Injunctive Relief for Fraudulent Letters of Credit

March 16, 2010

Content originally posted on MGLAW.net

For many trade creditors and lenders, letters of credit are an essential tool for reducing transaction risks. When a letter of credit is issued to a beneficiary, the issuer (usually a bank) promises to honor the beneficiary's demand for payment, thereby substituting its own creditworthiness for that of the customer. Long regarded as the traveler's checks of commercial trading, these seemingly currency-like instruments have a dirty little secret - banks may be enjoined from honoring them when fraud is involved.

I. What is a Letter of Credit?

A letter of credit (sometimes referred to as an "LC") is a financial instrument in which someone (usually a bank) undertakes to pay a third party on behalf of someone else (usually the bank's customer), provided the third party complies with the terms and conditions specified in the letter.

Background

The letter of credit is by no means a new concept. Actually, scholars believe an ancient Egyptian cuneiform tablet contains the earliest surviving letter of credit. Bankers in ancient Greece are also thought to have issued rudimentary letters of credit to travelers who were afraid or unable to transport gold and silver across foreign lands, and Roman bankers used to issue their customers receptum argentarii (commitments to pay the customers' debt). While letters of credit have evolved quite a bit since the days of stone tablets, their primary function is still to facilitate business transactions by re-distributing risk.

There are typically three parties to an LC transaction: the issuer (usually a bank) - the party that issues the LC at the applicant's request; the applicant (usually the customer of the issuing bank) - the person who requests the LC from the issuer; and the beneficiary - the person who is entitled to payment from the issuer upon the beneficiary's complying presentation of a draft.

Almost all LCs are irrevocable, meaning they cannot be amended or cancelled without prior agreement of the beneficiary and the issuing bank. The most common types of LCs are commercial LCs and standby LCs. The commercial LC is widely used as a payment device in the international sale of goods or services. Under this type of LC, the bank pays the seller only when the seller presents the specified proof of performance that is required by the LC (e.g., a bill of lading to prove goods were shipped). The purpose of this type of LC is to give the seller assurance of payment before he parts with the goods and prevent the buyer from having to pay in advance of shipment.

Unlike commercial LCs, where the issuing bank anticipates making payment if the parties perform, a standby LC is generally used as a security mechanism to guarantee the performance of underlying obligations. A standby LC is similar to a surety/guarantee in that it is intended to answer for a default on an underlying agreement. However, sureties/guarantees and standby LCs are not identical. Specifically, sureties and guarantees are secondary obligations, whereas a standby LC is a primary obligation. A surety's or guarantor's obligation is contingent upon default of the underlying agreement, so one must examine the underlying agreement and the relevant facts to verify a default has in fact occurred before liability attaches to a surety or guarantor. Without an underlying default, there is no obligation to pay. A standby LC issuer's obligation, on the other hand, depends not upon the default itself, but upon the beneficiary's presentation of conforming documents required under the LC, which may or may not include documents evidencing default.

Fundamental Principles

The two fundamental legal principles governing LCs are the independence principle and the strict compliance principle. These principles embody the policies and values that inform the LC transaction. Strict compliance refers to the principle that any document presented by a beneficiary to an issuer must, on its face, strictly comply with the terms and conditions of the LC. If the presentation does not strictly comply, the issuing bank must dishonor it.

The independence principle refers to the fact that the bank's obligation to pay is irrespective of any disputes between the parties as to the underlying obligations. A breach of the underlying agreement, by either party, has no effect on the duty of the issuing bank to honor a draw on the LC when the terms and conditions of that letter of credit have been met. However, there is one recognized exception - the independence principle does not apply in cases of fraud.

The fraud exception was developed to prevent abuse of the independence principle and process of court by unscrupulous beneficiaries. For example, in the seminal case of Sztejn v. J. Henry Schroder Banking Corp., 31 N.Y.S.2d 631 (N.Y.Sup.1941), the Supreme Court of New York County ruled that an injunction prohibiting the issuing bank from paying on the seller's drafts was proper where the seller was contractually obligated to deliver bristles, but instead shipped worthless boxes of cow hair and rubbish. Since Sztejn was decided, most states have adopted the fraud exception to LC transactions, allowing banks the option to honor or dishonor drafts where fraud is involved and allowing applicants injunctive relief in certain circumstances.

II. Injunctive Relief in Tennessee (§ 47-5-109(b))

Tennessee has adopted the Revised Uniform Commercial Code Article 5, which governs LC transactions. See Tenn. Code Ann. § 47-5-101, et seq. Under the statute's fraud exception, banks have the right (but not the duty) to dishonor a draft where the beneficiary has committed fraud, even if the documents comply with the LC. See Tenn. Code Ann. § 47-5-109(a). However, because banks may be liable for wrongful dishonor if fraud is not proven, most banks choose to honor a draft despite an applicant's claims of fraud. Thus, if an applicant wants to prevent the issuer from honoring a draft, often injunctive relief is the only recourse.

