A Revocable and an Irrevocable Letter of Credit - Essay Example

Name: Professor: Course: Date: Fraud exception in letters of credit Introduction Commercial letter of credits are essentially the backbone of every international trade. The letters of credit essentially encompasses a legal and contractual agreement made by an issuing bank on behalf of the esteemed customer who is involved in the international commercial transaction, in favor of a beneficiary via a confirming or an advising bank. The issuing bank in doing so thus guarantees payment and acts as a payee so that the beneficiary can confidently provide for the goods or services to the customer. The issuing bank commits itself to honor any form and kind of drawings that are intended to trickle down to the beneficiary.1 Letters of credit are therefore very important in promoting the customer credit worthiness. Essentially two forms of letters of credit dominate the international market, which are the standby letter of credit and documentary credit. Documentary credits can either be revocable or irrevocable or even confirmed and not confirmed. The differences and advantages entrenched in their differences are the bulwark of their dependency.2 The differences between a revocable and an irrevocable letter of credit lie in the fact that at the will of the buyer and without any constructive notice he may cancel a revocable letter of credit. On the other hand the irrevocable letter of credit entails a form that cannot be varied, cancelled, changed or modified in any way. The seller is much protected by the irrevocable letter of credit and thus in most of international commercial transactions the irrevocable letter of credit is used.3 The irrevocable letters of credit can further be classified as either confirmed or non-confirmed in nature. The confirmed irrevocable letter of credit is a great tool to the international commerce. The non-confirmed irrevocable letters of credit entails a scenario where the advising bank does not guarantee any payment to the seller. 4 The advising bank only and usually pays the seller upon conditions fulfillment and reception of the funds from the issuing bank. Even though the confirmed letters of credit are fairly expensive they are safer for the parties since the level of trust and confidence is enhanced.5 There are other forms of letter of credit; these include; special letter of credit, back-to-back letter of credit, deferred payment or usuance letter of credit, Red clause letter of credit, Resolving letter of credit and transferable letter of credit. Characteristics of letters of credit The first characteristic is revocability nature of letters of credit. This means issuing bank in the case of revocable letter of credit has the mandate to cancel and modify the nature of letters of credit while the irrevocable letter of credit cannot in any way be amended by the banks and the parties. The second characteristic is negotiability. The issuing bank is obligated to pay the choice of the beneficiary be it the advising bank or another nominee The third characteristic of letters of credit is Assignment and transferability. This essentially means that a letter of can be paid out to a third-party. Fourthly relates to sight and time drafts. A time draft denotes that the beneficiary receives payment after a defined lapse of time while the sight draft becomes payable immediately upon being presented for payment.6 History of fraud exception Scholars trace the fraud exception on the celebrated case from America, Sztejn v J.Henry Schroeder Banking Corporation7 where an irrevocable letter of credit was opened by the Issuing bank on behalf of the beneficiary. The transactions involved bristles. Every rightful and legal document was exchanged including the bill of lading among the parties. Subsequently Sztejn discovered that instead of bristles the consignment shipment contained mere rubbish; he therefore applied for an injunction.8 Shientag J who ruled even though the buyer and the seller are not entitled to interfere with the transaction and further that the banks are not allowed to examine and be concerned about the merchandise of the products exchanged by parties, there is an exception where the beneficiary perpetrate fraud intentionally. This position is echoed in two other American cases, the case of NMC Enterprises Inc v Columbia Broadcasting System Inc 9 where the buyer successfully obtained a preliminary injunction as against the beneficiary. The beneficiary made misrepresentation of the quality of the technical and communication equipments that the buyer intended to buy. The court extended fraud exception to underlying contract.10 This position is retaliated in the case of United bank Limited v Cambridge Sporting Goods Corp11 in this case an irrevocable letter of credit was made on behalf of a Pakistanian Manufacturer. Transactions involved gloves. Unfortunately the gloves that the manufacturer sent to the buyer were very old, worthless and defective in nature. The court rightfully observed that the seller had an established deceitful intention and should not be unjustly rewarded by allowing the payments to be successfully made to him. 12 Australian position Australia position echoes the US position in the case of Sztejn. In Contronic Distributors Pty Ltd v Bank of New South Wales, the Supreme Court acknowledged that the buyer could rightfully be granted an injunction against the seller who presents the letter of credit to be materialized while there is fraud. 