCC Article 5 has adopted “material fraud” as the standard of fraud under the fraud rule. While the Article itself does not define “material fraud”, 89 Official Comment on s 5-109 has made some efforts to explain it. For commercial letters of credit, it has indicated that material fraud “requires that the fraudulent aspect of a document be material to a purchaser of that document or that the fraudulent act be significant to the participants in the underlying transaction”.90 An example has been provided to illustrate the point:
Assume … the beneficiary has a contract to delivery 1,000 barrels of salad oil. Knowing that it has delivered only 998, the beneficiary nevertheless submits an invoice for 1,000 barrels. If two barrels in a 1,000 barrel shipment would be an insubstantial and immaterial breach of the underlying contract, the beneficiary’s act, though possibly fraudulent, is not materially so and would not justify an injunction. Conversely, the knowing submission of those invoices upon delivery of only five barrels would justify an injunction.91
For standby letters of credit, the Official Comment states that “[m]aterial fraud by the beneficiary occurs only when the beneficiary has no colorable right to expect honor and where there is no basis in fact to support such a right to honor”.92 For further illustration, it has quoted the following passage from Ground Air Transfer v. Westate’s Airlines:
We have said throughout that courts may not “normally” issue an injunction because of an important exception to the general “no injunction” rule. The exception, as we also explained in Itek, 730 F.2d at 24-25, concerns “fraud” so serious as to make it obviously pointless and unjust to permit the beneficiary to obtain the money. Where the circumstances “plainly” show that the underlying contract forbids the beneficiary to call a letter of credit, Itek, 730 F.2d at 24; where they show that the contract deprives the beneficiary of even a “colorable” right to do so, id., at 25; where the contract and circumstances reveal that the beneficiary’s demand for payment has “absolutely no basis in fact,” id.; Dynamics Corp. of America, 356 F Supp. at 999; where the beneficiary’s conduct has “so vitiated the entire transaction that the legitimate purposes of the independence of the issuer’s obligation would no longer be served,” Itek, 730 F.2d at 25 (quoting Roman Ceramics Corp. v. Peoples National Bank, 714 F.2d 1207, 1212 n. 12, 1215 (3d Cir. 1983) (quoting Intraworld Indus., 336 A 2d at 324-25); then a court may enjoin payment. 93
Neither s 5-109 nor its Official Comment suggests that the beneficiary’s intention to defraud should be proved, so it seems that “material fraud” under Revised UCC Article 5 looks “more to the severity of the effect of the fraud on the transaction rather than the state of mind of the beneficiary”.94 The thrust of Revised UCC Article 5 is very encouraging. Section 5-109 of the Article has not only laid down a standard of fraud in the law of letters of credit, but also set forth a standard of “a unique kind of fraud” — “letter of credit fraud”,95 a standard specially designed to fight fraud in that mercantile specialty, the letter of credit. In so doing, Revised UCC Article 5 has accepted the Task Force’s recommendations and has endorsed the approach espoused in the case of Emery-Waterhouse.
However, one aspect of the Official Comment is not entirely satisfactory: the example provided for the illustration of the meaning of the standard of fraud for standby letter of credit cases is not as typical as it might be. In the example, Ground Air Transfer v. Westates Airlines,96 Westates provided Charter One with planes and crew services for charter flights and Charter One arranged for a standby letter of credit to guarantee that Westates would not suffer harm should Charter One fail to carry out its contractual obligations. It was agreed that a copy of a ten day default notice would be provided if the letter of credit was to be called.
When a dispute arose and each party claimed that the other had broken the contract, Charter One reacted by withholding certain fees and, anticipating Westates’ draw on the letter of credit, sought a preliminary injunction to enjoin Westates’ obtaining payment under the credit. An injunction was issued by the trial court on the basis that the beneficiary would not be likely to win the underlying contract dispute with the applicant.97 But the decision was reversed by the First Circuit, because
Westates, the beneficiary, can truthfully say that it satisfied the letter of credit’s express conditions; it mailed a ten day notice to Charter One …. More importantly, since Westates has at least a “colorable” claim that it acted lawfully under the contract in doing so, Westates’ call would not fall within the traditional exception for forgery or fraud.98
Reading the facts, Ground Air Transfer was a typical case of a dispute over a simple contract, involving a possible call on a letter of credit. There was no fraud at all in the case, let alone “material fraud”. A typical example providing guidance for the understanding of “material” fraud should be one in which fraud is not only involved but also “material”.
Case Studies
Although the revision of Article 5 of the UCC was completed seven years ago, Revised UCC Article 5 has already been adopted by nearly all the States in the US, and was first applied by US courts as early as September 1997. Nonetheless, the standard of fraud set out in s 5-109 of the Article has not often been tested.99
In Western Surety Co v. Bank of Southern Oregon,100 Western Surety Company (WSC) issued performance bonds on behalf of Black Oak Construction Company (BOC) for work BOC was performing in the State of Washington. WSC also issued performance bonds for work BOC was performing in Oregon. To counter-guarantee the performance bonds, the defendant, the Bank of Southern Oregon (the Bank), opened two letters of credit in favour of WSC. The two letters of credit were essentially identical except for the serial number, the issuing date, the expiration date and the aggregate amount. When BOC defaulted on its project in Washington and the performance bonds were called, WSC presented the Bank with drafts under the letter of credit for payment. The Bank dishonoured on the basis that it believed one of the letters of credit was issued for the project in Oregon and had nothing to do with the project in Washington.
WSC brought suit against the Bank for wrongful dishonour. Because the Bank could not prove that the letter of credit was limited to a specific job, the court ruled for the plaintiff by applying the standard of “material fraud” set forth in Revised UCC Article 5, s 5-109, stating:
The relevant Oregon statute provides that an issuing bank, acting in good faith, may dishonor a draft on a letter of credit, if the presentation of the draft would facilitate a material fraud by the beneficiary.
… However, fraud, as an affirmative defense to the obligation under a letter of credit is to be narrowly construed. … Fraud is not a viable defense if the beneficiary has even a colorable claim or any basis in fact to funds from the letter of credit.101
By so ruling, although the Court claimed it was applying the standard of “material fraud” embodied in s 5-109, its position was similar to that adopted in cases of “egregious” fraud considered above.
In New Orleans Brass v. Whitney National Bank and the Louisiana Stadium and Exposition District,102 New Orleans Brass (Brass) applied for a standby letter of credit with the Whitney Bank in favour of the Louisiana Stadium and Exposition District (LSED) as a guarantee for rental payments. A dispute arose about the rental payments and LSED presented documents under the letter of credit. Brass sought an injunction to prevent the honouring of the letter of credit on the basis that the documents submitted contained false representations, and drawing on the letter of credit would cause irreparable injury, but its request was denied.
On appeal, the decision was affirmed by the Fourth Circuit because no “material fraud” as defined in Revised UCC Article 5, s 5-109, was found in the case. In reaching its conclusion, the Court applied the standard of “material fraud” set forth in Revised UCC Article 5, s 5-109, particularly as elaborated in the Official Comment, and cited the whole paragraph of Ground Air Transfer quoted above to the effect that the fraud rule can only be invoked when the demand for payment has “absolutely no basis in fact” or the beneficiary’s conduct has “so vitiated the entire transaction that the legitimate purposes of the independence of the issuer’s obligation would no longer be served”.103 By so ruling, the Court was taking a similar position to that taken in Western Surety, an approach closely resembling that in the “egregious” fraud cases.
In Mid-America Tire v. PTZ Trading Ltd Import and Export Agents,104 the dispute arose out of extensive negotiations for the purchase of Michelin tyres by Mid-America Tire (MAT) and Jenco from PTZ Trading Ltd (PTZ) through agents of PTZ, financed by a letter of credit. Throughout negotiations, PTZ’s agents made specific representations to the buyers as to the quantity, quality and price of the tyres. When the agreement was made, the quantity, quality and price of the tyres all failed to match what had been promised. The buyers sought an injunction to prevent honour and payment of the letter of credit. The trial court granted the injunction on the basis that the sellers’ agents had made material misrepresentations to the buyers.
However, the decision was reversed by the majority judgement on appeal. The appellate court first asked: “how should ‘material fraud’ … be interpreted”?105 After lengthy discussions, it answered that it “must be narrowly limited to situations of fraud in which the wrongdoing of the beneficiary has … vitiated the entire transaction” 106 and/or the demand for payment under the letter of credit “has absolutely no basis in fact”,107 taking exactly the same approach to the standard of fraud as adopted in the case of New Orleans.
However, Valen J disagreed with the majority view and stated;
By committing fraud, it is my opinion that PTZ violated its obligations of “good faith, diligence, reasonableness, and care” … [I]f the beneficiary, PTZ, fails to act in good faith in its dealings and perpetrates a fraud upon the applicant, MAT, the letter of credit may be enjoined.”108
By regarding the beneficiary’s violation of its obligation of “good faith, diligence, reasonableness and care” as the commitment of “material fraud”, Valen J seems, with respect, to have inadequately advocated “an overly broad fraud exception … material fraud under revised U.C.C. section 5-109 is explained in the official comments, and nowhere is that concept equated with the concept of ‘good faith’”.109
This short survey of cases reveals that the US courts in applying the standard of “material fraud” embodied in Revised UCC Article 5 appear to have generally taken a similar approach to the “egregious” fraud cases mentioned above. They have taken the position that the fraud rule may only be applied in limited situations where the demand for payment under the letter of credit “has absolutely no basis in fact”. This is “an unduly narrow” approach.110 However, it is more disturbing to find that some judges have interpreted the standard of “material fraud” as equivalent to a violation of the obligation of
“good faith, diligence, reasonableness, and care
”. This is close to the standard of “constructive fraud” mentioned above, and utterly inappropriate. This indicates that divergent views as to the standard of fraud may still appear in future in the US although a uniform and appropriate standard of “material fraud” has been set forth in Revised UCC Article 5, s 5-109.
The Position in the United Kingdom (English Law)
As in many jurisdictions, the fraud rule in the law of letters of credit is recognised in English law. However, there are no statutory provisions in respect of the fraud rule in the United Kingdom as in the United States, it is merely embodied in the English common law. The leading English case on the fraud rule is United City Merchants (Investments) Ltd v Royal Bank of Canada, 111 where Lord Diplock stated:
To this general statement of principle [of independence], … there is one exception: that is, where the seller, for the purpose of drawing on the credit, fraudulently presents to the confirming bank documents that contain, expressly or by implication, material representations of fact that to his knowledge are untrue. Although there does not appear among English authorities any case in which this exception has been applied, it is well established in the American cases of which the leading or “landmark” is Sztejn v J Henry Schroder Banking Corp (1941) 31 N.Y.S. 2d 631.112
This statement may be said as the concise summary of the fraud rule in English law, so it has been cited in almost all English letter of credit fraud cases ever since. It has shown that the fraud rule is recognised in England, and that Sztejn is also the “foundation stone of English law in this area”.113
Although the fraud rule has been recognised in England, English courts have been reluctant to interfere with the operation of a letter of credit. The reason has been explained by the well-known statement of Jenkins LJ of the Court of Appeal in the case of Hamzeh Malas & Sons v British Imex Industriers Ltd:114
[I]t seems to be plain enough that the opening of a confirmed letter of credit constitutes a bargain between the banker and the vendor of the goods, which imposes upon the banker an absolute obligation to pay, irrespective of any dispute there may be between the parties as to whether the goods are up to contract or not. An elaborate commercial system has been built up on the footing that bankers’ confirmed credits are of that character, and, in my judgment, it would be wrong for this court in the present case to interfere with that established practice. … That system … would break down completely if a dispute as between the vendor and the purchaser was to have the effect of “freezing,” if I may use that expression, the sum in respect of which the letter of credit was opened.115
Because English courts have normally taken this non-interference approach, it is necessary to mention some of the other issues affecting the application of the fraud rule before considering the standard of fraud. They are: (1) the standard of proof; and (2) the requirement of beneficiary fraud.
