American Law On Documentary Credit Fraud example essay topic

1 Introduction - Letters of Credit in International Trade. In international trade, payment by means of a letter of credit has become so widely used that Justice Kerr of the English Court has called the instrument, "the life-blood of international commerce". [1] It is the most effective method to secure payment in an international trade transaction, in a way that takes care of the interests of both the seller and the buyer. This is due to the sanctity of the document. 1.1 Difficulties in International Sales Transactions.

Payment for goods sold in international sales transactions is often problematic, due to the international character of the transaction. The parties usually have their places of business in different states, and are therefore subject to different national legal systems. Furthermore, the seller will often transport goods across large distances and across national borders. Under such circumstances, the seller has a great interest in ensuring that it will receive payment for goods sold once the goods leave its possession and control, and the buyer has a corresponding interest to ensure that the seller has dispatched conforming goods before making payment in terms of the sale agreement. [2] When goods travel across national borders, they are moved outside the jurisdiction in which the seller resides. Once outside the seller's jurisdiction, any attempts to regain control or possession of the goods will be significantly more difficult for the seller.

Similarly, if the seller does not receive payment once the goods are delivered, it is all the more difficult to pursue the buyer for payment, because the buyer and all of his assets will probably be outside the seller's jurisdiction. The seller will deliver goods to a foreign jurisdiction where he has little influence, and possibly very little knowledge of the applicable law. Foreign law may govern many aspects of the transaction including procedures to obtain payment, and the seller may be required to obtain any court order necessary to enforce such payment, through a foreign forum, where it does not have easy access to the wheels of justice. This may prove to be inconvenient and expensive. [3] Similarly, if the buyer makes payment for the goods prior to receiving delivery, and if the seller fails to make delivery or delivers nonconforming goods, then the buyer is left facing a similar prospect of pursuing the seller in a foreign jurisdiction. 1.2 Letters of Credit.

The system of documentary credits that is in use in current international trade has largely alleviated these problems relating to payment. The parties establish a letter of credit, [4] which enables the seller to obtain payment from a bank within his jurisdiction. The buyer establishes the letter of credit in such a manner, that payment is promised on presentation of certain documents, the contents of which confirm that the goods being delivered to the buyer are goods that conform to the terms and conditions of the underlying sales agreement. [5] The seller need only comply with the documentary conditions as specified in the credit, and is thereafter assured of payment.

[6] 1.3 The Mechanics of Letters of Credit. The commercial practice of documentary credits entails that the buyer makes an application to a bank to issue an undertaking to make payment to the seller, once the bank receives certain documentation on behalf of the buyer from the seller, indicating that the seller has dispatched conforming goods. This undertaking, if issued, is known as a letter of credit or a documentary credit. [7] The buyer, as applicant, will inform the bank of the documentary requirements that he wishes to have inserted into the letter of credit. [8] These requirements are essentially designed to ensure that the seller submits documentation that records his compliance with its obligations in terms of the underlying sales agreement. [9] The buyer will normally request the seller to submit clean shipping documents proving that the goods have been delivered to a carrier for carriage, and the seller's commercial invoice listing the goods, the quantities, and the price of the goods.

The buyer may also request the seller to submit insurance documentation, certificates to prove quantity or quality, packing lists, and any other documentation required to show that the seller has complied with the terms of the underlying sales agreement. [10] The seller will then submit all the stipulated documents to the issuing bank or to the bank nominated to receive documents and to make payment. If the submitted documents comply strictly with the terms of the credit, then the paying bank is obliged to make payment in terms of the credit, to the seller. [11] 2 The Principle of Strict Compliance, and the Independence Principle. It is trite that every letter of credit involves at least three separate and independent transactions, between three different parties.

[12] Two distinct doctrines uphold the sanctity of the letter of credit, secure the payment transaction, and thus promote the efficiency of international trade. The doctrine of strict compliance is not the focus of this dissertation, but it is a vital component of the structure of credits. It gives rise to the doctrine of independence and therefore to the fraud exception, which in essence allows a piercing of the doctrine of independence. It therefore merits brief discussion for the purposes of a wider discussion of the fraud exception. 2.1 Strict Compliance.