13 This position is similarly reflected in the case of Inflatable Toy Company Pty Ltd v State Bank of New South Wales Ltd14 Young J stated that the exercise of determining fraud should not be merely confined within the documentary evidence since the very uttering of the documents reflect and shows a standpoint of actual fraud in the contractual agreement as between the parties. In the Inflatable Toy Case the applicant –buyer never succeeded in obtaining an injunction as against the beneficiary. The main contention although founded on fraud, the judge peeled through the contract and found a lot of correspondent which would infer some form of ratification between the parties. Though discrepancies were evident, the judge was of considered opinion that if the parties are very conversant of the commercial reality and are prepared to continually accept the situation then the court will not find any element of fraud. The fraud exception in both jurisdictions in US and Australia seems to continually show some form of inconsistency. The main reason that the applicant brings the attention to the bank is in order to circumvent the issue of payment. If a transaction is shrouded and tainted with fraud, then the beneficiary is rightfully denied the opportunity to get the money. The payment is however only stopped upon clear evidence of fraud on the record, especially with a fraudulent bill of lading.15 Over time, the court has developed a three-tier determination method of regarding or otherwise disregarding to honor or dishonor beneficiary complaints. The first issue that the court determines is whether the complaint concerns a disputable underlying contract or a genuine fraud on the record. Secondly the court determines the source of the complaints about the fraud, whether it is from a third party or the applicant and finally whether the complainant if a rightful holder of the documents. As regards what constitute the clear form of fraud that does not relate to the underlying contract, the position has been inconsistent? In the case of Society of Lloyd’s v Canadian Imperial Bank of Commerce and Others (1993 Rep 579)16 the court never gave a succinct decision as to what amount a clear constructive notice of fraud. The defendants had alerted the bank about the ensuing suspicion of fraud on the part of the beneficiary. The bank failed to honor their desire and directions since, based on the documents in the picture the beneficiary were vindicated. The court held based on the UCP that the beneficiary does not bear the burden of having to prove that there is no fraud in the underlying contract. 17 The sufficiency of amount of evidence delivered to the bank before it effectively denies the payment to the beneficiary was the subject of interrogation in the case of Edward Owen Engineering Ltd v Barclays Bank International Ltd (1978) 1ALL ER 976. The court placed the onus of establishing the fraud on the part of the applicant who has to successfully prove that based on his documentary evidence payment should not in any way be effected since the beneficiary has perpetuated fraud. Clear evidence has to be surrounded and not merely some form of suspicion.18 The second issue that the court has to determine is whether the seller actually made the forgery or it was made by a third party. Justification should be appropriate. Such a scenario was the subject of consideration in the case of United City Merchants V Royal Bank of Canada (1979 1 QB 267) the case regarded a contract of shipment. The letter of credit was to be realized upon the bill of lading clearly showing that the goods were shipped on December 15th in 1976. Unknown to the seller the goods were shipped at a later date but the documents were false fully backdated. In such an instance, the court of the first instance ruled in favor of the seller that since they were not involved in the fraud deal then the payment should be made good. Upon appeal, the court denied this contention and held that the bank has a right to refuse to affect any kind of payment and the consideration as regards the very identity of the forger remains in the very bare minimum an immaterial issue.19 The principle that guides such transaction is ex turpi causa non oritur actio which essentially means that the fraud exception does not extend to cases where the beneficiary is not a party to the contract. This in essence means that the confirming bank is allowed and obliged to make payment even when on the face of record is evident that a third party is involved in a forgery. Lord Diplock held the view that in disregarding payment in every instance of suspicion on fraud would essentially undermine the foundation of the letter of credit. 20 In establishing the existence of fraud the court has also required that the applicant prove existence of recklessness on the part of the maker of a statement. According to common law established in the case of Derry v Peek it is important in establishing fraud the existence of a state of mind that the make knew that the statement was false and made it recklessly without taking into consideration the truth of it. In the recent case of KBC Bank v Industrial Steels UK Ltd the court was of considered opinion that it is imperative to interrogate the beneficiary state of mind before establishing the existence of fraud. This was the case despite the fact that the beneficiary had at all material times held the belief that his statements and the documents that he possessed were very correct.21 One of the foundations of fraud exception is the rule that ‘fraud unravels all’. This should apply even in instances where the fraud is committed by a misleading third party like a shipment agent and while the beneficiary is honestly unaware of the fraud. In commercial transactions, the beneficiary is always given an