by John F. Dolan

Simply put, the issue before the UK Court of Appeal in the infamous Banco Santander case, discussed in several past articles in this magazine, was whether a nominated bank could discount its own deferred payment undertakings free of the issuer's fraud defence, that is, whether the nominated bank was a "protected party".

Lawyers for the nominated bank in Banco Santander characterized the issue as one of authority, a contract or practice issue and a matter of private agreement. Did the issuer authorize the nominated bank, they asked, to discount the DPUs? If the nominated bank was so authorized, the lawyers continued, the issuer's fraud defence did not apply against the nominated bank.

In my view, the lawyers' argument raised a false issue. They characterized a question of law as a question of agreement or practice. Note, moreover, that the lawyers did not argue that the issuer had waived its defences, an argument different from the authority argument. In any event, issuers usually do not waive their defences, and UCP 600 does not have any rule to that effect.

Protected parties

Accepting that false characterization in Banco Santander, the UCP 600 drafters addressed the authorization/practice issue in sub-article 12 (b), stipulating that incorporation of UCP 600 into a letter of credit gives the nominated bank, as a matter of practice, the authority to discount its own DPU. Thus, UCP 600 resolved the authorization issue. But the authorization issue was a false issue. The real issue is one of law, and that issue remains unresolved in many jurisdictions. The issue is one of determining the scope of the exceptions to the fraud defence, i.e., deciding what parties are protected, since only some are protected from the defence. Everyone else acts subject to it.

The issue of law in Banco Santander was whether the holder of a DPU is a protected party. Protected parties are parties that usually act without knowledge of the issuer's defences and who are, by law, protected from those defences.

Confirmers are protected parties. A confirmer that honours the beneficiary's draft by whatever method is protected, not by practice or mandate, but by law, from the issuer's fraud defence. Thus, if on May 1 the confirmer pays the beneficiary, and if on May 15 the container arrives at the applicant/buyer's loading dock with cartons of rubbish, the issuer must reimburse the confirmer. The confirmer is a protected party.

Nominated banks that pay, accept or negotiate without knowledge of the beneficiary/seller's fraud are also protected parties. Here authority is important. Banks that are not nominated banks and are not confirmers act either for themselves or for the beneficiary who is usually the source of the fraud. Banks that are not nominated do not act for the issuer, have no mandate and generally act subject to the fraud defence.

Assignment law

Traditionally, in law, an assignee stands no higher than its assignor. This is the rule long ago expressed by the Romans as the nemo dat rule: "Nemo dat quod non habet". One cannot give what one does not have. The nominated bank issues its DPU to the beneficiary. If the beneficiary is guilty of fraud and the fraud is evident before the DPU comes due, as a matter of law the beneficiary may not enforce the DPU; the nominated bank will not claim reimbursement from the issuer, the issuer will not claim reimbursement from the applicant buyer, the fraudulent beneficiary will not receive value and all will be right with the world.

Under the nemo dat principle of assignment law, if the nominated bank takes its own DPU from the fraudulent beneficiary, it is an assignee, and the nominated bank takes what the beneficiary had - a DPU subject to the fraud defence. Under assignment law, this nominated bank/assignee will not be able to obtain reimbursement from the issuer, the issuer will not obtain reimbursement from the applicant/buyer and all will not be right with the world - the fraudulent seller benefits from his fraud, and the nominated bank that honours its DPU before it learns of the fraud will bear the loss.

Confirmers and nominated banks

Yet, the law protects the confirmer and the nominated bank that pays the beneficiary or negotiates his documents. The law fashions that protection in order to protect the innocent confirmer or nominated bank from taking the loss occasioned by the beneficiary's fraud. Rather, the law shifts the loss to the issuer, who must reimburse. But the issuer will have reimbursement from the applicant/buyer, who will bear the loss for having done business with a rogue, the beneficiary.

That is not to say that authority is never an issue. It is. Silent confirmers, that is, confirmers who confirm at the request of the beneficiary, are not protected from the fraud defence. Neither is the presenter nor a collecting bank acting at the request of the beneficiary. Those banks are the beneficiary's banks and are subject to defences good against the beneficiary, since they act for the beneficiary.

Confirmers, other than silent confirmers, and nominated banks act for the issuer. They have the issuer's mandate, and they are protected parties. When banks acting on the issuer's mandate present the documents to the issuer, they act in their own right, not as the beneficiary's agent.

