Экзамен зачет учебный год 2023 / The independence principle of letters of credit and demand guarantees

5

THE FRAUD EXCEPTION

I.INTRODUCTION

1.General Nature of the Exception

Fraud is the first exception to the principle of independence of letters of credit and demand 5.01 guarantees to be recognized by the courts.1Where there is fraud by the beneficiary the excep­

tion allows for the principle of independence to be breached so that the right of the benefi­ ciary under the instrument may be defeated on the basis of facts outside the documents tendered. In other words, where there is an allegation of fraud, the bank is allowed to depart from the general rule and look beyond the documents tendered into the facts. An example is where the beneficiary has tendered a document which appears on its face to comply with the requirement of the instrument but the document contains a material false statement such as the wrong date of shipment. In such a case, if the bank is presented with evidence of the true facts by the account party, the exception allows the bank to look beyond the document into the facts and to refuse to make payment to the beneficiary if the evidence of fraud is clear.

1 In many common law jurisdictions the leading case is the decision of the New York court in Sztcjn v. ] Henry Schroder Banking Corporation, 31 NYS 2d 631 (1941). In England, see DiscountRecords Ltd v. Barclays Bank Ltd [1975.1 1 WLR315 \Edward Owen Engineering Ltd v. Barclays Bank InternationalY*a?[l978] QB 159. In Australia, see Contronic Distributors Pty Ltd (Receiver and Manager Appointed) v. Bank o fNew Smith Wales (1984) 3 NSWLR 110. In Canada, see Bank o fNova Scotia v. Angelica-Whitewear[\)%7\ DLR 161.

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The Fraud Exception

5.02 Where the exception applies, a number of consequences are possible. First, as indicated above, the bank is entitled to refuse to make payment even though the documents presented appear on their face to comply with the requirements of the instrument. Secondly, if the bank makes payment under a letter of credit with knowledge of clear or obvious fraud it may not be entitled to reimbursement, except where the payment was made not to the beneficiary himself but to an innocent third party within a protected class.2 Thirdly, where the bank makes payment before it has knowledge of fraud on the part of the beneficiary, it is entitled to claim reimbursement from the bank that instructed it or from the account party if it was instructed directly by the account party.3 Fourthly, where the bank makes payment to the beneficiary before it becomes aware of the beneficiary’s fraud, it has a right to claim damages in deceit against the beneficiary.4 Fifthly, if the account party has evidence of fraud, he can apply for an injunction to prevent the beneficiary from making a demand for payment and/ or to prevent the bank from making payment to the beneficiary.5 Alternatively, the account party may apply for an interim freezing order (.Mareva injunction) in respect of the proceeds of the letter of credit or demand guarantee.6

2. The Juristic Basis of the Exception

5.03 There is no fraud exception based on UCP 600, URDG 758 or ISP98. The ISP98 expressly states that the rules do not make provision for ‘defences to honour based on fraud, abuse or similar matters. These matters are left to the applicable law’.7 The UN Convention on Independent Guarantees and Standby Letters of Credit contains some provisions8 which serve a similar function to the fraud exception.9 These provisions are therefore applicable in the case of a demand guarantee or standby letter of credit to which the Convention applies. As the United Kingdom has not ratified the Convention it is not in force in England. Under English law the fraud exception has developed as part of the common law.101

5 .0 4 The legal basis on which the exception is recognized in English law was explained by Lord Diplock in the leading case of United City Merchants (Investment) Ltd v. The Royal Bank o f Canada'1where he stated that:

The exception for fraud on the part of the beneficiary seeking to avail himselfof the credit is a clear application of the maxim ex turpi causa non oritur actio or, if plain English is to be preferred, ‘fraud unravels all’. The courts will not allow their process to lie used by a dishonest person to carry out a fraud.12

2For a discussion on the parties within the protected class, see paras 5.89 to 5.109.

3See discussion in para 5.52.

4See the discussion in Chapter 1 1.