opportunity to alter the documents so that they are compliant with the terms and conditions that are stipulated in the letters of credit. However, no guarantee exists that the documents presented will be compliant and not forged. If a bank turns a blind eye on the documentary discrepancies and goes ahead to effect payment it may be held liable for contributory negligence. This was considered in the case of Standard Chartered Bank v Pakistan National Shipping Corporation & Others SCB had misrepresented some information to the issuing bank, Incobank that the right documents had been presented and therefore payment ought to have been effected. Incobank however refused to effect payment based on other discrepancies in the record. The court held that SCB would have been liable for dishonesty and therefore contributory negligence had the payment been made to the parties. In the case of Angelica-Whitewear the Supreme Court held that the banks could not absolve themselves from liability by applying an exemption liability clause. The court held that such a clause would undermine Article 8 of the UCP and further lower the credibility of documentary credit position in international trade. If a bank therefore effected payment in existence of fraud and discrepancies, it cannot absolve itself from liability. This essentially means that the bank cannot compel the customer to reimburse the bank after making such a serious overlook in course of its activities.22 The courts have shown a consistent embrace of the attitude that the banks should exercise due diligence as regards transactions. In every contract, the bank should look beyond the documents to interrogate carefully the absence of manifest lack of good faith in getting the right scienta to prove existence of fraud. The bank is not supposed to check the underlying contract or even consider the nature of goods that are being exchanged by the parties. In the case of Angelica Whitewear the court held that the fraud exception should not be extended to the documentary fraud alone but rather should extend to instances of underlying transaction. This position was echoed by Lord Denning in the case of Edward Owen Engineering Ltd. What this essentially means is that fraud exception should not be confined to the documentary fraud alone.23 This position is distinguishable to the strict adherence rule that was upheld in the case of Maurice O’Meara Co v National Bank of New York (1925 636). The case involved a contract of some print paper. Though the documents were correct, fraud was found in the underlying contract since the paper was not of the right quality. The court held that the defendant had other remedies and fraud exception should only be allowed for documentary fraud and not on the underlying contract. Need for reforms Good faith as a precondition of payment For a long time the banks have used the independence principle as the only element of consideration when determining whether to effect the payment to the beneficiary. As elaborated above, in most instances the sellers can be actuated by malice and therefore benefit unjustly if they tender the appropriate documents to the bank. This ought to be reformed and the element of good faith as added to assist in facilitating the payment to the right party. This position has been the subject of consideration in the case of Banco Santander SA v Banque Paribus (2000) 1 ALL ER 776, the court was of considered decision that apart from the act of beneficiary tendering the right documents. There is a great need that the banks investigate the bonafide good faith of the same beneficiary. Thus as one of the precondition before the payment is channeled the seller has to show he has acted in good faith throughout through the transaction.24 In the Santander case, the court held that strict compliance and independence principle which require the beneficiary to present the right document should not be the basis of effecting payment, rather the good faith of the beneficiary. This case illustrates the key responsibility placed upon the shoulders of the bank to be careful before channeling any form of payment to the beneficiary. 25 Banks independent checks This important reform is very necessary in the UCP and widely embraced by the International Maritime Bureau. This proposal opines that the banks should make independent checks to determine the authenticity of transactions and documents used in international commerce such as a bill of lading. Documentary credits have been used for a long time to the disadvantage of the buyers. Therefore, a degree of necessary requirement for the bank it is to interrogate the activities of the clients. Through independent checks, the bank can easily establish the existence of warning signs of fraudsters among the clients that it intends to serve. 26 Submission reforms In some cases, the beneficiary gets some part of the payment upon partial and full submission of documents. In some banks, they are reported to give 90% of the payment upon remission of partial document and the rest upon further presentation of the documents. In most instances, the banks have often been known to give payment upon the beneficiary providing merely a letter of indemnity and an invoice. An indemnity letter in most instances guarantees that the beneficiary is ready to remit and submit the rest of the documents that includes the bill of lading and the certificate of quality. Such premises is faulty and a reform is necessary to ensure that the beneficiary do not get any form of payment unless all the necessary documents are delivered and not merely on an invoice and an indemnity letter. Such presumptions are very costly