Introduction The rises in international trade over the last few decades lead to the boost in popularity of Letters of credit as a payment instrument. The considerable time lag between when the goods leave the country of the seller and reach the country of the buyer meant that the traditional methods of payment used in the case of domestic transactions were unsuitable. Two critical features of the letters of credit, resulted in it being considered as the best alternative. 1. The principle of Autonomy of the Letter of Credit 2. The doctrine of Strict compliance Doctrine of Strict Compliance
According to the doctrine of strict compliance, banks are bound to pay the beneficiary the amount due under the credit upon the presentation of documents as mentioned in the letter of credit. Autonomy of the Letter of Credit According to the principle of autonomy of credit, the letter of credit which is a contract entered into between the applicant and the issuing bank is a separate and independent transaction from the underlying contract of sale entered into between the buyer and the seller. This principle was first recognized in common law. For example it was stated by Jenkins L.Order now
J. in Hamzeh Malas & Sons v British Imex Industries Ltd. 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 ( conform ) are up to contract or not. ” Parties to a letter of credit often regard the principle of Autonomy of credit as a term of the credit, by expressly indicating in the text of the credit that it is subject to the rules of the UCP 600.
The principle of Autonomy of Credit is confirmed by Article 4 of the UCP, which provides that, “a credit by its nature is a separate transaction from the sale or other contract on which it may be based”. The efficacy of letters of credit relies on the combination of the doctrine of strict compliance and the principle of autonomy of credit for the purpose of providing security to the beneficiary of the instrument against default by its counterparty under contract and for the purpose of protecting a beneficiary from carrying credit risk during the course of a dispute under the underlying contract, or in order to support the obligation of the account party to pay a sum of money to the beneficiary. Exception to the Principle of Autonomy of Credit Fraud as an exception to the principle of autonomy of credit, although has been considered by the judicial systems of various jurisdictions, the Judges have been reluctant to intrude on the working of the instrument on any basis.
The perspective of the Judiciary has been that any interference would hamper the efficacy of the process, and as a result sole purpose the letters of credit was designed to serve would be lost. This is seen in the first English case to consider fraud as an exception to the principle of autonomy, which was Discount Records Ltd v Barclays Bank Ltd Lloyd’s Rep 444 where it was held that a mere allegation of fraud was insufficient to issue an injunction.
However, with time Judicial systems have attempted to strike a balance between on the one hand safeguarding the efficient working of letters of credit as an instrument of payment, and on the other ensuring that no one benefits at a cost to another, through the commission of acts of fraud, or engaging in conduct which is considered to be unconscionable by the wider society, and/or provisions of statute in some jurisdictions.
Following is an analysis of the changing attitudes of Judges and the legislatures of a few key territories. Position in the United States The position in the United States is laid down in Article 5-109 of the Uniform Commercial Code, which provides that: 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. The UCC has not provided an answer to the question, as to how the word ‘material’ should be interpreted or when n a particular transaction would be regarded as “materially fraudulent”.
Therefore the key in attempting to obtain an injunction against a beneficiary of a letter of credit would be to examine the point of view of the Judges. It was held in the case of Ground Air Transfer v. Westates Airlines (1990) that: “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. ”
The courts further went on to lay down certain circumstances in which granting an injunction would be justified, such as where the fraud is, “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, . . . where they show that the contract deprives the beneficiary of even a colorable right to do so, . . . where the contract and circumstances reveal that the beneficiary’s demand for payment has absolutely no basis in fact, . . where the beneficiary’s conduct has so vitiated the entire transaction that the legitimate purpose of the independence of the issuer’s obligation would no longer be served . . . ” In the case of Mid-America Tire v. PTZ Trading Ltd Import and Export Agents , the courts held that the statement must be narrowly limited to situations of fraud in which the wrongdoing of the beneficiary has vitiated the entire transaction and/or the demand for payment under the letter of credit has absolutely no basis in fact.
Following a thorough examination of the UCC and a string of cases decided by the US courts, one may arrive at a conclusion that the decision of Justice Shientag in the case of Sztejn v J. Henry Schroeder Banking Corp. is continued to be applied as the standard. In this case Justice Shientag stated : 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. A close evaluation of Justice Shientag’s decision in the context of the UCC would lead one to the conclusion that the standard applied in that case is synonymous to the standard the UCC has laid down, as interpreted by the Judges of the present day.
In the event the case was to be decided today, it is more probable than not that the same decision would be arrived at. The intentional failure to ship any goods ordered by the buyer would be seen as ‘a material fraud’. It may be further deduced that a mere breach of a warranty would not be a material fraud. Therefore the current position in the US seems to be the standard of fraud laid down by Justice Shientag in the case of Mid-America Tire v. PTZ Trading Ltd Import and Export Agents. Position in the United Kingdom
The applicability of fraud as an exception to the Autonomy principle has been addressed by common law, as there is no statutory provision with regard to the matter. Fraud as an exception to the Autonomy principle seems to be narrowly construed by the English Courts. In a few notable cases in the English Legal System, it has been held that in the event of forgery of documents, required to be presented under a letter of credit, in situations where the fraud is perpetrated by a third party, and not by the beneficiary, the fraud rule will not be upheld.