The Standard of Proof
Sticking to the general non-interference approach towards the operation of letters of credit, English courts have set up a very high standard of proof in the application of the fraud rule, requiring claimants to prove that fraud has clearly been committed in the transaction. In R D Harbottle (Mercantile) Ltd v Nat Westminister Bank Ltd, Kerr J stated: 116
Except possibly in clear cases of fraud of which the banks have notice, courts will leave the merchants to settle their disputes under the contracts by litigation or arbitration as available to them or stipulated in the contracts. … Otherwise, trust in international commerce could be irreparably damaged.117
The difficulty of meeting this standard of proof is well demonstrated by the case of Discount Records Ltd v Barclays Bank Ltd,118 where the plaintiff, an English buyer, contracted with a French company, Promodisc, to buy 8,625 discs and 825 cassettes. The buyer instructed the defendant to issue a documentary credit in favour of the seller. The seller shipped goods purporting to be those ordered and presented the draft with documents regular on their face to the confirming bank in Paris, which the bank accepted. When the goods arrived, the buyer inspected the goods in the presence of a representative of the issuer. The inspection revealed that “there were 94 cartons, but of these two were empty, five were filled with rubbish or packing, twenty-five of the records boxes and three of the cassette boxes were only partly filled, and two boxes labelled as cassettes were filled with records; instead of 825 cassettes, as ordered, there were only 518 cassettes and 25 cartridges … Out of the 518 cassettes delivered, 75 percent were not as ordered … out of the 8625 records ordered, only 275 were delivered as per order. The rest were not as ordered and were either rejects or unsaleable”. 119
Relying upon Sztejn, the buyer attempted to enjoin the issuer from honouring the seller’s drafts drawn upon the letter of credit, alleging that the seller was guilty of fraud. Megarry J of the Chancery Division rejected the buyer’s claim, distinguished the case from Sztejn and said:
[I]t is important to notice that in the Sztejn case the proceedings consisted of a motion to dismiss the formal complaint on the ground that it disclosed no cause of action. That being so, the court had to assume that the facts stated in the complaint were true. The complaint alleged fraud, and so the court was dealing with a case of established fraud. In the present case there is, of course, no established fraud, but merely an allegation of fraud. The defendants, who were not concerned with that matter, have understandably adduced no evidence on the issue of fraud. Indeed, it seems unlikely that any action to which Promodisc was not a party would contain the evidence required to resolve this issue. Accordingly, the matter has to be dealt with on the footing that this is a case in which fraud is alleged but has not been established.120
In Discount Records, the buyer obtained its evidence in the presence of a third party, the issuer, showing that a great proportion of the shipment was either rubbish or empty cartons, but it was striking to hear the court to say that there was “no established fraud, but merely an allegation of fraud”. In a case as such the plaintiff is regarded as having only produced “mere allegation of fraud”, it is not difficult to imagine how hard it is to establish fraud in English courts in a letter of credit fraud case.
Reqirement of Beneficiary Fraud
Under English law, beneficiary’s involvement or knowledge of fraud is required when applying the fraud rule. In other words, even if fraud is involved the transaction, the fraud rule cannot be applied if the fraud has been committed by somebody other than the beneficiary. This has been illustrated by the cases of United City Merchants (Investments) Ltd v Royal Bank of Canada121 and Montrod Ltd v Grundkotter Fleischvertriebs GmbH.122 As the facts of the cases are novel and the issues involved are significant to the development of the fraud rule, both of them deserve detailed treatment.
The Case of United City Merchants
United City Merchants is famous for its novel facts and its reasoning for third party fraud.123 In this case, Glass Fibres and Equipment Ltd (GFE), an English company, entered into a contract selling glass fibre making equipment to a Peruvian company named Vitrorefuerzos SA (Vitro). Payment was to be made by an irrevocable letter of credit issued by the Banco Continental SA of Peru and confirmed by the Royal Bank of Canada (RBC). GFE assigned their rights, entitlements and benefits under the letter of credit to United City Merchants (UCM). Shipment was to be from London to Callao on or before December 15, 1976. On completion of the equipment, GFE sent it to their forwarding agents, and told the forwarding agents, who in turn told a Baker, an employee of the loading brokers, the details of the requirements for the bills of lading, including the latest shipment date. The goods were nevertheless shipped on December 16, not on December 15 as required, which was discovered by RBC. When the documents were presented, they were rejected.
The plaintiffs sued for wrongful dishonour. The defendants contended that the presentation was fraudulent in that the goods were not loaded on December 15. Mocatta J of the Queen’s Bench Division found that “Mr Baker was not the plaintiffs’ agent for making out the bills of lading and that there was no fraud on the part of the plaintiffs in presenting them
”,124 relied on the principle of ex turpi causa non oritur actio, rejected the defendants’ propositions and concluded:
Where there has been personal fraud or unscrupulous conduct by the seller presenting documents under the letter of credit, it is right that a bank should be entitled to refuse payment against apparently conforming documents on the principle ex turpi causa non oritur actio. But here I have held that there was no fraud on the part of the plaintiffs, nor can I, as a matter of fact, find that they knew the date on the bills of lading to be false when they presented the documents. … Accordingly, I take the view … that the plaintiffs are … entitled to succeed. 125
The trial court’s decision was reversed on appeal. The Court of Appeal reasoned that the applicant’s mandate to the bank was only to pay against genuine documents, forged documents were not conforming and valid, and that the fact that the fraud had been committed by a third party other than the beneficiary could not prevent the bank from raising the defence of fraud against the beneficiary, therefore that the bank would be justified in refusing to pay against forged documents. Ackner LJ stated:
[T]he buyer, unless otherwise agreed, cannot be deemed to have authorised the banker to pay against documents which are known to be forged. If the documents are forged, then obviously they are not valid. The buyer’s instructions to the banker must be construed as requiring the acceptance of valid documents only….
It is the character of the document, not its origin, that must decide whether or not it is a “conforming” document, that is a document which complies with the terms of the credit. …[I]f I am correct in my view that it is the character of the document that decides whether it is a conforming document and not its origin, then it must follow that if the bank knows that a bill of lading has been fraudulently completed by a third party, it must treat that as a nonconforming document in the same way as if it knew the seller was party to the fraud.126
The Court of Appeal also considered the issues of risk allocation between innocent parties and the bank’s security interest resulting from the fraud by a third party. As for the former, Stephenson LJ observed:
Banks trust beneficiaries to present honest documents; if beneficiaries go to others (as they have to) for documents they present, it is important to all concerned that those documents should accord, not merely with the requirements of the credit but with the facts, and if they do not because of the intention of anyone concerned with them to deceive, I see good reason for the choice between two innocent parties putting the loss upon the beneficiary, not the bank or its customer.127
As for the latter, Ackner LJ stated:
A banker cannot be compelled to honour a credit unless all the conditions precedent have been performed, and he ought not to be under an obligation to accept or pay against documents which he knows to be waste paper. To hold otherwise would be to deprive the banker of that security for his advances, which is a cardinal feature of the process of financing carried out by means of the credit.128
Further, the Court of Appeal, based on the principle of strict compliance, took the view that the decision of Mocatta J had put the bank in a curious position by saying:
The latest date for shipment of the machinery was December 15, 1976. The machinery was in fact shipped on December 16, 1976, and if the bill of lading had shown that date the bank would have refused to pay upon presentation of the documents because of the strict rule that the documents must comply in every respect with the terms of the letter of credit … [I]t would be a strange rule that required a bank to refuse payment if the document correctly showed the date of shipment as December 16, yet obliged the bank to make payment if it knew the document falsely showed the date of shipment as December 15 and that the true date was December 16.129
The House of Lords overruled the decision of the Court of Appeal and restored that of Mocatta J. First, relying also upon the doctrine of ex turpi causa non oritur actio as the basis for the application of the fraud rule, Lord Diplock, who delivered the judgement of the Court,130 held that the fraud rule was not applicable in the case because the fraud was committed by a third party without the knowledge of the beneficiary by stating:
The instant case, however, does not fall within the fraud exception. Mocatta J. found the sellers to have been unaware of the inaccuracy of Mr. Baker’s notation of the date at which the goods were actually on board American Accord. They believed that it was true and that the goods had actually been loaded on or before December 15, 1976, as required by the documentary credit …
[The] proposition which does not call for knowledge on the part of the seller/beneficiary of the existence of any inaccuracy would embrace the fraud exception and render it superfluous.131
Then, Lord Diplock rejected RBC’s argument that a confirming bank was legally not obliged to pay to the beneficiary of a letter of credit against the presentation of documents, although conforming on their face with the terms of the credit, containing some statement of material fact that was not accurate, on the basis that under the provisions of the UCP the bank was obliged to pay the beneficiary when the documents tendered were on their face conforming to the terms of the credit, saying:
It has … never been disputed that as between confirming bank and issuing bank and as between issuing bank and the buyer the contractual duty of each bank under a confirmed irrevocable credit is to examine with reasonable care all documents presented in order to ascertain that they appear on their face to be in accordance with the terms and conditions of the credit, and, if they do so appear, to pay to the seller/beneficiary by whom the documents have been presented the sum stipulated by the credit, or to accept or negotiate without recourse to drawer drafts drawn by the seller/beneficiary if credit so provides. It is so stated in the latest edition of the Uniform Customs…. 132
Finally, Lord Diplock denied the Court of Appeal’s ruling that the bank was entitled to refuse to pay against forged documents regardless of the identity of the fraudster, and observed that the pre-dated bill of lading in the case was not a nullity, saying:
The Court of Appeal reached their half-way house in the instant case by starting from the premiss that a confirming bank could refuse to pay against a document that it knew to be forged, even though the seller/beneficiary had no knowledge of that fact. From this premiss they reasoned that if forgery by a third party relieves the confirming bank of liability to pay the seller/beneficiary, fraud by a third party ought to have the same consequence.
I would not wish to be taken as accepting that the premiss as to forged documents is correct, even where the fact that the document is forged deprives it of all legal effect and makes it a nullity, and so worthless to the confirming bank as security for its advances to the buyer. … I would prefer to leave open the question of the rights of an innocent seller/beneficiary against the confirming bank when a document presented by him is a nullity because unknown to him it was forged by some third party; for that question does not arise in the instant case. The bill of lading with the wrong date of loading placed on it by the carrier ‘s agent was far from being a nullity. It was a valid transferable receipt for the goods giving the holder a right to claim them at their destination, Callao, and was evidence of the terms of the contract under which they were being carried.133
Viewed in term of legal principle and commercial policy, it is, with respect, submitted that the judgment of the Court of Appeal is more convincing134 and that those of Mocatta J and the House of Lords are hard to accept for the following reasons.
First of all, the UCP provides that, in a letter of credit transaction, “all parties concerned deal with documents, and not with goods, services and/or performances to which the documents may relate”,135 and that the bank is entitled to honour its obligation when documents presented are facially conforming. It is designed to protect the bank and stops it from opening the door to scrutinise the underlying transaction, which is not within the scope of its normal business.136 However, it is not to say that the bank is obliged to pay the beneficiary or the presenter even if it knows that the documents are not telling the fact of the truth, eg, the tendered documents have been forged. Because documents are the sole concern for everybody in a letter of credit transaction, the required quality for them must be high. Documents must not only facially conforming with the terms of the credit but also be genuine and valid and reflect the true facts. The genuineness of the documents is the foundation of the success of letters of credit.137 If the documents tendered are forged or fraudulent, they are not conforming with the credit under the law of letter of credit albeit facially in compliance with the terms of the credit. It is the nature of the documents, not the identity of the fraudulent party, which matters: the fraud rule applies if the documents presented are forged or fraudulent.
