The “fraud exception” and the L/C independence principle

As L/C practitioners know, the documentary credit is a bank’s undertaking to pay against presentation of documents which comply with the terms and conditions of that undertaking (L/C). It is a well-established principle of the documentary credit that it is independent from the contract of sale on which it is based. As a corollary, banks deal only with documents and not with the goods/services to which documents relate. The seller (the beneficiary) has the bank’s undertaking to pay provided it presents compliant documents to the bank. The bank, in its examination of documents and judgement, decides whether to take them up or to refuse (for discrepancies) independent of the buyer (the applicant).

 

 

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How far the seller’s performance risks are mitigated very much depends on the documents required by the documentary credit that are issued on the instructions of the buyer – in other words, on the correct selection of the documents in line with other terms of the contract of sale (above all, the delivery terms) and their correct and precise description. The buyer´s knowledge and experience and/or those whose services he uses (the issuing bank) are crucial. Any dispute regarding the delivery of goods or any other term or condition of the contract of sale, etc., should be decided separately from the L/C transaction.

Even though the independence principle is accepted worldwide, occasionally courts decide that issuing banks are estopped from making payment under L/Cs based on an alleged contractual failure by the seller to fulfil its obligations under the contract. This happens despite the fact that the essence of the documentary credit is that if the seller/beneficiary meets the conditions of the L/C (presents compliant documents), then he is to be paid regardless of any possible dispute concerning the delivery of the goods to the buyer (applicant). This is the choice the contracting parties made when they concluded the contract of sale and selected the documentary credit as the instrument of payment. Therefore, in my view, these judgments are clearly incorrect.

Fraud exception

However, there is one well-established exception to the independence principle, the so-called “fraud exception”. Even here, unless it is clear from the documents themselves that they are fraudulent, banks are reluctant to be the party to decide that fraud occurred.

In general, there should be no problem with courts intervening in independent bank undertakings, such as those involving L/Cs, in this exceptional case. No bank wants to be obliged to knowingly pay a fraudster. It would be absurd if the issuing bank or the confirming bank were obligated to pay its deferred payment undertaking at maturity to a fraudster simply because the L/C is legally independent from the contract of sale.

But if courts are to employ the fraud exception, it should be under very strict conditions.

– The fraud must be established. It must be “outright fraud”, such as fraudulent presentation of documents for non-existent cargo, or similarly, “proven manifest fraud”.

– The injunction can only be employed in order to prevent a payment to the beneficiary in case the fraud in relation to presentation of documents took place.

There is a difference between “manifest fraud” on the one hand and an “alleged fraud” or a “commercial dispute” on the other. Courts are expected to draw a line between these different situations. A further convergence of laws and their interpretation in relation what constitutes a fraud in the context of independent banking undertakings would be very welcome. In any event, an injunction should be granted only in very exceptional cases of fraud to prevent payment to the beneficiary.

If the beneficiary has been already paid by the nominated bank (confirming bank) by means of negotiation or as prepayment of its deferred payment undertaking or prepayment or purchase of the draft accepted by that nominated bank as per sub-article 12 (b) of UCP 600, then it is too late. The documentary credit in that situation has been already discharged towards the beneficiary; there only remains the reimbursing obligation of the issuing bank towards the nominated bank as per sub-article 7 (c). Any intervention by the courts to prevent the issuing bank from reimbursing the nominated bank, which in good faith and as clearly authorized by UCP 600 paid the beneficiary, is clearly wrong.
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Pavel Andrle discusses technical LC details with an eBSI consulting client.

UCP 600 and fraud

It is said that UCP 600 does not deal with fraud, that the fraud issue is to be settled according to the applicable law. While it is true that UCP 600 does not mention fraud directly, my belief is that the essence of UCP 600 is to protect banks that adhere to the UCP in cases of fraud. Consider article 34, which provides: “A bank assumes no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any document, or for the general or particular conditions stipulated in a document or superimposed thereon … “. Another sub-article, 12 (b), gives a nominated bank that accepted a draft or incurred a deferred payment undertaking authority to prepay or purchase a draft accepted or a deferred payment undertaking incurred by that nominated bank.

