Documentary fraud
Introduction
Letters of credit can be termed as protean financial instruments. One of the reasons for terming it that way is due to its unique legal structure. In an attempt to describe its legal structure, they have since been referred to as specialty contracts because of the special set of rules that govern them. The primary rule is the independence principle. Regarding this principle, letters of credit should be separated from other contracts that generate them. The act of keeping them independent from the other contract enables the independent principle to insulate the letters of credit from performance dispute since the letters function as swift payment mechanism. However, its insulation can be tampered with in the event of illegality like when fraud is detected. For this reason, letters of credit can be defined to mean a letter from a bank that guarantees that the payment of a buyer to a seller shall be received in a timely manner and bear the correct amount due. In any event the buyer fails to make the necessary payments as required, the bank will be required to pay on behalf of the buyer the amount the buyer owes.
Enforceable rights and liability of parties involved in a letters of credit under UCP
There are eight main actors involved in a letter of credit contract. These parties include the following;
Applicant of the letters of credit/ the importer
An applicant is the main player in a letter of credit since the applicant initiates the letter of credit. Under normal circumstances, the buyer is often the applicant who opens the letter of credit. This means that the applicant opens the letter of credit consistent with the applicant’s instructions and the payments necessary is arranged to open letter of credit with their bank. The applicant organizes the opening of the letter of credit with their bank following the terms of agreements made between the buyer (normally the applicant) and the seller.
Letter of credit issuing bank
This denotes the bank that will be issuing the letter of credit upon an application by the applicant. The bank is also another main party in this transaction. The issuing bank carries the responsibility of paying the amount on receipt of documents from the supplier of the merchandises who in this case is the beneficiary under the letter of credit.
The issuing bank is under an obligation as a matter of law, to inspect the relevant documents to establish whether the said documents appear on their face to be in agreement with the credit letter. If the bank makes payments founded on non- complying documents, the issuing bank loses its right of reimbursement by the importer.
Beneficiary party / Exporter
As the name states, a beneficiary party is that party (normally the seller) who benefits from the letter of credit. This is because the letter is opened by the applicant in favour of the beneficiary. The beneficiary receives the amount stated under the letter of credit. The beneficiary is responsible for submitting all relevant documents in conformity with the terms and conditions provided for under the letter of credit
Advising Bank
Advisors Bank is bestowed with the responsibility of communicating with the necessary parties under the letter of credit in addition to the relevant authorities. This is the party who send documents to the opening bank under the letter of credit. Pursuant to Article 9 of the UPC, the bank shall satisfy itself as to the legitimacy of letters of credit and advice precisely reflecting on the terms and conditions of the letter of credit.
Confirming bank
This is the party that confirms and assurances that it shall assume the obligation of payment or negotiation approval under the credit.
As a matter of law, Article 8 of the UPC provides that the confirming bank is tasked with adding its own confirmation to compensate exporter on presentation of documents. This is done upon authorization or a request made by the issuing bank.
Negotiating bank
The negotiating bank negotiates documents conveyed by the beneficiary of the letter of credit. It negotiates by verifying and confirming the terms and conditions under the letter of credit on behalf of the beneficiary so as to evade inconsistencies.
Reimbursing Bank
This is the bank that is tasked with the authorization of honoring the reimbursement claim of negotiation, payment and acceptance.
Exceptions to the independent rule
The independence Principle of letter of credit law
Courts have introduced an exception to the use of the independence principle so as to address fraud cases. This is to prevent the injustices suffered by victims in circumstances where payment is made in a fraudulent transaction. Under the letter of credit, the validity of a document should bear prominence as compared to document compliance. The loss of value in documents as time goes by has led to instances where there exist a lot of inconsistencies between the documents presented and the goods supplied under the letter of credit. Originally, the integrity of the documents formed basis of the letter of credit most importantly the bill of lading which is the title document representing the merchandise. The introduction of container shipments has however affected the value of documents since those documents no longer represent the goods supplied as before. Before the introduction of container shipping, the transporter had to check the goods being transported physically and place the bill of lading on the goods stating the nature of those goods and the conditions in which the goods were in. with the introduction of container shipments, it is difficult applying the same rules and the bill of lading only notes anodyne notations that do not specify details on the goods in question.
Such developments in this area of commerce have affected the integrity of the documents which are wholly depended on when letters of credit system is concerned.
For such reasons, the independence principle had to have exception such as the fraud exceptions to be discussed below.
