Article

Factual Summary: To pay for a shipment of metal, Applicant arranged for Issuer to open a one hundred eighty day deferred payment LC issued in Dubai, UAE for US$851,700 in favor of Beneficiary, which was confirmed in Geneva, Switzerland at Issuer's request. The LC was valid for two months from the date of issuance.

On Beneficiary's presentation of documents, Confirmer determined that the documents complied with the terms of the LC and forwarded them to Issuer. Before the documents had been received by Issuer, Confirmer discounted the amount due at maturity to Beneficiary. Confirmer's notation to Beneficiary indicated that "our discount without recourse on the financial risk only". By these terms Confirmer meant to limit its risk to country risk and risk of Issuer's insolvency, and not assume the commercial risk between the buyer and seller.

On receipt of the documents, Issuer endorsed the bills of lading and forwarded them to Applicant, which gave Issuer promissory notes equal to the amount of the LC. Issuer informed Confirmer that it had taken up the documents as conforming and would pay on the due date.

On hearing rumors of fraud by Applicant and subsequently learning of Applicant's attempts to reschedule its debts to banks, Confirmer alerted Beneficiary and Issuer. An investigation by the ICC International Maritime Bureau revealed that the two containers involved did not contain goods incompliance with the agreement. The investigation also revealed that transactions financed by Beneficiary, including the one in question in the instant case, were fraudulent in that either no merchandise had been shipped or what was shipped had a much lower value than what was claimed. The excess money was misappropriated by Applicant. The total loss from the "Solo Frauds", as they are known, was estimated to be US$300,000,000.

Although Beneficiary was listed as "seller" in the LC, in fact it was a financial intermediary that did not participate in the delivery of the merchandise. It did, however, know that the sale was fictitious. Criminal complaints were filed by Issuer in Geneva against Beneficiary's officers.

After the fraud was revealed, Issuer filed a motion for interim relief in Geneva to prevent Confirmer from claiming the amount due under the LC on the maturity date, which was dismissed. On the maturity date Issuer failed to pay Confirmer.

Confirmer then sued Issuer for reimbursement by filing a request for payment from Issuer in the Swiss courts in Geneva, seeking the amount it was owed under the LC plus interest. The local court granted judgment for Confirmer. On appeal, the intermediate appellate court affirmed. On appeal, the judgment for Confirmer was overturned, Issuer's appeal was granted, and the case was remanded to the trial court to determine costs.

Legal Analysis:

1. Choice of Forum; Choice of Law: The court noted that the LC did not contain a choice of forum or applicable law clause. It also noted that Issuer was located in UAE while Confirmer was located in Switzerland, and that there is no international treaty between Switzerland and the UAE Therefore, the court applied its own choice of law rules, the Swiss Federal Act on International Private Law (FAIPL), to determine the applicable law. The court concluded that "[i]n a dispute bearing on the relations between a confirming bank and an issuing bank, it is considered that it is the confirming bank that provides the characteristic service [citation omitted]. Since the head office of [Confirmer] is in Geneva, it is therefore Swiss law that is applicable, which also corresponds to the law on which the parties rely."

2. UCP500, Application of: Although the record did not reveal whether the credit was subject toUCP500, the court took it "into account" since "these rules find an application in the letter of credit relationship between the two banks".

3. Confirmer, Relation to Issuer; Issuer, Relation to Confirmer: The court noted that the relationship between a confirmer and an issuer is "identical" to that between the issuer and the applicant. It described this latter relationship as "as a combination between a mandate ... and an appointment". Accordingly, it concluded that "[t]he confirming bank is mandated and appointed by the issuing bank and sub-agent of the purchaser, whereas the beneficiary (the seller) is appointed twice". The court noted that one consequence of this relationship is that it may obtain "repayment" from the issuer based on its mandate and "[t]hus, the confirming bank that pays a documentary credit to the beneficiary may obtain repayment from the issuing bank based on section [citation omitted]. By paying the beneficiary, the bank does not acquire the latter's debt by subrogation against the purchaser".

4. Deferred Payment Credit: The court described a deferred payment credit as one where the presentation of required documents "does not correspond with the time of payment". It stated that such an undertaking "helps procure credit for the purchaser" and makes a drawing by means of a draft unnecessary. The court explained that "the payment to the beneficiary is not made when the documents are released, but at a later date, as stipulated under the credit; therefore the purchaser may assume ownership of the merchandise before paying for it. Then it has the option to resell the goods before the due date and will be able to pay the amount of the documentary credit on the day stipulated in the settlement".

