Documentary Credits and Performance Bonds in International Trade: Two Sides of the Same Coin?

Introduction

International trade may not only involve higher profits but also, high financial risks. Usually, traders part with the goods prior to receiving payments or payments may have been made for goods that are non-conforming. Among other modes of payments, documentary letters of credit facilitate international trade transactions. The fundamental aspects of documentary credits are — principle of strict compliance and autonomy. Strict compliance, as it applies in the English letter of credit law mandates the banks to examine whether the documents tendered by the beneficiary strictly comply with the letters of credit.¹ The autonomy principle is the factor insulating the seller’s rights from the obligation of the bank from the underlying sale contract.² A similar approach is followed for payment undertakings by means of first demand guarantees and stand-by letters of credit. The disquisition of this article is that like letters of credit, performance bonds (in-principle) are autonomous subject to the exceptions of fraud³ and illegality.⁴

Principle of autonomy: In documentary credits and performance bonds

By means of a documentary credit, a bank may be substituted with the buyer as the party to guarantee payment to the seller or beneficiary.⁵ The payment by the bank is for documents tendered as shipment sales do not guarantee delivery of goods.⁶ While documents represent goods in transit, documentary credits ensure adherence to documentary requirements as security for shipped goods. Banks exercise “autonomy” when making payments for compliant documents. Autonomy under English letter of credit law is “… independence of the underlying contract from the credit”⁷ and restricts the obligation to the examination of documents tendered for payment rather than the “… subject-matter of the underlying contract”. Independence is to the extent that payment against documents is necessary even if goods do not arrive.⁸ The credit is construed to be autonomous and banks issuing credits assume “absolute obligation to honour them without investigating the underlying contract”.⁹ This not only ensures prompt payment to the beneficiary making documentary credits financially attractive and effective. Uniform Customs and Practices for Documentary Credits (UCP) are the standard practices applicable and codified by the International Chamber of Commerce (ICC) of which Articles 4 and 5 enshrine the autonomy principle. It stipulates that “credits are separate from the underlying contract”. Banks examine only documents “on their face”, as per Article 14(a), for documents that “look or appear genuine” are compliant by the standard of the bank. Simply put, documents presented to the bank that undertakes to make a payment are required to be “in conformity” with the documents as per the documentary credit. From Article 34, it is understood that banks do not assume liability or responsibility for the genuineness of the documents. While actual genuineness of the documents cannot be tested, this provision ensures documents remain in circulation after all, documents are of commercial value.

Performance bonds fall within the category of first demand guarantees to secure the seller’s performance, particularly in shipment sales. The seller procures the performance bonds to be provided to the buyer for protection in the event of seller’s non-performance. Simply put, it is an incentive for the seller to discharge the contractual obligations in a sale contract otherwise the buyer may claim payments at the cost of the seller. The distinguishing aspect between an ordinary letter of credit and performance bond is that the buyer (beneficiary) can “call-in” the guarantee immediately in case the seller fails to perform. Unlike a documentary credit which functions on presentation of documents and strict compliance criteria as a standard of examination by the bank, a performance bond can “triggered at the simple demand of a buyer” subject to the terms of opening the performance bond.¹⁰ This induces a high risk of being left with forged documents. Various academic views such as of Professor C. DeBattista departs from the traditional view of autonomy of the performance bond. He comments that “performance bonds are default undertakings and essentially, perform a security function rather than that of a primary payment mechanism”¹¹, suggesting that the comparison with letters of credit is flawed. However, in a more general understanding, performance bonds function on the principles of autonomy and separation in the manner similar to documentary credits. It is noteworthy that operating on “simple demand” without verification or furnishing proof of the seller’s default exposes to abuse from the beneficiary. However, the mechanism of “first demand” is premised on immediate payment. The courts interpret the terms of the performance bonds in the literal sense.¹² This is the autonomy of the bank’s undertaking to make payment provided the demand by the beneficiary is made as per the terms of the guarantee, even in an event of objection by the seller to the request of the beneficiary.¹³ The bank’s undertaking for payment upon request is absolute and autonomous, separate from the underlying contract.

In Edward Own Engg. Ltd. v. Barclays Bank International Ltd., a fraud allegation was on a performance guarantee which was taken “on a similar footing to a letter of credit”.¹⁴ It was held that the bank must honour the guarantee irrespective of any dispute between the buyer and the seller, except where “obvious fraud to the knowledge of the bank”. Though the buyer was found to be in breach of the sale contract for failing to open a conforming letter of credit, buyer could receive payment under the bank guarantee and no fraud was established. The threshold for establishing fraud was set very high. Therefore, upholding that performance guarantees are separate from the underlying sale contract.