Tenn. Code Ann. § 47-5-109(b) provides the method for obtaining injunctions in LC transactions. This section provides that a court may enjoin the presentment and honor of an LC upon an applicant's claim that a required document is forged or materially fraudulent, or that honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant, as long as the court finds that certain conditions are met. However, as might be expected, the burden for meeting the injunction standard and overcoming the general rule of independence is very high.

Claim of Fraud

In order to qualify under the fraud exception, the applicant must first allege material fraud on the part of the beneficiary. Material fraud occurs where the underlying contract "deprives the beneficiary of even a ‘colorable' right to" make presentment on a letter of credit, but the beneficiary presents the letter of credit for payment anyway. Ground Air Transfer, Inc. v. Westates Airlines, Inc., 899 F.2d 1269, 1273 (1st Cir.1990) (citing Itek Corp. v. First Nat'l Bank of Boston, 730 F.2d 19, 25 (1st Cir.1984)); see also Rockwell Int'l Systems, Inc. v. Citibank, 719 F.2d 583, 589 (2nd Cir. 1983) ("We think the essence of the fraud exception is that the principle of the independence of a bank's obligation under the Letter of Credit should not be extended to protect a party that behaves so as to prevent performance of the underlying obligation; the ‘fraud' inheres in first causing the default and then attempting to reap the benefit of the guarantee." (citations omitted)). The fraud must be so serious as to make it obviously pointless and unjust to permit the beneficiary to obtain the money, and the beneficiary's demand for payment must have "absolutely no basis in fact." Itek, 730 F.2d at 24-25 (quoting Dynamics Corp. of Am. v. Citizens & S. Nat'l Bank, 356 F.Supp. 991, 999 (N.D.Ga.1973)).1

The Official UCC Comments provide the following example: assume a beneficiary has a contract to deliver 1,000 barrels of salad oil. Knowing that it has delivered only 998, the beneficiary nevertheless submits an invoice showing 1,000 barrels. If two barrels in a 1,000 barrel shipment would be an insubstantial and immaterial breach of the underlying contract, the beneficiary's act, though possibly fraudulent, is not materially so and would not justify an injunction. Conversely, the knowing submission of an invoice for 1,000 barrels upon delivery of only five barrels would be materially fraudulent. Thus, the materiality determination for the alleged fraud will be a fact intensive question.

Relief Not Prohibited; Adequate Protection; Likelihood of Success (§ 47-5-109(b)(1); § 47-5-109(b)(2); § 47-5-109(b)(4))

Once the applicant sufficiently alleges material fraud, the court must find that four additional conditions are met. The first condition is that relief must not be prohibited under the law applicable to an accepted draft or deferred obligation incurred by the issuer (i.e., to a letter of credit). The second condition is that any beneficiary, issuer, or other person who may be adversely affected is adequately protected against any loss that it may suffer because the relief is granted. If the applicant seeks only a preliminary or temporary injunction, the beneficiary should be adequately protected by the extension of the LC until a trial on the merits is held. Third, the court must find that, on the basis of the information submitted to the court, the applicant is more likely than not to succeed under its claim of fraud, and the beneficiary must not qualify for protection under subsection 47-5-109(a)(1) (which provides protection for holders in due course and similarly situated persons).

State Requirements (T.C.A. § 47-5-109(b)(3)

Finally, the court must find that the state law conditions for injunctive relief are satisfied. In Tennessee, courts balance four traditional equitable factors to determine whether injunctive relief is appropriate.

(i) Success On the Merits

The first factor courts consider is whether the movant is likely to succeed on the merits of his claim. For this factor to weigh in favor of preliminary injunctive relief, the applicant need not prove conclusively that he will prevail at trial; rather, it is "sufficient if [he] raise[s] questions going to the merits [that are] so serious, substantial, difficult, and doubtful as to make them a fair ground for litigation and thus for more deliberate investigation." Six Clinics Holding Corp., II v. Cafcomp Systems, Inc., 119 F.3d 393, 402 (6th Cir. 1997).

(ii) Irreparable Harm

The second factor courts are to consider is whether the applicant will suffer irreparable harm without the grant of injunctive relief. In LC situations, the damages are primarily monetary. Normally, an allegation of money damages does not constitute irreparable harm because a later award of money damages will make the damaged party whole. Langley v. Prudential Mortg. Capital Co., LLC, 554 F.3d 647, 649 (6th Cir. 2009) (The general rule is that "a plaintiff's harm is not irreparable if it is fully compensable by money damages.") (citations omitted).