The doctrine of strict compliance protects the interests of the buyer and of the paying bank. When submitting the required documents, the law expects the seller to comply strictly with the requirements stated in the letter of credit. [13] This assures the buyer that the bank will not pay the seller, unless the seller presents documents that satisfy the requirements of the buyer. The bank is protected in that it is not required to make any judgement calls as to the relevance of the requirements contained in the letter of credit. The bank is not called upon to make any decisions as to substantial compliance by the seller. [14] Lord Sumner quite aptly encapsulates the doctrine with the following statement: "There is no room for documents which are almost the same, or which will do just as well".

[15] Similarly, Lord Dip lock states: "The banker is not concerned whether the documents for which the buyer has stipulated serve any useful commercial purpose or as to why the customer called for the tender of a document of a particular description. Both the issuing banker and his correspondent bank has to make quick decisions as to whether a document which has been tendered by the seller complies with the requirements of a credit". [16] In terms of the doctrine, the beneficiary's performance has to comply precisely with the terms and conditions as contained in the letter of credit. The bank is not required to make any judgment as to the adequacy of the performance of the beneficiary, nor as to the importance of any particular term of the letter of credit. If performance were not made in strict accordance with the letter of credit, the bank would then be contractually obliged to the applicant, to refuse payment on the credit. [17] American law also upholds and applies the doctrine of strict compliance, and need not be specifically referred to, due to the fact the approach of the American courts is identical to that of the English Courts as referred to above.

[18] 2.2 Independence. The corollary to this doctrine is that the seller will always receive payment from the bank if he submits documents that strictly comply with the credit, regardless of any developments in the underlying sales agreement, or in the relationship between the seller and the buyer. The seller will be paid regardless of any disputes that may arise in respect of the underlying sale. [19] The independence principle safeguards the position of the seller, and thereby promotes the efficiency of international trade. It holds that the relationship between the seller and the issuing bank in respect of the letter of credit is completely independent from any ancillary agreements between the seller, the buyer, and the issuing bank. In reality, there are at least three separate agreements in such transactions.

[20] These are the contract of sale between the seller and the buyer and the contract between the buyer and the issuing bank pertaining to the issue of the letter of credit to the seller. There is also the contract between the issuing bank and the seller regarding the issuing bank's undertaking to make payment of a certain sum of money to the seller, as soon as the seller has complied with certain documentary conditions. It is this latter agreement that is independent of the other two. International commercial law strongly recognises and confirms the independence of the agreement between the issuing bank and the beneficiary as evidenced in the letter of credit, from all the other underlying and ancillary agreements. [21] As far back as 1867, Lord Cairns quite aptly stated the principle underlying documentary credits. 'The person taking bills on the faith of it is to have the absolute benefit of the undertakings in the letter, and to have it in order to obtain the acceptance of his bills, without reference to any collateral or cross claims.

' [22] Oelofse states that the whole rationale of the letter of credit in international trade is that it is used to provide the beneficiary with a secure and swiftly-operating instrument to provide payment, to the exclusion of any disputes that may arise with respect to the underlying contract of sale. [23] Essentially, the buyer must first pay the seller, and can thereafter refer any disputes in relation to the underlying agreement for litigation. [24] It is well recognised that the system of documentary credits which has been established over centuries, provides security for both buyer and seller. It forms the basis upon which banking institutions extend credit facilities to the various parties in such transactions. Ignoring these principles would seriously jeopardize and undermine the confidence of international traders, because the security of the payment obligations of the bank would be eroded. [25] 2.3 The Uniform Customs and Practice for Documentary Credits (UCP).

