Article

Factual Summary:

Plaintiff, acting as an agent for a buyer, obtained an LC in the amount of US$ 1,004,000 to finance the export of jeans to the Netherlands. Upon an initial presentation, the adviser, a corporate affiliate of the issuer, found numerous discrepancies in the documents, gave notice, and held the documents. The beneficiary submitted a second set of documents, including a different bill of lading, (so that the adviser now held two different bills of lading) but the adviser again found discrepancies, gave notice, and again held the documents. A third presentation of documents was then made, and forwarded to the issuer. Several discrepancies were noted by the issuer and the applicant was contacted and told of at least some of the discrepancies. The applicant reportedly waived those discrepancies of which it was told, and the issuer made payment.

Upon review of the documents on the day it received them, the applicant noticed other discrepancies and inconsistencies in the documents, but negotiated with the beneficiary for six weeks before notifying the adviser that the documents were fraudulent. Afterwards, the applicant brought an action against the beneficiary and obtained a note in settlement, but the beneficiary defaulted on the note.

Thereupon, the applicant brought an action against the issuer and adviser for fraud, aiding and abetting the beneficiary's fraud, wrongful honor of the LC, and conversion. To support the fraud claim, the applicant alleged that the adviser had altered the documents to facilitate payment to the beneficiary. The banks alleged that the applicant participated in the fraud. On motions to dismiss and for summery judgment, the trial court granted some and denied other motions to dismiss and granted summary judgment to the applicant on its wrongful honor claim.

Legal Analysis:

1. Wrongful Honor: Strict/Substantial Compliance: Noting that "there is disagreement as to the standard applicable when an applicant sues an issuer for wrongful dishonor", the court concluded that, even under the so-called "substantial compliance" standard (the less rigorous one), the "documents submitted by [the beneficiary] did not substantially comply".

2. Compliance: Draft : Notation That it is Drawn Under LC: The LC required presentation of a draft noting the LC number and issuer. The draft did not contain the notation and the court concluded that it was discrepant even though the issuer could identify the LC against which it was drawn, the purpose of the notation.

3. Compliance: Copies: Copies of Invoice Different from Invoice: The LC required an original and four copies of the invoice. The invoice was apparently corrected to conform to the description of the goods but the copies were not. They, therefore, neither corresponded to the description of the goods nor were true copies. The court rejected the contention of the issuer's expert that "banks do not typically examine each apparent copy of a document with the same degree of care as the original" by noting that a discrepancy nonetheless existed. The court stated that "in a letter of credit transaction, when the applicant places such reliance on the bank's inspection of the documents, banks cannot fulfill their responsibility merely by 'eyeballing' documents."

4. Compliance: Bills of Lading: The LC required all original marine bills of lading (BoL). The three bills presented purported to be originals but contained blocked out areas which the court took to be copies and contained different identification information for the freight forwarder, as well as different markings indicating whether they were prepaid. The court concluded that the crossed out markings indicated the BoLs were not originals, that each original BoL should have been independently examined, and the difference in whether the shipping was prepaid was significant.

5. Other Discrepancies: Inspection Document, Insurance Document, and Packing List: The court noted that there were discrepancies in the required inspection document, insurance document, and packing list. The court concluded that there were seventeen discrepancies which should have been discovered. It further concluded that many related to the existence, quantity, or quality of the goods. It concluded that "no reasonable jury, properly instructed on the nature of the letter of credit transactions and the exacting obligations of the beneficiary and the issuer thereunder, could find that the documents submitted ... substantially complied with the letter of credit requirements."

6. Cause of Loss: The court rejected the issuer's argument that the applicant's loss was caused by the beneficiary's fraud. It ruled that the bank's payment in breach of its obligation caused the loss because if the issuer "had not honored [the beneficiary's] substantially nonconforming documents, [the applicants] would have sustained no direct loss ..." It further rejected the claim that the beneficiary's fraud was an intervening cause on the ground that the fraud "did not breach the chain of causation".