5See the discussion in Chapter 10, paras 10.16 to 10.64.

6See the discussion Chapter 10, paras 10.65 to 10.75.

7Rule 1.05 of ISP98.

8Esp. Arts 19 and 20.

9In the OHADA countries, the source of the fraud exception is Art. 36 of the Uniform Act on Securities 1997. In France, the exception, which had previously been recognized by the courts, is now contained in

Art. 2321 (2 ) of the Civil Code.

10MontrodLtd V. Gnmdkomr Ftehcbvertriebs GmbH [2002] 1 All ER (Comm) 257 at Г401

11[1983] 1AC 168.

12 Ibid., at 183.

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13See, e.g. Holman v.Johnson (1775) 1 Cowp 341, 343; Gray v. Thames Trains [2009] 3 WLR 167 at [30];

Stone dr Rolls Ltd v. Moore Stephens [2009] 3 WLR 455 at [18] and [20].

14In France see, e.g. Mattout, J-P, Droit bancaire international (3rd edn, 2004) at [254]. See also Stoufflet,

Le Credit Documentaire (1957) at 327, cited in Bank o fNova Scotia v.Angelica-Whitewear Ltd [1987] 1 SCR 59

at 82.

15 e.g. RD Harbottle (Mercantile) Ltd v. NationalWestminsterBank Ifts([1978] QB 146 at 155; Tukan Timber Ltdv. Barclays Bank Pic [1987] 1 Lloyd’s Rep. 171, 177; Czarnikow-Rionda v. Standard Bank [1999] 2 Lloyds

Rep. 187,203.

16 The implied term is not inconsistent with the wide scope of the account party’s indemnity to the bank, which in certain cases provide that the bank is not required to enquire whether the amount demanded by the beneficiary under the instrument is in fact due. Such a provision simply minors the general rule that a bank is not required to investigate the facts behind documents presented. Tire implied term as to fraud applies where the bank has clear knowledge of obvious fraud by the beneficiary.

17[1999] 2 Lloyd’s Rep. 187,203.

18In Montrod lad v. Grundkotter Fleischvertriebs GmbH [2002] 1 All ER (Comm) 257 at [41], Potter L.J.

referred to Rix J.’s analysis of the rationale of the fraud exception in terms of an implied contractual term with­ out any hint of criticism.

19 See the discussion at paras 10.42 to 10.44 in Chapter 10 below.

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The Fraud Exception

C.Claim by the paying bank against the beneficiaty

5.08If a similar implied term is required in the contract between the paying bank and the benefi­ ciary, to the effect that the beneficiary will not make a fraudulent demand for payment, it is suggested that it should be possible to imply such a term on the basis of Lord Diplock’s rationale. However, it is not clear whether such an implied term is required in the contract between the paying bank and the beneficiary.20 The beneficiary will in any event be liable to the paying bank in the tort of deceit if he knowingly makes a material false representation to the bank which induces the bank to make a payment which it would not otherwise have made.21 Thus, even if in the absence of an implied term the beneficiary will be entitled to payment in spite of his fraud, the bank will also have a counter-claim for damages for deceit which it is entitled to set-off against the beneficiary. For this reason, the bank is entitled to refuse to make payment in circumstances where if it pays it will have a claim against the beneficiary in damages for deceit.22