The fraud exception
As earlier mentioned, the primary principle that governs letters of credit is the independence principle. This particular principle is provided for in Article 3 and 4 of the UCP 500 .Under this principle, the issuing bank is obligated with the task of honoring a draft on a credit when it is complemented by documents which are in conformity with the terms and conditions of the credit on their face and which are independent of the performance of the agreement for which the credit was given.
The definition of a bank’s duty of examination is provided for under Article 13 of the UPC 500. This duty is in respect to document compliance which should comply with the international standard banking practices.
The application of the independence principle can be detrimental to this area of commerce that is why exceptions such as the fraud exception were incorporated to address this issue.
Before the modern developments like the introduction of cargo shipments as stated earlier in this work among others, fraud was not an issue of concern until after the Second World War. Through fraud, victims of the fraud end up losing a lot of money each year. For this reason, there was need to develop the fraud exception to the independent principle. In addition, the ICC banking commission commented that, despite having the independence principle entrenched in Article 3 and 4 of the UCP, and the right of the banks to seek reimbursement in accordance to sub Article 10 (d) and 14 (a), there is an exception namely: abuse of right or fraud. It can therefore be concluded that despite the establishment of the UCP, the fraud exception should balance the law on letters of credit to achieve equitable results.
Despite the provision of the fraud exception in place, this exception to the independence principle has raised quite a number of questions as summarized in the case of Angelica Whitewear. These questions or rather issues include:
- Whether the exception on fraud should apply only in cases involving fake documents or it should also extend to fraud in underlying contract.
- Whether the exception of fraud can be rebutted or opposed against a holder in due course of a draft
- Which approach is required to relieve an issuing bank of its obligation to honor a draft or to warrant the issue of an interlocutory injunction to enjoin the honor? Is it the demonstration of fraud or the sufficiency of proof which is requisite?
- Whether the exception on grounds of fraud should extend to a third party or limited to the beneficiary of the credit in the event where the beneficiary is innocent.
Despite having the fraud exception in place, it has proven to be quite difficult in its application which will be discussed in this work and how those challenges might be addressed to curb such vices in this area of commerce.
The Fraud Rule in U.K and Australia
United Kingdom
Quoting the authority of a case law in the UK, the United City Merchants (Investments) Ltd. v. Royal Bank of Canada was a case featuring the fraud rule where the payment of a letter of credit was rejected when a third party fraudulently pre dated the bill of lading. The beneficiary sued for wrongful rejection to honor the letter of credit. The Court based its decision on an American case, Sztejn v. J. Henry Schroder Banking Corporation. According to this case, an exception was established in the event where a seller presents fraudulent documents knowingly. More often than not, the UK does not apply the fraud rule despite its recognition in the UK jurisprudence. Justice Jenkins in the case of Hamzeh Malas & Sons v. British Imex Industries Ltd explained the reason as to why the UK jurisprudence is reluctant when it comes to the application of this rule. He noted that the opening of a letter of credit which has already been confirmed would constitute a bargain between the seller of the merchandise and the Banker. This will impose the obligation to pay upon a banker, despite any disputes that between the parties as whether the merchandises meet the requirements of the contact or not. Due to such reasoning by the courts, the courts have imposed very weighty burden of proof to plaintiffs which poses as one of the challenges especially in the application of this rule.
Australia
The first Australian case to apply the exception to the independent rule, the fraud rule, and further quote the Sztejn case was the case of Contronic Distributors Party Ltd. v. Bank of New South Wales. In this case, the plaintiff who was the financer of Contronic Distributors brought proceedings requesting the court to restrain the Bank from paying against the letter of credit and to further prevent GEC from presenting the documents after the financer discovered that the letter of credit was intended to also cover earlier debt the Contronic distributors owed GEC. The court granted the injunction. However, there are limitations of Australian cases on the fraud rule. The position of the Australian jurisprudence on the Fraud rule remains quite unclear.
Difficulties in invoking the fraud exceptions and how they can be addressed
As earlier noted, there seems to be inadequacy in the application of the said exception rule(fraud rule) and most of all, in piercing the independence principle veil. So far, the only mechanism put in place to curb such illegalities is fraud exception which has since proven to be inadequate. The fraud exception is very difficult to invoke since the threshold provided for by the law has since proven to be so high pertaining proof of fraud. This is because, for one to prove fraud, payment should not have been made. This in turn makes it difficult to detect fraud at an premature phase. Such problems are even worsened by the lack or the vagueness in the banks duty to buyer to make necessary investigations of possible red flags and the buyer’s duty to the bank to reimburse. The duty of the bank is mainly owed to the seller, hence, little incentive in the quest of identifying red flags and draw buyers attention to the associated implications of the lack of good faith on the seller’s part. The issue with such kind of an operation is that the buyer is compelled, normally, to take up any and all documents accepted by the banks to show to the transporter for the purposes of collecting goods.