Thus payment under a letter of credit would be made to the beneficiary, provided that the beneficiary is not party to the fraud. This position of was adopted by the English courts in the case of United City Merchants (Investments) Ltd v Royal Bank of Canada , where it was held by Lord Diplock : “ 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. ”
Following the rule laid down by Lord Diplock in the United City Merchants case, the position of the English courts was further confirmed by Potter LJ in the case of Montrod Ltd v Grundkotter Fleischvertriebs GmbH as it was held that: The fraud exception to the autonomy principle recognized 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.
In the article “The Identity of the Fraudulent Party under the Law of Letter of Credit,” by Xiang Gao it was stated, quoting another commentator that: he 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!
This is not a favourable state of affairs. In my opinion, for the effective functioning of letters of credit as a payment instrument, it is imperative that it commands the respect of all parties to the system. I. e. the beneficiary, the banks as well as the applicant. This fact was emphasized 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.
However it is encouraging to note some positive developments in the point of view taken by the courts with regard to the Autonomy principle. In the case of Sirius International Insurance Corp (Publ) v FAI General Insurance Co Ltd , the Court of Appeal, while acknowledging the principle of autonomy of credit, went on to state that, “there is no authority extending this autonomy for the benefit of the beneficiary of a letter of credit so as to entitle him as against the seller to draw the letter of credit when he is expressly not entitled to do so”.
Therefore according to this decision of the Court of Appeal, the beneficiary may be enjoined by the courts from drawing the funds under a letter of credit, even in situations where the terms of the credit agreement have been complied with, provided that the conditions stipulated in the underlying contract have not been fulfilled. Another instance which has been regarded by the courts of England, as a situation where it is necessary to grant an injunction against the beneficiary is where the underlying contract between the parties amounts to a fraudulent transaction.
In the case of Mahonia Ltd v JP Morgan Bank it was held by Colman J: It must logically be just as contrary to public policy to enable the claimant to enforce a contract which has been entered into for a foreign illegal purpose known only to himself as to enable him to enforce such a contract the purpose of which is known to both parties. In a few consequent cases such as the case of Group Josi, the Court of Appeal reversing the decision of the court of first instance have adopted a broad interpretation of the concept of illegality in upholding it as an exception to the principle of autonomy of credit.
In the case of TTI Team Telecom International Ltd v Hutchison 3G UK Ltd 1 All ER 913, Judge Thornton QC referring to the principle enunciated in the case Cargill International SA held that ‘lack of or breach of faith good faith’ would be a valid ground to grant an injunction preventing a beneficiary from receiving funds under a letter of credit and thus would be regarded as an exception to the autonomy principle. It may be surprising to note that the courts have attempted to strike a balance, by attempting to ensure that no one benefits by hiding behind the principle of autonomy of credit.
The Position in Australia The Australian courts have adopted a liberal approach in recognizing various exceptions to the autonomy principle in addition to the generally accepted exception of fraud. Fraud as an exception to the principle of autonomy of credit was first recognized in the case of Contronic Distributors Pty Ltd v Bank of New South Wales where it was held by Justice Helsham that it is sufficient in relying on fraud as an exception, “to establish an intention to obtain money by deceit on the part of GEC (the beneficiary) at the time the letter of credit is to be presented for payment. Unconscionable conduct was first recognized by the Victorian Courts in the case of Olex Focas v Skodaexport, which was later affirmed by the New South Wales Supreme Court in the case of Boral Formwork and Scaffolding v Action Makers. These could be regarded as land mark decisions in the area of law relating to letters of credit. In the case of Olex Focas, which was a case concerning a bank guarantee, an injunction was granted on the basis that the demands by the beneficiary were unconscionable and in contravention of s 51AA of the TPA.
The principle followed in Olex Focas was endorsed by the New South Wales Supreme Courts in Boral Formwork. It was held by Austin J that it was unconscionable under the TPA, for the beneficiary to demand an amount over and above the amount due to be paid. Both parties to the underlying contract had agreed that the buyers had to incur rectification expenses on the subject matter of the contract amounting to $174,065. 39. Thus injunction was granted on the basis that it was unconscionable under the TPA to claim an amount over and above what was due under the underlying contract.
Striking a Balance Having considered the approaches adopted by various legal systems as to the exceptions applicable to the fraud principle, the most important issue which needs to be addressed is, whether the original objective of the use of letter of credit still being served? Does it provide adequate security to the seller against default by the buyer? Does it protect a beneficiary from carrying credit risk during the course of a dispute under the underlying contract?