D.Claim by account party against the beneficiary

5.09Where it is the account party seeking to restrain the beneficiary from demanding or receiv­ ing payment the account party’s cause of action is not based on the contract between the paying bank and the beneficiary to which the account party is not privy. It is based on the underlying contract where the beneficiary’s fraud is one which induced the account party to enter into the contract.23 But where the beneficiary’s fraud is in making a false representation to the bank (for example, by presenting a document containing a false statement to the bank) it is not easy to see the account party’s cause of action against the beneficiary based on fraud. Since in such a case the fraud is perpetrated against the bank, it is the bank that has a cause of action against the beneficiary based on the tort of deceit. There is some divergence of judicial opinion in the English authorities concerning the account party’s cause of action against the fraudulent beneficiary. In United Trading Corporation SA v. Allied Arab Bank Ltd,24 where the question was whether the account party had a cause of action against the paying bank, the Court ofAppeal held that it was arguable that the account party had a cause of action in the tort of negligence since the bank owed a duty of care to the account party, as the party ultimately liable at the end of the chain, not to pay the beneficiary if the bank had evidence that the beneficiary’s claim was fraudulent. In GroupJosiRev. WalbrookInsurance,25 where the injunction sought was against the beneficiary of a letter of credit, Staughton L.J. did not express a final conclusion on the point, however, he stated his inclination to hold either that the account party has a cause of action such as that described in the United Trading case or that the account party’s claim for an injunction to restrain the beneficiary from demanding payment under the instrument is ‘a rare exception’ to the general rule requiring a cause of action for an injunction. However, a similar suggestion that no cause of action is required for an injunction against a beneficiary based on a fraudulent representation to the bank, because the court can rely on a general power to intervene in order to prevent fraud,

20No implied term is required where the issuing of the letter ofcredit or demand guarantee was procured by the fraud to which the beneficiary is a party.

21The beneficiary may also be committing an offence under the Fraud Act 2006.

22The bank’s claim in damages for deceit is discussed below at paras 11.02 to 11Л6 .

23e.g. Themehelp Ltd v. West [1996] QB 84.

24[1985] 2 Lloyd's Rep. 554 at 560.

25[1996] 1 Lloyd’s Rep. 345 at 359.

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II. M eaning o f Fraud

was rejected by Rix J. in Czarnikow-Rionda v. Standard Bank,26 So the precise position of English law on the question of the account party’s cause of action against the beneficiary in respect of a fraudulent demand is not yet settled. It is submitted that, if part of the purpose of the fraud exception is to afford the account party some protection against the beneficiary’s fraud or abuse, that purpose would be better served if the account party is entitled to defend himself by a pre-emptive strike. Therefore, the law should not adopt a position which pre­ cludes the account party from seeking an injunction against the beneficiary in a case where

the fraud is in a representation to the bank.

II. MEANING OF FRAUD

where the account party applies for an injunction to prevent the beneficiary from demanding payment or to prevent the bank from making payment to the beneficiary, it is not a require­ ment to show that the representee, the bank, has relied on the false representation or that the bank has suffered loss.32 In other words, the fourth and fifth elements of common law fraud listed in the preceding paragraph are not requirements for the fraud exception. Secondly, in the case of the fraud exception, where the account party seeks an injunction to stop the bank from paying or where the bank has already paid and the account party is refusing to reim­ burse the bank on the ground of fraud by the beneficiary, it is not enough to show that the

26 [19 9 9 ] 2 Lloyd’s Rep. 187 at 203.

27 Standard Chartered Bank v. Pakistan National Shipping Corp (No 2) [2000J 1 All ER (Comm) 1.

28[1983] 1 AC 168.

29Ibid., at 183.

30(1985) 30 BLR 48 at 63.

31In the same case Sir John Arnold also spoke of the fraud exception as ‘requiring something in the nature

of common law fraud, that is to say, established dishonesty’. 32 See discussion below at para 5.47.

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The Fraud Exception

beneficiary has knowingly made a material false representation; it must in addition be shown that the bank had knowledge of the beneficiary’s fraud.33

5.12 The elements of fraud for purposes ol the fraud exception are that there must be: (a) a mate­ rial false representation by the beneficiary, (b) the beneficiary must have known that the representation was false or did not have an honest belief that it was true, and (c) the bank is likely to act on the false representation or has acted on it and has suffered loss as a result. Where these three elements are established there will be fraud on the part of the beneficiary and the bank may refuse payment on this ground. However, where the account party seeks an injunction to prevent the bank from making payment or where the bank has already paid and the account party claims that it ought not to have paid, the account party must also establish, (d) that the bank has or had knowledge before payment of the beneficiary’s fraud.

