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International Trade Finance: The scope of the Fraud Exception to the Autonomy Principle and whether it might be extended

The importance of modalities of finance, in particular documentary credits and autonomous guarantees, to international trade may scarcely be overstated. There can be little doubt that undue court interference in these instruments would be harmful to commerce.

Although it appears that the principle that a bank must pay against a letter of credit if the documents are in order and the terms of the credit satisfied was established in English law sometime earlier[1],  the first case cited is usually Hamzeh Malas & Sons v British Imex Industries Ltd[2], where Jenkins LJ giving the judgment of the Court of Appeal stated:

“… it seems to be plain enough that the opening of a confirmed letter of credit constitutes a bargain between the banker and the vendor of the goods, which imposes upon the banker an absolute obligation to pay, irrespective of any dispute there may be between the parties as to whether the goods are up to contract or not. An elaborate commercial system has been built up on the footing that bankers’ confirmed credits are of that character, and, in my judgment, it would be wrong for this court in the present case to interfere with that established practice.”

In RD Harbottle (Mercantile) Ltd v National Westminster Bank Ltd[3] despite expressing some initial surprise that sellers should so bind themselves[4], Kerr J had little hesitation in holding that the position in respect of on demand guarantees was likewise. He stated[5]:

“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 as 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, the courts will leave the merchants to settle their disputes under the contracts by litigation or arbitration… The courts are not concerned with their difficulties to enforce such claims; these are risks which the merchants take. In this case the plaintiffs took the risk of the unconditional wording of the guarantees. The machinery and commitments of banks are on a different level. They must be allowed to be honoured, free from interference by the courts. Otherwise, trust in international commerce could be irreparably damaged.”

He put the matter rather more simply at p151, where he said: “Under the terms of the guarantees an absolute obligation to pay arose simply from a demand for payment by the buyers. The bank had given its own guarantee, and in effect pledged its own credit, to… pay on demand. Its reputation depends on strict compliance with its obligations. This has always been an essential feature of banking practice.”

The Court of Appeal confirmed Kerr J’s approach to performance guarantees in Edward Owen Engineering Ltd v Barclays Bank International[6]. In that case, Libyan buyers failed to take out the required form of letter of credit but claimed against the guarantee provided by a Libyan bank at the ultimate request of the English seller. The court held that the seller was not entitled to an injunction to prevent its bank from paying the Libyan bank under the counter-indemnity it provided in consideration of the guarantee. Denning LJ explained that:

“… the performance guarantee stands on a similar footing to a letter of credit. A bank which gives a performance guarantee must honour that guarantee according to its terms. It is not concerned in the least with the relations between the supplier and the customer; nor with the question whether the supplier has performed his contracted obligation or not; nor with the question whether the supplier is in default or not. The bank must pay according to its guarantee, on demand, if so stipulated, without proof or conditions.”

This strict rule was confirmed by the House of Lords in United City Merchants v Royal Bank of Canada[7].

More recently, the Court of Appeal in England confirmed the critical importance to international trade of the courts declining to interfere with the performance of finance instruments. Longmore LJ stated:

“Letters of credit are the lifeblood of commerce and must be honoured in the absence of fraud on the part of the beneficiary. The whole point of them is that the beneficiaries should be paid without regard to the merits of any underlying dispute between the beneficiary and its contractor.”[8]

He went on to cite the following passage of Lord Denning MR[9], which perhaps summarises the position best:

“If the court of any of the countries should interfere with the obligations of one of its banks (by ordering it not to pay under a letter of credit) it would strike at the very heart of that country’s international trade. No foreign seller would supply goods to that country on letters of credit – because he could no longer be confident of being paid. No trader would accept a letter of credit issued by a bank of that country if it might be ordered by its courts not to pay. So it is part of the law of international trade that letters of credit should be honoured…”

The autonomy principle

The above authorities encapsulate what is commonly referred to as ‘the autonomy principle’. The principle is founded in commercial considerations. Benjamin describes it as of “cardinal commercial importance” that documentary credits operate “entirely according to their terms and are independent of and insulated from the underlying contract in which they have their genesis”[10].

Autonomous finance documents are particularly important in international trade, given the geographical separation between the parties, which makes it difficult for the seller to gauge the buyer’s trustworthiness and creditworthiness[11].