Bankers' acceptances

There remains the true question in Banco Santander: whether the law treats DPUs as it treats bankers' acceptances. The bankers' acceptance is an investment medium and a financing medium. When a small entrepreneur draws a draft on a prime bank, the paper is worth little. The small entrepreneur may find investors willing to take his paper, but only at a steep discount.

When the bank accepts the draft, however, investor interest mounts. The paper now entails the financial obligation of a strong party. Merchants, investors and the law of trading nations recognize the value of bankers' acceptances and protect those who take that acceptance from defences in the underlying transaction.

The law codifying those rules is the law of negotiable instruments. When an investor takes the bankers' acceptance from the small entrepreneur, the taker is not an assignee of the entrepreneur. The investor holds the paper in his own right as a holder in due course. The investor is not subject to the nemo dat rule, but benefits from the good faith purchase protection negotiable instruments law fashions for holders in due course. Nothing in UCP 600, which is not law in any event, can alter law; and UCP 600 cannot weaken the strength of the acceptance holder, though one doubts that the UCP drafters would ever entertain an effort to weaken the acceptance and its holder, which is a preposterous idea anyway.

Trade acceptances

Sometimes, of course, merchants accept drafts drawn on themselves. Such acceptances are trade acceptances. These also move in the money market, though usually with less advantage and steeper discounts than the golden acceptance, the bankers' acceptance.

The bankers' acceptance also arises outside letter of credit transactions. A borrower may need to finance, say, $10,000,000 on 360-day terms. The borrower can draw one hundred drafts in the amount of $100,000 on prime commercial banks. When the banks accept the drafts, the borrower will be in a position to sell the drafts in the money market at favourable rates. That type of financing appears to have been at the nub of the transaction Jim Barnes describes in the Fortis Bank (Nederland) N.V. case he discussed in the April-June issue of DCInsight (at page 15). In that case, the borrower used a synthetic letter of credit to overlay the financing arrangement to ensure that the borrower had a market for the acceptances.

Those obligations were acceptances, and law, not practice or grants of authority, protects innocent parties that take those acceptances. The free alienability with good faith purchase protection for the investors who purchase bankers' acceptances from sellers or borrowers is critical to finance trade or other commercial activity.

Rather than an authority issue, the matter for ruling in the Banco Santander case was one of deciding whether the DPU merits the protection the law has fashioned for bankers' acceptances. As I pointed out in the January-March issue of DCInsight (at page 11), the UK court arguably reached the proper result under UK law in Banco Santander, though it did not use proper reasoning. It was not a question of authority. It mattered not whether the nominated bank's mandate permitted the nominated bank to discount its own acceptances. The law of trading nations commands that permission, whether the issuer or the UCP mandates it or not.

Contract authority is not relevant to the inquiry. Anyone may take a bankers' acceptance; and if it does so in good faith and without notice of the fraud, the taker takes free of the fraud defence. But Banco Santander involved a DPU, not an acceptance.

DPUs and negotiable acceptances

DPUs are not negotiable instruments, however. The transfer of a DPU is not the negotiation of such a negotiable instrument, and the issuer of a DPU should not expect that its DPU travels free of the fraud defence, unless law, not contract or rules of practice, ordains that it travel free of the defence.

Clearly, under law, anyone, including the nominated bank, may purchase the DPU, which is an obligation, a chose in action that is almost always freely assignable. But does the DPU purchaser benefit from a rule of law protecting it from the fraud defence, and does the law deprive issuers of the choice of mandating DPUs that are subject to the fraud defence or mandating bankers' acceptances, which are free of that defence? Some issuers clearly would prefer the former, but they may not have the option in some countries.

Some nations have fashioned that protection for takers of DPUs. By court rule in the PRC, by UCC Article 5 in the US and by at least one court decision in South Korea, the law of those nations protects DPUs, rendering them the equivalent of negotiable acceptances. Other states, such as the UK and, one suspects, other Commonwealth states, do not.

In short, parties seeking the answer to the question of the DPU holder's freedom from the fraud defence should look to the law, not the UCP and not to practice or the issuer's mandate.

John F. Dolan is Distinguished Professor, Wayne State University Law School, Detroit, Michigan, US. His email is Thanks to Xiang Gao for his comments on the subject of this article.