1. Material False Representation

A. False representation

5.13 For the beneficiary to be guilty of fraud it must be shown that a false representation of fact or law34 has been made. In many cases this will be in the form of misstatements. However, active non-verbal conduct can also amount to a misrepresentation.35 In the context of the fraud exception the misrepresentation is either in the documents presented to the bank or in the wider transaction.

(i) Fraud in documents

5.14 If a beneficiary presents a document to the bank which contains a material false representa­ tion this can constitute fraud. The leading case is United City Merchants v. Royal Bank o f Canada,3637There, the beneficiary presented to the bank a bill of lading which stated a false date of shipment. The House of Lords held that a false statement of fact in a document pre­ sented to the bank could attract the fraud exception if the other requirements are satisfied. In that case the House of Lords endorsed the decision in the United States case of Sztejn v. J. Henry Schroder Banking Corporation.37 The claimant’s action before the New York Supreme Court was to restrain the payment or presentment for payment of drafts under a letter of credit issued to secure the purchase price of hog bristles bought by the claimant from the beneficiary ol the credit. The beneficiary shipped some material and, through the correspon­ dent bank, presented drafts and related documents for payment by the issuing bank. The complaint alleged that the material shipped were not hog bristles but rather cowhair, other worthless material and rubbish’.38 In other words, although the documents tendered may appear to conform to the credit they contained material false representations of fact. The defendant bank, by a motion, applied for the complaint to be dismissed on the ground that

33Ihe requirement of the banks knowledge is discussed below at paras 5.49 to 5.62.

34Pankkania v. Hackney LBC [2002] EWHC 2441 (Ch) (statements of law were misrepresentations under the Misrepresentation Act 1967). See also in the field of mistake, Kleinwort Benson Ltd v. Lincoln City Council

[1999] 2 AC 349 (money paid under mistake of law is recoverable just as money paid under mistake of fact);

Brennan v. BoltBurdon [2005] QB 303.

35Gordon v. Seiko Ltd (1986) 18 HLR219; Spice Girls Ltd v. Aprilia WorldService SK[2002] EMLR 510.

36[1983] 1 AC 168.

3731 NYS 2d 631 (1941).

38Ibid., at 633.

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II. M eaning o f Fraud

the facts disclosed did not constitute a cause ofaction. For purposes of the motion, the allega­ tions of the complaint were deemed to be established. On those bases, Shientag J. held that there was fraud and that the fraud disclosed a cause of action which entitled the account

party to an injunction to stop payment.

The position is the same in the case of a demand for payment under a performance bond. 5.15 Where a performance bond requires the beneficiary to present documents, in addition to his written demand for payment, then if a document presented contains a material false state­

ment or if the document is forged the fraud exception applies. In State Trading Corporation o fIndia Ltd v. E D & F M an (Sugarj Ltdl39 for example, where a performance bond required a demand for payment to be accompanied by a beneficiary’s notice stating that the account party has defaulted on his obligations under the underlying contract, Lord Denning M.R. observed that a term could be implied into the underlying contract that the beneficiary, when giving a notice of default, must honestly believe that there had been default on the part of the account party. Therefore, where there is no default and the beneficiary presents a notice of default to the bank when he does not honestly believe that the account party has defaulted, that will be a material false representation which can amount to fraud.40

(ii) Fraud in the transaction

39[1981] Com LR235.

40Esal (Commodities) Ltdv. Oriental Credit Ltd [1985] 2 Lloyd’s Rep. 546, 550; IE Contractors Ltd v. Lloyds

Bank Pic [1990] 2 Lloyd’s Rep. 496, 500.

41 In a case where, as in Solo Industries Ltdv. Canara Bank [2001] 1WLR 1800, the bank contends that the performance bond itself is voidable on the ground that the bank was induced to issue it by fraud on the part of the beneficiary, the independence principle is not engaged as it is the validity of the instrument itself that is challenged.