The principle may operate harshly. For example, in Edward Owen[12] the English seller was left with no remedy against the Libyan buyer who had precipitously demanded under the autonomous guarantee as it would be impossible for it to obtain a visa for the purpose of bringing a claim in Libya. The justification for this is that were it otherwise the court might be obliged to look beyond the documents presented to it, which would “deal a serious blow to the ordinary processes of international banking and international commerce”[13]. In essence, a letter of credit or demand guarantee is treated like cash.

The autonomy principle is confirmed by the worldwide-accepted International Chamber of Commerce Uniform Customs and Practice for Documentary Credits, the current edition of which is UCP 600, in particular articles 4 and 5.

It should be noted that the autonomy principle does not apply to challenges to the validity of the instrument itself, which logically are preliminary to its application; see Solo Industries UK Ltd v Canara Bank[14].

Exceptions to autonomy principle

Given its magnitude, it is not surprising that the autonomy principle has few exceptions in international law. Apart from when the terms of the credit require as much (which will be extremely rarely given the prevalence of UCP), there are just two instances where the court might look beyond the terms of the credit and the documents presented. These are when realisation of the credit would contravene public policy and where the circumstances fall into what the courts have described as the fraud exception. This essay focusses on the latter.

The fraud exception, not provided for expressly by UCP and specifically reserved to common law by ISP98, was established firmly in international law by the New York Court of Appeals in Sztejn v J Henry Schroder Banking Corp[15], which was cited with approval by the English Court of Appeal in Edward Owen Engineering Ltd v Barclays Bank International Ltd.

It was explained in GKN Contractors Ltd v Lloyd’s Bank plc[16] that a claim under a letter of credit (and by analogy autonomous guarantee) is fraudulent where the beneficiary does not honestly believe in the validity of the claim. Benjamin explains this on the basis that:

“The autonomy principle insulates the beneficiary’s rights under the credit from the underlying reality; the exception pierces that insulation to the beneficiary’s detriment, and therefore the exception requires the dishonesty of the beneficiary itself.”[17]

In United City Merchants (Investments) Ltd v Royal Bank of Canada[18] the House of Lords confirmed that the fraud must be by the beneficiary in order for the exception to apply and that a banker would not be entitled to refuse to make payment under a letter of credit where the beneficiary was not party to the fraud. It is also a requirement that the bank has knowledge of the fraud[19].

Lord Diplock, in the above case, left open the question whether the bank would be liable to pay against a document (presented under the letter of credit) that was a nullity because, unknown to the beneficiary, it had been forged by a third party. Whether there should then be a general nullity exception, apart from the fraud exception already identified, is perhaps the most controversial question affecting the principle of autonomy.

The Court of Appeal held there to be no separate nullity exception in Montrod Ltd v Grundkotter Fleischvertriebs GmbH[20]. In that case, the seller signed a certificate of inspection required by the letter of credit on behalf of the applicant for the document, believing honestly but wrongly that it had authority to do so. It was argued that the certificate was therefore a nullity and that the bank was consequently not obliged to pay against the letter of credit. The court held that the bank was obliged to pay in the circumstances of the case and that there was no general nullity exception. Delivering a judgment with which the other members of the court agreed without reservation, Potter LJ acknowledged that Lord Diplock had left the matter open where there had been a forgery by a third party but considered that there was nothing to suggest that he would have recognised any nullity exception to extend to circumstances where the third party honestly believed he had authority. That being so, Potter LJ held that there was no reason why the fact that the innocent third party who produced the document was in fact the beneficiary should of itself create a ground for non-payment[21]. That left no room for a nullity exception separate to the fraud exception.

Potter LJ held that there were sound policy reasons for not extending the law by creation of a general nullity exception stating:

“The creation of a general nullity exception, the formulation of which does not seem to me susceptible of precision, involves making undesirable inroads into the principles of autonomy and negotiability universally recognised in relation to letter of credit transactions.”[22]    

Professor Richard Hooley has criticised[23], the decision in Montrod identifying “three good reasons why the Court of Appeal was wrong to reject a general nullity defence”, which are that:

(1) “the bank’s undertaking in the credit is to pay against conforming documents not those that appear to conform”;

(2) “a nullity document is a worthless piece of paper” and “offers no security to the bank which has paid out under the credit” whereas “the principle of autonomy only works because the bank’s obligation to pay has something of value – the commercial documents – to bite on”;

(3) “… most worryingly, the Montrod decision seems to tolerate the circulation of forged documents in international trade… There is a real danger that the circulation of such documents will undermine the trust that is the foundation of trade”.

