The Current Status of the Fraud Rule

6.06 This chapter will present the current position of the fraud rule in international rules and conventions and also in the jurisdictions of the US, the UK, and China.

has been applied in the context of an application for an injunction to stop payment on a performance bond until a final resolution of the dispute between the parties. In my view, both letters of credit (including standby letters of credit) and independent guarantees, including performance bonds, are documentary transactions, so the same rules should be applied. Therefore, in this chapter, when I discuss the fraud rule in the law of letters of credit, I also cover the law of independent guarantees.

A.                                               International Rules and Conventions

1.   ICCRules

The Uniform Customs and Practice for Documentary Credits (‘UCP’) published by the 6.07 International Chamber of Commerce (‘ICC’) is silent with respect to the issue of fraud and the fraud rule. The reason is that the UCP is simply designed to provide a contractual framework for dealings between issuers and beneficiaries, and issuers and correspondent banks.

Both the content and the interpretation of all of the ICC rules are influenced by the fact that 6.08 ‘their function is to serve as rules of best banking practice, not rules of law’,^[555] and the issue of fraud is considered as ‘the province of the applicable law and of the courts of the forum’.^[556] Any injunctive relief on the ground of fraud by the beneficiary should therefore be dealt with by national laws. In other words, although ‘[t]he ICC drafters are clearly aware of the fraud issue’,^[557] and have implicitly recognised the existence of the fraud rule in various juris­dictions,^[558] they have deliberately left it out.^[559]

2.    UN Convention

(a)                Any document is not genuine or has been falsified;

(b)    No payment is due on the basis asserted in the demand and the supporting docu­ments; or

(c)                Judging by the type and purpose of the undertaking, the demand has no conceivable

basis............................

6.10 While paragraph (a) focuses on fraud in the documents, paragraphs (b) and (c) are related to fraud in the underlying transaction. Paragraph (2) of article 19 explains the meaning of the term ‘no conceivable basis’ as follows:

(a)    The contingency or risk against which the undertaking was designed to secure the beneficiary has undoubtedly not materialised;

(b)    The undertaking obligation of the principal/applicant has been declared invalid by a court or arbitral tribunal, unless the undertaking indicates that such contingency falls within the risk to be covered by the undertaking;

(c)    The underlying obligation has undoubtedly been fulfilled to the satisfaction of the beneficiary;

(d)    Fulfilment of the underlying obligation has clearly been prevented by wilful miscon­duct of the beneficiary; or

(e)    In the case of a demand under a counter-guarantee, the beneficiary of the counter­guarantee has made payment in bad faith as guarantor/issuer of the undertaking to which the counter-guarantee relates.

6.11 Paragraph (3) of article 19 further provides that, if fraud is involved, not only can the is­suer refuse payment, but also the applicant can take court measures against the beneficiary by stating that ‘in the circumstances set out in subparagraphs (a), (b) and (c) of paragraph

(1)                    of this article, the principal/applicant is entitled to provisional court measures in ac­cordance with article 20’.

6.12 Under the Convention, the fraud rule can be briefly summarised as the following: if it is ‘manifest and clear’ that fraud or abusive drawing under standby letters of credit or inde­pendent guarantees is established, the fraud rule can be applied, no matter whether fraud is involved in the documents, as stated in paragraph (1) (a) of article 19, or is related to the underlying transaction, as stated in paragraphs (b) and (c) of article 19(1).

B.    lang=EN-US>National Laws

1.          UnitedStates

6.13 The current fraud rule in the law of letters of credit in the US is provided in s 5-109 of Article 5 of the Uniform Commercial Code (‘UCC’),^[560] which reads:

(a)    If a presentation is made that appears on its face strictly to comply with the terms and conditions of the letter of credit, but a required document is forged or materially fraudulent, or honour of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant:

(1)    the issuer shall honour the presentation, if honour is demanded by (i) a nominated person who has given value in good faith and without notice of forgery or material fraud, (ii) a confirmer who has honoured its confirm­ation in good faith, (iii) a holder in due course of a draft drawn under the letter of credit which was taken after acceptance by the issuer or nominated person, or (iv) an assignee of the issuer's or nominated person's deferred obligation that was taken for value and without notice of forgery or ma­terial fraud after the obligation was incurred by the issuer or nominated person; and

(2)    the issuer, acting in good faith, may honour or dishonour the presentation in any other case.