This view is supported by the provisions of the UCC and the UN Convention. Under Prior UCC Article 5, s 5-114(2), the fraud rule would be applicable when “a required document is forged or fraudulent or there is fraud in the transaction” regardless of the identity of fraudulent party. Revised UCC Article 5, s 5-109, now contains a similar provision.138 Article 19(a) of the UN Convention provides that the fraud rule can be invoked if it is “manifest and clear” that “any document is not genuine or has been falsified”. That is to say, the UN Convention is also mainly concerned with the nature of the documents, not the identity of the party perpetrating the fraud.139
It is also supported by many cases both in and outside the United Kingdom. For example, in Edward Owen Engineering Ltd v Barclays Bank Int Ltd,140 Lord Denning MR said that “the bank ought not to pay under the credit if it knows the documents are forged or that the request for payment is made fraudulently in circumstances when there is no right to payment”.141 In Etablissment Esefka International Anstall v Central Bank of Nigeria,142 it was stated that:
The documents ought to be correct and valid in respect of each parcel. If that condition is broken by forged or fraudulent documents being presented — in respect of any parcel — the defendants [the bank] have a defence in point of law against being liable in respect of that parcel.143
In Old Colony Trust Co v Lawyers’ Title and Bank Trust Co,144 the Second Circuit upheld a bank’s refusal to honour a fraudulent warehouse receipt on the basis that “when the issuer of a letter of credit knows that a document, although correct in form, is, in point of fact, false or illegal, he cannot be called upon to recognise such a document as complying with the terms of a letter of credit”.145 In Sztejn, the Court stated that “the application of this doctrine [the principle of independence] presupposes that the documents accompanying the draft are genuine and conform in terms to the requirements of the letter of credit”.146
Secondly, the nature of the letter of credit transaction requires that the documents tendered must be genuine. The letter of credit is designed and developed to facilitate the underlying transaction between the applicant and the beneficiary. The documents required under the letter of credit transaction perform particular functions. In a commercial letter of credit transaction, for example, normally a commercial invoice and a set of bills of lading are required. The commercial invoice is the statement by the beneficiary of the goods shipped. The bill of lading represents the carrier’s receipt for what has been received for shipment and serves as the document of title to the shipment as well. When the applicant asks the issuer to issue the letter of credit and pay the beneficiary in exchange for the documents, it expects that the documents will be those evidencing the performance by the beneficiary of its obligations under the underlying contract. For the issuer’s part, it normally takes the documents as security when the letter of credit is issued and paid. In order to perform these functions, the central requirement for the documents is that they are genuine, evidencing the truth of the fact. Only genuine documents can meet the bargain of the parties and be accepted by bankers and applicants, whose interests otherwise will not properly be protected. Trusting that genuine documents will be tendered, the applicant authorises the issuer to pay the beneficiary, and the issuer agrees to pay the beneficiary when facially conforming documents are received; applicant and issuer agree to use the letter of credit scheme and not to go behind the documents. If documents cannot be taken to mean what they say, the commercial foundation of letters of credit will vanish.147 Although it is not explicitly stated in every letter of credit that the documents should be genuine, it is logically recognised that there is an implied warranty by the beneficiary or the presenter that documents tendered are genuine.148
Thirdly, the principle of strict compliance in the law of letters of credit requires that documents tendered for payment must be in strict compliance with the terms of the credit. “Even a minor deviation from the terms of the credit having no commercial significance disentitles the beneficiary to payment except where it falls within the limits of tolerance provided by the UCP as incorporated in the credit”.149 If the letter of credit specifies, for example, that the bill of lading must evidence shipment on or before December 15, but the bill of lading tendered shows that the goods are shipped on December 16, the bank is bound to refuse to honour the letter of credit unless the discrepancy is waived, otherwise the buyer may refuse to reimburse it on the basis that the bank has not strictly obeyed its instructions. In United City Merchants, if the bills of lading had not been fraudulently antedated or the beneficiaries had tendered one bearing the true date of loading, the bank could have simply refused to honour their presentation, citing the principle of strict compliance, and the beneficiaries would not even have had a case to argue.150 Once the documents had been fraudulently antedated, the beneficiaries could come to the court and win the case, which has prompted commentators to cry:
It is disturbing that whilst a document stating the true loading date could have been rejected by the bank in the light of the doctrine of strict compliance, a document in which the loading date was fraudulently misrepresented by its maker constituted a valid tender in the beneficiary’s hands.151
Fourthly, letters of credit are instruments employed by contractual parties to reduce and allocate their risks in the underlying transaction. Genuine and valid documents are bargained for by the applicant and the issuer, who are expected to take risks in the normal course of business, but should not legally be required to take the risk of accepting falsified documents. The beneficiary “himself has a duty to tender documents which are in order, and that fact that he acted in good faith in tendering forged documents is thus irrelevant”.152 The state of mind of the beneficiary should not affect the issue.153 However, “[t]his fundamental point appears to have been overlooked by Mocatta J [and later by the House of Lords] in The American Accord when he held that the beneficiary was entitled to collect payment despite the insertion of a fraudulent shipping date on the bill of lading, since the fraud had been committed by the loading broker who was the agent of the carrier, not the seller/beneficiary.”154
Commercial policy justifies placing the risk of loss as a result of third party fraud on the beneficiary. The decision in United City Merchants was based on the theory that the fraud was committed by a third party without the knowledge of the beneficiaries: the beneficiaries were innocent. However, in the case, all the parties directly involved in the letter of credit transaction — the applicants, the beneficiaries and the banks — were innocent; only Mr Baker was guilty of fraud. Under such circumstances, who should suffer the resulting loss? Although contractual relationships with the loading agents were not discussed in the case, the facts indicate that the beneficiaries had a closer relationship with them than the banks or the applicants. In such circumstances, it is the beneficiaries “who put [the loading broker] in the position in which he made the bill, and made it fraudulently, and … it is they … who should pay”.155
Viewed from the pubic policy for the control of fraud, third party fraud also ought to be within the scope of the fraud rule and the beneficiary ought to be the party bearing any loss resulting from third party fraud. A rule of this kind would provide an incentive for the beneficiary, who normally receives documents from third parties and then submits them for payment, to exercise more diligence over them. The alternative view makes the beneficiary’s fraud easier to conceal as the beneficiary may well claim the fraud was perpetrated by a third party other than itself. Not surprisingly, as a result of the decision of the House of Lords, it has been commented:
English law … appears to protect shrewd sellers who utilise the services of third parties discreet enough to keep their fraudulent practices to themselves. The law in effect encourages sellers not to inquire into the details of the activities of third parties involved in their transactions so long as the bills of lading appear valid, for any knowledge of wrongdoing would jeopardise the sellers’ chances of being paid. A bank which receives firm evidence external to the documents of fraud by a third party does not even have the option of refusing to honour a credit governed by English law as stated in the American Accord.156
This is obviously not an ideal result. It will and has already led English courts in the wrong direction. The recent case of Montrod Ltd v Grundkotter Fleischvertriebs GmbH157 is an example.
The Case of Montrod
The facts of the case are novel. In Montrod, Grundkötter Fleischvertriebs GmbH (GK), a German company, and Ballaris, a Russian company, entered into a contract for the sales of frozen pork. Payment was to be made by a letter of credit issued by Standard Chartered Bank in London (SCB) in favour of GK through the advice of its German bank, Commerzbank, at the request of Fibi Bank (FB), which in turn was acting on the instructions of Montrod, a finance and investment company providing letters of credit to others in international trade. The credit, which named Montrod as the applicant, was subject to UCP 500 and payable 45 days after sight on presentation of specified documents, including inspection certificates signed by Montrod.
Montrod was not the buyer in the underlying contract as in most letter of credit transactions. It had no contact at all with Ballaris, the buyer, nor with GK, the seller. It was approached to provide the credit through an entity in Singapore. In the course of negotiations, GK dealt with Ballaris on the basis that Ballaris could speak on behalf of Montrod, and it was led to understand that one of its employees, Mr Wieler, should sign the inspection certificates on behalf of Montrod. However, unknown to GK, Ballaris were in fact not entitled to speak for Montrod as to the contents of the credit. Montrod required the signed certificates as a “locking clause” to ensure that, by withholding its signature, that the credit would not be operable until it had been put in funds by Ballaris.
GK despatched the goods by means of 20 lorry shipments to Ballaris and the inspection certificates for each truck load were signed by Mr Wieler on behalf of Montrod. By 22 March 2000 six sets of documents were presented to SCB and FB and accepted. On 27 March 2000, however, Montrod informed FB that the certificates of inspection were not issued by it and no payment was to be executed. On the same day FB informed SCB that the certificates of inspection presented were forgeries. By 6 April 2000, SCB received another fourteen sets of documents, which were accepted as conforming on their face to the terms of the credit.
On 11 April 2000, Montrod applied in the High Court for: (1) a declaration that no valid certificates of inspection had been issued by Montrod capable of satisfying requirements of the credit; and (2) an injunction restraining FB and SCB from making payment under the credit. But its claims were dismissed on 19 April 2000 by Judge Steele, who found that, upon the evidence before him, Montrod failed to establish a case of fraud on the part of GK, or of notice of such fraud on the part of SCB, while acknowledging the right of Montrod to renew the application before a commercial judge if and when further evidence became available.
On 7 June SCB made payment in the light of the failure of Montrod’s application before Judge Steel and the absence of any renewed application upon the basis of such further evidence which had become available. SCB sought reimbursement from FB, and FB sought summary judgment against Montrod if it were to be found liable to SCB. So when the case was before Judge Raymond Jack of the Queen’s Bench Division,158 the beneficiary had already been paid, the issuer, SCB, was out of money, and the buyer, Ballaris had disappeared.
The action was based on the following two grounds: (1) fraud by GK was clear to SCB when it made payment; and (2) the inspection certificates purporting to be signed with the authority of Montrod were nullities and non-conforming. But both of them were rejected. As to the first argument, Judge Jack found that the inspection certificates had been signed without Montrod’s authority but that GK had not been fraudulent, saying:
I am satisfied for reasons to which I will come that Grundkotter did not know at least until Montrod had served the witness statement of Mr Hoory dated 10 April 2000 that it had no authority from Montrod to sign the inspection certificates on Montrod’s behalf. Grundkotter had believed that it had that authority. Until then it had no knowledge of the actions and intentions of Montrod other than as appeared from the credit itself…. Grundkotter have not acted dishonestly. …
It follows that Montrod and Fibi Bank have fallen far short of establishing that there was clear evidence of fraud before Standard Chartered either when the documents were presented or when it paid. Subject to the nullity argument, Standard Chartered is therefore entitled to be reimbursed by Fibi Bank.159
As to the second point, Judge Jack found that the so-called “nullity exception” was not an exception recognised by English law to stop payment of a letter of credit when documents presented are conforming “on their face” with the terms of the credit. After citing the full passage of Lord Diplock in the case of United City Merchants as quoted above,160 he stated:
This is very slender support for the submission that there exists in parallel with the fraud exception a second exception covering documents which are nullities to the knowledge of the bank at time of payment though the beneficiary is innocent of any deception. There is, in my view, no other support that has been found in the reported cases.161
He further cited a number of articles of UCP 500 and observed that such an exception was not supported by the terms of the UCP by saying:
The one established exception is the fraud exception. So the comparison between the Articles cannot support the argument of Fibi Bank and Montrod for a second exception limited to nullity.
In my judgment the “nullity exception” should and does form no part of English law. It is unsupported by authority. It provides a further complication where simplicity and clarity are needed. There are problems in defining when a document is a nullity. The exception could have unfortunate consequences in relation to the rights of third parties.162
On appeal, Judge Jack’s finding that GK was innocent of fraud was not challenged. The appeal was focused on the so-called “nullity exception”, but it was dismissed by the Court of Appeal. First, in the view of the Court, the documents presented in the case were on their face complying with the terms of the letter of credit, so the issuer was obliged to pay the beneficiary in accordance with the provisions of UCP 500. Following the consideration of several articles from the UCP, Potter LJ observed:
The combination of the autonomy principle and the rule that the banks concerned deal in documents and not in goods (arts 3 and 4), together with the issuing bank’s undertaking of payment if the stipulated documents presented conform with the terms of the credit (see art 9) plainly entitled GK as beneficiary to obtain, and obliged SCB as issuing bank to make, payment against the documents presented, provided that they complied “on their face” with the requirements of the credit (see arts 13a, 14a, 14b and 14c). It has not been, and plainly could not be, argued on this appeal that the documents presented and, in particular, the inspection certificates were other than compliant on their face with the requirements of the credit. Leaving aside for a moment the exception of fraud on the part of the beneficiary (which the judge held not to exist) the liability of SCB to make payment under the UCP 500 terms is clear.163
Then, after considering some English cases, in particular, the case of United City Merchants, the Court of Appeal rejected the argument that a document conforming on its face with the terms of the credit was none the less of a character which disentitled the person making the demand to payment because it was fraudulent in itself independently of the knowledge and bona fides of the demanding party. Potter LJ stated:
The fraud exception to the autonomy principle recognised in English law has hitherto been restricted to, and it is in my view desirable that it should remain based upon, the fraud or knowledge of fraud on the part of the beneficiary or other party seeking payment under and in accordance with the terms of the letter of credit. It should not be avoided or extended by the argument that a document presented, which conforms on its face with the terms of the letter of the credit, is none the less of a character which disentitles the person making the demand to payment because it is fraudulent in itself, independently of the knowledge and bona fides of the demanding party. In my view, that is the clear import of Lord Diplock’s observations … While he left open the position in relation to a forged document where the effect of the forgery was to render the document a “nullity”, there is nothing to suggest that he would have recognised any nullity exception as extending to a document which was not forged (ie fraudulently produced) but was signed by the creator in honest error as to his authority; nor do I consider that such an exception should be recognised.164
In Montrod, the focus was the so-called “nullity exception”, but the facts of the case have shown that fraud was involved in the case: the fraudster was Ballaris. As Ballaris was neither the applicant nor the beneficiary of the letter of credit, it was a third party who was outside the credit transaction. Therefore, similarly to United City Merchants, Montrod is a case of third party fraud. However, due to the result of United City Merchants, the claimants had to formulate their arguments in such a novel way.
Montrod is legally the progeny of United City Merchants, but it has further narrowed the chances for the application of the fraud rule in the United Kingdom. In United City Merchants, the document was forged by a fraudulent employee of the loading brokers without the knowledge of the beneficiary, while in Montrod the forged document was the work of the innocent beneficiary itself, who was led to misunderstand the true situation by a fraudulent buyer. The combined effect of the two cases seems to be that now in the United Kingdom if the beneficiary or the party demanding payment in good faith presents documents which are on their face in compliance with the terms of the letter of credit but a forgery, the fraud rule will not apply, even though the forgery has been produced by the beneficiary itself provided the beneficiary does not realise they are producing a document that is forged or otherwise materially misrepresents the true state of affairs.