42e.g. Themehelp v. West [1996] QB 84. Although the beneficiary can be restrained on this ground, it is not entirely clear whether the court will restrain the bank from making payment on the ground that the underlying contract is voidable because of the beneficiary’s fraud.

43Edward Owen Engineering Ltd v. Barclays Bank InternationalLtd [1978] QB 159 at 169.

44United Trading Corp SA v.AlliedArab Bank [1985] 2 Lloyd’s Rep. 554, 559.

45[1983] 1 AC 168.

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The Fraud Exception

exception in terms of fraud in documents tendered by the beneficiary.46 That did not settle the question. On the one hand, Lord Diplock’s statement may be taken to mean that the exception is limited to fraud in documents presented to the bank and does not extend to fraud in the wider transaction. On the other hand, as the case was concerned with fraud in a document and there was no argument on the question whether the exception extends to fraud in the transaction, it may be too much to say that Lord Diplock intended to confine the exception to fraud in documents.

5.18It is submitted that the scope of the exception should be wide enough to include fraud in the transaction. First, to limit the exception to fraud in documents would narrow its scope to such an extent that it would not be able fully to attain its policy objective of discouraging fraud in trade finance transactions. For Lord Diplock’s maxim ‘fraud unravels all’ to mean what it says a beneficiary’s fraud in the underlying transaction should affect his entitlement to payment under the letter of credit. Secondly, considering that there are many high hurdles in the way of an account party seeking an injunction to stop payment on the ground of the fraud exception,47 to further restrict the availability of the exception by excluding fraud in the transaction would unduly narrow the scope of the exception. Thirdly, there seems no practical or legal difficulty for the exception to apply in the case of fraud in the transaction and, as explained below, in other jurisdictions the exception extends to fraud in the transaction. Fourthly, as already indicated,4849in the case of performance bonds the English courts have already recognized that the exception extends beyond fraud in the documents. Although a letter of credit is not the same as a performance bond, in the context of the scope of the fraud exception, there seems no reason why in the case of letters of credit it should be confined to fraud in documents.

5.19In any event, there is some indication that English law may be heading in the direction of accepting that the fraud exception is wide enough to include fraud in the underlying contract. Thus, in GroupJosi Re v. Walbrook Insurance49 part of the account party’s claim was that the underlying contract was voidable on the ground of fraudulent misrepresentation or non-disclosure on the part of the beneficiaries. The Court of Appeal did not reject the claim on the ground that the fraud exception did not extend to fraud or non-disclosure in the underlying contract. The claim failed because of lack of evidence of fraud on the part of the beneficiaries. Staughton L.J. proceeded on the basis that the account party could have been entitled to an injunction to restrain the beneficiaries from demanding payment under the letter of credit if there had been non-disclosure or misrepresentation sufficient to avoid the underlying reinsurance contracts. Similarly, in Czarnikow-Rionda Sugar Trading Inc v. Standard Bank London Ltd,50 the account party based its application for an injunction to prevent its bank from making payment under letters of credit issued by the bank on the ground that it, the account party, had entered into the underlying contracts on the basis of fraudulent misrepresentations by the beneficiary. The case proceeded as normal and the application was refused mainly on the ground of the balance of convenience. However, there was no objection either from the bank or the court that the application was based on fraud in the underlying contract and that this was not within the fraud exception. More recently

46Ibid., at 183.

47See discussion in Chapter 10.

48Para 5.16.

49[1996] 1 Lloyd’s Rep. 345.

50[1999] 2 Lloyd’s Rep. 187.

