Letters of credit and paying banks
A recent judgment* has confirmed that a paying bank must pay a seller under a letter of credit, once it has been presented with a compliant demand and the documents required by the letter. The only exception to this is if there is clear evidence of fraud, and the bank knows that the demand for payment is fraudulent (this is known as the ‘fraud exception’). However, a buyer wishing to prevent a bank paying out on this basis will have a very high hurdle to clear.
In this case, the letter of credit was issued by the bank (SB), as a means of paying the seller (APS) for supplying fluorescent bulbs to the buyer (CEB). Under its contract with APS, CEB had a right to inspect and test the bulbs prior to shipment. There was, however, no such requirement under the letter of credit.
A number of attempts were made by both parties to organise inspection of the bulbs, but the inspection did not take place. Since CEB did not want APS to be paid until it had inspected the bulbs, it applied to court for an injunction restraining SB from paying under the letter of credit.
At the injunction hearing an APS representative told the court that the bulbs would not be shipped unless CEB had inspected the goods. On this basis SB agreed not to pay under the letter of credit until the shipment was made. However, the goods were shipped 2 days later, without the inspection having been carried out. APS then provided SB with the documents required by the letter of credit, and demanded payment.
CEB went back to the court and asked for a second injunction restraining the bank from paying out under the letter of credit. This was on the basis that:
- APS shipped the bulbs before they had been inspected, in breach of an undertaking that its representative had made at court, and in breach of its contract with CEB; and
- APS had misrepresented that the bulbs would be made by Philips.
CEB argued that this meant that APS had been acting fraudulently, and so SB should not pay APS under the letter of credit.
CEB’s application initially succeeded, but the decision was successfully appealed by APS. APS’ appeal was successful because, despite the fact that APS had breached its contract with CEB and its Court undertaking, there was no clear evidence that APS had acted fraudulently, or that SB knew that APS was acting fraudulently.
The decision also highlighted that a court might not grant an injunction even where the fraud exception applies, if it thinks that the purchaser would have an adequate remedy against the bank in damages (i.e. a monetary award).
This decision makes it clear that in order to prevent a bank paying out under a letter of credit, a purchaser must prove that there is clear evidence of fraud, and that the bank was aware of such fraud. Even in the presence of both, it is possible that a court will still not grant an injunction.
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⃰ See the Privy Council decision Alternative Power Solution Limited v Central Electricity Board and another  UKPC 31