Based on the facts of Montrod, the decisions by Judge Jack and the Court of Appeal are supportable on the ground that the fraud rule could not be applied in the case because payment had already been made on 6 June 2000, well before the decision was made by either Judge Jack or the Court of Appeal. The paying bank is entitled to reimbursement when the documents tendered are on their face in compliance with the terms of the letter of credit even though there are allegations that fraud has been involved in the transaction. When payment has already been made, the fraud rule or the party who has committed fraud is irrelevant to the bank’s claim for reimbursement. What cannot be supported is the basis on which Judge Jack and the Court of Appeal denied the claim or the appeal of the applicant for the “nullity” argument.
In order to protect banks from being entangled in disputes between the parties to the underlying transaction, the UCP entitles them to pay against facially conforming documents and “assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any document … or for the good faith or acts or omissions, solvency, performance or standing of … any other person whomsoever”.165 But the notion that the UCP also entitles beneficiaries to payment by presenting documents that are on their face conforming to the letter of credit but are in fact forgeries is incorrect.166 If this becomes the prevailing view or the law of letters of credit, the commercial utility of the letter of credit will be in doubt. The Court of Appeal took the view that recognising the “nullity exception” or third party fraud would unfairly jeopardise the interest of the beneficiary, saying:
[T]here are sound policy reasons for not extending the law by creation of a general nullity exception…. [S]uch an exception would be likely to act unfairly upon beneficiaries participating in a chain of contracts in cases where their good faith is not in question. Such a development would thus undermine the system of financing international trade by means of documentary credits.167
However, allowing forged documents to trigger payment under a letter of credit poses “an equally serious potential threat to the commercial utility of letter of credit”.168 The prevalence of the letter of credit lies in the fact that it can provide a fair balance of competing interests among the parties involved. The normal operation of the letter of credit not only provides the beneficiary with safe and rapid access to the purchase price or a sum of money when the applicant defaults, but also provides the applicant with credit and/or other commercial benefits and protects the applicant against improper calls on the credit by requiring the beneficiary to present genuine documents indicating that it has properly performed its obligations under the underlying transaction. If forged or fraudulent documents are allowed to trigger payment, the balance assumed in the letter of credit scheme will be undermined. Like the success of any commercial vehicle, the popularity of the letter of credit is based on the faith of its users. As put by Professor Kozolchyk:
The certainty of payment of a letter of credit is crucial for those who, as beneficiaries, supply their goods or services to applicants. … Yet what about the applicant? To leave the applicant without a remedy against fraud would equally frustrate the applicant’s expectations of the letter of credit. After all, why should a good faith applicant agree to procure the issuance of a letter of credit and reimburse the issuing bank if the letter of credit becomes an automatic and unstoppable vehicle for the perpetration of fraud? As is true with other commercial legal situations, an approach that favours one party at the expense of the other undermines the viability of the institution.169
As already stated, whether the fraud rule will be applied or not depends upon the nature of the document tendered, not upon the identity of the fraudulent party. Documents tendered under a letter of credit should not only conform on their face with the terms of the credit but also should be genuine and mean what they should mean. If the documents tendered are forged or fraudulent, although they are on their face complying with the terms of the credit, the fraud rule should apply, no matter by whom and in what circumstances they are produced.
In Montrod, it is not clear from the reports whether Commerzbank had paid the beneficiary before presenting to SCB; if it had, the fraud rule could not be invoked at all in the case, even before the issuer paid Commerzbank or when the case was before Judge Steel. However, if Commerzbank had not paid the beneficiary or had not become a real negotiation bank, it is submitted that the fraud rule should have been applied or an injunction should have been issued by Judge Steel.
As in United City Merchants, commercial policy justifies placing the risk of loss as a result of third party fraud on the beneficiary in the instant case. In Montrod, all the parties directly involved in the letter of credit transaction — the applicants, the beneficiaries and the banks — were innocent; only Ballaris was guilty of fraud. Who should suffer the resulting loss? The applicant, Montrod, had no direct contact at all with Ballaris. It was the beneficiary, the seller, who had a contractual relationship with it. Therefore, it is the beneficiaries who put Ballaris in the position to make the error they did, and it is the beneficiaries who should therefore bear the loss.
Material Misrepresentation
All these cases have demonstrated that there are great difficulties in coming within the fraud exception to the autonomy of credits in the United Kingdom. When no fraud is found to have been committed in a transaction, there is no need for a court to consider the standard of fraud relating to the application of the fraud rule. Since there have been only a limited number of cases in which the fraud rule has been applied, the discussion of what kind of fraud can invoke the fraud rule has also appeared just in a few cases.
In the case of United City Merchants, when considering the issue of third party fraud and rejecting the defendants’ claim, Lord Diplock touched on the issue of standard of fraud. The passage has already quoted above, that is:
To this general statement of principle [of independence] as to the contractual obligations of the confirming bank to the seller, there is one exception: that is, where the seller, for the purpose of drawing on the credit, fraudulently presents to the confirming bank documents that contain, expressly or by implication, material representations of fact that to his knowledge are untrue.170
According to Lord Diplock, material misrepresentation is the kind of fraud that can invoke the fraud rule under the English law. Jack, writing as a scholar rather than a judge, has interpreted material misrepresentation as follows. The word misrepresentation “is very close to a statement of the elements of fraudulent misrepresentation which constitute the tort of deceit”.171 The tort of deceit contains the following elements: “(1) knowing the representation to be false; (2) without belief in its truth; or (3) recklessly, careless whether it be true or false”.172 The word “material” means “material to the bank’s duty to pay, so that if the document stated the truth the bank would be obliged to reject the documents”,173 which is close to the interpretation of material fraud in Official Comment on Revised UCC Article 5, s 5-109 in the United States. However, Jack’s interpretation seems to be at odds with Lord Diplock’s own words:
[T]he answer to the question: “to what must the misstatement in the documents be material?” should be: “material to the price which the goods to which the documents relate would fetch on sale if, failing reimbursement by the buyer, the bank should be driven to realise its security.” But this would not justify the confirming bank’s refusal to honour the credit in the instant case; the realisable value on arrival at Callao of a glass fibre manufacturing plant made to the specification of the buyers could not be in any affected by having been loaded on board a ship at Felixstowe on December 16, instead of December 15, 1976.174
In accordance with Lord Diplock, the misrepresentation should be “material” to the real value of the goods. Predating the bill of lading in the case was not considered material because it did not affect the value of the goods. But according to Jack’s scholar’s interpretation, predating the bill of lading should be considered material because the bank would have been obliged to reject the documents if the bill of lading had stated the truth of the loading date. It is, with respect, submitted that Jack’s interpretation is a far better statement of principle (though not an accurate interpretation of Lord Diplock’s judgment) and Lord Diplock’s observation is out of step with the wider law and practice of letters of credit.
Lord Diplock’s observation in United City Merchants that material misrepresentation is the kind of fraud that can invoke the fraud rule has been accepted by subsequent English cases. In Themehelp Ltd v. West,175 the Court of Appeal followed the words of Lord Diplock quoted with respect to the standard of fraud and affirmed the trial court’s decision.
In Banco Santander SA v. Bayfern Ltd, 176 the confirmer discounted the obligation of a deferred payment letter of credit before its maturity. Shortly after the discounting, some of the documents presented were found to be fraudulent. Subsequently, the issuer refused to pay the confirmer. The confirmer brought the action against the issuer in the Queen’s Bench Division for reimbursement and sought summary judgment, claiming it should be immune from the fraud rule despite fraud. For trial of preliminary issues, fraud was assumed to have been established in the case. The trial court ruled for the issuer on the basis of established fraud. On appeal, the decision was upheld by the Court of Appeal. Both courts cited with approval Lord Diplock’s above passage relating to the standard of fraud.
“Material misrepresentation” thus appears to have been settled as the standard of fraud in the English law governing letters of credit. In language, the English position is close to that of the US in Revised UCC Article 5, s 5-109: “material fraud”. As both of them have not been sufficiently tested, it is too early to make a reasonable comparison. However, if a comparison has to be made, the difference between the two appears to be that the US position is enshrined in a statute, but English position is embodied in the common law. This may mean that courts in the US will “look more on the severity of the effect of the fraud on the transaction rather than the state of fraud of the beneficiary”,177 whilst English courts, at least if Jack be correct, will require proof of the state of the mind of the fraudster.
The Position in Canada
Canadian courts have generally focused on the standard of proof rather than the standard of fraud in their application of the fraud rule. When considering the kind of fraud that can invoke the fraud rule, Canadian courts, like their English counterparts, are likely to ask whether “clear or obvious” fraud or “a strong prima facie case of fraud” has been shown, not how serious the fraud was in the sense of the standard of fraud being discussed here. Canadian courts have also considered whether the application of the fraud rule should be confined to cases of forged or fraudulent documents or extend to fraud in the underlying transaction. This is well illustrated by the case of Bank of Nova Scotia v. Angelica-Whitewear Ltd.178
In Angelica-Whitewear, the court considered four issues with respect to the application of the fraud rule, but the standard of fraud under discussion was not among them. When the court was considering the alleged fraud in the case, that is, the inflation of the prices in the invoice by some $17.00 per dozen above those agreed to in the sales contract, it was not interested in how serious the fraud was, but whether the fraud (1) had been “sufficiently established to the knowledge of the Bank before payment of the draft to make it clear or obvious to the Bank”,179 and (2) could “be regarded as having made invoice 0014 a false document in so far as its representation of the applicable prices was concerned, or whether it be regarded as fraud in the performance of the underlying sales contract”.180 The court put the question simply, was this “fraud of the kind that comes within the fraud exception”,181 which seems to indicate that fraud is a simple concept, the meaning of which is known by everybody in Canada.
Due to the general approach of the Canadian courts towards the standard of fraud, the issue, even when it is mentioned in a Canadian case, has normally been addressed in a very simple way. For example, in CND Research & Development Ltd v. Bank of Nova Scotia,182 when issuing an injunction restraining the issuer from paying the demand, Galligan J stated:
It is my opinion, in this case, an injunction ought to be granted. In my view, it ought to be granted for at least two reasons. The first is that the plaintiff has made out a strong prima facie case that the demand made by the agent of the Ministry of War is fraudulent. Delivery has clearly been made and claim for a payment of a delivery guarantee necessarily implying that delivery was not made is clearly untrue and false.183
However, this issue has been said to have been “dealt with in some depth”184 in the case of Cineplex Odeon Corp v. 100 Bloor West General Partner Inc.185 In Cineplex, a limited partnership was formed to develop a multifunctional complex. The parties had entered into a number of agreements, according to which the plaintiff, Cineplex, provided a letter of credit to secure its obligations under certain agreements. Cineplex defaulted in its obligation to build the project, and the letter of credit was called upon. The plaintiff moved to enjoin payment, claiming that it was not in default in the obligation that the letter of credit was meant to guarantee, any draw by the defendants would be fraudulent and thus the fraud rule should be applied. After reviewing the facts and the principle of independence, before dismissing the plaintiff’s motion, Blair J pointed out:
I pause at this point to note, in passing, a factor which occasionally seems to be lost amidst the melee in these sorts of disputes, disputes which more and more are finding their way to the courts in times of economic stress: the exception is “fraud”, not something less than fraud. 186
Then he went on:
In the eyes of the party seeking to prevent payment on the letter of credit, almost any conduct or position of the beneficiary which does not accord with the aggrieved party’s view of the universe may appear to be fraud, and therefore justify non-payment. Such, of course, cannot be the case, given the recognized characteristics of a letter of credit. …
Fraud is a straightforward five-letter word, meaning just what it says: “fraud”. Fraud is not simply a legitimate dispute or disagreement over the interpretation of a contract, however one- sided that dispute may appear. While the notion of fraud may elude precise definition, it is a concept well-known to the law, and it must, in my view, import some aspect of impropriety, dishonesty or deceit.
In Washburn v. Wright (1913), 31 O.L.R. 138 (App. Div.), Mr. Justice Riddell said, at p. 147:
…. Fraud is not mistake, error in interpreting a contract; fraud is “something dishonest and morally wrong, and much mischief is … done, as well as much unnecessary pain inflicted, by its use where ‘illegality’ and ‘illegal’ are the really appropriate expressions:” Ex p. Watson (1888), 21 Q.B.D. 301, per Wills, J., at p. 309.