7. Defenses: Waiver and Estoppel: The court rejected the claim that the applicant expressly waived discrepancies, as the issuer was unable to produce evidence that the applicant (or even the issuer itself) was aware of most or all of the discrepancies at the time the applicant allegedly waived them. Without knowledge of the particular discrepancies, or at least the magnitude of the discrepancies that existed, the court concluded that the applicant could not waive them. The court noted testimony from the issuer's account officer to the effect that the applicant was "quite cavalier" when notified of these discrepancies. It concluded that "a cavalier attitude and a statement about waiting to get the deal done after being told of three discrepancies technical discrepancies which do not rise to the level of substantial compliance does not create an issue of fact to the waiver of seventeen other discrepancies, some significant and rising to the level of substantial non-compliance when both [the issuer's account officer and the applicant] were unaware of those discrepancies."

8. Clause in Application Permitting Reliance on the Waiver: The court ruled that a clause in the LC application referring to waiver was inapplicable. The clause read that the issuer "may act in reliance on any oral, telephonic, telegraphic, electronic or written request or notice believed in good faith to have been authorized by the applicant, whether or not given or signed by an authorized person." The court concluded that "this clause merely permits the bank to proceed on its good faith belief that it was the applicant; it does not permit a finding of waiver when there could be none."

9. Waiver by Operation of Law: Applicant's Duty to Notify Issuer of Discrepancies: The issuer argued that the applicant "has a duty to notify the issuer within a reasonable time after receiving the documents that they do not comply with the letter of credit requirements, and to return those documents to the issuer." The court ruled that no such duty exists because it "has no basis in the law governing this transaction and makes little sense in the scheme of letter of credit transactions."

The court ruled that an applicant does not, by operation of law, waive its right to sue for breach of the application agreement by failing to object promptly and to return the documents to the issuer. Article 16 of UCP 400, which requires that an issuer notify the beneficiary of acceptance or rejection within a reasonable time, imposes no such obligation on the applicant vis-a-vis the issuer. In support of its conclusion that there was no such duty, the court stated that none was reflected in the UCP 500 revision which "easily could have extended the waiver rule to applicants if the drafters had so desired." Such a duty could not be found within the application agreement, nor did New York statutory, contract, or case law impose such a duty. The issuer's argument that a comment to prior UCC 5- 113(2) imposes such a duty was without merit because, (1) by the terms of the agreement, the UCP governed and (2) support for the comment was sparse and referenced transactions where the documents represented title to goods. The court rejected the analogy to sales law under which a party must elect its remedy because there is no ongoing executory relationship and because the issuer is "hired to ensure the documents' strict compliance with a letter of credit before payment. ..."

The court concluded that the cases cited by the issuer involved instances where the discrepancies were trivial rather than in support of what it called a "per se" waiver rule. Other cases involved exercise of dominion over the goods.

The court concluded that an "automatic" waiver "rule" means little sense in a letter of credit transaction. "If bankers want to require an applicant to report discrepancies promptly, they may include a provision in the application. ..." Nor, stated the court, does the absence of such a rule prejudice the issuer, chiefly because the issuer has already paid.

10. Applicant Not Required to Return Documents: The court rejected the argument that the applicant should have returned the documents promptly. Concerned about prejudice to the applicant, it noted that "nothing compels the issuer to return the reimbursement". It concluded that such a rule would "prejudice the applicant because it will have paid the issuer and be left without any documents to obtain the goods which may have been shipped", noting that the applicant was in the best position to mitigate damages in any event and the issuer could look to its security.

The court rejected the analysis of , Petra Int'l Banking Corp. v. First Amer. Bank of Va., 758 F. Supp 1120 (E.D. Va. 1991), aff'd, 953 F.2d 1383 (4th Cir. 1992), which ruled that an applicant has a duty to inspect and return discrepant documents and distinguished the facts because Petra involved "a technical defect, raised as an afterthought one year after. ..." In addition, " ... the applicant had actually used the documents to receive the goods, and had negotiated a settlement with the beneficiary. ..." The court noted that such a rule makes little sense in a LC transaction, where the issuer is often selected for its expertise; i.e., its familiarity with the UCP, normal banking usage, and the proper format of shipping documents. Further, the issuer's responsibility to pay upon presentation of conforming documents remains the same whether or not the applicant must inspect and notify the issuer of discrepancies independently.