5. Independence: In describing the independence principle, the court stated that "The appointment rules applicable to the documentary credit [citation omitted]imply that, as soon as the appointment is accepted without reserve, the appointed bank must make the payment, without being able to invoke exceptions taken from the provision report or the value report[citation omitted]. This realizes the abstraction principle, which is an essential rule of the documentary credit".

6. Fraud, Exception; Independence, Fraud Exception: In considering whether there can be an exception to the independence principle, the court stated that "Only the existence of an infraction of the law [citation omitted] allowed the appointed bank not to provide services". Describing this exception, the court noted that "The jurisprudence, however, proves very restrictive and only allows the appointee's option to claim an infraction of the law based on a defect affecting the report of value in particularly serious cases".

7. Fraud, Elements of: In explaining the elements necessary for there to be an exception to the independence principle, the court stated that "[t]he illicitness or contradiction of the spirit of the debt must be obvious; the defect must be legally evident and proof must be immediately possible as a matter of fact; the determining moment to judge the presence of these conditions is when the appointee claims the execution of the appointment; it is admitted that the appointee abuses its right when it knows or should know that it does not have any present or future right according to the value report based on immediately available proof [citation omitted]. Such is particularly the case involving a documentary credit in the presence of fraudulent devices [citation omitted], for example when it is established that the sale based on the letter of credit involves non-existent merchandise or of a much lesser value than the amount that the bank undertook to pay to the assignee".

8. Fraud: The court rejected Confirmer's argument that the fraud was confined to the applicant, noting that it had been proven that "the beneficiary was also involved". Nor did the court see any significance in the date when a conviction for the fraud was determined. It stated that "it is enough that the fraudulent act is evident at this point", that is, before the obligation to pay matured.

9. Independence, Excuse; Issuer, Excuse Due to Fraud; Fraud, Excuse of Issuer's Obligations Due to: The court began its analysis by considering whether the fraud "would have allowed the appointed bank to refuse payment of the amount of the letter of credit to the beneficiary on the due date." Having noted that the beneficiary had engaged in sufficiently serious fraudulent acts, the court concluded that the issuer may "meet its payment obligation before the due date".

10. Discount: Issuer claimed that Confirmer violated its obligations under the LC by making payment prior to the maturity date of the deferred payment. It argued that this discount excused Issuer from reimbursing Confirmer on the maturity date due to the subsequently proven fraud. In rejecting this argument, the court noted that a 1974 Swiss court decision had allowed an issuer to "meet its payment obligation before the due date" in the form of a discount, unless otherwise provided.

11. Deferred Payment Under UCP500 Art. 9(a): Issuer claimed that the revision of the UCP made the prior Swiss decision inapplicable to this case, and that UCP500 Section 9 (a) (ii) provides that deferred payments subsequent to 1974, the date of the Swiss decision, can only be made by an Issuer or Confirmer at maturity. Reviewing the provisions of UCP500 Article 9, the court noted that it "specifies that the confirmation of an irrevocable credit constitutes a firm commitment of the confirming bank in addition to that of the issuing bank, so that, if the credit is realizable by deferred payment, it must also pay on the due date(s) determined in accordance with the credit provisions." The court noted that "[s]ome authors conclude from this that prepayment is not compatible with the letter of credit with deferred payment as described under section 9 UCP 500".The court observed "this position does not clearly follow from the text of section 9 UCP 500, so that nothing allows for the statement that the appointed bank would violate the UCP by paying the amount in the documentary credit with deferred payment to the beneficiary before the due date". The court then concluded that "there is therefore no reason to depart from the position supported by this court in the decision dated 1974", which was consistent with Swiss and foreign bank practice and with the opinions of "most authors".

