Litigation annual review 2002: Banking fraud

United Kingdom

Letters of credit and performance bonds

Banking fraud Letters of credit and performance bonds It is a well-established principle that a bank is obliged to pay a beneficiary under a letter of credit if the documents, on their face, conform to the requirements of the letter of credit, irrespective of any under-lying dispute between the seller and buyer. The exception to this rule was described as follows by Lord Diplock in United City Merchants (Investments) Ltd v Royal Bank of Canada [1982] A. C. 169:

“To this general statement of principle as to the contractual obligations of the confirming bank to the seller, there is one established 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".

The application of this fraud exception has been considered in a number of recent cases.

Banco Santander SA v Banque Paribas

Is a confirming bank, which has discounted a deferred payment letter of credit, entitled to reimbursement where allegations of fraud are made after the payment is made, but prior to the date of reimbursement?

Banque Paribas had issued a letter of credit that was available by deferred payment, payable at 180 days from the date of the bills of lading. The credit was advised and confirmed on 8th June 1998 to the beneficiary, Bayfern Ltd, by the confirming bank Banco Santander.

Banco Santander accepted the documents from Bayfern, but in accordance with standard practice, did not wait the 180 days until maturity and made a discounted payment to Bayfern on 8th June 1998. Bayfern assigned its rights to payment under the credit to Banco Santander.

On 24th June 1998, Banque Paribas informed Banco Santander that the documents presented by Bayfern included false documents and notified Banco Santander that they would not be making reimbursement at maturity. For the purpose of a preliminary issue, an assumption was made that Bayfern had made a fraudulent presentation which would have entitled Banco Santander to refuse payment had it had notice of the fraud at the time.

  • At first instance the court decided in favour of Banque Paribas; the Court of Appeal held as follows:
  • As assignee of Bayfern's rights under the credit, Banco Santander could be in no better position than Bayfern and so Banque Paribas was entitled to refuse to reimburse Banco Santander in respect of its claim as assignee.
  • Banque Paribas was also entitled to refuse reimbursement on the ground that Banco Santander's mandate was to pay the beneficiary at maturity. Banco Santander therefore took the risk that if evidence of fraud came to light before maturity the issuing bank would be entitled to refuse to reimburse.

The decision was controversial since, as both parties accepted, it was common practice in London for confirming banks to discount deferred payment credits. Now, confirming banks are well advised not to discount such credits unless they have express authority to do so from the issuing bank.

Solo Industries UK Ltd v Canara Bank

What is the standard of proof where a beneficiary calls on a guarantee, but a fraud is alleged in the underlying instrument?

This case involved a performance bond, but it equally applies to letters of credit. Here, in defending a claim by Solo for summary judgment, the paying bank (Canara) sought to rely on fraud in the underlying documents. When asserting that a frudulent demand has been made, the paying bank is put to a strict test. In United Trading Corporation v Allied Arab Bank Ltd [1985] 2LLR. 552 that test was stated as follows:

"If the court considers on the material before it that the only realistic inference to draw is that of fraud, then the seller would have made out a sufficient case of fraud".

Canara Bank was, rightly as it turns out, concerned that the evidence of fraud in this case was insufficiently strong to pass the "only realistic inference" test. Instead they argued that the bond had itself been pro-cured by fraud. The Court of Appeal upheld Canara's submission that where the challenge was to the validity of the bond itself, rather than to the demand under it, it was sufficient for Canara to show that it had a real prospect of success at trial in accordance with CPR Part 24.

The decision is controversial as it appears to make it easier for banks to raise fraud as a defence to claims for payment under performance bonds (and by extension other instructions including letters of credit). It is difficult to avoid the conclusion that the court was influenced by the unusual facts of the case including the evidence of the related fraudulent activities of the Hamco companies. A consequence of the judgment is that paying banks are likely to be faced with increasingly difficult decisions as to whether they are obliged to pay when the evidence of fraud falls short of the "only realistic inference" test, but may point towards fraud in the underlying instrument.

Similar issues arose in Safa Ltd v Banque du Caire

Here the court held that if the bank could establish a real prospect of proving that the demand was fraudulent (even though there was no such evidence at the time of the demand) or that there was a misrepresentation by the beneficiary persuading the bank to enter into the letter of credit, it may be unjust to enter summary judgment against the bank.

Although the Court of Appeal high-lighted the unusually close relationship between the bank and beneficiary and the bank's role in a related transaction in this case, this decision opens the gates slightly further for banks wishing to refuse payment by allowing challenges where there is no unmistakable evidence of fraud by the beneficiary. This is, of course, a double-edged sword since the greater latitude it gives to refuse payment has to be off-set against the reduction in certainty from which banks draw comfort, knowing that in the absence of clear evidence of fraud by the beneficiary there is an unequivocal obligation that they will be paid.

Montrod Ltd v Grundkotter Fleischvertriebs - GmbH and another

What is the position where it is alleged that the documents are a "nullity"? The general rule is that the fraud exception applies where there is clear and unmistakable evidence that the beneficiary has made a fraudulent demand. But what is the position when the bank has no evidence that the beneficiary was involved in the fraud, but that the documents themselves are a nullity?

Usually the innocence of the beneficiary will prevent the bank from invoking the fraud exception. In United City Merchants v Royal Bank of Canada the House of Lords held that the fraud exception did not apply since the beneficiary had not known at the time he presented the documents, that the bill of lading had been falsely dated.

In the Montrod case, the letter of credit called for inspection certificates to be signed by Montrod. The applicant (who had instructed Montrod to procure the letter of credit) wrongfully led the beneficiary to believe that it, the beneficiary, had authority to sign the certificates on behalf of Montrod. The beneficiary presented the certificates unaware that they had not in fact been signed with Montrod's authority.

Jack J rejected the argument that a bank can refuse to pay the beneficiary because there is evidence that one of the documents is forged and a nullity, where there is no evidence that the beneficiary had acted fraudulently. There was no authority to support the existence of a nullity exception, which would be "contrary to the fundamental principle that banks consider the documents alone and should not take account of other matters, in particular disputes between applicant and beneficiary".

The Court of Appeal has upheld the decision stating that the fraud exception should not be extended to situations where, although the document may be forged, the beneficiary was innocent. On the facts of Montrod, the result is unsurprising. It remains to be seen whether, in future cases involving more fundamental allegations about the validity of the document, a court might be willing to take the concept of a nullity exception further.

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For further information on this article please contact the author Charles Spragge by telephone on +44(0)20 7367 2525 or by e-mail at [email protected].

For further information on this review in general, please contact Tim Hardy on +44 (0) 20 7367 2533 or by e-mail at [email protected].