Due to the growth in international trade, it became commercially necessary in the 1930's, to adopt an internationally unified approach in respect of documentary credit transactions. Banks had already been cooperating on a regional basis in order to create uniform rules in respect of such transactions. [26] The greatest impetus came from the ICC, which gathered support for its Uniform Customs and Practice for Commercial Documentary Credits (UCP). These were originally published in 1933. [27] Banking institutions in more than 140 countries worldwide have accepted the UCP for the purposes of documentary credit transactions.

The UCP upholds and applies the principle of independence. [28] Article 3 (a) reads: 'Credits, by their nature, are separate transactions from the sales or other contracts on which they may be based and banks are in no way concerned with or bound by such contracts, even if any reference whatsoever to such contracts is included in the Credit. Consequently, the undertaking of a bank to pay, accept and pay Drafts or negotiate and / or to fulfil any other obligation under the Credit, is not subject to claims or defences by the Applicant resulting from his relationships with the Issuing Bank or the Beneficiary'. [29] 'In credit operations all parties concerned deal with documents, and not with goods, services and / or other performances to which the documents may relate. ' [30] Accordingly, when deciding whether to make payment under the credit in favour of a beneficiary, the bank may only look to the terms of the credit itself. The bank may not raise any defences that are available to the Applicant in respect of the underlying agreement of sale.

[31] Notwithstanding the fact that the independence principle is stated in such absolute terms, as with most legal principles, the principle has to allow for certain limited exceptions. [32] In the case of the independence principle, such exceptions are perhaps a little more limited than usual. In fact, there is only one exception that has been widely recognised in international jurisdictions, and that is the fraud exception. [33] Certain courts have upheld other exceptions based on such concepts as legality, public policy, and comity considerations arising from international conventions. [34] These, are not as universally accepted as the fraud exception, are beyond the scope of this dissertation, and are only therefore briefly mentioned. 3 The Fraud Exception.

It may be useful to distil a basic approach in respect of the fraud exception, which is common in most jurisdictions. Most legal systems uphold the independence principle with a great degree of sanctity. However, one can envisage circumstances where it would be unconscionable to insist that a bank makes payment to a seller, if the seller has been unscrupulous towards the buyer. The issue of fraud is a perfect example. The essence of the exception is that the bank can either avoid payment, or can be prevented from making payment, if at the time of the presentation of the documentation stipulated in the letter of credit, the beneficiary has misrepresented a fact, which would otherwise have entitled the bank to avoid making payment on the credit. This would entail that the beneficiary, if it had been truthful in its representations, would have presented documentation that did not strictly comply with the requirements of the letter of credit.

This exception is available both as a defence which can be utilised by a bank to avoid claims for payment, or as an injunction or interdict obtained by a party to prevent the bank from making payment on a letter of credit. [35] The usual requirement is that the beneficiary's fraudulent conduct must be clearly established, and that the bank must have knowledge of this fraud before making payment on the credit. [36] In the matter of United Trading Corporation SA and Murray Clayton Ltd vs. Allied Arab Bank [37] it was stated that the mere allegation of fraud would not be sufficient. The court is expected to require strong corroboration of the allegation, usually in the form of contemporary documents.

[38] Notwithstanding this general approach, international jurisdictions differ in regards to the specific ambits of fraud exception, and in respect of other possible exceptions to the independence principle. Overall, the English case law on the fraud exception is largely based on developments in America. In the locus classic us of English law, the matter of United City Merchants [39], the courts relied heavily on the American Stzejn matter. [40] At the Queen's Bench Division, Moc atta J decided the matter squarely on the considerations outlined in Stzejn.

[41] English case law is of particular significance to the South African law in this area, due to the fact that it is likely to be extremely influential on the South African judiciary. [42] 4.1 Sztejn vs. J. Henry Schroder Banking Corporation. One of the first cases where the fraud exception was not only recognised but also applied, is the American case of Sztejn vs. J. Henry Schroder Banking Corporation. [48] In this matter, the court granted the buyer an injunction restraining the bank from honouring the draft drawn by the seller on the letter of credit. The seller had filled 50 cases with rubbish instead of the goods purchased in terms of the underlying agreement, in order to obtain a bill of lading from the carrier, which would reflect that the purchased goods had been delivered for carriage. Naturally, this conduct on the part of the beneficiary was fraudulent.