 

With respect to Professor Hooley, the first two arguments at least are somewhat technical, and seem to miss the commercial purpose of the autonomy principle. They may also be wrong. Viz:

(1) On the correct construction of letters of credit in their commercial context, the bank’s undertaking is to pay against documents appearing to conform. In any event, this is expressly the position under UCP 600 articles 14(a) and 15.

(2) Similarly, as a matter of construction, having regard to the commercial considerations underlying the principle of autonomy, the bank has agreed to pay against documents appearing to give it the security interest bargained for (which will entitle it to reimbursement on the same basis). Moreover, once banks have an obligation to discover whether a document is a nullity (which necessarily they would if the consequence was to deny the document of effect), they become involved, beyond a careful examination of the documents, in the realities of the underlying transaction. It is such enquiries that the autonomy principle seeks to avoid, for fear of the same causing a thrombosis in the lifeblood of commerce[24]. Even the fraud exception only applies to obvious fraud to the knowledge of the bank[25].

 

The third argument clearly addresses a concern of a commercial nature but does it justify a nullity exception? If Professor Hooley’s apprehension is well founded, it is a question of balancing competing commercial interests. He is certainly not alone in thinking that preventing fraud should be more important than the autonomy principle. In Singapore, the Court of Appeal upheld[26] a decision holding there to be a nullity exception (although without meeting Potter LJ’s concerns that the same was nebulous) and it has been said that “a general nullity exception is essential for instilling greater trust and maintaining sanctity in the international banking system… in order that parties may transact with confidence and clarity”[27].

 

Elsewhere Dr Ademun-Odeke[28] has argued impassionedly for a broad “nullity exception covering fraud committed by third parties with or without the knowledge of sellers and/or beneficiaries” to fight the use of documentary credits as tools of money laundering, basing himself in part on a contention that the authorities against a nullity exception were based on policy rather than a strictly correct legal analysis[29]. The latter argument ignores that, apart from any policy, the legal question is the correct construction of letters of credit and that “preserving the basis upon which the letter of credit and therefore international payment system works”[30] is a commercial consideration legitimately taken into account in that exercise. This writer holds to the view that it is right, and entirely in accordance with UCP 600 article 34, that this consideration is ultimately determinative. Finance instruments are tools of commerce; they “rely on their independence from the underlying contracts for their very utility. To allow a party to block payment on the basis of a breach of the underlying contract undermines the parties’ expectations and the contractual allocation of risk”[31] as was pointed out in Hamzeh Malas[32], this affects not just the contracting parties but third parties who have entered into back-to-back credits. Money laundering concerns should be met by other areas of the law; it is not the concern of banks to act as policemen.

 

A further question is how far the established fraud exception should apply. The better view so far as English law is concerned may be that the fraud must relate to the documents rather than the underlying transaction[33], certainly if the jurisprudential basis of the exception is an implied limitation on the bank’s mandate[34]. By contrast, foreign courts have often broadened the scope of the exception; in America, it includes fraud in the underlying transaction, whilst in Australia and Singapore the exception has been extended still further to unconscionable conduct. It is submitted that, although superficially attractive because of its ability to do fairness in a particular case, such a wide exception to the autonomy principle is undesirable. “To include mere unconscionable conduct which does not itself amount to fraud is to seriously threaten the autonomy principle on which the letter of credit system rests”[35]. Further, the concept is vague and potentially wide-ranging so that recognition might lead to a proliferation of challenges to letters of credit and guarantees, as has been experienced in Singapore[36]. In the interests of the utility of finance instruments, they should remain challengeable only on grounds of obvious fraud by the beneficiary apparent on the face of the document.

