Editor's Note: The Third Seminar of the International Commercial Expert Committee of the Supreme People's Court and Reappointment Ceremony of the First Group of Expert Members was held successfully on Augest 25, 2022. Over 40 experts from more than 20 countries and regions focused on the theme of the Development, Challenges and Countermeasures of Cross-Border Commercial Disputes during the seminar. Extensive and in-depth discussions were held within the framework of four specific issues. The texts of speeches delivered by the participants would be posted on the CICC's website. 

THE FRAUD RULE IN THE LAW OF LETTERS OF CREDIT REVISITED*

Gao Xiang

Professor and director of the Centre of International Banking Law & Practice, China University of Political Science and Law

Introduction

The fraud rule in the law of letters credit[1] means that, although documents presented are facially in strict compliance with the letter of credit, payment under the letter of credit may be stopped if fraud is found before payment is made, provided that the presenter is not an innocent third party. The fraud rule has been recognized worldwide since the landmark case of Sztejn v. J Henry Schroder Banking Corp[2] was handed down in 1941 in the US.[3] However, the fraud rule in the law of letters of credit is still developing and has proven to be 'the most controversial and confused area',[4] mainly because fraud is an "inherently pliable concept",[5] and different courts or jurisdictions have given different interpretations of the concept. After decades of reckoning and development, the current international rules and national laws and decisions by most of the courts in many jurisdictions, such as the US and the UK, emphasizing that the letter of credit is a unique commercial device and must be protected from simple contractual disputes because it is often not easy to distinguish simple contractual disputes from certain fraud claims,[6] have taken the position that the fraud rule must be applied in a strict fashion, or in cases where only "clear", "established", "egregious", or "material" fraud is involved.[7] However, in other jurisdictions, such as Australia and Singapore, a more flexible approach has been taken, where unconscionable conduct can trigger the application of the fraud rule.[8] 

The reason for the divergence of the views has been succinctly expressed in the Canadian case of Bank of Nova Scotia v. Angelica-Whitewear Ltd,[9] reflecting the tension between two different policy considerations:

The importance to international commerce of maintaining the principle of the autonomy of documentary credits... and the importance of discouraging or suppressing fraud in the letter of credit transaction[10]

On the one hand, if fraud is defined too widely, the fraud rule maybe applied too often and abused by an applicant who does not want the issuer to pay under the credit simply because it will not profit from the underlying transaction. If obstruction of payment of a letter of credit is repeated too often, business confidence in letters of credit as effective assurances of performance will be destroyed.[11] On the other hand, if fraud is defined too narrowly and the fraud rule cannot be applied in cases even though fraud has been clearly established, the effectiveness of the fraud rule, and the values embodied in the law against fraud, will be compromised. It may also discourage the use of letters of credit by Applicants and ultimately harm the commercial utility of letters of credit.[12] Moreover, it may also encourage fraudulent conduct by beneficiaries, which should not be allowed in any legal system under any circumstances, because it works against the values and the basis of the law. Unfortunately, increased occurrences of fraud have become a problem, and that is the focus of this chapter.

This chapter consists of four sections. Following this introduction, the second section will introduce the current status of the fraud rule and the problem arising therefrom. The focus will be on the current position of the fraud rule in international rules and conventions and in the US, the UK, and China. The third section will argue why and how the current fraud rule in some jurisdictions should be refined. The last section will conclude the chapter by advocating a bifurcated approach to solve the problem.

II. The Current Status of the Fraud Rule

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. These international rules and selected jurisdictional rules are important in terms of practice as well as legal development of the law of letters of credit. A number of cases illustrating the problem arising out the current fraud rule will also be analyzed.