In line with the above, sub-article 7 (c) defines the issuing bank’s reimbursing obligation towards the nominated bank: “… an issuing bank undertakes to reimburse a nominated bank that has honoured or negotiated a complying presentation and forwarded the documents to the issuing bank. Reimbursement for the amount of a complying presentation under a credit available by acceptance or deferred payment is due at maturity, whether or not the nominated bank prepaid or purchased before maturity. An issuing bank’s undertaking to reimburse a nominated bank is independent of the issuing bank’s undertaking to the beneficiary.

The last sentence in the previous paragraph underscores the fact that, even if the issuing bank would not be obliged to pay the beneficiary (because of the fraud), it must reimburse the nominated bank which already paid said beneficiary.

Negotiation

When the L/C is available by negotiation, UCP 600 says: ” … an issuing bank undertakes to reimburse a nominated bank that has honoured or negotiated a complying presentation and forwarded the documents to the issuing bank.

If the tenor is sight, then it is pretty straightforward; the reimbursement will be provided by the issuing bank when it takes up the documents. In this case, the negotiation might be effectively provided by the nominated bank only by advancing the funds to the beneficiary against the draft/documents. If the fraud is known only after the negotiation – advancing funds to the beneficiary – took place, then, in my view, there is no room for the fraud exception, as there only remains the reimbursement obligation of the issuing bank towards the nominated negotiating bank.

However, the situation may be less clear if the tenor (of the draft and/or documents) is usance. Then, according to the definition of the term “Negotiation” in article 2 of UCP 600, the nominated bank might either “advance funds” or “agree to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank“.

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Training in international standard banking practice and procedures can significantly reduce the risk of fraud.

If the nominated bank negotiates by advancing funds, i.e., pays the beneficiary against the presented draft/documents, then it is to be reimbursed by the issuing bank when the reimbursement is due, i.e., at the maturity date of the usance period. Again, I see no role for the fraud exception after the funds are advanced. If the negotiation is done by “agreeing to advance funds on or before the banking day on which reimbursement is due to the nominated bank“, this could be a different situation. If the beneficiary is paid when the maturity of the agreement to advance funds by the nominated negotiating bank is due, and if this is before the fraud is established, the issuing bank must reimburse the nominated bank at the maturity of the usance period. If, by contrast, the fraud is established before the agreement to advance funds is due, i.e., before the beneficiary is paid, then the idea that the nominated bank must in any case pay the beneficiary – the fraudster – and that the issuing bank must reimburse that nominated bank because the negotiation has already taken place, would seem to be unjust.

The other difficulty with negotiation could occur if the negotiation is completed after the presented documents are sent to the issuing bank. Is this negotiation as per UCP 600? It would seem that the definition of the term “Negotiation” suggests that it is to be made (whether in the case of an advance of funds or an agreement to advance funds) against the draft and/or documents. Indeed, the use of the word “purchase” in the definition suggests that negotiation must be made in this way.

The applicant and fraud

The buyer is responsible for its conduct. It has chosen its contract party and should get to know that party before it agrees to sign a contract with it. If the party is unknown to the buyer, the respective measures to be taken by said buyer and the details of the contract should reflect this. Moreover, if the use of a documentary credit is agreed upon, the conditions of the credit should be very well thought through. For instance, a pre-shipment certificate of quality issued by an independent inspection company with a clear requirement as to its content might be called for to minimize the risk of fraud. That said, many buyers are negligent and reckless regarding the selection of their business partners and the negotiation of the contract terms. If the fraudster/beneficiary has already been paid, then my view is that it is the buyer who should suffer the loss, not the banks that acted in good faith in accordance with the mandate they were given by UCP 600.

However, it is also true that in many well-known fraud cases the applicant was not an innocent party, but actually a fraudster himself. The bank can become a victim of a fraud committed by the applicant as a result of the security it took in relation to the L/C. Of course, this kind of fraud would not prevent the issuing bank from paying for compliant documents presented under the L/C unless the beneficiary was also a party to the fraud (and unless it had not already been paid, as discussed above).

Pavel Andrle is an international trade finance consultant and trainer for eBSI ExportAcademy and Secretary of the Banking Commission of ICC Czech Republic. His e-mail is pa@cmail.cz

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