Cases where the demand on the letter of credit can be said to be “clearly untrue or false”, or “utterly without justification”, or where it is apparent there is “no right to payment”, all fall within the foregoing principles and must be read in the context of those “fraud” principles.187
If this can be taken as a summary or generalisation of the Canadian position on the standard of fraud, the Canadian position is somewhat confusing or contradictory. As can be seen, the quoted passage, on one hand, is saying that fraud in Canada means something of “dishonesty” or “deceit”, or “clearly untrue or false”, which is similar to common law fraud, requiring the intention of the fraudulent party. But on the other hand, it is saying that a call on the letter of credit that is “utterly without justification” or “where it is apparent there is ‘no right to payment’” can also mean fraud in Canada, which is similar to the American position, looking more to the sharpness of the fraudulent conduct. However, this may be the true reflection of the Canadian position: on one hand, being a country of English tradition, understandably the Canadian courts traditionally follow the approach of their English counterparts closely, adopting the standard of common law fraud; on the other hand, the influence of the US position in the area of letter of credit law, can be seen in everywhere in the world, and at least some of the Canadian courts, are also closely following the US approach on these issues.
The Position in Australia
In Australia, in the small number of cases that have considered the fraud rule, two kinds of standard of fraud have been suggested: intentional fraud and gross equitable fraud.
Intentional Fraud
The standard of intentional fraud was set forth in the case of Contronic Distributors Pty Ltd (Receiver & Manager Appointed) v. Bank of New South Wales.188 In the case, Contronic wished to purchase semi-conductors from GEC, to whom it was already indebted for earlier dealings. It suggested the use of a letter of credit, which would cover both the existing indebtedness and the purchase price of the goods that it wished to purchase. Contronic’s business had been financed from time to time by Balfour, which granted credit facilities to Contronic by way of applying for letters of credit from the Bank of New South Wales in favour of the suppliers. This transaction was also financed by Balfour in the same way, but the financier did not know the letter of credit would also cover the earlier debt. When the financier discovered the true state of affairs, it brought proceedings to restrain the bank from paying against the letter of credit, and GEC from presenting the documents. The Supreme Court of New South Wales granted the injunction. When issuing the injunction, Helsham J of the Court said:
It seems to me that the case could be decided on a simple basis of fraud. I think it is sufficient to enable … Balfour …, in any event to get relief in these proceedings, to establish an intention to obtain money by deceit on the part of GEC at the time that the letter of credit is to be presented by it for payment. GEC would then be obtaining money by the use of documents it knows to be false and which were brought into being by it with its connivance.189
Gross Equitable Fraud
The standard of gross equitable fraud was suggested in Hortico (Australia) Pty Ltd v. Energy Equipment Co (Australia) Pty Ltd,190 where Energy Australia had a contract with Hortico for the design, supply and installation of a boiler. Hortico arranged for the issuance of a bank guarantee in favour of Energy Australia. Later the contract was terminated by both parties and Energy Australia made a demand on the guarantee for damages. Hortico brought the action to enjoin the payment under the guarantee, alleging inter alia that the guarantee was contemplated only to be security for the performance of the contract by the plaintiff and not also for damages as the defendant claimed.
The plaintiff’s argument was dismissed by Young J of the Supreme Court of New South Wales. However, the respected judge said in obiter:
[W]ith commercial transactions such as the present, the courts have consistently taken a “hands off’ approach, and it does not seem to me that anything short of actual fraud would warrant this Court in intervening, though it may be in some cases (not this one), the unconscionable conduct may be so gross as to lead to exercise of the discretionary power.191
The view that gross equitable fraud might invoke the fraud rule was restated some ten years later by the same judge in the case of Inflatable Toy Co v. State Bank of NSW.192 In Inflatable, the plaintiff, the buyer, ordered from the seller inflatable plastic toys to be delivered in instalments and paid for by letters of credit. For one instalment, some discrepancies appeared between the documentation and the facts. The buyer accepted the discrepancies when the seller told it what had happened, but changed its mind later and brought an action to prevent the issuer from paying the accepted bill of exchange, alleging that the seller was guilty of fraud in presenting documents which it knew to be untrue. Young J rejected the buyer’s claim. But again as a passing dictum, after citing Sztejn, Hortico and other cases relating to the fraud rule, he stated, “I should note, in case what I said is read later too widely, that is still wise to keep open the possibility that unconscionable conduct may be an exception”.193
However, the idea that gross equitable fraud may invoke the fraud rule was rejected by Batt J of the Supreme Court of Victoria in Olex Focas Pty Ltd v. Skodaexport Co.194 In that case Olex Focas entered into a contract with Skodaexport for the supply and installation of telecommunications, telesupervisory and instrumentation systems in connection with the construction of an oil pipeline in India. Skodaexport was the head-contractor for the project, and Olex was one of the subcontractors engaged by Skodaexport.
Skodaexport agreed to pay Olex what were termed mobilisation/procurement advances for 15 percent of the contract price. As security for the repayment of the advances, Olex was required to provide independent guarantees to Skodaexport, known as mobilisation/procurement guarantees (mobilisation guarantees). In addition, Olex was required to provide another type of guarantee, known as performance guarantees, for 10 percent of the contract price, to secure the good performance of its obligations under the underlying contract. All the guarantees were payable “at sight forthwith on first demand … without protest or demur or proof”.195 Skodaexport was allowed to call upon part of the guarantees.
When disputes arose, Skodaexport allegedly threatened to call upon the full amount of the guarantees unless Olex would accept its terms for the settlement of the disputes.196 By this time, the advances secured by the mobilisation guarantees had largely been repaid. The plaintiffs also claimed that collectively 95% of the equipment had been supplied and 78% of the design, construction, integration and commissioning services had been provided. Olex sought interlocutory injunctions to prevent the independent guarantees from being paid on two grounds: (1) that Skodaexport, by threatening to make demand on the guarantees, was acting fraudulently, without a belief that it was entitled to the sums secured by the guarantees; and (2) that Skodaexport, by threatening to call up the guarantees, was committing unconscionable conduct within the meaning of s 51AA of the Trade Practices Act 1974.
Batt J, when considering the plaintiff’s first basis, followed the traditional line of English cases requiring a high standard of proof and, at the beginning of his analysis, stated:
Now in Victoria, as in England, the law is clear. The principle is clearly established that payment by a bank and a demand therefor by a beneficiary under an unconditional performance bond or guarantee, as under a confirmed irrevocable letter of credit, will not be restrained except in a clear case of fraud, of which the bank is clearly aware at the time of, probably, the proposed payment, or in the case of forgery of documents (which is probably applicable only to letters of credit) or, perhaps, in the case of illegality of the underlying contract197
Then the learned judge considered a number of English and Australian cases, cited long quotations from them to the effect that only clear fraud could activate the fraud rule198 and rejected the plaintiffs’ request for injunction on the basis of fraud. When considering the point espoused by Young J in Hortico that gross equitable fraud might invoke the fraud rule, the judge said:
In my view his Honour was speaking in very guarded terms, prefacing his mention of that concept by reference to the general “hands-off” approach taken by courts with respect to commercial transactions. … I would not with respect, having regard to all the other cases I have cited, treat gross unconscionability falling short of actual fraud as a ground for an injunction.199
Therefore, in Australia to date, while two kinds of misconduct that may invoke the fraud rule have been suggested, only “intentional fraud” has been applied. As for gross equitable fraud, it has been mentioned twice by the same judge in obiter in the Supreme Court of New South Wales, but has not been applied in any case. Moreover, it has been rejected by the Supreme Court of Victoria. Whether the standard of gross equitable fraud can become a real ground for the application of the fraud rule in Australia remains to be seen.
The Position under the UN Convention
The United Nations Convention on Independent Guarantees and Standby Letters of Credit (UN Convention) has taken a different approach to fraud from that of Revised UCC Article 5. While the latter has provided a general standard of fraud for the application of the fraud rule — material fraud — the former has avoided “terms ‘fraud’ and ‘abuse of right’”200 and adumbrated in Article 19 three substantive grounds to invoke the fraud rule:
- Any document is not genuine or has been falsified;
- No payment is due on the basis asserted in the demand and the supporting documents; or
- Judging by the type and purpose of the undertaking, the demand has no conceivable basis.
As for demands that have “no conceivable basis”, Article 19(2) of the Convention further refined this as follows:
- The contingency or risk against which the undertaking was designed to secure the beneficiary has undoubtedly not materialised;
- The undertaking obligation of the principal/applicant has been declared invalid by a court or arbitral tribunal, unless the undertaking indicates that such contingency falls within the risk to be covered by the undertaking;
- The underlying obligation has undoubtedly been fulfilled to the satisfaction of the beneficiary;
- Fulfilment of the underlying obligation has clearly been prevented by wilful misconduct of the beneficiary; or
- In the case of a demand under a counter-guarantee, the beneficiary of the counter-guarantee has made payment in bad faith as guarantor/issuer of the undertaking to which the counter-guarantee relates.
This list may not be exhaustive, but it is an impressive and encouraging way in which to define the kind of misconduct that may invoke the fraud rule. It undoubtedly stands as the most detailed provision so far with respect to clarification of the misconduct that may bring the fraud rule into play. These provisions are “clear and narrow in scope and provide an excellent international standard”.201 They will undoubtedly provide good guidance for courts to enhance their application of the fraud rule.
While the Convention requires “manifest and clear” evidence to invoke the fraud rule, it does not mention that the wrongdoer’s intention should be proven. Reading the text, the Convention, like Revised UCC Article 5, seems to emphasise more the nature of the misconduct rather than the fraudster’s state of mind. However, having rules is one thing, properly implementing them is another, because implementation of the rules is in the hands of individual courts. As courts may still apply the standard of proof of some English judgments, the real value of these rules remains to be seen.
Conclusion
The fraud rule is “the most controversial and confused area”202 in the law governing letters of credit, mainly because the standard of fraud is hard to define. The divergent views expressed by courts and commentators with respect to the essence of the standard of fraud reflect the tension between two different policy considerations:
the importance to international commerce of maintaining the principle of the autonomy of documentary credits …; and the importance of discouraging or suppressing fraud in the letter of credit transaction.203
On the one hand, if fraud is defined too widely or the standard of fraud is set too low, the fraud rule may be abused by an applicant who does not want the issuer to pay the credit simply because it will not profit from the underlying transaction. If obstruction of payment of a letter of credit is permitted too often, business confidence in letters of credit as effective performance assurances will be destroyed.204
On the other hand, if fraud is defined too narrowly or the standard of fraud is set too high, the effectiveness of the fraud rule will be compromised. A very rigid standard of fraud may encourage the growth of fraudulent conduct by beneficiaries, discourage the use of letters of credit by applicants and ultimately harm the commercial utility of letters of credit.205
A proper standard of fraud therefore should be one reflecting a sensible compromise between the competing interests. Legally, it should serve the purpose of the fraud rule and be workable for the courts. Commercially, it should facilitate the utility of letters of credit. Based on these considerations, extreme concepts or standards of fraud, such as egregious fraud, which may be too rigid, and constructive fraud, which may lead to the fraud rule being abused, should be avoided, and a proper and practical standard of fraud should be adopted.
A combination of the provisions of Revised UCC Article 5, s 5-109, and those of Article 19 of the UN Convention, provides the best solution, yet devised, to defining the limits of the fraud exception. Under Revised UCC Article 5, s 5-109, “material fraud” may invoke the fraud rule. As considered above, the standard of material fraud has not only avoided extreme ideas such as egregious fraud and constructive fraud but also has reflected the unique nature of letters of credit. However, because “material” is a general term, the implementation of the standard of material fraud provided in Article 5 remains uncertain despite some guidance provided by the case law, because different courts may interpret it divergently, as they have interpreted Sztejn. However, this uncertainty may to some extent be reduced by recourse to the provisions of Article 19 of the UN Convention, where a detailed list of the types of misconduct that constitute material fraud has been adumbrated. The misconduct listed in the Convention provides substantial practical guidance to courts and letter of credit users. Accordingly, if the fraud rule can be formulated in a way that combines the standard of material fraud embodied in s 5-109, as a general standard, with the provisions of Article 19 of the UN Convention as detailed examples, the predicability of the rule will be greatly enhanced.
The best place for the fraud rule to be so formulated is in the terms of the Uniform Customs and Practice for Documentary Credits206 — the influential rules for letters of credit that are incorporated by reference into virtually all credits issued worldwide. The publisher of the UCP, the International Chamber of Commerce, is the most qualified body to prescribe the fraud rule as it has the greatest expertise in letters of credit matters.207
As the UCP is, in form, merely a set of contractual terms whatever provisions it might include regarding fraud would be subordinate to local law on the issue.208 However, there is no reason to expect that courts would not give to UCP provisions on fraud the same weight they have given to its other provisions. After all the UCP prescribes the doctrine of autonomy209 so why should it not also prescribe the exception and limits to the doctrine?
It is hoped that in the next revision of the UCP, the revision committee chooses to deal with the issue of fraud, and in doing so takes its lead from the UCC and the UN Convention. If the UCP embraces the law on fraud as set forth in Section 5-109 of the UCC, as amplified by the definition of fraud from Article 19 of the UN Convention, the result will be a highly workable jurisprudence that will serve to enhance the commercial utility of letters of credit and limit their use to perpetrate fraud.