It was stated by Kerr J referring to documentary credit as a payment instrument, in Harbottle (RD) (Mercantile) Ltd v National Westminister Bank : “They are the life blood of international commerce… They must allow to be honoured, free from interference by the courts. Otherwise trust in international commerce could be irreparably damaged. ” In the case of Wood Hall Ltd v Pipeline Authority it was held that performance guarantees were to be “as good as cash” .
Therefore it is evident that the level of reliability and efficacy expected of payment instruments such as performance bonds and letters of credit is relatively high in that they are presumed to be “as good as cash”. The question that seems to persist is whether letters of credit continues to remain as a stimulant to international trade, considering the apparent restriction to the autonomy principle through the formulation of various novel principles as valid grounds upon which courts have thought it justifiable to grant an injunction.
On the contrary, one may argue that it is important that a balance is struck between on the one hand safeguarding the original purpose of Letter of Credits as payment instruments, while at the same time ensuring that it is not used by certain persons, especially fraudsters for the purpose of making profits at a cost to another, in turn causing injustice to them. Conclusion It may be stated that the shift towards the recognition of a few novel methods as exceptions to the autonomy principle is justifiable.
As stated before, in order for a payment instrument to work efficiently, it is important that it operates in such a manner that it draws the faith of all parties to the transaction. Therefore although the strict approach adopted by the British courts before may not be justified, the inclination to recognize exceptions more readily and grant an injunction against the beneficiary is commendable. The necessity of the latest developments in
Australia with the developments of the principle of unconscionability under the TPA as an exception to the autonomy of credit is justifiable to the extent that a strict approach and a high standard of proof is adopted ensuring that the efficient working of the payment instrument is not hindered. One may argue that, a further move towards adopting a lower standard of proof is necessary because, although the buyer of the goods may be able to enforce his/her rights through a separate cause of action for breach of the underlying contract, often the fraudster disappears once he has obtained the money.
However, it is important to understand that any further risk which the applicant of the letter of credit (the buyer of the goods) may be subject to would be a risk he/she is required to take in the usual course of trade, and any further changes would hamper the whole process, and the purpose the letter of credit in international business would be lost. The best balance seems to be stricken by the approach adopted by the US system. However there is a lack of certainty as to what the status of the law is with regard to the particular matter.
Therefore it is important that a set of rules are laid down as to when a particular transaction would be regarded as fraudulent and when it would not be regarded so. This would in my opinion act as a further stimulant to international trade as the parties to a contract would be informed of the status of the law with regard to the principle of autonomy and it’s exceptions prior to committing to a contract. Therefore let us hope that the abovementioned issues with regard to the principle of autonomy are addressed in the next revision of the Uniform Customs and Practice for Documentary Credits.
Finally may I emphasize the fact that it is of immense importance that the parties take all practical steps within their limits to ensure the avoidance of any complications which may arise later on. Bibliography 1. International Business Law by Bryan Mercurio, Leon Trakman, Meredith Kolsky & Bruno Zeller. 2. Hamzeh Malas & Sons V British Imex Industries Ltd 2 QB 3. ICC Uniform Customs and Practice for Documentary Credits 2007 Revision. 4. Matthew Bisley and James Mok, Unconscionable demands under letters of credit, performance bonds and bank guarantees (2005) JBFLP 5. International Trade Law (2010) by Indira Carr and Peter Stone, 6.
Uniform Commercial Code (UCC) 7. Ground Air Transfer v Weststates Airlines 899 F. 2d 1269 (1990). 8. United City Merchants (Investments) Ltd v Royal Bank of Canada 1 Lloyd’s Rep 267, 1 Lloyd’s Rep 604, AC 168 9. Mahonia Ltd v JP Morgan Bank EWHC 1938 (Comm) 10. Montrod Ltd v Grundkotter Fleischvertriebs GmbH 1 All ER (Comm) 257 11. UNSW Law Journal (2001) 24(1) – The Identity of the Fraudulent Party under the Law of Letter of Credit by Xiang Gao. 12. Sirius International Insurance Corp (Publ) v FAI General Insurance Co Ltd EWCA 470 13. RD) (Mercantile) Ltd v National Westminister Bank Ltd 2 All ER 862. 14. Journal of International Maritime Law (2003) 9 (6) – ‘Documentary Credits and illegality in the underlying transaction’ by Jason Chuah. 15. Robin Burnett & Vivienne Bath, Law of International Business in Australasia (2009). 16. Xiang Gao* and Ross P Buckley, ‘A Comparative Analysis of the Standard of Fraud Required Under the Fraud Rule in Letter of Credit Law’ (2003) Oxford U Comparative L Forum 3 at ouclf. iuscomp. org. 17. Dixon, William M, As good as cash? ‘The diminution of the autonomy principle’(2004) 32(6): Australian Business Law Review at 391-406.