United States: Part III: When Findings Of Fraud Can Undo The Guarantee In A Letter Of Credit

Raymond Patella and Michael Viscount write:

This is the final installment in a three-part series on letters of credit by attorneys in Fox Rothschild's Financial Restructuring & Bankruptcy Practice. Part I focused on the advantages of letters of credit as a credit enhancement tool. Part II explored the use of letters of credit as collateral in bankruptcy proceedings. Here, in Part III, we conclude the series with an outline of important fraud exceptions.  

Ordinarily a letter of credit, or LC, is a reliable guarantee of payment that enhances a party's credit by shifting the credit risk from the customer to the financial institution and is unlikely to be affected by a bankruptcy. However, a finding of fraud can change the picture dramatically.

Under the Uniform Commercial Code, courts have at times permitted the issuer to refuse to pay, notwithstanding the beneficiary's proper document presentation, if the LC document "is forged or materially fraudulent," or if "honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant." Note that the issuer has no obligation to dishonor the beneficiary's payment demand; the issuer may honor, despite the fraud, as long as it does so in good faith.

The UCC and courts fashioned the fraud exception carefully. For example, the First Circuit has held that a court may enjoin payment when it "concerns 'fraud' so serious as to make it obviously pointless and unjust to permit the beneficiary to obtain the money. [Such circumstances include:] where the circumstances 'plainly' show that the underlying contract forbids the beneficiary to call a letter of credit, where they show that the contract deprives the beneficiary of even a 'colorable' right to do so, where the contract and circumstances reveal that the beneficiary's demand or payment has "absolutely no basis in fact", [or] 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." (Ground Air Transfer, Inc. v. Westates Airlines, Inc., 899 F.2d 1269 1272-73 (1st Cir. 1990) (emphasis in original) (citations omitted).

Fraud in Underlying Transaction

Courts and legal commentators have long been divided as to whether fraud in a transaction should include only fraud in the LC transaction or should also include fraud in the underlying transaction. UCC § 5-109 provides that fraud in the transaction includes both fraud in the LC transaction and one in the underlying transaction. Therefore, if the beneficiary committed fraud in the underlying transaction, the applicant may prevent the beneficiary's draw by requesting so of the issuer, although the issuer is under no obligation to accept that request. Also, the applicant may ask a court to enjoin the beneficiary's draw based upon the beneficiary's fraud in its underlying transaction with the applicant.

In Mid-America Tire, Inc. v. Ptz Trading Ltd., 768 N.E.2d 619 (Ohio 2002), the court held that the beneficiary's fraud in the underlying transaction justified an injunction against the issuers honoring the LC, where foreign buyers promised American buyers they could sell certain goods, many of which the buyer-applicants could not legally import or sell in the United States. The court issued an injunction because honoring the LC would facilitate the seller-beneficiary's fraud in the underlying transaction, which was to sell the illegal goods.

Fraud in the Draw

Many cases prompt courts to issue an injunction against payment — or to justify the issuer's refusal to honor the beneficiary's payment demand — as a result of a beneficiary's fraud in the draw. In a New York case, Sztejn v. J. Henry Schroder Banking Corp., the beneficiary presented invoices and bills of lading describing the merchandise as "bristles," as the LC required. The beneficiary, however, had shipped cow hair and other worthless rubbish instead of bristles. The Sztejn court held that the beneficiary was practicing fraud on the issuer by supplying the issuer with fraudulent documents, instead of the fraud merely involving the beneficiary's breach of the underlying contract.

The Second Circuit, in Brenntag International Chemicals, Inc. v. Bank of India, 175 F.3d 245 (2nd Cir. 1999), issued an injunction against the issuer-bank from making payments to the beneficiary. The beneficiary could draw upon the stand-by LC only when the applicant failed to perform its obligations and only after the beneficiary submitted certain documents, including a default letter stating that the beneficiary did not receive payment due from the applicant. The beneficiary submitted a default letter to the issuer, and the Second Circuit affirmed an injunction against payment because the default letter was facially fraudulent; the default letter on its face was "not true and could not have been true" when the letter was written.

Parties involved with LCs are well advised to seek the advice of counsel if they suspect fraud in any aspect of the LC relationship.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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