Fraud Objection as an Exception to the Principle of Independence of Documentary Letters of Credit under Slovak Law
Stanislav Behil
Managing Associate
A letter of credit can be broadly defined as an irrevocable obligation of a bank, as the issuer of the letter of credit, derived from the letter of credit (letter of credit) to pay the beneficiary of the letter of credit a specific amount upon meeting the terms outlined in the letter of credit. A documentary letter of credit is, in essence, a letter of credit where the conditions are based on presenting documents to the issuing bank.
A documentary letter of credit may take the form of a commercial or merchandise letter of credit. Such a letter of credit acts as a payment method. A buyer (K) and a seller (P) from different countries (i.e., importer and exporter) agree that K will not pay P the purchase price for goods directly but via a letter of credit after P submits certain documents (e.g., transport documents, certificates of origin, invoices). K, as the applicant, requests the issuing bank (B) to issue the letter of credit. B issues the letter of credit, committing to pay P as the beneficiary upon presenting the required documents specified in the letter of credit.
Both forms (functions) of a letter of credit are characterized by the principle of independence (or abstraction or autonomy). This principle means that B’s obligation under the letter of credit is independent of the underlying transaction between K and P (i.e., the contractual relationship between K and P established by the purchase agreement), to which the letter of credit serves either as a payment mechanism (commercial letter of credit) or as a security mechanism (stand-by letter of credit).
This principle is clearly expressed in Article 4(a) of the UCP 600 rules[1] issued by the International Chamber of Commerce in Paris, titled "Credits vs. Contracts":
„A credit by its nature is a separate transaction from the sale or other contract on which it is based. Banks are in no way concerned with or bound by such contract, even if any reference to it is included in the credit. Consequently, the undertaking of a bank to honor, negotiate, or fulfill any obligation under the credit is not subject to claims or defenses by the applicant resulting from their relationship with the issuing bank or the beneficiary...“.[2]
The independence principle is considered the cornerstone of letters of credit. P must be assured that if the terms of the letter of credit are met (i.e., the documents are submitted), payment for the goods will be made through the letter of credit regardless of (legitimate or illegitimate) objections from K concerning the delivered goods (e.g., regarding defects).
According to Article 5 of the UCP 600, titled "Documents vs. Goods, Services, or Performance," it is stated that "Banks deal with documents, not with goods, services, or performance to which the documents may relate." These documents effectively substitute the goods (services, performance) in the context of the letter of credit transaction. In practice B, following the UCP 600 rules to which the letter of credit typically refers, examines the documents within five business days to ensure that they appear on their face to comply with the terms of the letter of credit, UCP 600 rules, and international standard banking practices. If discrepancies are found in the documents, B will refuse to honor the letter of credit.
A practical question arises when fraud is committed by P. Imagine a scenario where, under a purchase agreement (as the underlying transaction), P is supposed to deliver steel bars to K in another country, with the purchase price to be paid through a letter of credit governed by UCP 600, upon the presentation of certain documents. However, instead of delivering the agreed goods, P delivers worthless scrap metal while submitting the required documents referring to steel bars to B and demanding payment under the letter of credit. K then discovers the fraud and informs B. Would B be entitled to refuse payment? According to Article 4 of the UCP 600, B’s obligation to pay under the letter of credit is not subject to objections or defenses from K (the applicant) arising from their relationship with P (the beneficiary), i.e., the purchase agreement. Similarly, Article 5 of the UCP 600 emphasizes that B deals with documents, not goods. Moreover, the UCP 600 does not explicitly provide any exceptions applicable[3] to such an evident case of fraud.
At first glance, the straightforward answer might seem to be that B must honor the letter of credit, leaving K to pursue claims against the fraudulent P. However, under Slovak (and not only Slovak) law, this answer is incorrect.
First, the nature of the UCP 600 rules referenced by letters of credit must be clarified. The UCP 600 rules are generally accepted trade customs in international commerce as per § 264 of the Slovak Commercial Code (ObZ). Under § 730 of the ObZ, such trade customs form part of the contract’s content rather than serving merely as interpretative tools.
Pursuant to the mandatory provision of § 264(2) of the ObZ, the UCP 600 rules take precedence over default statutory provisions but not over mandatory (imperative) statutory provisions. Thus, Slovak mandatory provisions apply to letters of credit governed by UCP 600 rules when Slovak law is the governing law.
Such mandatory provisions include § 265 of the ObZ, which states that the exercise of rights contrary to the principles of fair trade practices does not enjoy legal protection, and the provisions of the Civil Code (OZ) on good morals (§ 3(1) of the OZ).
In Slovak law, these mandatory provisions allow addressing situations where P (the beneficiary) fraudulently seeks payment under a letter of credit, exploiting the abstract nature of the letter of credit obligation and the principle of independence. These provisions override the independence principle expressed in the UCP 600. Under certain circumstances (to be assessed by courts on a case-by-case basis), B may refuse payment under the letter of credit even if documents meeting the letter of credit terms, UCP 600 rules, and international standard banking practices (a "complying presentation") are submitted. Parties to the letter of credit cannot agree (even by referring to the UCP 600 rules, which strictly define the independence principle) to exclude mandatory provisions of national law.
Since letters of credit are international banking instruments, consideration must also be given to how fraud cases are addressed in other jurisdictions. It would be peculiar for Slovak law to lead to conclusions diametrically opposed to those in other countries, particularly those heavily involved in international trade.
In this respect, it is worth noting that the above conclusion concerning the possibility of overriding the independence principle in cases of fraud aligns with case law in economically significant countries. The fraud exception has long been recognized by courts in the USA and the UK (see landmark cases such as Sztejn v. J. Henry Schroder Banking Corporation (1941, New York Supreme Court) and United City Merchants (Investments) Ltd v. Royal Bank of Canada). Fraud in letters of credit is also codified in the U.S. Uniform Commercial Code, Article V, § 5-109 ("Fraud and Forgery"). French courts also appear to permit exceptions to the independence principle under certain conditions (e.g., Cass. com. 16 December 2008, no. 07-18.729).
Fraud as an exception to the principle of independence or abstraction of letters of credit is also mentioned in Czech literature on UCP 600 interpretation: „Therefore, the bank's commitment to honor, negotiate, or fulfill any obligation under the letter of credit is not subject to claims or objections from the applicant arising from its relationship with the issuing bank or the beneficiary... The above sentence in UCP 600 aims to counter attempts to intervene against the abstract nature of a documentary credit. The established exception allowing courts to intervene in this abstract relationship is in cases of proven fraudulent conduct, according to the principle "fraus unravels all." However, the abstract and documentary nature of the credit, primarily anchored in Articles 4 and 5 of UCP 600, does not preclude defenses against fraudulent conduct (e.g., through legal action).“
An objection that intervening in the principle of abstraction or independence of the letter of credit threatens its essence and could undermine its reliability as a tool in international trade is only partially valid in the context of fraudulent activities. The crux of the matter lies in whether the credibility of the letter of credit would be more at risk if courts did not intervene to prevent fraudulent beneficiaries from exploiting its abstract nature in specific cases.
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[1] Uniform Customs and Practice for Documentary Credits (Uniform Customs and Practice for Documentary Credits), Version 600. These rules are published by the International Chamber of Commerce in Paris and are widely accepted and used in letter of credit transactions worldwide.
[2] In the Slovak Commercial Code ("ObZ"), this principle is succinctly expressed in operative § 685 ObZ: "The bank's obligation under a letter of credit is independent of the legal relationship between the applicant and the beneficiary."
[3] At this point, we do not address any potential criminal law aspects of such conduct, but only civil law aspects.