At the hearing of the matter, the beneficiary did not contest the fact that the goods delivered were not the goods that were contemplated by the agreement of sale. The only issue that was placed in dispute was whether the buyer's allegations could enable the court to prevent payment on the credit. [49] The Court quite rightly rejected the Defendant's averments that the Plaintiff lacked a cause of action. The Defendant argued that the bank could only concern itself with the documents, which on their face complied with the terms of the credit. [50] The court recognised and strongly supported the independence principle, but made a distinction between a situation where the seller had breached certain warranties or conditions, and the case where the seller was blatantly fraudulent in attempting to claim payment for goods that it had failed to ship.

During the course of his judgement, Shientag J stated the following: [51] 'It is well established that a letter of credit is independent of the primary contract between the buyer and the seller. The issuing bank agrees to pay upon presentation of documents, not goods. This rule is necessary to preserve the letter of credit as an instrument for the financing of trade. ' 'It would be a most unfortunate interference with business transactions if a bank before honouring drafts drawn upon it was obliged or even allowed to go behind the documents, at the request of the buyer and enter into controversies between the buyer and the seller regarding the quality of the merchandise shipped. ' The court nevertheless found that the beneficiary's fraud, of which the issuing bank had notice, was sufficient grounds for granting the injunction preventing the bank from making payment to the beneficiary, contrary to the independence principle. Shientag distinguished this matter from one that involved a mere breach of the agreement of sale, on the basis that the seller had intentionally failed to ship the goods ordered by the buyer.

[52] Shientag stated that despite the broad language used in previous cases to uphold the independence principle, he was not referred to any cases involving intentional fraud on the part of the seller. [53] Shientag quite significantly stated that: 'the principle of independence of the bank's obligations under the letter of credit should not be extended to protect the unscrupulous seller. ' [54] This distinction allowed Shientag to make the bold decision of restraining the bank from making payment on the documentary credit. Shientag based this exception squarely on the ex tur pi caus a rule. This established a trend of thought that has since been followed in various jurisdictions, including in English and South African law.

[55] As a final note on this judgement, the Plaintiff in this matter alleged that the fraud existed in the documents that accompanied the drafts for payment, in that they misrepresented the nature of the goods that were dispatched by the seller. In accordance to this view, it could be argued that this matter relates to fraud in the documents, and not merely fraud that exists in the underlying transaction. [56] 4.2 Beyond Sztejn. The Sztejn matter was central to the development of the law relating to the fraud exception in America, as it was the first reported matter where the exception was upheld in no certain terms, and where a broad formulation for the exception was outlined by the court.

Simply stated, the independence principle should not be extended to protect an unscrupulous seller, who is seeking to receive payment, through conduct which is clearly fraudulent. In this regard, it is vital to recognise the distinction between a fraud that relates to the underlying agreement, and one that relates to the documents. Judicial decisions in this regard have been conflicting. Some courts have held that the fraud must pertain to the presentation of the documents, and not merely to the underlying transaction. However, this distinction is sometimes superficial. A case in point is the Sztejn matter.

[57] The fraud in question was the delivery of worthless goods rather than the goods purchased, and this in turn became a documentary issue, when the seller presented documents falsely reflecting delivery of conforming goods. It is thus unclear whether the fraud relates to the underlying transactions, the documentation, or both. Shientag sought to overcome this problem by treating the fraud as one that existed in the documentation. [58] Furthermore, it is quite clearly equitable that the independence principle be ignored when the fraud is one relating to a fundamental aspect of the underlying agreement, such as delivery of goods in terms of the agreement.

