Letter of Credit Fraud

Facts

On March 4 1996, the plaintiff, Zhongbao, signed a sales contract with Billiongold, pursuant to which Zhongbao opened an irrevocable LC in Billiongold's favor. Billiongold (the beneficiary), in conjunction with Winwick (a carrier), presented a set of forged documents to the issuing bank in Xiamen. The bill of lading states that it was issued by Winwick, on behalf of Rishelle (a charter party). In reality, Rishelle never authorized Winwick to issue the bill of lading on its behalf.

The plaintiff then obtained all documents from the Xiamen issuing bank. After getting the documents against acceptance, Billiongold discounted the draft to a company in London.

Upon the arrival of the vessel at the designated port, the plaintiff discovered that the expected goods were not on board. The plaintiff then sued the defendants, requesting that the court declare the sales contract invalid, void the LC and stop payment, and hold the defendants jointly liable for its losses.

Summary of Judgment

The Xiamen Maritime Court found that Rishelle had not authorized Winwick to act as its agent and had no part in the fraud carried out by Winwick and Billiongold (who failed to enter a reply or appear in court). Accordingly, the Court dismissed charges against Rishelle.

Finding that Billiongold and Winwick intentionally defrauded the plaintiff and that Billiongold failed to deliver the goods to the plaintiff as agreed in the contract, the Court ruled that the sales contract was invalid, stopped payment under the LC, and entered a default judgment against Billiongold and Winwick holding them jointly liable. The Court apparently wanted to protect the plaintiff, a local company. After all, the plaintiff had signed a sales contract to buy goods but never received them. Yet if the issuing bank made payment under the LC, the plaintiff would be required to reimburse the issuing bank regardless of whether it had received the goods.

A Rash Decision

Letter of credit transactions are based on the independence principle whereby claims between the parties with respect to the underlying contract shall not affect the rights and obligations of the banks and other parties under the letter of credit. However, fraud is a common exception to the independence principle. Like courts in other jurisdictions, the Supreme People's Court allows courts to freeze payment under the LC where there is fraud.

On the other hand, the Supreme Court has clearly stated that the issuing bank must make payment, even where there is fraud, if the issuing bank has accepted the draft under the LC, and as a result the issuing bank's obligation under the LC is converted into a duty of unconditional payment.1 In practice, beneficiaries who commit fraud will invariably discount the draft once it is accepted. The purchaser, who often will have acquired the draft in good faith for the fair market value, then applies to the issuing bank for payment. The issuing bank cannot rely on fraud as an excuse to refuse payment to a holder in due course.

The Xiamen Court's decision in this case clearly is at odds with the Supreme Court's previous rulings. The Court's decision determined the rights and obligations of the issuing bank and holder in due course, even though neither was a party to the suit. The decision was not only unfair to the good faith purchaser of the discounted draft, it also harmed the reputation and interests of the issuing bank and of the Chinese banking industry generally.

Because the issuing bank was not a party to the suit, it cannot appeal the court's judgment or its order to freeze payment. However, if the holder in due course sues the issuing bank abroad, the issuing bank will be held liable for not only the original amount owed but for interest as well. In addition, the issuing bank will incur litigation costs.

Endnote:

1 It should be noted that the Supreme Court's interpretation that the issuing bank's obligation to make payment becomes unconditional once it accepts the draft is controversial.

By Jin Saibo,

Yi Wen Law Firm,

Beijing