A. International Rules and Conventions

1. ICC Rules

The Uniform Customs and Practice for Documentary Credits (UCP) published by the 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 frame work for dealings between issuers and beneficiaries, and issuers and correspondent banks. It is not concerned with the rights and duties of parties to the underlying contract, nor is it the function of the UCP to regulate issues which are the proper province of national law and national courts.[13] Similarly, the ICC's special rules for stand by letters of credit, the International Standby Practices (ISP98), takes a similar approach and leaves the issue of fraudulent or abusive drawing or defense to honour based on fraud, abuse or similar matters...to applicable law.[14] The Uniform Rules for Demand Guarantees (URDG) published by the ICC are also silent on the fraud rule, leaving it to the courts of the various jurisdictions.[15]

Both the content and the interpretation of all of the ICC rules are influenced by the fact that "their function is to serve as rules of best banking practice, not rules of law",[16] and the issue of fraud is considered as "the province of the applicable law and of the courts of the forum".[17] 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[18] and have implicitly recognized the existence of the fraud rule in various jurisdictions,[19] they have deliberately left it out.[20] 

2. UN Convention

Unlike the ICC rules, the United Nations Convention on Independent Guarantees and Standby Letters of Credit (the Convention) has made an effort to address the issue of fraud. First, the Convention puts up a general requirement in article15(3) in relation to beneficiary demands for payment, providing that "[t]he beneficiary, when demanding payment, is deemed to certify that the demand is not in bad faith and that none of the elements referred to in subparagraphs'(a), (b) and (c) of paragraph(1) of Article 19 are present". Article 19(1) provides that the guarantor/issuer has a right, as against the beneficiary, to with hold payment if one of the following is "manifest and clear":

(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...

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) Theundertakingobligationoftheprincipal/applicanthasbeendeclaredinvalidby a court or arbitral tribunal, unless the undertaking indicates that such contingency falls within the risk to becovered by the undertaking;

(c) Theunderlyingobligationhasundoubtedlybeenfulfilledtothesatisfactionofthe beneficiary;

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

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

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".

Under the Convention, the fraud rule can be briefly summarized 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 inparagraphs(b) and (c) of article 19(1).

B. National Laws

1. United States

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);[21]

(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 goodfaith,(iii)aholderinduecourseofadraftdrawnundertheletterofcredit whichwastakenafteracceptancebytheissuerornominatedperson,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 dishonor the presentation in any other case.

(b) If an applicant claims that are quired document is forged or materially fraudulent or that honour of the presentation would facilitate amaterial 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).

As can be seen, in order for the fraud rule to apply in the US, "material fraud" is needed. Since "material fraud" is a generic term, like the term "no conceivable basis" provided in article 19 of the Convention, and it is not defined in the s 5–109 of the UCC itself, efforts have been made to explain the concept in the second paragraph of the Official Comment of the article, which states:

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.

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 ... [22]

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. Where the circumstances "plainly" show that the underlying contract forbids the beneficiary to call a letter of credit, Itek, 730 F.2d at 24; where they show that the contract deprives the beneficiary of even a "colourable" right to do so, id., at 25; where the contract and circumstances reveal that the beneficiary's demand for payment has "absolutely no basis in fact," id.; Dynamics Crop. of America, 356 F. Supp. at 999; where the beneficiary's conduct has so vitiated the entire transaction that the legitimate purposes of the independence of the issuer's obligation would no longer be served,Itek, 730 F.2d at 25 (quoting Roman Ceramics Corp. v. Peoples National Bank, 714 F.2d 1207, 1212 n. 12, 1215 (3d Cir. 1983) (quoting Intraworld Indus, 336 A 2d. at 324-25); then court may enjoin payment. [23]

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".

The fraud rule in the US has been tested in many cases. It has generally been a success story.[24] However, in some cases, the application of the rule has raised serious questions. The typical example in the US is Al Makaaseb General Trading Co v. United States SteelInternational Inc.[25] decided in 2006 by the US District Court for the Western District of Pennsylvania. In the case, Vijaya Gajapathy Engineers (VG), an Indian company, entered into a contract of sale with the defendant, United States Steel International (USSI), a US company located in Pittsburgh, for the purchase and transport of 756 metric tons of seamless steel pipes to be delivered to the dock at the Port of Mobile, Alabama. On the eve of delivery of the pipes to the dock, VG discovered that it was unable to obtain the letter of credit as required, and 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 judgment.