and should not be entertained in the banking arena and transactions.27 Concept of assignment However, in most instances the beneficiary can genuinely appoint and assign a third party to receive payment on their own behalf, such a set up may be subject to abuse. The beneficially may involve themselves in a sham contract because they correctly know that the payment will still be effected from the issuing bank to the advising bank. A clear set of guidelines ought to be embraced to limit the number of transactions where assignment is given by the beneficiary, since they can leave a lacuna for fraud.28 Negotiability Negotiability is one of the main characteristics of documentary credit. It is entrenched and permitted under Article 500 of UCP where the beneficiary is paid a portion of the money before the maturity draft based on the reflected sum in the drafts. In most instances the confirming bank doesn’t offer any form of warranty while offering payment to the beneficiary. It owes no duty to the issuing bank, and thus a great temptation arises of effecting payment and later claiming some form of reimbursement. This point was noted in the case of First Union National Bank v Paribas (2001 US Dist Lexis 2909) where the beneficiary presented the documents to the confirming bank before the maturity date. The confirmer discounted based on the guarantee that the issuing bank would reimburse the money. When a conflict arose between the parties, the issuing bank successfully argued against liability since the confirmer had turned a blind eye on a blatant existence of fraud in the letters of credit. Such an area needs to be reformed so that discounting and negotiability is checked appropriately.29 Embracing the illegality exception The illegality exception intervenes to buttress and fairly well reform the fraud exception. This rule can be traced in the case of Mahonia Ltd v JP Morgan Chase Bank (2003) EWHC1927 Coleman J held the view that the courts should not at all allow the beneficiary to benefit from the illegality of underlying contract. Any transaction tainted with an illegality should not be entertained by the parties. The illegality issue was well discussed in the infamous case of American Accord by Lord Diplock.30 Insufficient rules and principles in relation to letters of credit With the growth of technology and Information Technology (IT) so has the development of fraud. This is especially so with electronic documents which can perpetrate fraud. The UCP needs to incorporate elements of technology.31 Conclusion The Fraud Exception is an important principle that is geared to prevent fraud especially by the beneficiaries. The place of injunction in fraud cases is very pertinent. It is through injunction that the beneficiary is denied the opportunity to enrich himself or herself unjustly. Though a preliminary injunction is discretion of the court, there is a great need to regulate the rules that govern such injunctions. The injunctions may be negatively used by the buyers to delay the process. They should bear costs and interests for such action. The law too ought to reflect the need to ensure that the banks are protected from the beneficiary who sues, until an injunction application is determined. The current environment is not water tight enough to deter the continuance of fraud by the fraudsters. If at all the beneficiary have benefited from the loopholes to mint out innocent buyers their hand earned money. Submissions opine that if the courts continue to give a wider interpretation of the independence principle, the fraud exception continue to lose its meaning. In administering justice, the courts should not be blurred by the independence principle. The beneficiary should not influence by any means the banks to effect payment. The main objective of the court should be to protect the buyers by ensuring fairness upon being drawn to the allegation of fraud. Any activities whether acted by a third party or even a beneficiary should be restrained if it has been conducted in bad faith. The fraud exception should continue to hold an esteemed position since it seeks to protect the buyers’ rights and protects the banks securities. BIBLIOGRAPHY Secondary material: books Booysen Hercules, International Transactions and the International Law Merchant (Pretoria, Interlegal, 2005). Filiberto Agusti, International Business Law and its Environment (Mason, South- Western, 7th Ed, 2004). Gao Xiang, The Fraud Rule in the Law of Letter of credit: A Comparative Study (Kluwer, Law International, 2002) Griffin Bernadette, The Law of International Trade (London, LexisNexis Butterworth’s, 3rd Ed 2003) Schimitthoff Clive M., Schmitthoff’s Export Trade: the Law and Practice of International Trade (London, Stevens & Sons, 2000) Stephan Paul B, Wallace JR Don & Julie Roin. A. International Business and Economics: Law and Policy (New York, Contemporary Legal Education Series, 2nd Ed, 2006). Zhang Linxiang, Theory and Practice of Letters of Credit, (HongKong, Wan Yuan Book Ltd, 2007). Secondary material: articles Aicher Robert D., Cotton Deborah L & Khan TK. Credit Enhancement: Letter of credit, Guaranties, Insurance and Swaps (The Clash of Cultures). (2004). 59 The Business Lawyer 897. Barnes James G., Letter of Credit: 2000 Cases (56 The Business Lawyer, 2001) Blodgett Mark S. & Mayer Donald O., International Letters of Credit: Arbitral Alternatives to Litigating Fraud (2000) 35 American Business Law Journal 49 Buckley Rose P., Potential Pitfalls with Letter of Credit. (2006). The Australian Law Journal 26- 70. Gao Xiang, The Fraud Rule in Law of Letter of Credit in the P.R.C (The International Lawyer, 2007). Read More