12. Fraud, Deferred Payment Undertaking; Deferred Payment Undertaking, Fraud: The court inquired if either Applicant or Issuer could refuse payment subsequent to prepayment. It surveyed the literature, classifying authorities into two general groups: i) those who do not believe that prepayment is proper; and ii) those who believe prepayment to be proper. Since the first group did not believe that a bank may discount a deferred payment obligation ,the court noted that it would not allow a bank that did so to obtain reimbursement from the applicant. Among those who believed that a bank could properly discount a deferred payment obligation, the court noted three groups: i) those who would not allow fraud discovered subsequent to the discount to be raised as a defense in an action for reimbursement; ii) those who believe that a discount differs from the commitment arising under the credit and constitutes a loan, so that the bank acts at its own risk in discounting and is not entitled to the abstraction available under letter of credit law; iii) those who do not characterize the discount as a loan, but regard the discount as an act against the interest of the applicant in that it deprives the applicant of the right to assert fraud prior to the due date so that the risk of loss remains with the bank.

The court also surveyed judicial decisions, noting that they revealed similar disparity. It cited a 1981Italian decision that concluded that subsequent fraud had no impact; a German decision that treated the prepayment as a loan, although the decision did not involve a confirming bank; a 1987 French decision that indicated that a confirmer that prepays its deferred payment obligation would be subject to the defense of fraud because the obligation to reimburse does not mature until the due date; and an English decision that ruled that the debt was owed to the beneficiary only on the due date so that "[t]he confirming bank that alone makes the decision to prepay the beneficiary must bear the risk of discovery of a fraud before the due date". The court deduced from these authorities what it described as a "trend" recognizing that a bank that prepays must bear the risk of fraud discovered after prepayment but before the maturity date. It described this trend as "convincing". The court stated that the very notion of a deferred payment connotes "a delay between the presentation of the documents and the payment." While recognizing that either the issuer or the confirmer can prepay the amount owed, the court stated that being able to prepay "would not, nevertheless, allow the bank that paid before the due date to unilaterally amend to its own benefit the terms of the letter of credit with deferred payment, when, as provided by section 9 d/i UCP 500, once opened, the irrevocable documentary credit may not be amended without the agreement of all parties. If the purchaser or the issuing bank in the case of a 4-way relationship [citation omitted] is denied the possibility to claim a fraud discovered after the prepayment to refuse repayment to the appointed confirming bank on the due date, the latter is left to unilaterally protect itself against such a risk. It would suffice to discount the letter of credit as soon as possible after accepting the documents to avoid any objection related to a fraud discovered subsequently."

13. Deferred Payment Undertaking; Fraud, Deferred Payment Undertaking: Confirmer argued that the purpose of a deferred payment undertaking is not to allow "the purchaser to verify the status of the merchandise in case of delay of payment or to protect it against possible fraud". The court noted, however, that "it is also true that the exception in [Swiss Documentary Credit Law] in case of fraud represents exactly an exceptional situation in which it is admitted that one may distance oneself from [the independence principle]."

14. Notice of Refusal; Documents, Disposition and Disposal of; UCP500 Article 14(e): Confirmer argued that Issuer was liable to repay Confirmer despite the fraud, because Issuer was unable to return the documents presented which it had forwarded to Applicant. Issuer responded, and the court agreed, that UCP500 Art. 14(e), which precludes a bank from relying on discrepancies if it fails to hold documents at the disposal of the presenter, only applies to the acceptance of documents, and "[t]his provision would therefore not prevent the bank that realizes afterwards that it was cheated, from claiming fraud, for the only reason that after having accepted without reserve documents apparently compliant with the terms in the letter of credit, it disposed of them."

Comments by James E. BYRNE:

1. Choice of Law: Although this decision departs from traditional choice of law analysis, it reached the same result, concluding that the confirmer is bound by its own law, which was also the law of the forum.

2. UCP, Application as Standard Practice; Standard LC Practice, courts recognizing UCP as embodying: The decision is one of the few that are prepared to apply the UCP whether or not a credit is issued subject to the UCP. While it is probable that this credit and the confirmation was subject to the UCP, the court indicates that the record does not reflect this fact. That itself raises a more serious question, namely how a court can resolve an issue related to a letter of credit without having the text of the credit before it.

3. Fraud Exception, Illegality: While we do not have the original French text, it appears that the court has stated that the exceptions to the independence principle arise in situations where there is an "infraction of the law". In the event that this observation is interpreted to mean that there must bean illegality for this exception to operate, it misstates LC law. The exception to the obligation to honor recognized in LC law arises only where the documents are forged or where there is letter of credit fraud in the transaction underlying the LC. The doctrinal source of illegality lies outside LC law, and illegality should be restricted in regards to its impact on LC independence.

