by Jim Barnes

I have a 40+ year history with fraud/abuse defences and claims as counsel for banks and others in these typically very contentious matters. I had a hand in two major efforts to codify the fraud/abuse exception in section 5-109 of the Uniform Commercial Code, which is in effect throughout the US, and in Articles 19 and 20 of the UN Convention on Independent Guarantees and Standby Letters of Credit. Here is some of what I have learned. The fraud/abuse exception is an exception within an exception. Letters of credit and independent guarantees are themselves exceptional in the much larger world of ordinary promises and guarantees.

The fraud/abuse exception limits the independence of independent undertakings (i.e., letters of credit and demand guarantees, referred to collectively as "L/Cs"). Indeed, the independence principle is understandable only by understanding the exceptions and qualifications to it.

The justifiable exceptions to L/C independence are based on sovereign compulsion and fraud/abuse. Sovereign compulsion includes government agency "sanctions" (based on whatever a sovereign deems of overriding importance to it, with little or no regard for the desires of the applicant, issuer, beneficiary or any nominated bank). Sovereign compulsion also includes court injunction orders (which are typically, but not necessarily, based on a court finding of fraud/abuse made at the request of the applicant after the issuer has refused to dishonour voluntarily). This paper is focused on fraud/abuse, i.e., an exception that is intended to protect L/C users against abuse of the independence principle, and on the role of banks and courts in applying the exception.

International practice rules do not provide for fraud/abuse as grounds for dishonour or for a court order interfering with presentation, honour or the disposition of L/C proceeds. ISP98 Rule 1.05c leaves defences based on fraud, abuse and similar matters to applicable law. Numerous ICC Banking Commission opinions on UCP credits have treated such matters as subject to applicable law. So, what does or should applicable L/C law do about fraud/abuse?

L/C law should deter fraud/abuse

The law of independent undertakings should permit issuing and confirming banks to dishonour drawings that abuse the independence principle. I use "fraud" and "abuse" interchangeably; others use words such as "dishonest", "bad faith" and "unconscionable".

All of these words are helpful in indicating that the exception is limited to extraordinarily bad activity, but all suffer from the fact that they originated outside L/C law and practice and lack universal meaning. The word "fraud" is associated with an element of reliance, which prejudices a valid L/C fraud claim when the evidence shows that an L/C issuer relied more on its right of reimbursement than on the bona fides of presented documents. I rather like the concept of "abuse of right", meaning in the L/C context an abuse of the right to payment independent of any underlying performance, but it has little or no legal significance in the US.

Voluntary dishonour

Issuing and confirming banks should be allowed to defend dishonour on the basis of fraud/abuse. L/C law should be clear on the scope of the fraud/abuse defence, because there is considerable incentive for beneficiaries (and their banks) to push the fraud boundaries in one direction and for applicants (and their banks) to push in the opposite direction. Also, banks should not be pressured to decide whether a drawing is abusive or whether another bank should be reimbursed notwithstanding beneficiary fraud. Rather, courts should be enabled to decide whether or not to interfere with the honour of a drawing, i.e., whether there is the requisite fraud/abuse, whether court interference would prejudice an innocent nominated bank, etc.

An issuer or confirmer that dishonours based on fraud/abuse should do so because it is willing and able in the circumstances to put its own reputation on the line and defend its decision to dishonour in those markets and courts that matter to it.

Involuntary dishonour (injunction)

If an issuer or confirmer does not voluntarily dishonour but is instead timely enjoined from honour under applicable law by an appropriate court, then its defence is based on the injunction, which is a kind of sovereign compulsion defence, not fraud/abuse. Its value lies in the fact that enjoined parties, as well as courts elsewhere, will generally respect an injunction issued from a court located in an appropriate jurisdiction and applying apparently applicable L/C law.