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.

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, 324-325(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 (MasterEdition). 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, NationalAss'n, 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.[26] 

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.

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.United Kingdom

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.

The English courts "have traditionally been very reluctant"[27] 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.[28] 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. Nat Westminster Bank Ltd.[29]

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 inclearcases 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.[30]

The difficulty to establish "clear" fraud in English courts has been well demonstrated by the first English case to cite Sztejn with approval:[31] Discount Records Ltd v Barclays Bank Ltd,[32] 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".[33]

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.[34]

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.

The leading case in the UK is United City Merchants (Investments) Ltd v. Royal Bank of Canada[35], 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".[36]

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.[37] The beneficiary in this case was not affected by the fraud rule as it had not been dishonest.

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.[38]

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"[39] 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".[40] 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"[41] 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."[42]

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

In China, the fraud rule is provided in the Rules of the Supreme People's Court Concerning Several Issues in Hearing Letter of Credit Case (Chinese LC Rules) published in late 2005.[43]

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) Other circumstances that constitute letter of credit fraud.

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.

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.

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.

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.

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.

However, it is worth mentioning a Chinese case where the influence of US law may clearly be seen. In the case of Industrial Bank of Korea Seoul v. Lianyungang Kuchifuku Foods Co Ltd,[44] 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:[45]

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).

The case was handed down by the JHC, but it so ruled under the guidance of the SPC of the PRC. Before handing down the judgment, the JHC went through the special internal court procedure and applied for an opinion from the SPC because there were two different opinions within the JHC:[46]

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.

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.

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.

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".

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.

III. Refining the Current Fraud Rule

A.The Rationale

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 the two 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.

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 rule is fundamental values or the common basis of the general law against fraud. It is well known that "fraud unravels all".[48] "There is as much public interest in discouraging fraud as in encouraging the use of letters of credit."[49] The fraud 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.

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

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

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,[50] where Ackner L. J. 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.[51]

Griffith L. J. 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.[52]

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".[53] 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 authorizes 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 recognized that there is an implied warranty by the beneficiary that documents tendered are genuine.[54]

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?

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.

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

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 minimize 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"[55] 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 prompt payment and allocation of risks will disappear, the business confidence in letters of credit as effective performance assurances will be destroyed,[56] 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.

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

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 probably 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.

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.

*This article was first published in Christopher Hare & Dora Neo ed., Trade Finance: Technology, Innovation &Documentary Credits (Oxford University Press 2021), pp. 101-117. and was lightly edited for publication at the Seminar with authorization.

[1] Unless the context requires otherwise, the term “letter of credit” is used broadly in this chapter to include commercial letters of credit, standby letters of credit, and independent guarantees.

[2] (1941) 31 NYS 2d 631.

[3] For a comprehensive discussion about the fraud rule in the US, the UK, Australia, and Canada, see Xiang Gao, The Fraud Rule in the Law of Letters of Credit: A Comparative Study (Kluwer Law International 2002).

[4] “Fraud in the Transaction:” Enjoining Letters of Credit during the Iranian Revolution (1980),93 Harvard Law Review 992, 995. 

[5] Gerald T McLaughlin, Letters of Credit and Illegal Contracts: The Limits of the Independence Principle(1989), 49 Ohio State Law Journal 1197, 1203 (hereafter McLaughlin, Letters of Credit and Illegal Contracts).

[6] McLaughlin, Letters of Credit and Illegal Contracts (n. 5).

[7] See Gao Xiang and Ross P Buckley, A Comparative Analysis of the Standard of Fraud Required under the Fraud Rule in Letter of  Credit Law(2003), 12 Duke Journal of Comparative and International Law 293.

[8] See Dee Felicity Monteiro, Documentary Credits: The Autonomy Principle and the Fraud Exception: A Comparative Analysis of Common Law Approaches and Suggestions for New Zealand(2007), 13 Auckland University Law Review 144, 159–61 (hereafter Monteiro, Autonomy Principle and the Fraud Exception: Comparative Analysis ). It should be noted that, in Australia and Singapore, the test of unconscionability 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.