Footnotes
# An earlier version of this article was published in the Duke Journal of Comparative & International Law Vol 13 (Spring 2003) 293. This version is substantially revised and expanded. Our thanks to the anonymous referees for the Oxford University Comparative Law Forum whose comments so assisted in that process. All responsibility is ours.
* Judge, the Supreme People’s Court of the People’s Republic of China; Senior Fellow, Tim Fischer Centre for Global Trade and Finance, Bond University, Australia.
** Professor and Executive Director, Tim Fischer Centre for Global Trade and Finance, Bond University, Australia. Our thanks to our able research assistant, James Walsh, for his assistance with the footnotes.
1 The policy tension behind the fraud rule was well expressed by Le Dain J in the leading Canadian case of Bank of Nova Scotia v. Angelica-Whitewear Ltd, 36 DLR 4th 161 (Can. Sup. Ct. 1987), in these terms:
The potential scope of the fraud exception must not be a means of creating serious uncertainty and lack of confidence in the operation of letter of credit transactions; at the same time the application of the principle of autonomy must not serve to encourage or facilitate fraud in such transactions. (at 168)
2 G T McLaughlin, ‘Letters Of Credit and Illegal Contracts: The Limits of the Independence Principle’, 49 Ohio State L J 1197, 1203 (1989).
3 McLaughlin, id. For example, in a commercial letter of credit transaction, “[i]t is not always easy to determine whether an alleged discrepancy between the description of the goods in the documents and their actual nature is indicative of a fraud. Unless there is a blatant fraud, the banker cannot assert the deficiency of the goods against the seller.” Anthony G. Guest, Benjamin’s Sale of Goods 1716 (5th ed. 1997).
4 G A Fellinger, ‘Letters of Credit: The Autonomy Principle and the Fraud Exception’, 1 J Banking & Finance L & Practice 4, 22 (1990).
5 The terms of The Uniform Customs and Practice for Documentary Credits (ICC Publication No. 500, 1994) are not addressed as they are silent on the issue of fraud.
6 The Uniform Commercial Code (“UCC”) is a collection of model statutes drafted and recommended by the National Conference of Commissioners of Uniform State Laws and the American Law Institute for enactment by the legislatures of the states of the United States. It consists of 11 different Articles, each covering a different aspect of commercial law. Article 5 of the UCC is a uniform statutory scheme governing letters of credit. It was first drafted in the 1950s (“Prior UCC Article 5”) and thoroughly revised in 1995 (“Revised UCC Article 5”). The Revised UCC Article 5 has been adopted by most of the jurisdictions in the US. For a list of the jurisdictions that have adopted Revised UCC Article 5, see UCC Article 5 – Letters of Credit at .
7 31 N.Y.S.2d 631 (1941). For detailed discussion of the case, see infra notes 17– 27 and accompanying text.
8 146 N.E. 636 (1925).
9 Id. at 639.
10 Ibid.
11 Id. at 641.
12 Fellinger has suggested that “Justice Cardozo’s dissenting opinion … envisions a scenario where there is a total lack of consideration in the underlying sales contract”. Fellinger, supra note 4, at 11. See also Graham & Benjamin Geva, ‘Standby Credits in Canada’, 9 Canadian Business L J 180, 197 (1984).
13 Phillip W. Thayer, ‘Irrevocable Credits in International Commerce: Their Legal Effects’, 36 Columbia L Rev 1327, 1336 (1936).
14 M C Campbell, Guaranties and Suretyship Aspects of Letters of Credit, 85 U Pennsylvania L Rev 261, 275 (1937).
15 E L Symons, Letter of Credit: Fraud Good Faith and the Basis for Injunctive Relief, 54 Tulane L Rev 338, 340 (1980).
16 (1941) 31 NYS 2d 631, 633.
17 Ibid.
18 Id, 634. Emphasis added, citations omitted.
19 Ibid. Emphasis added.
20 Symons, supra note 15, at 361.
21 Fellinger, supra note 4, at 12; Henry Harfield, ‘Enjoining Letter of Credit Transactions’, 95 Business L J 596, 603 (1978).
22 H A Getz, ‘Enjoining the International Standby Letter of Credit: The Iranian Letter of Credit Cases’, 21 Harvard Int’l L J 189, 206 (1980).
23 M Megrah, ‘Risk Aspects of the Irrevocable Documentary Credit’, 24 Arizona L Rev 255, 258 (1982).
24 35 N.Y.S.2d 985 (1942).
25 J F Dolan, The Law Of Letters Of Credit: Commercial And Standby Credits 7-45 (rev ed. 1996); Symons, supra note 15, at 362 et seq.
26 Supra note 24, at 988-989. Citations omitted, emphasis added. It should be noted that Sztejn was among the authorities mentioned by the judge.
27 Prior UCC Article 5, ss 5-114(1) and 5-114(3), emphasised the principle of independence and the issuer’s entitlement for reimbursement after honour, reading respectively:
(1) An issuer must honor a draft or demand for payment which complies with the terms of the relevant credit regardless of whether the goods or documents conform to the underlying contract for sale or other contract between the customer and the beneficiary. The issuer is not excused from honor of such a draft or demand by reason of an additional general term that all documents must be satisfactory to the issuer, but an issuer may require that specified documents must be satisfactory to it.
(3) Unless otherwise agreed an issuer which has duly honored a draft or demand for payment is entitled to immediate reimbursement of any payment made under the credit and to be put in effectively available funds not later than the day before maturity of any acceptance made under the credit.
28 West Virginia Housing Development Fund v. Sroka, 415 F. Supp. 1107, 1114 (1976). But cf, Symons, supra note 15, at 340: “A careful review of Sztejn and other pre-Code cases, the wording and cross references in section 5-114, and the pervasive standard of good faith in the UCC — defined in section 1-201(19) as ‘honesty in fact’ — reveal that the middle ground standard, intentional fraud, is the proper interpretation of the pre-Code cases and the UCC”.
29 Symons, id. at 346. Symons did a LEXIS search of “egregious fraud” on 4 June 1979 in both the General Federal and All States libraries. Two cases were found in the former library and three were found in the latter. Symons, id. This author did the same search on 29 July 1998 and altogether ten cases were found. On 4 June 2002, the author did another search using “letters of credit and egregious fraud” in the library of “Federal & State Cases Law”, only 13 items were found.
30 E.g. Harfield, supra note 21; J B Justice, ‘Letters of Credit: Expectations and Frustrations (Pts 1 & 2)’, 94 Business L J 424 & 493 (1977).
31 Harfield, id. at 602. But in the same article Harfield also used the phrase “actual and intentional fraud” to define the “egregious” fraud he was discussing. Id. at 604.
32 Symons, supra note 15, at 347.
33 Id.
34 K L Macintosh, ‘Letters of Credit: Dishonour When a Required Document Fails to Conform to the Section 7-507(b) Warranty’, 6 J L & Commerce 1, 6 (1986).
35 336 A.2d 316 (1975).
36 Id. at 321.
37 Id. at 324-25, citing Dynamics Corp of America v. Citizens & Southern Nat’l Bank 356 F.Supp. 991, 999 (1973). Emphasis added.
38 378 A.2d 562 (1977).
39 Id. at 567, citing Intraworld, supra note 35, at 324-325. Emphasis added.
40 Justice, supra note 30, at Pt 1, 424.
41 14 UCC Rep. Serv. 1427 (1974).
42 Id. Emphasis added. Taken away from the facts of the case, this paragraph is sound and well reasoned. However, against the factual background of the case, the result of the case is disappointing as “the dispute between the customer and the beneficiary appears to have been a classic case involving breach of warranty, and it is clear that an injunction should not be granted in such a case.” Justice, supra note 30, at pt 2, 502-503.
43 474 F. Supp. 420 (1979). For special treatment of the case, see P C Reed, ‘A Reconsideration Of American Bell International Inc v. Islamic Republic Of Iran’, 19 Columbia J Trans’l L 301 (1981).
44 474 F. Supp. 420, 425 (1979). Emphasis added.
45 Derry v. Peek, 14 App. Cas. 337, 347, (1889) (Lord Herschell).
46 It has been said that “[i]ntentional fraud could be shown by establishing the common law elements of fraud”. Aetna Life & Casualty Co v. Huntington National Bank, 934 F.2d 695, 698 (1991). On 4 June 2002, the day when the search for “egregious fraud” was done, this author also did searches in the same library for the other standards of fraud discussed here using the following phrases: “letters of credit and intentional fraud”, “letters of credit and common law fraud”, “letters of credit and letter of credit fraud”, “letters of credit and flexible fraud”, and “letters of credit and constructive fraud”, and found 61, 284, 42, 8 and 93 items respectively. Although these figures could not necessarily reflect what standards of fraud courts actually had applied in the cases and might reflect only the frequency courts had used the terms in their discussions, they could serve as a kind of indication showing what kind of terms and standards courts are more likely to use in the US.
47 R P Buckley, ‘The 1993 Revision of the Uniform Customs and Practice for Documentary Credits’, 6 J Banking & Finance L & Practice 77, 97, note 278 (1995).
48 If the intention of the beneficiary to defraud had not been proven, NMC Enterprises might have been well treated as “a breach of warranty matter”. See Report of the Task Force on the Study of UCC Article 5, ‘An Examination of UCC Article 5 (Letters of Credit)’, 45 Business L 1521, 1614 (1990) (Task Force Report).
49 757 F.2d 399 (1985).
50 Id. at 402.
51 Id. at 405. Emphasis added.
52 392 N.Y.S.2d 265 (1976).
53 Id. 268.
54 Id. 271. Emphasis added.
55 See Note, ‘Letters of Credit: Injunction As a Remedy for Fraud in UCC Section 5-114’, 63 Minnesota L Rev 487, 500, (1979).
56 The Task Force noted that “[m]ost of the cases favouring a flexible standard have nonetheless been supported by a showing of serious misconduct equivalent to the shipment of rubbish”. Task Force Report, supra note 48, 1614. However, this result might be affected by the fact that Prior UCC Article 5 was silent with respect to the standard of fraud. Whenever the “flexible standard” was quoted, it was read together with the facts of Cambridge Sporting Goods. If the term “flexible standard” was used in a statute and courts had applied it without reading the facts of Cambridge Sporting Goods, the situation might have been different.
57 356 F. Supp. 991 (1973).
58 Id. at 998-99, citing SEC v. Capital Gains Research Bureau Inc, 375 U.S. 180, 193-94 (1963). Emphasis added. Because of this statement, Dynamics becomes the oft-quoted case for the standard of “constructive fraud” (e.g. Fellinger, supra note 4, at 13; H P Kee, ‘The Fraud Rule in Letters of Credit Transactions’, in C Chinkin (ed.), Current Problems of International Trade Financing 235, 246 (1983)) or “ordinary breach of contract” (e.g. United Trading Co v. Allied Arab Bank 1985(2) Lloyd’s Rep. 554, 561 (Ackner LJ)). However, it should be noted that, because the court of Dynamics also made the statement that “the court views its task in this case as merely guaranteeing that India [the beneficiary] not be allowed to take unconscientious advantage of the situation and run off with plaintiff’s money on a pro forma declaration which has absolutely no basis in fact”, a statement cited in many cases for the standard of “egregious fraud”, this case has occasionally been classified as a case of “egregious fraud”. See Symons, supra note 15 , at 373-374.
59 R Bertrams, Bank Guarantees in International Trade 257 (2nd ed. 1996). Illegality can be another one, but cases are scarce in this respect. E.g. United City Merchants v. Royal Bank of Canada 1979(1) Lloyd’s Rep. 267; 1981(1) Lloyd’s Rep. 604; 1983 A.C. 168. For discussion about the illegality defence, see McLaughlin, supra note 2. In Australia, another defence, unconscionable conduct within the meaning of s 51AA of the Trade Practices Act 1974, has unfortunately become available since the case of Olex Focas Pty Ltd v. Skodaexport Co, 134 F.L.R. 331 (1996). For a discussion about Olex, see infra notes 120-125 and accompanying text.
60 Bertrams, id. According to Professor Kozolchyk, during the last twenty years, with the increasing abuse by beneficiaries of their power to demand payment of letters of credit whose “literal tenor could not be read to support such demands, courts and commentators had to reassess the meaning of strictness in the letter of credit law. The judicial dilemma was frequently perceived to be as serious as choosing between formalism and assumed certainty of the law on the one hand and equity and uncertainty on the other”. B Kozolchyk, Preface, 24 Arizona L Rev 235, 235 (1982).
