The implementation of the fraud exception rule: a comparative study
| Pages | 977-993 |
| DOI | https://doi.org/10.1108/JFC-02-2020-0016 |
| Date | 25 May 2020 |
| Published date | 25 May 2020 |
| Author | Zaid Aladwan |
| Subject Matter | Accounting & Finance,Financial risk/company failure,Financial crime |
The implementation of the
fraud exception rule:
a comparative study
Zaid Aladwan
Department of Law, University of Sussex, Falmer, UK
Abstract
Purpose –The purpose of this paper is to examine the application of the fraud exception rule and try to
analyze the different approaches in regard to the implication of fraud rule in letters of credit. Further, this
paper tries to explore if there is an obstaclewhen applying such exception rule in common law and whether
there is an overlapwith interpreting the said rule. The same fact appearsin civil law courts as well.
Design/methodology/approach –This paper is a comparative study which usesanalytical approach
and criticallegal thinking.
Findings –The scope of the fraud defence, the US legal systems demonstrate that the scope of the fraud rule is
extended and covers both fraud in documents and fraud in the underlying contract, while in contrast, in UK the
rule’s scope is restricted to fraud in documents only.Such an approach is reasonable, as it is justified by applying
the Uniform Customs and Practice for Documentary Credits (UCP) rules strictly. That is to say, English courts
apply the rules literally, even if it does not lead to fair judgements, while in contrast, American courts seek to enforce
justiceevenifitgoesbeyondtherules.Inanycase,restrictingthefraudexceptiontofraudinthedocumentsisthe
proper approach. The reason for such restriction, o nt he one hand, is to maintain the integrity of letters of credit and,
on the other hand, to affirm the autonomy principle.
Originality/value –Extending the scope of the fraud defence will require banks to go beyond the
documents, which is not logical. Banksare neither expert in such transactions nor required to do so. Most
importantly, banks are concerned with documents only; it is for the court to go beyond the documents.
Although this approach could be criticized, it is important to ensure that the validity of the documentary
credit instrumentis not compromised. As established by academics, any argumentneed not engage the bank
unless it is in respectof the presented documents. In short, “pay now, argue later”is paramountto distinguish
parties’litigationsfrom banks vs parties’litigations. In any case, it canbe suggested that extending the fraud
rule exception to include fraud in the underlying contract from Jordan perspective is not the proper one
because itis necessary to maintain the integrity of letters of creditand to affirm the autonomy principle.
Keywords United Kingdom, United States, Civil law, Letters of credit, Common law,
Fraud exception rule
Paper type Research paper
1. Introduction
Fraud is one of the most common threats to international business transactions,
especially when a mechanism such as documentary credit is used (International Maritime
Bureau of the ICC, 2002;Alavi, 2016). It is believed that letters of credit transactions are
the “ideal vehicle for money laundering”(Odeke, 2012). Unfortunately, the Uniform
Customs and Practice for Documentary Credits (UCP) 600 does not address this issue
(Kurkela, 2007;Bridge, 2017a, [6.78]). The International Chamber of Commerce justified
this omission by arguing that it should be left to national jurisdictions to fill the gap[1].
As such, most national jurisdictions recognize the “fraud exception rule”as a caveat to
the autonomy principle (Mugasha, 2003, p. 137; Bridge, 2017a, [6.85]). Although this
exception is internationally accepted, there has been diversity among lawmakers and
Fraud
exception rule
977
Journalof Financial Crime
Vol.27 No. 3, 2020
pp. 977-993
© Emerald Publishing Limited
1359-0790
DOI 10.1108/JFC-02-2020-0016
The current issue and full text archive of this journal is available on Emerald Insight at:
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courts in relation to its interpretation. This has led to unconvincing judgements and a
variety of outcomes.
The starting point of the fraud exception is the case of Sztejn, where therewas both fraud
in the documentation and fraud in the underlyingcontract. In this case, the plaintiff alleged
that the beneficiary shipped cow hair and other rubbish instead of bristles as contracted.
The court commented that in such a situation,the autonomy principle should not protect the
unscrupulous seller as the fraud was called to the bank’s attention before the drafts and
documents were presentedfor payment [2].
Although the court in the Sztejn casedid not explicitly state on which basis the fraud had
been found, it is implicit that the fraud can be characterizedas both fraud in the documents
(where the documents did not represent the actual goods shipped) and fraud in the
underlying transaction.
In contrast, in the benchmark case in England, the American Accord, the court held that the
fraud exception can only be established if the fraud appears in the documents[3]. The facts of
this case can be briefly summarized as follows: an English company entered into a contract to
sell glass fibre–making equipment to a Peruvian company named Vitrorefuerzos SA,and
payment was to be made by an irrevocable letter of credit. Shipment was to be on or before 15
December 1976. However, shipment actually took place on 16 December, but the loading
broker’s employee, not acting for, and without the knowledge of, the sellers orthe consignees of
the letter of credit, fraudulently entered 15 December as the date of shipment on the bill of
lading. Upon presentation, the bank refused such tender and held that the presentation was
fraudulent because the goods were loaded on 16 December and not on 15 December as agreed.
From these landmark cases, it is clear that there is a dispute as to whether the fraud exception
can be established if the fraud relates to the underlying transaction or in the documents.
Therefore, this paper will deal with the issueof the implementationof the fraud exception
rule from differentapproaches by answering the following question:
Q1. Should the fraud exception rule apply only to fraud in the documents presentedor
should it be extendedto fraud in the underlying transaction?
Moreover, it will answer the question citedpreviously by analyzing the legal regime applied
by four different jurisdictions, namely, the UK and the USA (as common law systems) and
China and Jordan (as civil law systems). These particular jurisdictions were chosen for a
number of academic and legalreasons. Starting with the common law regimes, Englandhas
been chosen because it has a long historyin dealing with letters of credit and is rich in case
law on the application of this payment mechanism. In contrast, the USA has been chosen
because it is the only jurisdictionthat has codified the law in relation to the issue of letters of
credit, in particular,under Article 5 of the Uniform Commercial Code 1958 (Davidson,2001).
Furthermore, itprovides some key literature regarding the use of documentarycredits.
2. Fraud in the documents or the underlying contract of sale?
Letters of credit are contracts that are independent to the contract of purchase. The law on
this point is clear unless there is fraud on the part of the seller[4]. However, as mentioned
earlier, the UCP rules do not address the fraud issue, meaning that there are neither
provisions in the rules to dealwith it nor remedies. In this regard, national jurisdictions have
established a “fraud exception rule”as an exception to the autonomy principle. However,
even though the fraud exception rule is the only exception to the autonomy principle and
recognized by almost every jurisdiction in the world; it is a complicated rule and “riddled
with many difficulties”(Burrows, 2015;Bridge, 2017a;Horowitz, 2010;Low, 2011). This
exception does not properly solve the problem as different legal jurisdictions have
JFC
27,3
978
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