[9] (1987) 36 DLR 4th 161 (hereafter Nova Scotia v Anglica-Whitewear).

[10] Ibid 168.

[11] Robert Jay Gavigan, Wysko Investment Company v Great American Bank:A New Attack on the Usefulness of Letters of Credit (1993),14 Northwestern Journal of International Law and Business 184, 202 (hereafter Gavigan, Wysko Investment Company v. Great American Bank: New Attack on the Usefulness of LCs).

[12] Cf. Stephen J Leacock, Fraud in the International Transaction: Enjoining Payment of Letters of Credit in International Transactions (1984), 17 Vanderbilt journal of Transnational Law 855, 899. 

[13] Ross P Buckley, The 1993 Revision of the Uniform Customs and Practice for Documentary Credits (1995),6 Journal of Banking and Finance Law and Practice 77,95ff.

[14] International Chamber of Commerce, International Standby Practices (ICC Publication No 590, 1998) (hereafter ICC, ISP 98) Rule 1.05(c).

[15] RIVF Bertrams, Bank Guarantees in International Trade (2nd edn, Kluwer Law International 1996) 25 (hereafter Bertrams, Bank Guarantees in International Trade).

[16] Roy Goode, Abstract Payment Undertakings and the Rules of the International Chamber of Commerce (1995),39 St Louis University Law Jounal 725, 727.

[17] Ibid. 

[18] J F Dolan, Commentary on Legislative Developments in Letters of Credit Law: An Interim Report (1992), 8 Banking & Finance Law Review 53, 63.

[19] This is evidenced by the Opinions of the ICC Banking Commission (1980-1981)(No. 399, International Chamber of Commerce, ICC Banking Commission 1982), where it was asked by a bank in Bangladesh whether a negotiating bank, which had paid and been reimbursed, was liable to refund the money to the issuing bank when the bill of lading tendered was found to beforged. The Commission replied at page 27: [T]he negotiating bank passing forward what proved to be a forged bill of lading was protected by Article 9 [equivalent of Article 34 of UCP 600] unless it was itself a party to the fraud, or it had knowledge of the fraud prior to presentation of the document, or unless it had failed to exercise reasonable care, eg., if the forgery were apparent “on the face” of the document.

[20] K. A. Barski, Letters of Credit: A Comparison of Article 5 of the Uniform Commercial Code and the Uniform Customs and Practice for Documentary Credits (1996), 41 Loyola Law Review 735, 751.

[21] UCC, art. 5 was first promulgated in 1950s, and thoroughly revised in 1995. In this chapter the revised version will be referred as the “revised UCC article 5”, and the previous version will be referred as “prior UCC article 5”.

[22] Official Comment of s 5–109 of revised UCC article 5, [3](1st sentence). 

[23] Ground Air Transfer v Westate’s Airlines(1990) 899 F 2d. 1269, 1272-73.

[24]  Cf. Huiwen Li, The Standard of “MaterialFraud” in the Law of Letters of Credit in the United States of America (LLM Thesis, China University of Political Science and Law 2016) (written in Chinese with title translated by the author,  who was her supervisor) [unpublished], online:<http://epub.cnki.net/kns/brief/result. aspx?dbPrefix=CDMD>.

[25] 412 F Supp (2d) 485 (WD Pa 2006).

[26] Ibid 496 (footnotes omitted).

[27] Pugh-Thomas A, Letters of Credit-Injunctions-The Purist And The Pragmatist: Can A Buyer Bypass The Guarantor And Stop The Seller From Demanding Payment From The Guarantor? (1996), 11 Journal of International Banking Law 210, 210.

[28] Bertrams, Bank Guarantees in International Trade (n. 15) 266.

[29] [1977] 2 All ER 862 (QB). 

[30] Ibid 870 (emphas is added).

[31] G A Fellinger, Letters of Credit: The Autonomy Principle and the Fraud Exception (1990), 1 Jounal of Banking and Finance Law and Practice 4,17.