(b)    If an applicant claims that a required document is forged or materially fraudulent or that honour of the presentation would facilitate a material fraud by the benefi­ciary on the issuer or applicant, a court of competent jurisdiction may temporarily or permanently enjoin the issuer from honouring a presentation or grant similar re­lief against the issuer or other persons only if the courts find that:

(1)    the relief is not prohibited under the law applicable to an accepted draft or de­ferred obligation incurred by the issuer;

(2)    a beneficiary, issuer, or nominated person who may be adversely affected is adequately protected against loss that it may suffer because the relief is granted;

(3)    all of the conditions to entitle a person to the relief under the law of this State have been met; and

(4)    on the basis of the information submitted to the court, the applicant is more likely than not to succeed under its claim of forgery or material fraud and the person de­manding honour does not qualify for protection under subsection (a)(1).

6.14

As can be seen, in order for the fraud rule to apply in the US, ‘material fraud' is needed.

Necessarily courts must decide the breadth and width of ‘materiality'. The use of the word requires that the fraudulent aspect of a document be material to a purchaser of that docu­ment or that the fraudulent act be significant to the participants in the underlying trans­action. Assume, for example, that the beneficiary has a contract to deliver 1,000 barrels of salad oil. Knowing that it has delivered only 998, the beneficiary nevertheless submits an invoice showing 1,000 barrels. If two barrels in a 1,000 barrel shipment would be an insub­stantial and immaterial breach of the underlying contract, the beneficiary's act, though possibly fraudulent, is not materially so and would not justify an injunction. Conversely, the knowing submission of those invoices upon delivery of only five barrels would be ma­terially fraudulent.

New Roman">6.15 The example set out in the paragraph above seeks to explain what the term ‘material fraud' means in a scenario of a commercial letter of credit. As for standby letters of credit, it has stated:

Material fraud by the beneficiary occurs only when the beneficiary has no colourable right to expect honour and where there is no basis in fact to support such a right to honour... ^[561] We have said throughout that courts may not ‘normally issue an injunction because of an important exception to the general ‘no injunction' rule. The exception, as we also explained in Itek, 730 F.2d at 24-25, concerns ‘fraud' so serious as to make it obviously pointless and unjust to permit the beneficiary to obtain the money.

6.16 As can be seen, to apply the fraud rule in the US, ‘material fraud' is required. For commer­cial letters of credit, material fraud ‘requires that the fraudulent aspect of a document be material to a purchaser of that document or that the fraudulent act be significant to the participants in the underlying transaction'. Further, the ‘beneficiary's act, though possibly fraudulent, would not justify' the application of the fraud rule if it is not materially fraudu­lent. Even if the beneficiary knowingly or intentionally delivers fewer goods than contracted or commits fraud, the fraud rule cannot be applied if the fraudulent act is ‘an insubstantial and immaterial breach of the underlying contract'. For standby letters of credit, the fraud involved should be ‘so serious as to make it obviously pointless and unjust to permit the beneficiary to obtain the money'. In summary, under revised UCC article 5 in the US, even if fraud is clear and established, the fraud rule cannot be applied if the fraud is not ‘material’.

6.17 The fraud rule in the US has been tested in many cases.

made a deal with the plaintiff, Al Makaaseb General Trading (AMGT'), a company head­quartered in the United Arab Emirates, for the plaintiff to act as the financier on the letter of credit, for which it became the applicant. One of the documents required for the payment of the letter of credit was a dock receipt. When a dispute rose, AMGT sued USSI, alleging, among other things, fraud and forgery in connection with the letter of credit and moved for summary j udgment.

6.18

AMGT alleged that the 28 February 2004 dock receipt was ‘fraudulent’ because it errone­ously indicated that all 184 pieces of pipe had been unloaded at the designated pier on or before Saturday, 28 February 2004, when in fact, thirty-two pieces of pipe contained in two railroad cars which were physically at the port were not actually physically unloaded by the stevedore until 3 March 2004. Although the dock receipt was dated 28 February 2004, it was not signed until 3 March 2004, when all of the thirty-two remaining pieces had been unloaded.