4. Independence, Basis: The opinion seems to assume that acceptance of the applicant's application constitutes the beginning, and possibly source of, the independence principle. If so, it is incorrect. The source of the independence principle lies in a bank's undertaking to a nominated bank or beneficiary. It is the very essence of the principle that this obligation is different from any application by the applicant. The application is accidental. Absent an undertaking there is no independent obligation whether or not there has been an application.

5. The court properly rejected the argument that a bank cannot discount its own obligation. This argument is based on a twisted theoretical approach that fails to recognize the nature of the bank's obligation, its independent character from that of the issuer, or the application. Its interpretation of UCP500 Article 9(a) is also sound so far as it goes in rejecting an unduly and unintentionally narrow interpretation that is hostile to discounting.

6. The most significant and troubling aspect of this decision is its treatment of the fraud exception to the independence principle in a situation involving a deferred payment undertaking. With it, one more court has added its voice to those of England, France, and Singapore to the view (this court calls it a trend) that a confirmer that discounts its own obligation is not entitled to be reimbursed if fraud is discovered prior to maturity of the credit.

7. It is hard to understand the basis for this conclusion. Many of these courts have been prepared to allow negotiating banks or banks that have issued their acceptances to claim reimbursement notwithstanding the claim of beneficiary fraud. What is the difference where there is a deferred payment undertaking? Only that there is no draft (or need not be one). Courts find some solace in the notion that the law of negotiable instruments provides an exception in the doctrine of holder in due course. However, the law of letters of credit provides a principle of independence which is as strong, if not stronger, than that of negotiable instruments. There is no need for there to be a draft for negotiation. Under UCP500, banks can negotiate against documents. Nor should there be any need for a draft for a confirmer to be entitled to the same treatment as would a bank that had accepted a draft and discounted it.

8. There is some talk about the need for a mandate or authority from the issuer to discount the deferred payment undertaking. On what ground? The undertaking is that of the confirmer, not that of the issuer. The confirmer can discount its own undertaking if it wishes to do so.

9. Nor can it be fairly argued that by discounting the undertaking the confirmer increases the risk of fraud to the applicant. There is no allocation of such a risk. The risk rests with the applicant, period. The applicant and, where it is insolvent, the issuer seeks to take advantage of a fortuitous circumstance to prevent financial loss as a result of a poor business decision (choosing to deal with the beneficiary who is a fraudster) or extending credit to the applicant (who is insolvent). None of these risks were ones that the confirmer undertook.

10. In addition, in this case there is a double fraud. The applicant and beneficiary were in collusion. Indeed, it appears the applicant bore greater culpability. To shift such a risk from the issuer to the confirmer is highly unfair. The confirmer is the one party least able to prevent such a loss.

11. What about the argument that the confirmer should not have extended trade finance? That argument is silly. There is a serious need for such finance. Banks are prepared to and able to extend it at a reasonable price. They will create documents and agree to terms that permit them to do so and, in effect, overrule these court decisions by their practices and agreements. How much better to save everyone grief by admitting that this line of decisions is another example of courts misunderstanding practice.

12. Preclusion: The court reaches a sound result on the preclusion argument, although it does not adequately explain its rationale. Preclusion underUCP500 Article 14 turns not on examination, but on the notice of refusal and its terms. Here, there was no notice of refusal and, under the preclusion rule, the issuer was obligated to honor unless there was LC fraud. The question at this stage would be not whether there was preclusion in failing to return the presented documents, but conversion, and, if so, what damage was incurred.

13. Something that the court neglected to note was the US statute. Revised Uniform Commercial Code Article 5 (1995) anticipated this situation and expressly protects the nominated bank that discounts its deferred payment undertaking. § 5-109(a) provides:

(a) If a presentation is made that appears on its face strictly to comply with the terms and conditions of the letter of credit, but a required document is forged or materially fraudulent, or honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant:

(1) the issuer shall honor the presentation, if honor is demanded by (i) a nominated person who has given value in good faith and without notice of forgery or material fraud, (ii) a confirmer who has honored its confirmation in good faith, (iii) a holder in due course of a draft drawn under the letter of credit which was taken after acceptance by the issuer or nominated person, or (iv) an assignee of the issuer's or nominated person's deferred obligation that was taken for value and without notice of forgery or material fraud after the obligation was incurred by the issuer or nominated person; and

(2) the issuer, acting in good faith, may honor or dishonor the presentation in any other case.

[JEB/lhd]

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