This difficulty of meeting the high standards of proof can be demonstrated by the case of Discount Records Ltd. v. Barclays Bank Ltd. where the plaintiff sued the defendant, the seller, for allegations of fraud. This was because, out of 100 percent of the agreed shipments, more than 75 percent were not as ordered. The buyer was to receive 8625 disks and 825 cassettes. When the shipment arrived, the buyer inspected the goods in the presence of a representative of the issuer. The inspection revealed that out of 825 cassettes, 307 were missing. Out of the 518 received, 75 percent were not as ordered. Out of the 8625 records ordered, only 275 were delivered as ordered. The rest were either rejects or unusable. Despite this finding, the court ruled that no fraud was established. The court stated that those were mere allegations of fraud.
With this kind of approach, it is practically impossible to obtain an injunction to stop payment of letter of credit especially in the English courts.
The UPC should, in bid to resolve this issue, provided for a law that directs the relevant duties of the bank towards the buyer. The bank should hold as its obligation to identify red flags that might be an indication of fraud, lack of good faith and genuineness of the goods.
This can only be achieved if the standard of proof can be lowered so that it can be practical carrying the exercise out so as to help cure fraud in this section of commerce.
The UPC should further incorporate the obligation of good faith for all parties of this transaction and this should constitute a separate exception to the principle of independence in addition to the exception of fraud. The term “Good faith” is defined in §5-102 of the Revised UCC as “honesty in fact in the conduct or transaction concerned”. This inclusion will be effective and it is also possible since it was tested in Swiss law on which the court pierced the veil of the independence principle and looked beyond to establish the existence of fraud.
CONCLUSION
The discussions above in this work make it clear that the fraud rule which is the exception rule to the independence principle is an vital part of the law that governs letters of credit. This rule was developed to address a lacunae in the law in question that is; to prevent dishonest beneficiaries from misusing the letter of credit system and duping the applicant of the letter of credit and the issuer as demonstrated in the case of Discount Records Ltd. v. Barclays Bank Ltd. The fraud rule can be termed as a special type of a rule since it is contradiction with the primary principle of the law of letters of credit which is the independence principle as mentioned earlier. In the same footing, the application of this rule should be with caution so that it will not undermine the authority of the independence principle hence undermining the commercial value of the letter of credit.
The fraud rule has had a long history in regards to its development. It has also gained codification in the UNCITRAL Convention at the international level as well as recognition by virtually all jurisdictions. Presently, the rule has however proved to be a developing area of law in some jurisdictions as discussed above. The most unfortunate fact in the development of this rule is that the fraud rule has not yet gained recognition in the Uniform Customs and Practice for Documentary Credits which acts as the dominant rule of law for letters of credit that are fused by reference into essentially all credits issued globally.
For the journey started by Lord Mansfield in his judgment in the case of Pillans v. Van Mierop to reach its end, the UPC needs to address the issue on fraud. If this is achievable, the international commercial community will delight in a letter of credit system that protects it from fraudsters.
BIBLIOGRAPHY
Articles/Books/Reports
Gerald McLaughlin, Letters of Credit and Illegal Contracts: The limits of the independence principle (Ohio State Law Journal, 1989) Vol. 49:1197.
ICC Publication No. 565, Opinions of the ICC Banking Commission 1995-1996 (ICC Publications, 1997) at 22
- Lowe, Fraud and the Documentary Credit (Report of the ICC International Maritime Bureau, ICC Publications, 1994) at 7
Roy Goode, Abstract Payment Undertakings in P. Cane and J. Stapleton, Essays for Patrick Atiyah (Oxford University Press, 1991) 209-236, at 234.
William McCurdy, Commercial Letters of Credit (Harvard Law Review, 1992) 35(5), 539-592.
Case laws
Bank of Nova Scotia v. Angelica-Whitewear Ltd (1987) 1 S.C.R 59 at 167
Sztejn v. J. Henry Schroder Banking Corporation (1983) A.C. 168,183 (H.L. 1982) (Lord Diplock)
Contronic Distributors Party Ltd. v. Bank of New South Wales (1984) 3 N.S.W.L.R. 110
Discount Records Ltd. V Barclays Bank Ltd. (1974) 1 All E.R. 1071
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