The fraud exception

The principle of autonomy is subject to the fraud exception where “documents on their face complying with the terms and conditions of the credit are presented in furtherance of fraud”.¹⁵ Applicable according to the national law, fraud exception to documentary and autonomous guarantees functions alike.¹⁶

Lord Diplock referred to Hamzeh Malas & Sons v. British Imex Industries Ltd.¹⁷ and was of the view that “…… fraud exception on the part of the beneficiary seeking to avail himself of the credit is a clear application of the maxim ex turpi causa non oritur actio, or in plain English, ‘fraud unravels all’. The courts will not allow their process to be used by a dishonest person to carry out a fraud”.

The American Accord is a seminal decision on fraud as an exception to the bank’s duty for payment against documents compliant “on their face”.¹⁸ It provides the exception relating to fraudulent documents presented to the bank, within the seller’s knowledge. Excluding fraud on account of a third party, it was held that the exception applied to a beneficiary or to which the beneficiary was a party. Therefore, the extent of the fraud exception was limited to the conduct of the beneficiary only. This does not apply to fraud in the underlying transaction. The court cautioned that the decision is based on public policy, merely as a deterrent to a dishonest person having no implications on the exercise of autonomy in documentary credits, clarifying Lord Diplock’s view that “fraud unravels all”. Not limited to the fraud of the beneficiary, the fraud exception demands the bank (on its own motion) to decline payment to an apparently compliant presentation where the bank has knowledge of the fraud, as per Edward Owen Engg. Ltd. v. Barclays Bank International Ltd.¹⁹ Rightly held that the fraud exception to autonomy operates through an implied limitation upon the mandate to the bank under the credit.²⁰

Proving fraud requires “established or obvious fraud”, established very clearly.²¹ Laid down in Turkiye Is Bankasi AS v. Bank of China, the test of “seriously arguable fraud” is “significantly more stringent than a good arguable case”.²² It is most likely that evident forgery will not go unnoticed to a beneficiary when tendering documents as if “genuine”. It is unfair for the beneficiary to expect the bank to examine whether the allegations it makes on fraud are unfounded or not.²³

To deny the right of reimbursement to a bank, it must be proved that the bank had knowledge of the fraud “at the latest at the time it paid” with clear evidence on the fact of fraud and “established or obvious fraud” in the knowledge of the bank.²⁴ However, the bank must pay against apparently complying presentation, in absence of the knowledge of fraud.²⁵

Banks may refuse payment where the buyer may obtain an injunction.²⁶ American Cyanamid Co. v. Ethicon Ltd. laid the three-stage test proposing — evidence of merits, adequacy of damages as alternative remedy and overall, balance of convenience.²⁷ It is trite law that a mere allegation of fraud is not sufficient, and neither should it be vexatious or frivolous. In Alternative Power Solution Ltd. v. Central Electricity Board, it was held that it must be established clearly that the beneficiary could not have honestly believed in the validity of its demands and the bank was aware of the fraud or the fact.²⁸ This approach establishes that where conforming documents are presented, the bank has an obligation to pay the beneficiary. However, the exception is where documents presented are “clearly fraudulent”.²⁹ Prevention of payments under the autonomous instruments do not find the usual difference in evidential burden between interim proceedings and final trial.³⁰ Therefore, the crucial aspect is how fraud is determined. Amongst all defences, fraud is likely to succeed based upon a high standard of proof.³¹

To conclude, Benjamin rightly comments that autonomous undertakings are vital to financing international trade and that a wide basis to the fraud exception can become “thrombosis of the lifeblood of international commerce (credits)”. The objective should be to prevent profit or benefit from one’s own wrongdoing.³² Following Lord Toulson’s view, law should be applied consistently to serve in the interest of justice.³³ The equitable remedy of injunctions must be subject to a high standard of proof where there is compelling evidence of fraud for the principle of autonomy must be upheld and protected from excessive court intervention. Wrongdoers often perceive documentary credits as soft or vulnerable targets. Failure to consider that permitting the “fraud exception”, thereby, setting aside the principle of autonomy, makes it an easy target which may be used as a shield. Therefore, the basis of the fraud exception should be public policy.