However, American courts have extended this principle far beyond this initial exception. Some courts have even gone as far as to apply the exception to cases where the fraud was constituted by nondisclosure during the negotiation of the underlying agreement. [59] On the other hand, many courts have adopted the view that the independence principle can only apply in cases where the fraud relates to a fundamental aspect of the contract. [60] It is averred that the latter approach is the more correct approach, at least in respect to a fraud that relates to the underlying agreement, and it is the approach most favoured by American courts. [61] In light of the strength with which the independence principle is upheld, it should be expected that only a fundamental fraudulent action on the part of the seller would warrant a piercing of the principle. If this were not the case, then a party could use a minor breach or minor misrepresentations for the purposes of avoiding its obligations in terms of the agreement, and international trade would thus be adversely affected in that the application of the exception in this manner would increase the uncertainty of such payment transactions.

Perhaps it is simpler to state that the fraud in question will be considered as fundamental enough to justify the bank to refuse payment on the letter of credit, if in terms of the laws relating to the principle of strict compliance, the bank would be entitled to refuse payment if it was aware of the true position. [62] This is vital because certain fraudulent acts or representations may not in terms of strict contractual principles be fatal to the agreement between the parties, whereas in terms of the doctrine of strict compliance relating to letters of credit, the bank would be justified in refusing to make payment on the letter of credit. [63] A case in point is the matter of United City Merchants, where the fraud related to the date of shipment, which was one day later than that stipulated on the letter of credit. In terms of normal contractual principles, this may not have been sufficient to allow the buyer to cancel the agreement of sale, but it is sufficient in terms of the doctrine of strict compliance, to warrant the bank's refusal to make payment on the letter of credit. [64] 4.3 The American Uniform Commercial Code (UCC). [65] The Stzejn matter was an important milestone in the development of American law relating to the fraud exception.

The American law on documentary credit fraud is codified in the Uniform Commercial Code, (UCC), [66] as a direct result of the Stzejn matter. [67] The UCC provides one of the few examples of a codified system of law relating to documentary credit transactions. [68] In most jurisdictions, the law relating to documentary credits arises through jurisprudence and case law. The courts commonly apply the provisions of the Uniform Customs and Practice for Commercial Documentary Credits (UCP), due to the vast number of banking institutions internationally that adopt these rules for the purposes of all documentary credits that they issue. Furthermore, the UCC makes specific provisions regarding the exceptions to the independence principle, with particular reference to the fraud exception, whilst the UCP remains silent in this regard. [69] Whilst the laws of most international jurisdictions relating to the fraud exception arises from common-law and from jurisprudence, American laws relating to the fraud exception are solidly founded in codified form in this statute.

Note that in the event of a conflict between the rules of the UCC and the UCP, and when the letter of credit has been issued in terms of the UCP as is normally the case, certain State legislatures have provided that Article 5 of the UCC will be inapplicable in respect of any matter covered by the UCP. However, and in light of the fact that the UCP does not deal with the fraud exception, all issues relating to fraud on the part of the beneficiary in such states, will still be dealt with in terms of the UCC. [70] The UCC allows a bank to avoid payment on a letter of credit, if the documents presented are fraudulent, or if there is fraud in the transaction. [71] This latter ground for exception is important in that it clearly refers to a fraud relating to the underlying transaction, which need not necessarily be contained in the documentation presented to the bank.

This goes further than English law, which requires the fraud to be contained in the documentation and not solely in the underlying transaction. [72] 4.4 Fraud in the Documents and Fraud in the Underlying Transaction. Prior to the revision to the UCC, [73] there was an ongoing debate as to whether the concept of fraud in the underlying transaction, as provided in the old Article 5-114 of the UCC, referred only to the transaction between the issuer of the credit and the beneficiary, or whether it also referred to the underlying transaction between the beneficiary and the applicant of the credit. [74] The former is the narrow approach, and the latter, the broad approach.

