Payment by Letter of Credit and the 'Fraud Exception'

In most areas of international trade, letters of credit remain the preferred payment method and are regularly used between buyers and sellers in cross-border transactions.  Many letters of credit are made subject to the familiar UCP 600 (or the ‘2007 Revision of Uniform Customs and Practices for Documentary Credits, UCP 600’ to use its full name).  The UCP 600 was prepared by the International Chamber of Commerce and prescribes uniform customs, practices and definitions when using letters of credits in international trade.  The UCP 600 is the current version of the UCP.

Payment by the bank under a letter of credit

A fundamental principle of documentary credits under English law is that the obligations of the parties to the documentary credit are entirely distinct and separate from the terms of the underlying sale of goods contract.  This principle applies to letters of credit, including if they are subject to the UCP 600.  What this means in practice is that a dispute between the parties to the underlying contract will not prevent a bank from making payment under a related letter of credit, where the documents presented by the seller comply with the LC.

This general principle is modified by only two narrow exceptions; where a fraud is perpetrated by the seller in order to drawn down under the LC, or where there is illegality.

The fraud exception

The English Privy Council recently considered in detail the fraud exception in the case of Alternative Power Solutions v Central Electricity Board and Another [2014].  The court restated that only in exceptional circumstances will a buyer be entitled to obtain an injunction restraining a bank from making payment under a letter of credit on the ground of fraud.

In brief, the case involved an allegation by the Central Electricity Board of Mauritius (the Buyer) that Alternative Power Solutions (the Seller) had, by fraudulent means, shipped a quantity of light bulbs to the Buyer knowing that these failed to comply with the manufacturing requirements of the sale contract.  Payment was by way of a LC.  The Buyer obtained an injunction from the Mauritian Court, preventing the bank from making payment under the LC, which decision was upheld by the Mauritian Court of Appeal.

The English Privy Council, acting as the ultimate appeal court in this matter, summarised the correct approach to take when assessing fraud and payment under a letter of credit.  Its key findings can be summarised as follows:

To establish the fraud exception, it must be seriously arguable on the available facts that the beneficiary of the LC (the Seller) could not have honestly believed in the validity of its demand for payment under the LC and that the bank knew that.

Misconduct by a party under the sales contract (here, not allowing the light bulbs to be inspected by the Buyer prior to shipment) is restricted to a breach of the sale contract and generally cannot form the basis of a fraud allegation to halt payment under a LC.

Even if fraud is established, a Buyer will rarely be entitled to an injunction to prevent the bank from paying under the LC, as the Buyer’s alternative remedy of ‘damages’ against the bank should it make payment whilst on notice of a fraud, would in almost every case adequately compensate the Buyer.  

The Privy Council referred to both the damage a bank was likely to become exposed to, and knock-on consequences to other involved banks if payment was restrained, as generally outweighing any claim for damages that a Buyer might have against the bank for making payment in the knowledge of a fraud, as justification for the conclusion that it will almost always be more convenient to allow the bank to make payment under the LC.

Comment

Whilst in ‘theory’ it is not impossible to obtain an injunction preventing a bank from making payment under a LC on the ground of fraud, in ‘practice’ it would likely be impossible to secure an injunction, because an award of damages, instead of an injunction, will almost always be adequate and meet the balance of convenience test stressed by the Privy Council.

Buyers should take care that LCs detail very clearly all of the documents required to achieve payment by a Seller.  If anything is missed, and the LC is not amended by agreement, it is very unlikely that payment could then be stopped if compliant documents are tendered to the bank – despite a genuine underlying issue with performance of the sales contract or with the goods.                 

Andrew Iyer   IY LEGAL

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