61 Kee, supra note 58, 242. Kee mentioned four kinds of standard without the standard of “letter of credit fraud”.
62 For a list of US cases, see Getz, supra note 22, 248-252. Besides litigation, other channels were created for US companies to block payments under standby letters of credit. On November 14, 1979, the President of the United States issued an executive order to block the transfer of “the property and interests in property of the Government of Iran, its instrumentalities and controlled entities and the Central Bank of Iran”. Executive Order No 12170, 44 Fed Reg 65,729 (1979), quoted in Touche Ross & Co v. Manufacturers Hanover Trust Co, 434 N.Y.S.2d 575, 576 (1980). To implement the Order, the US Treasury promulgated the Iranian Assets Control Regulations, which at first allowed American issuing banks to discharge their liabilities under their standby letters of credit by paying into blocked accounts of the Iranian beneficiaries, but later directly blocked payment of the standby letters of credit themselves. See M P Zimmett, ‘Standby Letters of Credit in the Iran Litigation: Two Hundred Problems in Search of a Solution’, 16 L & Policy Int’l Business 927, 941 (1984). On January 19, 1981, as part of the agreement to release the American hostages, the United States and Iran agreed to establish the Iran-US Claims Tribunal at the Hague, for claims and counterclaims of nationals of the United States against Iran and claims of Iranian nationals against the United States. For a detailed treatment of the Tribunal, see Symposium, ‘On The Iran-United States Claims Tribunal’, 16 L & Policy Int’l Business 667 et seq. (1984). For some articles about the Iranian cases, see J D Becker, ‘Standby Letters of Credit and Iranian Cases: Will the Independence of Credit Survive?’, 13 UCC L J 335 (1981); Comment, ‘Fraud in the Transaction: Enjoining Letters of Credit during the Iranian Revolution’, 93 Harvard L Rev 992 (1980); R J Driscoll, ‘The Role Of Standby Letter Of Credit In International Commerce: Reflections After Iran’, 20 Virginia J Int’l L 459 (1980); Getz, id; Kimball & Sanders, ‘Preventing Wrongful Payment of Guaranty Letters of Credit–Lessons from Iran’, 39 Business L 417 (1984); Reed, supra note 43 ; Weisz & Blackman, ‘Standby Letters of Credit after Iran: Remedies of the Applicant’, 1982 U Illinios L Rev 355; Zimmett, id.
63 Driscoll, id. at 459.
64 Zimmett, supra note 62, at 930.
65 Id. at 937. The two cases were John Carl Warnecke & Assocs v. Bank of America Nat’l Trust & Savings Ass’n, No. 749626 (N.D. Cal. April 17, 1979) and KMW International v. Chase Manhattan Bank N A, No. 79 Civ. 1067 (S.D.N.Y. Mar. 29, 1979), payment injunction vacated 606 F.2d 10 (1979).
66 Zimmett, supra note 62, at 937. Notice injunctions were widely used in the Iranian cases. They were injunctions under which plaintiffs were not seeking injunction of the payment, but only that they be given notice prior to payment by the issuer so that they could investigate the facts and determine whether the demand for payment was fraud or not. Id. at 938.
67 474 F. Supp. 420 (1979).
68 Driscoll, supra note 62, at 475.
69 For another pre-hostage case with a similar view, see KMW International v. Chase Manhattan Bank NA, 606 F.2d 10 (1979).
70 434 N.Y.S.2d 575 (1980).
71 It is not clear why the issue of force majeure was not raised in the pre-hostage cases. However, it is inconceivable that there were no such clauses in them because the amount of money involved was huge and the parties involved were sophisticated multinational corporations.
72 The report is relatively brief and many aspects of the case are not clear.
73 Supra note 70, at 577-578 (Schwartz J). Reading the word “guaranty” in the report, it can be concluded that it is merely another word used for the term “independent guarantee” under discussion.
74 Cf, A Loke, ‘Standby Letters of Credit and Performance Bonds: The Lesson of the Iranian Experience’, in C Chinkin (ed.), Current Problems of International Trade Financing 283, 289 (1983). For circumstances where payment of a counter-guarantee may be stopped, see Article 19(2)(e) of the UN Convention.
75 Bertrams noted that, in the post-hostage Iranian cases, not only the standard of fraud was lowered, but all the other requirements for equitable relief such as the likelihood of success were not as stringent as they should have been. See Bertrams, supra note 59, 270-271, notes 58-61 and accompanying text.
76 Zimmett, supra note 62, 946. See also F von Marschall, ‘Recent Developments in the Fields of Standby Letters of Credit and Performance Bonds’, in C Chinkin (ed), Current Problems of International Trade Financing 260, 282 (1983): “the Iranian experience seems to be a good illustration of saying that hard cases make bad law. Cases deciding problems arising out of the Iranian revolution should be examined carefully and it should always be asked whether their reasoning is generally acceptable or whether the judge may have acted with a mind influenced by a recent television-picture of a commercially irresponsible Ayatollah”. Footnote omitted.
77 Task Force Report, supra note 35, 1613, citing Intraworld Industries Inc v. Girard Trust Bank, 336 A.2d 316, 324 (1975).
78 Id. at 1614. Citations omitted.
79 Id. at 1613.
80 Id. at 1614.
81 Id. at 1615.
82 Id.
83 Id. at 1614.
84 Id. at 1615.
85 R S Rendell, ‘Fraud and Injunctive Relief’, 56 Brooklyn L Rev 111, 113 (1990).
86 Task Force Report, supra note 48, at 1615.
87 Id.
88 Emphasis added.
89 See also P S Turner, ‘Revised UCC Article 5: The New US Uniform Law on Letters of Credit’, 11 Banking & Finance L Rev 205, 225 (1996).
90 Official Comment to Article 5 of the Uniform Commercial Code 1, 2nd para.
91 Id.
92 Id. at 3rd para, 1st sentence. Emphasis added.
93 Id. quoting Ground Air Transfer v. Westate’s Airlines, 899 F.2d 1269, 1272-1273 (1990).
94 Buckley, supra note 47, at 97. See also Task Report, supra note 48 , at 1615.
95 Dolan, supra note 25, at 7-47.
96 899 F.2d 1269 (1990).
97 Id. at 1274.
98 Id.
99 There may be a number of reasons for this. The main reason is that most of the cases tried until recently were still applying Prior UCC Article 5 because letters of credit involved in those cases were issued before Revised UCC Article 5 was adopted. Another reason may be that “[t]he number of reported cases involving fraud declined significantly” following the promulgation of Revised UCC Article 5. J G Barnes & J E Byrne, ‘Letters of Credit: 1995 Cases’, 51 Business L 1417, 1425 (1996). According to the two authors, the decline was one of the “signs of the impact of the … revised UCC Article 5”. Id. at 1418. This may be a reasonable observation because, by setting forth the standard of material fraud, s 5-109 has provided courts some guidance in dealing with cases of this kind, and has showed letters of credit users that litigation reasons such as “constructive fraud” will not be supported. As a result, parties who might have used such reasons prior to the promulgation of Revised UCC Article 5 may have stopped doing so. The authors searched the LEXIS library “Federal and State Cases” a number of times, the last on 5 June 2002. Only three cases were found: Mid-America Tire v. PTZ Trading Ltd. Import and Export Agents 2000 Ohio App. LEXIS 5402; 43 UCC Rep. Serv. 2d (Callaghan) 964 (2000); New Orleans Brass v. Whitney National Bank and the Louisiana Stadium and Exposition District, La. App. LEXIS 1764 (2002); and Western Surety Co v. Bank of Southern Oregon, 257 F.3d 933 (1999); 2001 U.S. App. LEXIS 15565; 44 U.C.C. Rep. Serv. 2d (Callaghan) 1239 (2001).
100 257 F.3d 933; aff’d 2001 U.S. App. LEXIS 15565; 44 U.C.C. Rep. Serv. 2d (Callaghan) 1239 (2001).
101 Id. Citations omitted and emphasis added.
102 La. App. LEXIS 1764 (2002).
103 See supra note 93 and accompanying text.
104 2000 Ohio App. LEXIS 5402; 43 U.C.C. Rep. Serv. 2d (Callaghan) 964 (2000) (Young PJ; Walsh J concurred, Valen J dissented).
105 Id.
106 Id. Citing Roman Ceramics Corp. v. People’s Natl. Bank, 714 F.2d 1207, 1212 footnote 12 (C.A.3, 1983), which was in turn quoting Intraworld Industries, Inc. v. Girard Trust Bank, 461 Pa. 343, 359, 336 A.2d 316, 324-325 (1975), as quoted in the text above accompanying footnote 26.
107 Id.
108 Id.
109 J G Barnes & J E Byrne, ‘Letters of Credit: 2000 Cases’, 56 Business L 4 (2001), reprinted in Annual Survey of Letter of Credit Law & Practice 13, 18 (2002).
110 Id.
111 [1979] 1 Lloyd’s Rep 267, [1981] 1 Lloyd’s Rep 604, [1983] AC 168.
112 [1983] AC 168, 183, per Lord Diplock.
113 R Jack et al, Documentary Credits (3rd edn 2001), 260.
114 [1958] 2 QB 127.
115 Id, 129.
116 [1977] 2 All ER 862.
117 Id, 870. Emphasis added.
118 [1975] 1 All ER 1071.
119 Id, 1073.
120 Id, 1074. Citations omitted, emphasis added.
121 [1979] 1 Lloyd’s Rep 267, [1981] 1 Lloyd’s Rep 604, [1983] AC 168.
122 [2001] EWCA Civ 1954, [2002] 3 All ER 697, [2002] 1 All ER (Comm) 257, [2002] 1 WLR 1975.
123 For a more discussion of the case, see Xiang Gao, ‘The Identity of the Fraudulent Party under the Fraud Rule in the Law of Letters of Credit’, (2001) 24 U New South Wales L J 119, at 128 et seq. This case involves another important issue regarding the law of letters of credit: whether payment of a letter of credit should be enforced if the underlying contract is illegal. Vitro, the buyers, requested, and GFE, the sellers, agreed, to double the purchase price of their contract in the related documents and transfer the excess amount to a draw-down account in favour of an American company in Miami closely associated with Vitro. The reason for this was to avoid the Peruvian foreign exchange control regulations, under which it was prohibited to withdraw money from Peru and then transfer it to the US. It was therefore argued that the underlying contract between GFE and Vitro was illegal and/or unenforceable, as its enforcement would be in violation of Peru’s exchange control regulations and the Bretton Woods Agreement Order 1946. This argument was successful in the first instance, and partly successful on appeal in the sense that part of the letter of credit was allowed to be paid, and part was enjoined. The trial court found that the sales contract between GFE and Vitro was an exchange contract because it was a monetary transaction in disguise, and payment made under the letter of credit would give effect to an exchange contract in violation of Peruvian law and the Bretton Woods Agreement Order 1946. So it held that the letter of credit transaction was unenforceable. The Court of Appeal agreed that the sales contract was a “monetary transaction in disguise” and held that the letter of credit was “part and parcel” of the scheme to evade the Peruvian foreign exchange regulations. However, it would enforce part of the sales contract which was not contrary to the Peruvian law by allowing the plaintiffs to recover the sales price of the equipment. The House of Lords upheld the decision of the Court of Appeal on this point. As this is outside the scope of this article, it will not be discussed further. For a detailed discussion of the point, see, eg, L C Cansler ‘International Letters Of Credit – The American Accord Case – Fraud Exception Limited’ (1982) 17 Texas Int’l L J 229, 241; G T McLaughlin ‘Letters Of Credit and Illegal Contracts: The Limits of the Independence Principle’ (1989) 49 Ohio State L J 1197.
124 [1979] 1 Lloyd’s Rep 267, 278.
125 [1979] 1 Lloyd’s Rep 267, 278.
126 [1981]1 Lloyd’s Rep 604, 628-9.
127 Id, 620.
128 Id, 628. Citations omitted.
129 Ibid, per Griffith LJ. Citations omitted, and the word Dec. in abbreviation has been changed to December.
130 Lords Fraser, Russell, Scarman and Bridge concurred.
131 [1983] AC 168, 184. Because of the name of the ship involved, this case is often known as the case of American Accord.
132 [1983] AC 168, 184.
133 Id, 187-188.
134 See also C M Schmitthoff (1981) J Business L 381, 383: “[t]he decision of the Court of Appeal represents sound commercial sense. In particular, its decision that a bank should not honour a letter of credit if, to its knowledge, a fraudulent bill of lading is tendered, is correct, and it is immaterial in this connection whether the seller was a party to the fraud or the fraud was committed by a third party without the knowledge of the seller. Banking business could not be carried on with the necessary expedition if the bank were compelled to make detailed inquiries into the nature of the fraud.”