Brad Pomfret
23 Essex Street
M
anchester and London

10th April 2017

Bibliography

Books

  • Bridge et al, Benjamin’s Sale of Goods (2nd Ed Sweet & Maxwell)
  • H. Dalhuisen, ‘Dalhuisen on International Commercial, Financial and Trade Law’ (Hart Publishing 2004)

Journals

  • Hooley, ‘Fraud and Letters of Credit: Is there a Nullity Exception?’ (2002) 61 Cambridge LJ 279
  • Ademun-Odeke, ‘Double invoicing in International Trade: The Fraud and Nullity Exceptions in Letters of Credit: Are the America Accord and the UCP 500 a Crooks’ Charter?’ (2006) 18 Denning LJ 115
  • 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 UL Rev 144
  • Al-Tawil, ‘Letters of Credit and Contract of Sale: Autonomy and Fraud’ (2013) 16 Int’l Trade and Bus L Rev 159
  • H Alavi, ‘Illegality as an exception to Principle of Autonomy in Documentary Letters of Credit: A comparative approach’ (2016) Kor UL Rev 3

Case law

  • Hamzeh Malas & Sons v British Imex Industries Ltd (1958) 2 QB 127
  • RD Harbottle (Mercantile) Ltd v National Westminster Bank Ltd (1978) QB 146
  • Edaward Owen Engineering Ltd v Barclays Bank (1978) QB 159
  • United City Merchants Investments Ltd v Royal Bank of Canada (1982) 2 WLR 1039
  • GKN Contractors Ltd v Lloyds Bank plc (1986) WL 408333
  • Czarnikow-Rionda Sugar Trading Inc v Standard Bank London Ltd (1999) 2 Lloyd’s Rep 187
  • Themehelp Ltd v West (1996) QB 84
  • Solo Industries UK Ltd v Canara Bank (2001) 1 WLR 1800
  • Montrod Ltd v Grundkotter Fleischvertriebs GmbH (2002) 1 WLR 1975
  • National Infrastructure Development Company Ltd v Banco Santander SA (2017) EWCA Civ 27

[1] See for example, Prehn v Royal Bank of Scotland (1869-70) L.R. 5 Ex. 92

[2] (1958) 2 QB 127

[3] (1978) QB 146

[4] Ibid, at 150

[5] Ibid, at 155-156

[6]  (1978) QB 159

[7] (1983) 1 AC 168

[8] National Infrastructure Development Company Ltd v Banco Santander SA (2017) EWCA Civ 27, paragraph 44

[9] Power Curber Intl Ltd v National Bank of Kuwait (1981) 1 WLR 1233

[10] Benjamin para 23.004

[11] J. H. Dalhuisen, ‘Dalhuisen on International Commercial, Financial and Trade Law’ (Hart Publishing 2004) 456-4557

[12] Edward Owen Engineering Ltd v Barclays Bank (1978) QB 159

[13] Consolidated Oil Ltd v American Express Bank Ltd (2000) CA unreptd

[14] (2001) 1 WLR 1800

[15] (1941) 31 NYS 2d 631

[16] (1985) 30 BLR 48 at 63

[17] Benjamin, paragraph 24.023                                            

[18] (1983) AC 168

[19] Benjamin, paragraph 24.024

[20] (2002) 1 WLR 1975

[21] Ibid paragraphs 56-57

[22] Ibid paragraph 58

[23] Hooley (2002) CLJ 279

[24] Intraco Ltd v Notis Shipping Corp (1981) 2 Lloyd’s Rep 256 at 257, per Donaldson LJ

[25] Ibid n12 per Lord Denning MR p169

[26] Beam Technologies v Standard Chartered Bank (2003) 1 SLR 597

[27] Tareq Al-Tawil, ‘Letters of Credit and Contract of Sale: Autonomy and Fraud’ (2013) 16 ITBLR 159

[28] Ademun-Odeke, ’Double invoicing in International Trade: The Fraud and Nullity Exceptions in Letters of Credit – Are the America Accord and the UCP 500 Crooks’ Charters!?” (2006) 18 DLJ 115

[29] Ibid, p143

[30] Ibid

[31] F Monteiro, ‘Documentary Credits: The Autonomy Principle and the Fraud Exception: A Comparative analysis of Common Law Approaches and Suggestions for New Zealand’ (2007) 13 AULR 144

[32] Ibid n2

[33] Benjamin paragraph 24.034, disagreeing with the majority decision in Themehelp Ltd v West (1996) QB 84

[34] Czarnikow-Rionda Sugar Trading Inc v Standard Bank London Ltd (1999) 2 Lloyd’s Rep 187 at 203

[35] Monteiro (ibid) 159

[36] H Alavi, ‘Comparative Study of Unconscionability Exception to the Principle of Autonomy in Law of Letter of Credits’ (2016) Acta U. Danubius Jur. 94

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