However, if an applicant can show that the beneficiary will likely be unable to satisfy a money judgment in the future or that honor of the LC will force the applicant into bankruptcy, the applicant may be able to demonstrate irreparable harm, and this factor could weigh in favor of granting injunctive relief. See Wright, Miller & Kane, Federal Practice and Procedure, § 2948.1 ("a risk that the defendant will become insolvent before a judgment can be collected, may give rise to the irreparable harm" and "when the potential economic loss is so great as to threaten the existence of the moving party's business, then a preliminary injunction may be granted, even though the amount of direct financial harm is readily ascertainable"); Republic of Panama v. Republic National Bank of New York, 681 F. Supp. 1066, 1070 (S.D.N.Y. 1988) (Irreparable harm was present where there was risk that if LC were honored that "funds would be dissipated and irretrievably lost.") (citations omitted); Sperry International Trade, Inc. v. Israel, 670 F. 2d 8, 12 (2nd Cir. 1982) (Irreparable harm may be shown if wrongful presentment and honor would force applicant under Letter of Credit into bankruptcy.).

Often times, though, evidence of future insolvency is not enough to overcome the policies disfavoring injunctive relief, particularly in international LC transactions. See, e.g., Hendricks v. Comerica Bank, 122 Fed.Appx. 820, 825, 2004 WL 2940879, 5 (6th Cir. 2004) (where applicants' only alleged injury was monetary, evidence of beneficiary's insolvency, without more, did not establish irreparable harm). Furthermore, "even where insolvency threatens to frustrate a damage award, conclusory assertions of a defendant's financial weakness do not demonstrate a likelihood of such harm." Fluor Daniel Argentina, Inc. v. ANZ Bank, 13 F.Supp.2d 562, 564 (S.D.N.Y.1998) (citations omitted).

(iii) Substantial Harm to Others

Third, courts consider the substantial harm that the injunction could cause. In an LC injunction, the beneficiary is likely to be the only entity harmed by an injunction. The applicant may be required to post an injunction bond to minimize that potential harm. See Wright, Miller & Kane, Federal Practice and Procedure, § 2948.2 ("Further, if an injunction bond can compensate defendant for any harm the injunction is likely to inflict, the balance should be struck in favor of plaintiff."). If the applicant is seeking only a temporary injunction and the LC is not set to expire during the temporary period, there is at least an argument that the risk of harm is low, as the beneficiary would still have time to present the draft for payment after expiration of the temporary injunction.

(iv) Public Policy

Finally, courts are also to consider and weigh whether the public interest is advanced through the issuance of injunctive relief. Tennessee has a strong public policy in favor of upholding contracts. AmeriGas Propane, Inc. v. Crook, 844 F. Supp. 379 (M.D. Tenn. 1993) (citing Tenn. Code Ann. § 47-50-112(a) (2001) (contracts shall be enforced as written, subject to statutory and common law defenses). Some argue this factor weighs in favor of injunctive relief in the LC context because courts should not allow a breaching beneficiary to benefit from his breach. On the other hand, parties in an LC transaction "bargain for the advantages and disadvantages of the credit; they recognize its functions and negotiate its terms." Southern Energy Homes, Inc. v. AmSouth Bank of Alabama, 709 So.2d 1180, 1187 (Ala.1998). To change the terms of the contract after-the-fact would infringe upon the parties' right to contract freely.

Besides contractual freedom, there are also other policy arguments against allowing injunctive relief in LC transactions. In an injunction action, the court is forced to look beyond the terms of the LC and delve straight into the underlying contract. This weakens the independence principle and diminishes one of the LC's most attractive characteristics-certainty of payment. Langley, 554 F.3d 647, 650; see also, Southern Energy Homes, Inc. v. AmSouth Bank of Alabama, 709 So.2d 1180, 1187 (Ala. 1998) (citations omitted). As a result, the LC could lose some of its appeal as a tool in commercial transactions.

III. Conclusion

The main purpose of the letter of credit is to ensure that funds for payment are available (i.e., to ensure creditworthiness) in order to facilitate and promote commercial transactions. Absent sufficient evidence of fraud, courts generally will not interfere with that purpose by examining the underlying contract. Courts have enjoined the payment of an LC where the applicant has overcome the strong presumption against granting such relief. This introduces some uncertainty to the once currency-like LC (e.g., what constitutes a material fraud can differ by jurisdiction). At the same time, though, it deters fraud and reduces the number of boxes of cow hair flying through the mail.

1 In Tennessee, material fraud can arise out of a breach of the underlying agreement, provided that the breach rises to the level of depriving the beneficiary of even a colorable right to make presentment. However, in at least one other jurisdiction, a breach of the underlying agreement, alone, is not a ground for enjoining the letter of credit. SAVA Gumarska in Kemijska Industria D.D. v. Advanced Polymer Sciences, Inc., 128 S.W.3d 304, 320 (Tex. App. 2004), rehearing overruled (While the beneficiary's breach of the underlying agreement was such that he was not entitled under the law to keep the proceeds of the letter of credit, the breach did not constitute material fraud permitting the court to enjoin payment under the letter). In SAVA, the court explained that the applicant's appropriate recourse to deal with the underlying breach was to seek recovery of the proceeds from the beneficiary after the letter of credit was paid. Id. at 321.