6.19

The Court rejected the claim and held:

What plaintiff does not demonstrate, even under the broadest reading of the above facts, is how these events could ‘so vitiate the underlying transaction’ as to constitute a material fraud. See Intraworld Industries, Inc. v. Girard Trust Bank, 461 Pa. 343, 336 A.2d 316, 324­325 (Pa. 1975).The Official Comments to Section 5109 of the U.C.C. explain that ‘material fraud’ would not include petty or inconsequential discrepancies, that the courts must examine the underlying transaction when there is an allegation of material fraud, and that material fraud by the beneficiary occurs only when the beneficiary has no colorable right to expect honor and where there is no basis in fact to support such a right to honor. Vol. 2B Uniform Commercial Code (U.L.A.) § 5-109 (Master Edition). Even accepting plaintiff’s position that the facts of a discrepancy is not disputed, the Court does not see how this discrepancy amounts to a fraud at all, much less a ‘material fraud,’ such that USSI had no colorable right to expect honor.

As discussed above, plaintiff alleges that the dock receipts contained untruthful repre­sentations. The dock receipt is the presentation document submitted pursuant to a L/C presentment, and accordingly, even if the minor delay in unloading could be construed to render the receipt false, the warranty of presentment was not breached because ver­acity was not a condition of the letter of credit. PNC Bank, National Assn, 912 F. Supp. 169; Farmers-Merchants Bank & Trust Co. v. Travelers Indem. Co., 791 F. Supp. 150, 153 (W.D. La 1992). Accordingly, accepting plaintiff’s position that there is no dispute of material fact on this issue, defendant USSI is not liable for breach of the warranty of presentment as a matter of law.^[565]

6.20

The facts of the case are clear. That is, the dock receipt stated that all 184 pieces of pipe were unloaded at the designated pier on or before 28 February 2004, but thirty-two pieces of pipe were actually not unloaded until 3 March 2004. The dock receipt, which was a re­quired document for the payment under the letter of credit, was not telling the truth. The beneficiary was not honest. It had lied or committed fraud in relation to the dock receipt. However, because the dock receipt did not affect the value of the goods, the court took the view that the beneficiary’s dishonest behaviour did not ‘so vitiate the underlying transaction as to constitute a material fraud’. Therefore, the fraud rule was not applied and payment was not stopped.

6.21 The consequence of the judgement is this: because the beneficiary had lied or acted fraudu­lently, it presented ‘complying documents’ and obtained payment; if it had acted honestly or not lied or not committed fraud, it could not have presented complying documents and obtained payment. It is obviously a very strange and unfair result! Is it good law?

2.          UnitedKingdom

6.22 The fraud rule is recognised in the UK, but only in cases, not in statutes, as there is no statu­tory law in this area in the UK.

6.23 The English courts ‘have traditionally been very reluctant’^[566] to interfere with the payment of a letter of credit and have adopted an inflexible and narrow approach towards the applica­tion of the fraud rule.^[567] They have saddled plaintiffs with a great burden of proof, requiring them to establish the existence of clear or obvious fraud known to the issuer in order to apply the fraud rule. The oft-quoted passage is the following statement of Kerr J in R D Harbottle (Mercantile) Ltd v National Westminster Bank Ltd:^[568]

It is only in exceptional cases that the courts will interfere with the machinery of irrevocable obligations assumed by banks. They are the life-blood of international commerce. Such obligations are regarded collateral to the underlying rights and obligations between the merchants at either end of the banking chain. Except possibly in clear cases of fraud of which the banks have notice, courts will leave the merchants to settle their disputes under the contracts by litigation or arbitration as available to them or stipulated in the contracts.... Otherwise, trust in international commerce could be irreparably damaged.^[569]

6.24 The difficulty to establish ‘clear’ fraud in English courts has been well demonstrated by the first English case to cite Sztejn with approval:^[570] Discount Records Ltd v Barclays Bank Ltd,^[571] where the plaintiff, an English buyer, contracted with a French seller, Promodisc, to buy 8,625 discs and 825 cassettes. The buyer instructed the defendant to issue a documentary credit in favour of the seller. The seller shipped goods purporting to be those ordered and presented a draft with documents regular on their face to the confirming bank in Paris and the documents were accepted. When the goods arrived, the buyer inspected them in the presence of a representative of the issuer and found that ‘there were 94 cartons, but of these two were empty, five were filled with rubbish or packing, twenty-five of the record boxes and three of the cassette boxes were only partly filled, and two boxes labelled as cassettes were filled with records; instead of 825 cassettes, as ordered, there were only 518 cassettes and 25 cartridges... Out of the 518 cassettes delivered, 75% were not as ordered... out of

the 8625 records ordered, only 275 were delivered as per order. The rest were not as ordered and were either rejects or unsaleable’.^[572]