135 Article 4 of the UCP.
136 Cf, R Goode Commercial Law (2nd edn 1995),1008.
137 [1981]1 Lloyd’s Rep 604, 620. A G Davis The Law Relating to Commercial Letters of Credit 3rd (1963), 149: “If the documents are forged, then obviously they are not valid. The buyers’ instructions to the banker must be construed as requiring the acceptance of valid documents only, and the bankers’ promise to the seller must be similarly construed. Any other construction would defeat the whole intention behind letter of credit transactions.” M Megrah “Risk Aspects of the Irrevocable Documentary Credit” (1982) 24 Ariz L Rev 255, 257: “The implicit obligation of the banker is to pay against ‘genuine’ conforming documents; otherwise credits would be a sham and open to all sorts of chicanery.”
138 For the details of the provision, see supra note 88 and accompanying text. For further analysis of the provision, see, Xiang Gao, ‘The Identity of the Fraudulent Party under the Fraud Rule in the Law of Letters of Credit, (2001) 24 U New South Wales L J 119, 123-124.
139 For the details of the provision, see infra note 200 and accompanying text. For further analysis, see, Gao, ibid 124-125.
140 [1978] 1 All ER 976.
141 Id, 982.
142 [1979] 1 Lloyd’s Rep 445.
143 Id, 447, per Lord Denning MR. Emphasis added.
144 (1924) 297 F 152.
145 Id, 158. Emphasis added.
146 31 NYS 2d 631, 634. Emphasis added.
147 Cf, R Goode, ‘Abstract Payment Undertakings’ in P Cane and J Stapleton (ed.), Essays for Patrick Atiyah (1992), 209, 230-231.
148 See, eg, Benjamin’s Sale of Goods 5th ed (1997), 1715; H Harfield, Bank Credits And Acceptances 5th ed (1974), 80; R H Ryan ‘Who Should Be Immune from the ‘Fraud in the Transaction’ Defense in a Letter of Credit Transaction’ (1990) 56 Brooklyn L Rev 119, 126; G W Smith ‘Irrevocable Letters of Credit and Third Party Fraud: The American Accord’ (1983) 24 Virginia J Int’l L 55, 58
149 Goode, supra note 147, 228.
150 Cf, Griffith LJ in United City Merchants v Royal Bank of Canada [1981]1 Lloyd’s Rep 604, 632,
151 Benjamin’s Sale of Goods 5th ed (1997), 1715. See also, Cansler, supra note 123, 240:
“The House of Lords decision leaves banks in an anomalous position. Under a documentary credit, a confirming bank has a duty to honour conforming documents. After American Accord, banks must honour a credit and accept fraudulently completed documents, unless they were fraudulently completed by the beneficiary.”
152 Goode, supra note 147, 294. See also Smith, id, 62.
153 Smith, ibid.
154 Goode, supra note 147, 294. Footnote omitted.
155 United City Merchants v Royal Bank of Canada [1981] 1 Lloyd’s Rep 604, 623, per Stephenson LJ.
156 Smith, supra note 148, 58, 70.
157 [2001] EWCA Civ 1954, [2002] 3 All ER 697, [2002] 1 All ER (Comm) 257, [2002] 1 WLR 1975.
158 According to the report, Judge Jack heard and decided the case on 28 November 2000.
159 [2001] 1 All ER (Comm) 368.
160 See supra note 133 and accompanying text.
161 [2001] 1 All ER (Comm) 368.
162 [2001] 1 All ER (Comm) 368, 381.
163 [2001] EWCA Civ 1954, [2002] 3 All ER 697, [2002] 1 All ER (Comm) 257, [2002] 1 WLR 1975, Emphasis added.
164 Ibid.
165 Ibid.
166 Cf, Goode, supra note 147, 229-230; see also Davis, supra note 137 , 150.
167 [2001] EWCA Civ 1954, [2002] 3 All ER 697, [2002] 1 All ER (Comm) 257, [2002] 1 WLR 1975. Citations omitted.
168 Smith, supra note 148, 96.
169 B Kozolchyk ‘The Immunisation of Fraudulently Procured Letter of Credit Acceptances: All Services Exportacao Importacao Comercio SA v Banco Bamerindus Do Brazil SA’ (1992) 58 Brooklyn L Rev 369, 370. For comments to the similar effect, see also A G Givray ‘Letters of Credit’ (1989) 44 Business L 1567, 1618: “If issuers were always bound by the face of presented papers, even when seemingly clean in form but fouled by forgery or other fraud, then letters of credit would be so prone to abuse as to become useless.” J E Byrne ‘Critical Issues in the International and Domestic Harmonisation of Letter of Credit Law and Practice’ in Commercial L Annual (1995) 389, 397: “If the credit becomes a vehicle unduly favouring one side or another, it will lose its primary attraction as a balanced safeguard for both interests of applicant and beneficiary.”
170 See also supra note 111. Emphasis added.
171 R Jack et al., Documentary Credits (3rd edn. 2001), 66.
172 Id. at 267.
173 Id. at 266.
174 1983 A.C. 168, 186.
175 1995(4) All E.R. 215.
176 1999 Lloyd’s Rep. Bank 239; aff’d in 2000 Lloyd’s Rep. Bank. 165.
177 Buckley, supra note 47, at 97.
178 36 D.L.R. 4th 161 (1987).
179 36 D.L.R. 4th 161, 178 (1987).
180 Id.
181 Id.
182 18 C.P.C. 62 (1980).
183 Id. at 65. Emphasis added.
184 S. P Jeffery, ‘Standby Letters of Credit: A Review of the Law in Canada’, 14 Banking & Finance L Rev 505, 528 (1999).
185 1993 A.C.W.S.J. LEXIS 43709; 1993 A.C.W.S.J. 576951; 37 A.C.W.S. (3d) 1132 (1993).
186 Id. at para 29.
187 Id. at paras. 30-32. Some of the citations omitted.
188 1984(3) N.S.W.L.R. 110.
189 Id. at 114. Emphasis added. For more discussion of the case, see notes 87-90.
190 1985(1) N.S.W.L.R. 545.
191 Id. at 554. Emphasis added.
192 34 N.S.W.L.R. 243 (1994).
193 Id. at 251. Emphasis added.
194 134 F.L.R. 331 (1996).
195 Id. at 340 (for mobilisation guarantees) and 342 (for performance guarantees).
196 In fact Skodaexpert instructed its bank, the Czechoslovakian Commercial Bank, to call up all of the guarantees, and the bank did so. Id. at 345. For more information on proceedings in the case and a detailed summary of the beneficiary’s call on the guarantees, see R P Buckley, ‘Sections 51AA and 51AC of the Trade Practices Act 1974: The Need for Reform’, 8 Trade Practices L J 5, 6, note 6 (2000).
197 134 F.L.R. 331, 348 (1996). Emphasis added. For a special comment for this passage, see A L Tyree, ‘Performance Bonds and Section 51AA of the Trade Practices Act’, 8 J Banking & Finance L & Practice 338, 339 (1997).
198 E.g. Edward Owen Engineering Ltd v. Barclays Bank Int Ltd, 1978(1) All E.R. 976; and Bolivinter Oil S.A. v. Chase Manhattan Bank, 1984(1) Lloyd’s Rep. 251.
199 134 F.L.R. 331, 354 (1996). Emphasis added. Remarkably, Batt J enjoined the payment of the mobilisation guarantees on the basis of the plaintiffs’ second argument: Skodaexport’s calling up the guarantees was committing unconscionable conduct within the meaning of s 51AA of the Trade Practices Act 1974. This ruling has “surprised most commentators and criticism of it has been direct and frequent”: Buckley, supra note 196, at 6. By and large, criticism so far has focused on the point that the decision has misapplied 51AA of the Trade Practices Act (Cth) which provides that “[a] corporation shall not, in trade or commerce, engage in conduct that is unconscionable within the meaning of the unwritten law, from time to time, of the States and Territories”; and “the accepted scope of the section may have been broadened considerably”: R P Buckley, ‘Unconscionability Amok, or Two Readily Distinguishable Cases?, 26 Australian Business L R 323, 326 (1998). However, this approach also represents an undesirable development in the law of letters of credit, because it appears to have created another basis for the interference with the payment of letters of credit and independent guarantees at least in Australia: statutory unconscionable conduct, which may severely affect the commercial utility of letters of credit because “[t]he effect of the statute, applying as it does to international trade and commerce, is to work a substantial inroad into the well-established common law autonomy of letters of credit and performance bonds and other bank guarantees”: Olex Focus Pty Ltd v. Skodaexpert Co Ltd, 134 F.L.R. 331, 358 (1996). More alarmingly, this decision may have opened in Australia a “Pandora’s box” and led to more “exceptions” to the letter of credit payment system. For example, other sections of the Trade Practices Act, such as s 52, dealing with misleading and deceptive conduct, and s 53 dealing with false or misleading representations, may also be applied in future to letters of credit and independent guarantees. If this happens, the commercial utility of letters of credit and independent guarantees will be seriously eroded. For a series of articles criticising this ruling, see Robert Baxt, ‘Are Bank Guarantees Safe from the Unconscionable Conduct Provisions of the Trade Practices Act?’, 1997 The Australian Banker 62; R Baxt, ‘A Bombshell on Unconscionable Conduct’, 25 Australian Business L Rev 227 (1997); R Baxt, ‘Unconscionability Taken One Step Too Far?’, 25 Australian Business L Rev 301 (1997); R Baxt, ‘Unconscionable Conduct under Trade Practices Act’, 71 Australian L J 432 (1997); R Baxt and J Mahemoff, ‘Unconscionable Conduct Under the Trade Practices Act – An Unfair Response By the Government: A Preliminary View’, 26 Australian Business L Rev 5, 13-15 (1998); J Browne, ‘The Fraud Exception to Standby Letters of Credit in Australia: Does it Embrace Statutory Unconscionability?’, 1999 Bond L R 98; R P Buckley, ‘Sections 51AA and 51AC of the Trade Practices Act 1974: The Need for Reform’, 8 Trade Practices L J 5 (2000); A Tyree, ‘Performance Bonds and Section 51AA of the Trade Practices Act’, 8 J Banking & Finance L & Practice 338 (1997); W Pengilley, ‘Unconscionability: Are the Litigation Floodgates Opening in Relation to Commercial Transactions?’, 13 Australia & New Zealand Trade Practices L Bulletin 11 (1997); and B Zillmann, ‘A Further Erosion Into the Autonomy of Bank Guarantees’, 13 Building & Construction L 354, 357 (1997).
200 E E Bergsten, ‘A New Regime For International Independent Guarantees And Stand-By Letters Of Credit: The UNCITRAL Draft Convention On Guaranty Letters’, 27 Int’l L 859, 872 (1993).
201 Comment, Litigation Digest: Agritrade International Pte Ltd v. Industrial and Commercial Bank of China [1998] 3 SLR [Singapore], 4, 3 Documentary Credit World 8, 13 (2000).
202 Comment, supra note 62, at 995.
203 Bank of Nova Scotia v. Angelica-Whitewear Ltd, 36 D.L.R.4th 161, 168 (1987). For a typical view favouring a stringent rule, see H Harfield, ‘Identity Crisis In Letter Of Credit Law’, 24 Arizona L Rev 239, 239 (1982): “The rigid rules that govern letters of credit are structural. If they are subordinated to more pliable precepts appropriate to equitable resolution of disputes, the very existence of the letter of credit as a useful business device can be destroyed as surely as a wisteria vine can strangle an oak”.
204 R. J. Gavigan, ‘Wysko Investment Company v. Great American Bank: A New Attack on the Usefulness of Letters of Credit’, 14 Northwestern J Int’l L & Business 184, 202 (1993).
205 Cf. S. J. Leacock, ‘Fraud in the International Transaction: Enjoining Payment of Letters of Credit in International Transactions’, 17 Vanderbilt J Transnat’l L 855, 899 (1984).
206 ICC Publication No 500, supra note . The UCP is essentially a set of standard terms for banks drafted by bankers. The Working Group that prepared the latest revision was the first to include members other than bankers, in this case some bank lawyers and two law professors. The parties documentary credits serve, exporters and importers, are not directly represented in the drafting process. See J. Andrew Spanogle Jr, ‘The Arrival of International Private Law’, 25 George Washington J Int’l L & Economics 447, 492 (1992).
207 Courts in most jurisdictions outside the US are inexperienced with letters of credit, and the litigation of fraud under letters of credit is rare outside the US. Accordingly, there has been no opportunity elsewhere to develop a sophisticated and coherent body of case law on the issue of fraud in letters of credit. England has a sophisticated and well developed jurisprudence on letter of credit law in general, but not on the fraud issue in particular.
208 R Wight and A Ward, ‘The Liability of Banks in Documentary Credit Transactions under English Law’, 1998 J Int’l Business L 387, 390.
209 Articles 3 & 4 of the Uniform Customs and Practice for Documentary Credits, 1993 Revision, International Chamber of Commerce Publication No. 500.
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