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courts have rejected the view that the fraud exception is limited to fraud in the tendered documents. In Henderson v. Canadian Imperial Bank o f Commerce?1, for example, Berger J. rejected a contention that the fraud exception is confined to fraud in documents and granted an injunction restraining the bank from paying because of fraud in the underlying transaction.545That decision was approved by the Supreme Court of Canada in Bank o fNova Scotia v. Angelica Whitewear55 where it was declared that the fraud exception ‘should not be confined to cases of fraud in the tendered documents but should include fraud in the underlying transaction ofsuch character as to make the demand for payment under the letter of credit a fraudulent one’.56 Indeed the court went on to state that the fraud exception ‘should extend to any act of the beneficiary of a credit the effect of which would be to permit the beneficiary to obtain the benefit of the credit as a result of fraud’.57

51[2003] 1 Ail ER (Comm) 914 at [31].

521 999 SET 563.

53(1982) 40 BCLR318.

54In Henderson's case Berger J. followed the earlier case of Rosen v. Pullen (1981) 16 BLR 28, 126 DLR (ed) 62 (On. HC), where Craig J. took a wide view of the scope of the exception and granted an injunction restrain­ ing the bank from making payment under a letter of credit because of the beneficiary’s fraud in the transaction, even though there was no fraud in a document presented to the bank.

55[1987] DLR 161 at 176.

56Ibid., at [17].

57Ibid.

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The Fraud Exception

5.22In the United States it has long been recognized that the scope of the fraud exception extends to ‘fraud in the transaction’. The phrase ‘fraud in the transaction’ contained in the earlier version of the Uniform Commercial Code, Article 5-114, was interpreted to include cases where the account party was induced to enter into the underlying contract by the fraud of the beneficiary. In NMCEnterprises, Inc v. Columbia Broadcasting System, Inc,56for example, an injunction was granted to restrain a bank from making payment under a letter of credit on the basis of fraud in the ‘underlying transaction’. The buyer was induced to enter into the contract of sale by the fraudulent misrepresentation of the seller concerning the goods. The court rejected a contention that the fraud exception was limited to fraud in the docu­ ments required by the credit. Fraud in the transaction in Article 5-114 has also been inter­ preted to include a case, such as Sztejn v. J. Henry Schroder Banking Corp,589 where the seller shipped the wrong goods but presented documents which contained statements complying with the requirements of the credit. Thus in United Bank Ltd v. Cambridge Sporting Goods Corp,60interim injunctions were granted to restrain the bank from paying where the benefi­ ciary’s fraud consisted of shipping old, unpadded, ripped and mildewed boxing gloves instead of new ones as agreed in the underlying contract of sale. The court held that the fraud fell within the words ‘fraud in the transaction’ in Article 5-114. In the current, revised ver­ sion of the provision, Article 5-109, the fraud exception extends to ‘material fraud by the beneficiary on the issuer or the applicant’.6162This therefore extends to the beneficiary’s fraud that induced the applicant (account party) to enter into the underlying contract.

B. Materiality

5.23The false representation must be material. But what must it be material to? For letters of credit, in United City Merchants (Investments) Ltd v. Royal Bank o f Canada61 Lord Diplock rejected the suggestion that the false statement should be material to the buyer’s right to reject the goods, in the sense that if the true statement had been made the buyer would have been entitled to reject the goods (for example, if the correct date of shipment is stated and it is outside the prescribed period). The reason for rejecting this view of materiality is that it would undermine the autonomy of the letter of credit obligation since it would make the bank’s liability to pay under the credit dependent upon the buyer’s rights against the seller under the sale of goods contract. But this reasoning is, with respect, questionable, since the whole point about the fraud exception is that it allows the bank’s liability to pay under the instrument to be affected by facts outside of the requirements of the credit which could include the rights of the parties under the underlying contract. Indeed in a case where the fraud alleged is that the underlying contract was induced by fraud the bank’s liability to pay under the instrument is dependent on whether the parties have any rights under the underly­ ing contract.

5.24In United City Merchants it was also held that the question whether the misrepresentation is material is not to be determined by reference to whether the false statement affects the bank’s

5814 UCC Rep. 1427 (NYSC 1974).

5931 NYS 2d 631 (SC 1941).

60360 NE 2d 943 (NYCA 1976).

61Art. 5-109(a) and (b).

62[1983] 1 AC 168.

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