Factual Summary: In contracting to purchase aluminum metal, the buyer agreed to pay the seller a US$ 5 million pre-export advance, to be offset by future deliveries. The contract contained an undertaking by the seller to indemnify the buyer for any failure to deliver and for the corresponding decline of the advance balance. To assure payment under this indemnity, guarantor bank issued its performance bond or guarantee "unconditionally and irrevocably as a separate and continuing obligation to indemnify... (buyer) up to $5.75 million, in respect of any failure of (seller) to meet its obligations under (the indemnity provision in the contract)." To obtain funds to make the advance, the buyer assigned the performance bond to its lender bank as security. After some shipments, the seller encountered difficulties and ceased shipment, leaving outstanding $2.2 million of the advance. A claim for $1.6 million was paid under the guarantee, but the guarantor subsequently cancelled the bond "on the basis that it had reasonable grounds to believe that the purported purchase contract was a 'sham' transaction and that the bond had been obtained by fraud of which the buyer had notice". The seller subsequently repaid its lender and took a reassignment of the bond and sued the guarantor. At trial, the seller/ beneficiary's motion for summary judgment was denied. On appeal, it was held that denial of summary judgment was proper."

Legal Analysis

1.Classification: The trial judge treated the bonds "like promissory notes, bills of exchange, or cash", describing his approach as "the cash principle". The buyer/beneficiary argued that this approach was correct, likening the undertaking to LCs as well. The buyer/beneficiary argued: "If banks or their customers could avoid payment of obligations apparently arising from such instruments, by challenging the validity of the instruments, the flow of the 'life-blood of commerce' could be impeded no less significantly than it would be if challenges to the propriety of demands made under such instruments were permitted", quoting from RD Harbottle (Mercantile) Ltd v. National Westminster Bank Ltd (1978) QB 146, (1977) 2 ALL ER 862, 155G per Kerr, J. It contended that the only exception, fraud, "has been limited traditionally by insistence on a high standard of proof." The appellate court cited prior cases of guarantees with unconditional wording and noted the analogy by Lord Denning in (Edward Owen Engineering Ltd v. National Westminster Bank Ltd) (1978) QB 146, (1977), 2 ALL ER 862, between a performance guarantee and a LC, stating that "these. performance guarantees are virtually promissory notes payable on demand."

2. Fraud, Defense; Standard of Proof: The beneficiary argued that due to the cash-like nature of a performance bond, the standard of proof required for avoiding summary judgment should be the same as that required to obtain injunctive relief. The appellate court observed "both the fact, and the bank's knowledge, of fraud are concurrent preconditions to a bank having any right to withhold payment." The appellate court indicated that the guarantors were "overstating the standard of proof". Citing United Trading Corpn SA v Allied Arab Bank Ltd (Note) (1985) 2 Lloyd's Rep 554 (Ackner, LJ): "The evidence of fraud must be clear, both as to the fact of fraud and as to the bank's knowledge. The mere assertion or allegation of fraud would not be sufficient. We would expect the court to require strong corroborative evidence of the allegation, usually in the form of contemporary documents, particularly those emanating from the buyer. In general, for the evidence of fraud to be clear, we would also expect the buyer to have been given an opportunity to answer the allegation and to have failed to provide any, or any adequate answer in circumstances where one could properly be expected. If the court considers that 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. "While accepting that letters of credit and performance bonds are part of the essential machinery of international commerce (and to delay payment under such documents strikes not only at the proper working of international commerce but also at the reputation and standing of the international banking community), the strength of the proposition can be over-emphasized. As (the trial judge) observed in the judgment under appeal, it cannot be in the interests of international commerce or of the banking community as a whole that this important machinery that is provided for traders should be misused for purposes of fraud. Moreover, we would find it an unsatisfactory position if, having established an important exception to what had previously been thought an absolute rule, the courts in practice were to adopt so restrictive an approach to the evidence required as to prevent themselves from intervening. Were this to be case, impressive and high-sounding phrases such as 'fraud unravels all' would become meaningless. "The learned trial judge concluded that the test to be applied by the courts is the standard of the hypothetical reasonable banker in possession of all the relevant facts. Unless he can say 'this is plainly fraudulent; there cannot be any other explanation', the courts cannot intervene. We respectfully disagree. The corroborated evidence of a plaintiff and the unexplained failure of a beneficiary to respond to the attack, although given a fair and proper opportunity, may well make the only realistic inference that of fraud, although the possibility that he may ultimately come forward with an explanation cannot be ruled out. The claim before us is a claim for an interlocutory judgment. The first question is therefore. Have the plaintiffs established that it is seriously arguable that, on the material available, the only realistic inference is that the beneficiary could not honestly have believed in the validity of its demands on the performance bonds?"