[75] In respect of Article 5-114 of the old UCC, JF Dolan states that this latter ground for exception should be interpreted as referring to the credit transaction itself, and not to the underlying transaction between the parties. [76] This view is difficult to uphold due to the fact that if the fraud pertained to the credit transaction, this would be a matter between the bank and the beneficiary, and would have nothing to do with the underlying transaction, or with the transaction between the buyer and seller. It could be argued that it would not fall within the ambits of the independence principle, because it is a matter that is removed from the underlying transaction. [77] It can also not be argued that fraud pertaining to the documentary credit transaction can be equated to a fraud present in the documents that are presented to the bank. Article 5-114 (2) specifically made provision for documents that are fraudulent, and it is presumed that they would not repeat this concept in different words, in the same paragraph. The UCC made a distinction between documents that are fraudulent, and fraud that is present in the transaction.

It is therefore averred that the only logical conclusion regarding the wording of Article 5-114 of the old UCC, is that fraud present in the transaction, can only refer to the underlying transaction between the parties. The narrow approach limits the fraud to that which relates to the underlying agreement between the beneficiary and the issuer of the credit. There is case law to support the view that in order for the fraud to justify dishonour of the credit, it must be a fraud that exists in the presentation of the documents, and applies only when a fraudulent credit transaction is alleged, as opposed to a fraud relating to the underlying contract. [78] These cases seem to support the view suggested by Dolan in his analysis of Article 5-114. However, a vast body of case law was at odds with this narrow view, and with Dolan's assessment of this concept of fraud in the transaction.

There is ample case law that unequivocally holds that the drafters of the UCC utilized the term 'fraud in the transaction' as a flexible concept that needed to be interpreted in light of the prevailing circumstances of any particular case. [79] It is also instructive to note the judgement of NMC Enterprises, Inc. vs. Columbia Broadcasting Systems, which provides that if the sales or underlying contract is tainted with fraud, then any document, which the contract requires the beneficiary to present, is equally tainted with fraud. [80] This approach may be a convenient way to dispose of the distinction between fraud in the documents and fraud in the underlying transaction. The decision makes the distinction irrelevant because a fraud in the underlying transaction will always constitute a fraud in the documents as soon as documents are presented as required by the credit. [81] Since the revision of the UCC, this argument has become moot. [82] The new revision makes it quite plain that payment may be refused or interdicted not only in the case of forged or fraudulent documents, but also in the case of any other material fraud by the beneficiary on the issuer, or applicant.

[83] This is a clear indication of a choice in favour of the broad view. 4.5 Extent of Fraud Justifying Dishonour. The American courts have diversely treated the question of the extent or nature of the fraudulent conduct that would justify dishonour of a letter of credit. The approach has varied between a fraud serious enough to vitiate the entire transaction on the one hand, and fraud that is merely intentional fraud on the other hand. [84] Certain courts require that the fraud is of such a serious nature that it would outweigh any public policy considerations relating to the necessity to honour documentary credits. [85] In other words, the fraud must be of such a nature, that it so invalidates the entire transaction that the legitimate purposes of the independence of the issuing banks obligations, will no longer be served.

[86] Others require that the fraud be of such a nature so as to vitiate the entire transaction. [87] In this regard it has been held that the existence of fraud sufficient to vitiate the transaction in terms of the law of tort, will not necessarily be sufficient to justify a dishonour of a letter of credit. [88] Some courts have held that it is sufficiently fraudulent if a beneficiary attempts to receive payment on a documentary credit, if he does so knowing that he has failed to perform his obligations in terms of the underlying agreement. [89] It has for example been stated in Item Corporation vs. First National Bank of Boston that, ' [i] t was a fraud in the transaction for the beneficiary to make a call under a latter of credit under circumstances where the underlying contract plainly shows that he is not to do so. ' [90] Still others merely require that the fraud be intentional. [91] In this instance, all that is required is an intentionally fraudulently act, committed by the beneficiary.

The State court of New York for example, requires proof of an active, intentional fraud on the part of the beneficiary. [92] It is vital to note that a mere breach of contract that is not fraudulent, is not sufficient to justify dishonour. Fraud on the part of the beneficiary in such breach is a vital element. [93] All of these approaches have been recognized, and it has been held that the federal court must follow the definition given by the appropriate state court to the concept of fraud as used in the UCC. [94].