6.25

Relying upon Sztejn, the buyer attempted to enjoin the issuer from honouring the drafts drawn upon the letter of credit, alleging that the seller was guilty of fraud. Megarry J of the Chancery Division rejected the buyer's claim and said:

[I]t is important to notice that in the Sztejn case the proceedings consisted of a motion to dismiss the formal complaint on the ground that it disclosed no cause of action. That being so, the court had to assume that the facts stated in the complaint were true. The complaint alleged fraud, and so the court was dealing with a case of established fraud. In the present case there is, of course, no established fraud, but merely an allegation of fraud. The defend­ants, who were not concerned with that matter, have understandably adduced no evidence on the issue of fraud. Indeed, it seems unlikely that any action to which Promodisc was not a party would contain the evidence required to resolve this issue. Accordingly, the matter has to be dealt with on the footing that this is a case in which fraud is alleged but has not been established.^[573]

6.26

Despite the fact that the buyer in the case obtained its evidence in the presence of the issuer, showing that a great proportion of the shipment was either rubbish or empty cartons, the court ruled that there was ‘no established fraud, but merely an allegation of fraud’, because the seller was not involved with the proceedings.

6.27

The leading case in the UK is United City Merchants (Investments) Ltd v Royal Bank of Canada,^[574] where Glass Fibres and Equipment Ltd (‘GFE’), an English company, entered into a contract selling glass fibre-making equipment with a Peruvian company named Vitrorefuerzos SA (‘Vitro’). Payment was to be made by an irrevocable letter of credit issued by Banco Continental SA of Peru and confirmed by Royal Bank of Canada (‘RBC’). GFE assigned their rights, entitlements, and benefits due under the letter of credit to United City Merchants (‘UCM’), and notice of the assignment was given to the banks. Shipment was to be from London to Callao on or before 15 December 1976. The goods were nevertheless shipped by the loading broker on 16 December, not on 15 December as required. When documents were presented to RBC for payment, they were rejected on the basis that, among others, ‘information in our possession suggests that shipment was not in fact effected as it appears by the bill of lading’.^[575]

6.28

The beneficiary sued the confirming bank for wrongful dishonour, and won the case when it went on appeal to the House of Lords. The House of Lords approved of the trial judge’s reasoning that the fraud was committed by a third party without the involvement or know­ledge of the beneficiary, and should therefore not prevent the beneficiary from being paid on the letter of credit. This decision is consistent with the rationale behind the fraud rule in the English courts, which is that ‘fraud unravels all’: The courts will not allow their process to be used by a dishonest person to carry out a fraud.^[576] The beneficiary in this case was not affected by the fraud rule as it had not been dishonest.

6.29New Roman"> When considering the issue of third party fraud, Lord Diplock touched upon the kind of fraud that could invoke the fraud rule and said:

To this general statement of principle [of independence] as to the contractual obligations of the confirming bank to the seller, there is one exception: that is, where the seller, for the purpose of drawing on the credit, fraudulently presents to the confirming bank documents that contain, expressly or by implication, material representations of fact that to his know­ledge are untrue.^[577]

6.30 As can be seen, according to Lord Diplock, ‘material misrepresentation' of the fact can in­voke the fraud rule in the UK. As to what the term ‘material' means, Lord Diplock rejected two propositions by the counsel for the confirming bank. The first is ‘a misstatement of a fact which if the true fact had been disclosed would have entitled the buyer to reject the goods'^[578] because it ‘is to destroy the autonomy of the documentary credit which is its raison d’etre; it is to make the seller's right to payment by the confirming bank dependent upon the buyer's rights against the seller under the terms of the contract for the sale of goods, of which the confirming bank will have no knowledge'.^[579] The second is ‘material to the price which the goods to which the documents relate would fetch on sale if, failing reimbursement by the buyer, the bank should be driven to realise its security'^[580] because ‘the realisable value on ar­rival at Callao of a glass fibre manufacturing plant made to the specification of the buyers could not be in any way affected by having been loaded on board a ship at Flexistowe on December 16, instead of December 15, 1976'.^[581]

