Refining the Current Fraud Rule
A. The Rationale
6.45
As has been seen, under the position of the current fraud rule in the US, only ‘material fraud’ can invoke the fraud rule.
Following this approach, in some cases, as illustrated by thetwo cases in the US and China, even if fraud has been clearly established, if the fraud is not regarded as ‘material’, the fraud rule cannot be applied.
6.46 The application of the fraud rule in such a way has led to a very strange and unfair result: if the beneficiary behaves honestly, it cannot present complying documents, and therefore cannot be paid; if it behaves dishonestly, it can present complying documents and get paid! This should not be allowed. More importantly, the application of the fraud rule in such a way is against the fundamental values or the common basis of the general law against fraud. It is well known that ‘fraud unravels all’.[586] ‘There is as much public interest in discouraging fraud as in encouraging the use of letters of credit.’[587] The fraud rule is part of a sound legal system safeguarding the public policy of control of fraud. It is not good law nor good public policy to openly allow fraud which is not ‘material’ to be committed under the law of letters of credit. Fraud is wrong and should be prohibited and prevented in any case. When fraud is obvious, whether it is ‘material’ or not, the fraud rule should be applied.
6.47 Moreover, this application of the fraud rule is against the two basic principles of the law of letters of credit.
First, it is against the principle of independence. Because of the separation of transactions and the practice of letters of credit, how could the issuer know whether the predating in the cases discussed above so vitiates the underlying transaction as to constitute a material fraud or not? Secondly, it is against the principle of strict compliance, under which documents tendered for payment under a letter of credit must be in strict compliance with the terms and conditions of the credit. If the letter of credit specifies, for example, that the bill of lading must evidence shipment on or before 31 May as in the case of Lianyungang Kuchifuku Foods, but the bill of lading tendered shows that the goods are shipped on 1 June, the bank is bound to refuse to honour the letter of credit unless the discrepancy is waived. If the bank pays out, the buyer will not be obliged by a court to reimburse a bank that has not strictly obeyed its instructions. In Lianyungang Kuchifuku Foods, if the bills of lading had not been fraudulently predated (ie if the beneficiary had tendered one bearing the true date of loading), the bank could have relied on the principle of strict compliance and simply refused to honour the presentation. In such a situation, the beneficiary would not even have had a case!B. The Way Out
6.48 How to refine the fraud rule? A two-point standard of fraud or bifurcated standard of fraud should be adopted.
1. Simple Fraud for Fraud in Documents
6.49 For fraud in the documents, a clear simple fraud should trigger the fraud rule. Normally, fraud in documents is obvious and easy to establish, as shown in the cases discussed above.
Therefore, it is not necessary to take great pains to ascertain if fraud is involved. When fraud is clear and established, the fraud rule should be applied and payment should be stopped. Therefore, in relation to fraud in the documents, a simple fraud should trigger the application of the fraud rule, as provided in subsection (i) of Chinese LC Rules. This is clearly supported by the Court of Appeal in the case of United City Merchants,[588] where Ackner LJ stated:[T]he buyer, unless otherwise agreed, cannot be deemed to have authorised the banker to pay against documents which are known to be forged. If the documents are forged, then obviously they are not valid.... The banker's authority or mandate is to pay against genuine documents and that is what the bank has undertaken to do.[589]
6.50
Griffith LJ observed:
The latest date for shipment of the machinery was Dec. 15, 1976. The machinery was in fact shipped on Dec. 16, 1976, and if the bill of lading had shown that date the bank would have refused to pay upon presentation of the documents because of the strict rule that the documents must comply in every respect with the terms of the letter of credit ... [I]t would be a strange rule that required a bank to refuse payment if the document correctly showed the date of shipment as Dec. 16, yet obliged the bank to make payment if it knew the document falsely showed the date of shipment as Dec. 15 and that the true date was Dec. 16.[590]2
6.51
Secondly, it is also in line with the documentary nature of the letter of credit, or the centrality of the documents in letter of credit transactions. The genuineness of the documents is the foundation of the success of letters of credit, because ‘[b]anks deal with documents and not with goods, services or performances to which the documents may relate'.[591] Only genuine documents can meet the bargain of the parties and be accepted by issuers and applicants, whose interests otherwise will not be properly protected.
