Documentary Credit Fraud Liability .
I. What Counts as Fraud in LC?
| Type | Example | Is Bank Liable to Pay? |
|---|---|---|
| Beneficiary Fraud - Sztejn Type | Seller ships rubbish instead of bristles, but presents conforming B/L | Bank must NOT pay if it has notice of fraud before payment |
| Third Party Fraud - United City Merchants Type | Loading broker antedates B/L to show timely shipment, beneficiary innocent | Under English law, bank MUST pay - fraud by third party not by beneficiary does not trigger exception |
| Nullity / Forgery | B/L forged, non-existent ship | English: Bank must pay if beneficiary innocent - Montrod Ltd vs Grundkotter |
| Applicant-Beneficiary Collusion | Buyer and seller collude to siphon funds - Over-invoicing, round tripping | Bank liable to its own bank, but can recover from applicant. PNB-Nirav Modi LoU case |
UCP 600 Art 34: Bank assumes no liability for genuineness or falsification of documents.
II. Global Case Laws - The Fraud Exception Jurisprudence
1. Sztejn vs J. Henry Schroder Banking Corp (1941) 31 NYS 2d 631 - US - Cornerstone
One of the seminal cases establishing fraud exception is Sztejn where court held payment could be restrained if underlying transaction was tainted by fraud
Facts: Seller contracted to ship bristle, shipped rubbish and bribed inspection. Buyer sought injunction.
Held: Where seller's fraud is clearly established and bank has notice before payment, bank should not pay. Exception to autonomy.
2. United City Merchants (Investments) Ltd vs Royal Bank of Canada 1 AC 168 - House of Lords - Leading Case in England[1983]
Accepted as leading case of fraud issue. Also called American Accord Case.
Facts: Peruvian seller sold cement plant. Shipment from Peru to London, but loading broker fraudulently antedated B/L to comply with LC date. Beneficiary innocent.
Lord Diplock held:
The exception for fraud on part of beneficiary seeking to avail himself of credit is a clear application of maxim ex turpi causa non oritur actio - fraud unravels all. But fraud exception applies only when fraud is by beneficiary himself and bank has knowledge.
Result: Bank must pay - third party fraud not enough. This narrowed Sztejn.
3. Bolivinter Oil SA vs Chase Manhattan Bank (1984) - High Threshold
Court: Fraud must be very clearly established, not mere allegation. Bank's knowledge must be established. Injunction to stop payment will only be granted if applicant shows strong prima facie fraud and bank knows.
III. Indian Position - Stricter Than England
Indian Supreme Court adopted both but added two-part test:
4. Tarapore & Co., Madras vs V/O Tractoroexport, Moscow AIR 1970 SC 891
The opening of a confirmed letter of credit constitutes a bargain between the banker and the seller of goods which imposes an absolute obligation on the bank to pay
SC: Bank cannot be excused even if buyer says goods defective. Only fraud can stop. This is Indian foundation.
5. Federal Bank Ltd vs VM Jog Engineering Ltd (2001) 1 SCC 663 - Federal Bank Test
SC laid down Indian fraud exception test still followed in all HC:
Bank can refuse payment only if:
a) Egregious fraud - fraud that vitiates entire transaction, not mere quality dispute, AND must be strictly ascribable to beneficiary
b) Bank has notice of such fraud before payment
c) Irretrievable injustice - If injunction not granted, applicant cannot be compensated in damages, e.g., beneficiary is insolvent or will disappear
Only exception is when there is a clear fraud of which the bank had notice
Mere allegation not enough. This has been followed in Scrap Mould Will vs Metal Scrap Trade Corp 11 March 1989, UCO Bank vs Bank of India (1981), B.S. Aujla vs Kaluram Mahadeo (1981)
Indian courts: LC liability is absolute, injunction is exceptional.
6. PNB vs Nirav Modi / Mehul Choksi LoU Fraud (2018) - Document Destruction + LC Fraud
Not LC but Letter of Undertaking (LoU) - akin to LC. Brady House branch staff issued LoUs without CBS entry, SWIFT used. Beneficiary banks - Allahabad Bank, Axis, SBI Overseas - paid.
Liability: PNB argued fraud by its own staff + beneficiary collusion, so not liable. RBI and Bombay HC held:
- Under autonomy, issuing bank (PNB) is absolutely liable to paying banks who paid in good faith on conforming documents - UCP 600 Art 7
- PNB must pay then recover from fraudsters
- Paying banks also liable if they failed due diligence - allowed discount without underlying import
PNB paid Rs 6000+ Cr to other banks.
IV. Liability Matrix Under UCP 600 + BNS
Issuing Bank: Liable to nominated/confirming bank if documents comply on face. Cannot refuse citing fraud in goods. Liable under UCP 600 Art 7 unless beneficiary fraud proved with notice. Criminal: If colludes - BNS Sec 318 cheating + 316 criminal breach.
Confirming Bank: Same as issuing bank - independent undertaking. Must pay then claim.
Negotiating / Discounting Bank: If negotiates with knowledge of fraud, loses protection - becomes party to fraud. Banco Santander SA vs Bayfern Ltd 1 All ER - If bank had notice of fraud, cannot recover.[2000]
Applicant: Must reimburse issuing bank even if goods worthless, unless he obtains injunction before payment proving egregious fraud + bank notice + irretrievable injustice. Very high bar.
Beneficiary: If fraud, liable for cheating, forgery - BNS 318, 336, 338 + PMLA if siphoning.
V. How to Get Injunction in India - Practical
You must file suit before payment with:
- Affidavit showing clear fraud - e.g., shipping documents show vessel never sailed, verified from Lloyd's list
- Proof bank has notice - email + legal notice served on bank's trade finance head
- Show beneficiary is fly-by-night / shell - Irretrievable injustice
- Pray for injunction restraining bank from making payment under LC
Courts will not grant for mere quality dispute - "goods not as per sample" is not fraud.
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