6.31 Lord Diplock himself did not provide an answer to the question. However, it may be as­sumed from the judgment of the case that predating of bills of lading as occurred in the case can be taken as ‘material misrepresentation' because the House of Lords never denied the existence of fraud in the case. In fact, all of the three levels of the courts, the first instance, the Court of Appeal, and the House of Lords handled the case on the basis of letter of credit fraud. Therefore, it can be said that predating of bills of lading is taken as fraud in the law of letters of credit and can trigger the application of the fraud rule in the UK.

3.           China

6.32 In China, the fraud rule is provided in the Rules of the Supreme People’s Court Concerning Several Issues in Hearing Letter of Credit Cases (‘Chinese LC Rules') published in late 2005.^[582] Article 8 of the Chinese LC Rules provides:

Any of the following shall be considered as letter of credit fraud:

(i)     The beneficiary has forged documents or presented documents containing fraudulent information;

(ii)            The beneficiary has intentionally failed to deliver goods or delivered goods with no value;

(iii)   The beneficiary has conspired with the applicant or a third party and presented fraudu­lent documents whereas there is no actual underlying transaction; or

(iv)           lang=EN-US>Other circumstances that constitute letter of credit fraud.

6.33

Subsection (i) deals with fraud in the documents. It covers two types of situations: one is that the document does not exist at all but is simply forged by the beneficiary; the other is that the document exists but the information contained therein is fraudulent.

6.34

Subsection (ii) deals with fraud in the underlying transaction. Where fraud is alleged to have been involved in relation to the underlying transaction or goods, the fraud rule in the PRC can only be applied in circumstances where no goods have been delivered or where goods have been delivered but without any value. Other situations, such as where goods are of low quality or a lesser quantity is delivered than the contractual amount, cannot be treated as fraud.

6.35

Subsection (iii) deals with the situation where no genuine underlying transaction is in­volved. From time to time, cases are reported in the PRC where the beneficiary and the ap­plicant are in collusion to defraud the bank or to avoid the rules of foreign exchange control by making false contracts. Strictly speaking, it is not the type of fraud normally considered under the fraud rule of letters of credit.

6.36

Subsection (iv) is a catch-all clause to cover anything that might have been left over by sub­sections (i), (ii), and (iii). It is to serve as a safety valve to prevent any fraudulent acts from falling through the net. Again, strictly speaking, this is not the type of fraud normally con­sidered under the fraud rule of letters of credit.

6.37

Accordingly, though there are four sections under article 8 of the Chinese LC Rules, only sub­sections (i) and (ii) are relevant to illustrate, in the context of this chapter, the type of fraud that can invoke the fraud rule in the PRC. The fraud rule in China is different from that provided under s 5-109 of the revised UCC article 5 in the US or the position in the UK, where a catch all standard of fraud, or ‘material’ fraud or misrepresentation, is used. The fraud rule provided under the Chinese LC Rules is a two-point or bifurcated standard of fraud system:

(1)    For fraud in documents, as long as the documents are forged or fraudulent, the fraud rule can be triggered.

(2)    For fraud in the underlying transaction, if the transaction is for the sale of goods, it is only when goods have not been delivered or have been delivered but without any value that the fraud rule will be triggered. In other words, disputes over quality or quantity of goods cannot invoke the fraud rule at all in the PRC.

6.38

However, it is worth mentioning a Chinese case where the influence of US law can clearly be seen. In the case of Industrial Bank of Korea Seoul v Lianyungang Kuchifuku Foods Co Ltd,^[583] decided by the Jiangsu High People’s Court (‘JHC’) in 2003 under the guidance of the Supreme People’s Court of the PRC (‘SPC’), the appellant, Industrial Bank of Korea Seoul (‘IBK’) issued an irrevocable letter of credit in favour of Lianyungang Kuchifuku Foods Co Ltd (‘LKF') on 24 April 2002. The latest loading date was 31 May 2002. When the documents were presented, they were rejected by the issuer on the basis of fraud, as the goods were not loaded on board the ship until 4 am 1 June 2002, four hours later than the latest time per­mitted for loading under the letters of credit. The beneficiary sued the issuer for wrongful dishonour in the Nanjing Intermediate People's Court, which ruled in favour of the benefi­ciary on the basis that the issuer's claim of fraud was not proven. The issuer appealed on the basis that the beneficiary had presented a bill of lading that was predated, which is a fraud in the law of letters of credit. The JHC ruled in favour of the beneficiary by saying:^[584]