[32] [1975] 1 All ER 1071 (Ch) (hereafter Discount Records Ltd v Barclays Bank Ltd).

[33] Ibid 1073.

[34] Ibid 1074 (citations omitted, emphasis added).

[35] See the case reports at first instance [1979], 1 Lloyd’s Rep 267 (QB) (hereafter United City Merchants (at first instance)); before the Court of Appeal [1981], 1 Lloyd’s Rep 604 (CA) (hereafter United City Merchants (CA)); and before the House of Lords [1983], AC 168 (HL)(hereafter United City Merchants(HL)).

[36] United City Merchants (at first instance)(n. 35) 272.

[37] United City Merchants(HL)(n. 35) 184.

[38] 183 (emphasis added).

[39] Ibid 185.

[40] Ibid 185.

[41] Ibid 186. 

[42] Ibid 186.

[43] Adjudication Committee of the Supreme People’s Court of the People’s Republic of China, Zuigao Renmin Fayuan Guanyu Shenli Xinyongzhen JiaofengAnjian Ruogan Wenti De Guiding (24 October 2005, became effective on 1 January 2006).

[44] (2003) Su Min San Zhong Zi No. 052 ((2003)苏民三终字第052号) (hereafter Lianyungang Kuchifuku Foods).

[45] Quotation from ibid (translated by the author).

[46] Quotation from the internal report by the JHC to the Supreme People Court of the PRC [unpublished] (translated by the author).

[47] (2003) Min Si Ta Zi No 33 ((2003)民四他字第33号) (translated by the author).

[48] United City Merchants (HL) (n. 35) 184 (per Lord Diplock). See also United Trading Corporation v. Allied Arab Bank Ltd [1985], 2 Lloyd’s Rep 554 (CA); Contronic Distributors Pty Ltd v Bank of New South Wales [1984], 3 NSWLR 110; Hortico(Australia) Pty Ltd v. Energy Equipment Co (Australia) Pty Ltd[1985], 1 NSWLR 545.

[49] Dynamics Corp of America v Citizens & Southern Nat’l Bank (1973), 356 F Supp 991 (ND Ga 1973) 1000 (per Edenfield J).

[50] It should be noted that, although the decision of the Court of Appeal was overturned by the House of Lords, the point illustrated here should still be valid. Further, as discussed above, although the House of Lords used the term “material representation” when discussing the fraud involved in the case, it may be assumed from their judgment of the case that predating of bills of lading, a simple fraud in the documents, can be taken as “material misrepresentation” because they never denied the existence of fraud in the case. In other words, the position in the UK is different from that of the US, although both countries have used the word “material” to refer the standard of fraud.

[51] United City Merchants (CA) (n. 35) 628-29.

[52] Ibid 632.

[53] UCP 600, art. 5.

[54] See eg A G Guest (gen ed), Benjamin’s Sale of Goods(5th edn., Sweet & Maxwell 1997) 1715; H Harfield, Bank Credits and Acceptances(5th edn., Ronald Press Co 1974) 80; Reade H Ryan Jr, Who Should Be Immune from the “Fraud in the Transaction:” Defense in a Letter of Credit Transaction (1990–1991).56 Brooklyn Law Review 119, 126.

[55] Bertrams, Bank Guarantees in International Trade (n. 15) 257. Illegality may be another one, but cases are scarce in this respect. See eg United City Merchants(at first instance)(n. 35); United City Merchants(CA)(n. 35); and United City Merchants(HL)(n. 35). In Australia and Singapore, another defence-unconscionable conduct-has become available recent years. See Monteiro, Autonomy Principle and the Fraud Exception: Comparative Analysis (n. 8) 159-61.

[56] Gavigan, Wysko Investment Company v Great American Bank: New Attack on Usefulness of LCs (n. 11) 202.

*The original text is Chinese and has been translated into English for reference only. If there is any inconsistency or ambiguity between the Chinese version and the English version, the Chinese version shall prevail.