Any legal system that puts the issuer (or confirmer) at risk when it honours a fraudulent or abusive drawing invites dishonour whenever the issuer is notified of a claim of fraud by the applicant. The issuer may be able to mitigate a particular dishonour by paying later with interest, but damage is done to the L/C product as soon as that aspect of the legal system is recognized by the market. Similar market damage is done if courts develop the reputation of being too quick to interfere with L/C rights, particularly those held by overseas beneficiaries. On the other hand, courts that are predictably unable to deter L/C fraud with timely injunctive relief will invite more L/C fraud on local banks and applicants.

Reimbursement after honour

An issuer or confirmer should not be frightened into dishonouring because the law permits a post-honour defence or counterclaim based on the bank's receipt of information about another's fraud.

As to the effect of L/C fraud/abuse on the reimbursement rights of an issuing or confirming bank, the norm should be that honour is permitted and reimbursement required unless (1) the issuing (or confirming) bank was timely enjoined or (2) the bank was an active participant in the fraud, e.g., responsible for a corrupt bank employee's actions in accepting fraudulent documents or for inducing a beneficiary's employee to present fraudulent documents resulting in application of the L/C proceeds to other obligations of the beneficiary to the bank.

If the issuing bank is located in a jurisdiction that cannot issue injunctions to interfere with the honour of a fraudulent demand, that jurisdiction may deem it appropriate to enlist the banks in policing fraud by imperiling their rights to reimbursement on the basis of clear knowledge or knowledge or even notice of fraud. The better approach would be to deny post-honour relief to an applicant against an issuer that ignores the availability of a fraud defence unless the issuer is itself guilty of fraud. Such a jurisdiction will lose L/C business either way, because neither approach represents the best available compromise.

Uniform Commercial Code

Much of what I have learned about the L/C fraud exception is codified in section 5-109 of the Uniform Commercial Code in effect throughout the US (see and explained in the official UCC comments. Section 5-109 reflects the drafters' view that the exception is peculiar to L/C law. It focuses on material fraud by the beneficiary on either the issuer or the applicant. This allows for an L/C fraud defence or claim that is based on the underlying transaction as well as on the L/C itself. It thereby allows for a claim that a demand under a "demand only" L/C will consummate a fraud in an underlying scam transaction. It also covers forged or materially fraudulent documents, so as to make the beneficiary responsible for defective documents provided by others.

Section 5-109 is elaborate in protecting the reimbursement rights of confirming banks that honour in good faith (i.e., honestly). It provides a lower level of protection to non-obligated nominated banks, as they must show they gave value without notice of a fraud defence. Unlike issuing and confirming banks, nominated negotiating banks are free to decline to act until they have, in fact, acted and courts may wish to take that into account when deciding whether they are entitled to reimbursement. Even clearer, banks that give value without being nominated to do so have no obvious claim for protection under L/C practice, and L/C law should follow the distinction in practice between the reimbursement rights of nominated banks and the rights of un-nominated presenting banks.

Section 5-109 separately addresses court interference with L/C honour and essentially limits this interference to cases in which the court finds that the applicant will, more likely than not, succeed in proving L/C fraud and the absence of any protected nominated bank. The "more likely than not" test for proving L/C fraud reflects the equal weight given to protecting independent L/C rights and deterring L/C fraud, as well as insistence that that equal weighing be respected at the early stages of an injunction action.

This UCC section also provides for bonding to protect against wrongful injunctions and allows courts to condition injunctive relief on the unavailability of an adequate post-honour remedy. In the US, applicant injunction cases are dismissed as much because the applicant's post-honour remedies against the beneficiary appeared to be adequate as because the applicant's showing of fraud appeared to be insufficient.

UN Convention

The UN Convention on Independent Guarantees and Standby Letters of Credit also provides for voluntary and involuntary dishonour of fraudulent/abusive demands. But that is for another discussion, as are the rights of reimbursement of nominated banks other than confirming banks.

James G. Barnes is senior counsel at Baker & McKenzie LLP, Chicago, Illinois, USA
His e-mail is