Trusting that genuine documents will be tendered, the applicant authorises the issuer to pay the beneficiary, and the issuer agrees to pay the beneficiary when documents conforming on their face to the terms and conditions of the letter of credit are received. So, if documents cannot be taken to mean what they say, the commercial foundation of letters of credit will vanish. Although it is not explicitly stated in every letter of credit that the documents should be genuine, it is logically and generally recognised that there is an implied warranty by the beneficiary that documents tendered are genuine.[592]6.52
The key argument or the reason to tolerate fraud in the documents is that it seems unfair to the beneficiary to refuse payment where the fraud involved is merely of a technical nature. For example, in either the Chinese case of Industrial Bank of Korea Seoul or the US case of Al Makaaseb General Trading discussed above, the fraud was only related to the dating of the bill of lading or the dock receipt, and the fact that false dates were stated in the documents would seem to have made little difference with regard to the value of the goods. There were no disputes over the quality or quantity of the goods involved. How can such an insignificant misconduct lead to non-payment of a significant amount of money?
6.53 When these cases are looked at ad hoc, it does seem to be unfair. Nonetheless, when they are looked at in the context of the overall legal system, it is not unfair at all. Firstly, the law cannot encourage fraud, no matter how minor it is. Secondly, a letter of credit is, after all, an instrument of payment. It is designed to facilitate the underlying transaction between the applicant and the beneficiary. If the beneficiary fully performs its obligations under the underlying contract, it can obtain complying documents evidencing its full performance of the underlying contract, present the required documents, and promptly get paid.
If it cannot present complying documents, it means that the beneficiary hasn't fully performed its obligations under the underlying contract, or has broken the contract. For example, in the Chinese case of Industrial Bank of Korea Seoul, the beneficiary did not load the goods on board the ship on or before 31 May 2002 as required in the underlying contract. When the beneficiary has broken the contract, who should bear the consequence? Naturally it should be the beneficiary.6.54 One of the functions of the letter of credit is to allocate risks. In the normal course of business, if the beneficiary can fully perform its obligation under the contract, it has less risk than the applicant. However, if it cannot fully perform its obligation under the contract to present complying documents and breaks the contract, the risk should be kicked back to the beneficiary. Under such circumstances, if the non-compliance is insignificant, it can ask the applicant, through the issuer, to waive the discrepancies in the documents. If the applicant permits the waver, the beneficiary can still get paid through letters of credit. If the beneficiary cannot get the waver, it can get paid through the underlying contract, though it may have to bear the risk of reduced payment or even non-payment because the applicant may suffer loss or even become bankrupt due to the beneficiary's fault or other causes. Even if the beneficiary cannot get paid, it is not unfair because this is due to its own fault or breach of the contract.
2. High Standard for Fraud in the Transaction
6.55 For fraud in the transaction, the standard of fraud should be high. The reasons are obvious. The first reason is a legal and commercial one, ie to minimise the application of the rule and maintain the principle of independence and the commerciality of letters of credit.
‘Fraud is, in practice, virtually the only defence available when one seeks to escape payment'[593] in many jurisdictions. If fraud is defined too widely, the fraud rule may be abused by the applicant who does not want the issuer to pay simply because it cannot profit from the underlying transaction. If the fraud rule is abused and obstruction of payment of a letter of credit is repeated too often, the inherent commercial functions of letters of credit such as promptpayment and allocation of risks will disappear, the business confidence in letters of credit as effective performance assurances will be destroyed,[594] and eventually the principle of independence and the commercial utility of the letters of credit themselves will be harmed. The second reason is a technical one, ie fraud in the transaction is not clear and obvious, unlike fraud in the documents. In many cases, it is very hard to distinguish fraud from breach of contract. To maintain the commerciality of letters of credit, the standard of fraud must be set high to prevent disputes related to breach of contract from becoming disputes involving letter of credit fraud.
6.56
Therefore, for fraud in the underlying transaction, a very high standard of fraud is necessary and favourable. The current standard of ‘material’ fraud adopted in s 5-109 of revised UCC article 5 in the US or the standard of ‘non-delivery’ or ‘no value’ provided under subsection (ii) of article 8 of the Chinese LC Rules are adequate and appropriate.
IV. Conclusion
6.57
The fraud rule in the law of letters of credit is a difficult and developing area. Currently, at the international level, it is silent in all ICC rules but has been provided in the UN Convention, where it requires ‘manifest and clear’ fraud for the application of the fraud rule. At the national level, in the leading countries such as the US and the UK, the standard of ‘material’ fraud, is required to apply the fraud rule, although the word ‘material’ may mean different things. In China, before the Chinese LC Rules were promulgated in 2006, cases were influenced by the position of the US. After the Chinese LC Rules were promulgated, how similar cases for fraud in the documents will be decided still remains to be seen.
6.58
Unfortunately, applying the US standard of ‘material’ fraud in cases of fraud in the documents, where fraud is clear and obvious but not regarded as ‘material’, has led to an unfair and strange result. To solve the problem, it has been proposed that the fraud rule should be refined and that a bifurcated standard of fraud should be adopted. That is, for fraud in the documents, a clear and simple fraud should be able to trigger the application of the rule; for fraud in the transaction, a high standard of fraud should be adopted.