1.                         LKF had no intention of fraud. Evidence presented has illustrated that LKF had prepared the goods before the date of loading, transported the goods to the designated place and went through customs' formalities. IBK has no evidence to show that the goods prepared by LKJ are without value or inferior in quality, and no other evidence to show LKJ is using the predated bill of lading to commit fraud. 2. Although IBK is claiming that the goods ar­rived late because of the predating of bills of lading, it has not provided evidence showing that the applicant has suffered substantial loss due to the goods loaded one day late (in fact 4 hours).

6.40 The first opinion (majority view) was that the Korean bank cannot refuse payment on the basis of predating of bill of lading because:

1. Key elements for fraud under letters of credit. According to laws and court cases of other countries, letter of credit fraud should meet the following criterion: (1) fraud must be committed by the beneficiary or the beneficiary must have taken part in the fraudulent activity. Normally fraud relating to bills of lading refers to the beneficiary's tampering with the content of the bills of lading or conspiring with the carrier so the carrier is­sues a bill of lading with material fraudulent information; (2) the fraudulent act has caused the applicant (the buyer under the underlying contract) material damage, that is, the beneficiary's fraudulent act has fundamentally broken the underlying contract. As for fraud in relation to predating bills of lading, material fraud arises when the under­lying transaction is involved with seasonal or fresh goods, when the price of the goods changes dramatically or when the seller's delayed loading may have caused the buyer to breach its resale contract with its buyer, because the buyer will treat the seller's pre­dating of bill of lading as a gross breach of the contract.

3.      Looking at the causes and the consequences in the current case, the reason why the goods were not loaded timely was somewhat related to the fact that the applicant hin­dered the loading of the goods by the initial carrier. Further, the predating was only for

4 hours, and the Korean bank has no evidence to show that the buyer has suffered ma­terial loss due to the predating.

6.41

The second opinion was:

There are no provisions in China as to whether predating can be considered as fraud, and whether the issuer can refuse payment. Predating a bill of lading may normally harm the security of the transaction, and the issuer may refuse payment because the documents are in fact not in compliance with the terms and conditions of the letter of credit, no matter whether the beneficiary has taken part in predating the bills of lading or not.

6.42

The SPC issued a reply to the JHC and agreed with the first opinion, saying:⁴⁷

Predating bills of lading does not necessarily constitute fraud. Neither does it necessarily give the issuer the right to refuse payment. It should be dealt with according to different circumstances. If predating of bills of lading is caused by the beneficiary’s intentional fraud arising out of ill will, predating as a means of fraud shall be regarded as fraud even if predating is perpetrated by the carrier. In such a case, the bank can refuse payment on that basis. If predating of bills of lading is not caused by the beneficiary’s intentional fraud arising out of ill will, and the interest of the applicant is not damaged due to predating bills of lading, it shall not be regarded as fraud, and the bank cannot refuse payment on that basis. Looking at the circumstances of the case, KFJ should not be held as fraudulent, and the Korean bank is not entitled to refuse payment based on predating bills of lading.

6.43

On the face of the judgment, no fraud was found in the case by the JHC, which followed the opinion of the SPC that ‘Looking at the circumstances of the case, KFJ should not be held as fraudulent, and the Korean bank is not entitled to refuse payment based on predating bill of lading.’ It is likely that the judgment was heavily influenced by the US position of ‘material fraud’, as the JHC prefaced the first view by stating that this was ‘according to laws and court cases of other countries’.

6.44

The result of this case is the similar to that of the US case Al Makaaseb General Trading Co v United States Steel International Inc discussed above. That is, if the beneficiary had acted honestly and had not lied nor predated the bills of lading, it could not have presented com­plying documents and obtained payment. When it lied or acted dishonestly, it presented complying documents and obtained payment! This case was decided in 2003, which was be­fore the Chinese LC Rules were promulgated. How the Chinese courts will react to similar cases after the Chinese LC Rules have been published remains to be seen.