11. Illegality: Knowledge of the Fraud: The court rejected the banks' remaining defenses, (that the transaction involving gray market or counterfeit jeans underlying the LC was illegal, and that plaintiff's knowledge of the fraudulent nature of the documents should equitably stop them from asserting discrepancies). Although the reimbursement agreement permitted the issuer to assert this defense, the banks could offer no factual support for these assertions.

12. Fraud: Alteration of Documents: Bank Failure to Inform Applicant of Rejected Presentments: In its fraud claim, the applicant alleged three specific misrepresentations by the issuer and adviser. Only one, that the adviser altered the inspection report and added the term "jeans" to the packing list so as to make them appear conforming, withstood a motion to dismiss.

The applicant's attempt to impute knowledge of the subsidiary's actions to the parent corporation was not successful because no evidence was permitted to pierce the corporate veil. The applicant also claimed that the bank's failure to inform it of prior discrepant presentations constituted fraud. The court, however, found that the issuer had no duty to inform the applicant of prior presentations. The court also dismissed the applicant's final allegation, that the issuer misrepresented that the documents complied with the LC, because it simply restated the breach of contract claim.

13. Aiding and Abetting: Conversion: Applicant's aiding and abetting claim, namely that substantial compliance was given the beneficiary in its fraud, could not be maintained, as it did not allege any substantial assistance by the issuer. However, plaintiff's allegations that the adviser took actions to alter the documents so as to make them appear conforming created an issue of fact to be settled at trial.

Plaintiff's claim for conversion was time barred.

14. Punitive Damages: Because the applicant has "failed to allege any conduct aimed at the public generally which would justify such an award", its claim for punitive damages or exemplary damages was stricken in connection with the wrongful honor claim but allowed to stand in the fraud claim against the adviser. In regard to fraud, the court ruled that such damages are recoverable "where the defendant's conduct is gross, wanton, or deliberate and demonstrates a high degree of moral culpability." (Quoting from Caldwell Bankers Residential Real Estate Services, Inc. v Eustice, 190 A.D. 2 nd 839, 840, 594 N.Y.S. 2 nd 52, 53, (2 nd Dep't 1993).

15. Waiver of Jury Trial: The application contained a paragraph by which the parties waived the right to trial by jury, and the court concluded that the evidence was sufficient to prove that the waiver by the applicant was knowing and intentional. The court, noting the presumption in favor of a trial by jury, also noted that there was no indication that the term was not negotiable, that there was little disparity in bargaining power (the applicant was a longtime customer, had approached another bank, and was an experienced businessman), was conspicuous (it was on its own right above the signature line), and the applicant had the agreement for several days before signing.

Comment:

This thoughtful decision presents a number of serious issues for the letter of credit community. Unfortunately many are troubling and there will be no review at the appellate level because the case was settled. Among the matters which need thorough airing are:

1. The major lesson of the decision is that issuers should look to their applications. The theme which ran through the court's discussion of the standard by which examination of discrepancies was to be measured, waiver of discrepancies, timely notification of the issuer of the discrepancies, return of the documents, damages, and trial by jury is that the language of the application or reimbursement agreement makes a significant difference.

2. It must be asked, however, whether such matters should be exclusively within the domain of the application. Some issues in applicant/issuer relation-ships are, in fact, matters of letter of credit practice. This reality is demonstrated by the incorporation by reference to the UCP into most applications and reimbursement agreements. Where the UCP or similar rules of practice do not provide a rule, it is difficult to rely of general practices relating to letters of credit, as the Kools decision demonstrated. One conclusion which might be drawn from the decision is that rules of practice must address some of these issues directly. This area is one which bankers have skirted for some time. The standard response is that the UCP addresses only the relationship between the issuer, its correspondents, and the beneficiary.

While it is correct that the focus of the UCP is on these relationships and that the applicant is not a "party" to the LC, a number of the portions of the UCP relate to the obligation of the issuer to the applicant such as the disclaimer of responsibility for genuineness of documents or beneficiary fraud. Perhaps it is time to assure that standard practice regarding applicant/issuer relationships with respect to questions such as return of the documents and the duty to give the issuer timely notice of the presence of discrepancies are formulated and stated in a satisfactory matter. Such issues are too significant to leave to individual applications and judicial construction of them. In this respect, the ISP (which is discussed elsewhere in this issue) has made a notable beginning.