3. Fraud: Both the beneficiary and the guarantor recognized the existence of an excuse in the event of fraud. The guarantor, while accepting that an exception for fraud exists, "point(s) out, however, that is has never been successfully invoked in practice because of the heavy burden of proof. (It contends) that this is because proof of facts which, in the absence of explanation, would ordinarily establish fraud is not sufficient unless every possibility of an innocent explanation is excluded. it submit(s) that the courts will accordingly speculate whether an innocent explanation is possible, and will usually not infer fraud from mere silence in the face of the accusation." The appellate court reviewed the.95 2001 LC CASE SUMMARIES authorities and concluded: "This reasoning might suggest that a bank's duty to pay is conditional upon the honesty of the demand, although, in practice, the bank will be precluded from resisting any demand for payment or any application for summary judgment, if it lacks knowledge or proof of fraud."

4. Fraud, Defense, Summary Judgment: The beneficiary argued that the trial judge erred in concluding that the guarantor "has even a reasonable or real prospect of establishing the conspiracy or fraudulent misrepresentation that it alleges at trial." It noted legitimate concerns about 15 undocumented alleged shipments out of 56, that a further 22 had only a B/L, that 6 of the B/Ls for the remainder related to vessels not present in the stated loading port on the indicated date, and that all B/Ls were issued by a company controlled by a son-in-law of the person controlling the seller which did not itself own or operate any vessels. While recognizing that some shipments had been made, the appellate court indicated that the documentation for such an important contract was sufficiently confusing as to suggest that it could "not be taken at face value". Moreover, the evidence strongly suggested that the seller was involved in "a very large-scale fraud on the Indian exchange contract authorities" which suggested that they "engaged in a very high degree of fraudulent and fictitious trading, with a view to raising money from banks and staving off insolvency." The contracts with the buyer, in the opinion of the appellate court, had the "potential" of fitting into this pattern rather than representing long-term business commitments. Given this evidence, the appellate court concluded that summary judgment was appropriate even under the higher "fraud exception" test urged by the beneficiary. The appellate court, however, indicated that the test was "whether there was a seriously arguable case (or more real prospect) for saying, on the material now available, that the only realistic inference was that the purchase contract was never intended to be performed according to its terms." The appellate judge also stated that the test was "whether the guarantor bank has a real prospect of successfully defending the claim by justifying its claim to have avoided the bond." It concluded that the trail judge was correct in his dismissal of the motion for summary judgment.

Comment1. One wonders if the issue is not whether there is an outstanding issue of material fact on the question of whether there is LC fraud (or guarantor fraud). In this regard, discussion of the standard of fraud may be premature, except insofar as the material facts outstanding would need to rise to that level if proven. Perhaps the appellate court took this position but it is not entirely clear. 2. It is striking that the court is not able to state simply that an independent (or so-called 'unconditional' guarantee) is independent and must look to the law of bills of exchange for a parallel. In an interesting aside, the appellate court comments that it need not reach the question of the rights of innocent purchasers of the bonds because they were repurchased by the beneficiary. It comments, however, that such purchasers may be "vulnerable" to being able to claim a right for innocent purchasers available under bills of exchange "because there is no enactment in relation to performance bonds paralleling (the statute) in relation to bills of exchange." Indeed, the weakness of a system of pure case law, especially without proper rules of practice, is glaringly apparent in this discussion. It is a strong argument for both rules of practice and especially for adoption of the UN Convention. 3. The opinion also reveals the difficulties faced even on fundamental levels by the beneficiary of a guarantee not subject to rules and laws that establish its independence. 4. At the end of the day, it would seem obvious (and hardly necessary to relate in such a lengthy opinion) that summary judgment on the issue of fraud was premature.


The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.