3. Perhaps the first thought which occurs in considering a case of wrongful honor is whether the standard by which the examination of documents is measured is the same between applicant and issuer as it is between issuer and beneficiary. Known as the so-called "bifurcated standard", this notion has persisted because there is no inherent symmetry between the two examinations. This decision appears, within certain limits, to accept a dual standard. At several key places, the opinion recognizes and appears to accept the proposition that the issuer is not to be charged with technical discrepancies which are immaterial in an action by the applicant for wrongful honor (although it is not without doubt because the opinion adopted the least rigorous standard for purposes of its decision). The difficulty in Kools is that the court concluded that the discrepancies were substantial and material even if the substantial compliance standard were adopted.

4. Whether the court was correct or not in its assessment of the documents depends upon examination of them, something which cannot be done merely by looking at the opinion. Some of the alleged discrepancies, however (such as the difference between a copy and an original and the failure of the draft to identify the LC number), bordered on the technical and immaterial. Perhaps a more important question than the standard of examination is the fundamental question of what is an examination. Is it the duty of the issuer to the applicant to minutely scrutinize each document for discrepancies and to be, in effect, an insurer for discrepancies which turn out to be material but which could not be expected to be discovered upon an ordinary examination? As is common with such cases, both sides relied on expert witnesses. The plaintiff's expert, possessed of years of experience, and having the leisure of time and hindsight was able to point outnumerous discrepancies. An average document examiner could not be expected to approach the examination in the same fashion. The question is whether he or she should be held to the same standard as an expert who can examine at leisure and with years of experience. The court assumed that it was this guarantee of compliance that banks were marketing to applicants and, given this perspective, its decision naturally follows. Once it adopted this approach, the finding that there were discrepancies which were serious dictated the result. At the very least, a bank which does not intend to absorb such a risk would be well advised to so state in its reimbursement agreement.

5. Perhaps the most disappointing feature of the case is the failure of this capable judge to recognize the existence of a standard practice requiring applicants to give timely notice of discrepancies. The opinion assessed the reasons advanced for such a rule and rejected them. Underlying the analysis was the notion that the issuer has a duty to the applicant to identify each and every discrepancy and is a better position to do so than the applicant.

This notion is suspect. While the issuer possesses an expertise in examination documents, its services are akin to an auditor. It does not have an intimate familiarity with the transaction nor the time or wherewithal to become familiar with it.

The applicant is uniquely in possession of such knowledge. Moreover, the applicant is in contact with the beneficiary who is a stranger to the issuer. The issuer is, therefore, vulnerable to collusion between the applicant and the beneficiary whether before presentation or afterwards.

To permit the applicant to delay in raising the issue of discrepancies works a serious injustice to the issuer. The fact that the issuer has the collateral (which was significant to the court) is meaningless if the collateral is subject to loss in an action for wrongful honor. If the problem is solely documentary, the applicant must decide to take the conforming goods and waive the documentary discrepancies promptly. It cannot be allowed to await market developments before doing so. If there is also a problem with the merchandise, the applicant must decide whether it will deal with the problem or leave it to the bank. In these situations, prompt action invariably makes a difference. It permits the banks to bring to bear their risk management capabilities, to ascertain facts while they are still fresh, and to make the best out of a bad situation. To leave the question to a case by case method, depending on the circumstances of the type of loss and the relative knowledge and whether it caused damage, was thought by the Kools' court to be unsatisfactory. Unfortunately, the court concluded that the better rule was one which imposed no duty rather than recognizing such a duty, one which certainly underlies the expectations of the international operations community.

6. Lest anyone become to comfortable with the mere presence of various clauses in a reimbursement agreement, the decision regarding the waiver of right to trial by jury deserves close scrutiny. Such a provision is important in LC cases because it is difficult for juries to deal with LC practice and they are thought to be prejudiced against banks. Although the reimbursement agreement contained a waiver clause, the court did not automatically enforce it. Instead, it subjected it to careful scrutiny on several levels.

©1998 INSTITUTE OF INTERNATIONAL BANKING LAW & PRACTICE

COPYRIGHT OF THE INSTITUTE OF INTERNATIONAL BANKING LAW & PRACTICE

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.