Celebrated Cases on autonomous nature of Letter of Credit & Exceptions

One of the celebrated cases was the Judgment of Calcutta High Court titled as United Commercial Bank v. Hanuman Synthetics Ltd. & Ors. AIR 1985 Cal 96 wherein the principles of autonomous nature of Letter of credit independent from the underlying contract has been laid down in para 44 and 45:

"44. The law is well-established that the bank which has opened a letter of credit is not concerned with the relationship between the seller and the customer; nor with the question whether the seller had performed its contracted obligation or not. The bank is also not concerned with the question whether the seller is in default in any way or not. The machinery and the commitment of the bank are on a different level. It has been emphasized by the English Courts and also by the Supreme Court that the bank must be allowed to honour its commitments under a letter of credit free from interference by the Courts; otherwise, trust in international commerce will be irreparably damaged. The dispute as to the sufficiency of the performance between the buyer and the seller or between the seller and the buyer cannot be the reason for withholding the payment under a letter of credit. The bank is only required to see whether the event has happened on which its obligation to pay has arisen.

45. In this case, the Central Bank was required to pay in terms of the letter of credit against certain documents. The documents have been duly tendered and accepted by the Central Bank and the event has happened on which the Central Bank is now obliged to pay in terms of the letter of credit. Whether the goods that have been delivered are of merchantable quality or not or whether the goods are up to the contract or not or whether they are of the specified quality or quantity cannot be gone into by the bank. Similarly, the question whether the goods correspond with the description is also a question that must be resolved by the buyer and the seller in an appropriate proceeding. But the Central Bank which has opened a confirmed and irrevocable letter of credit cannot refuse to pay even when all the terms of the letter of credit have been fulfilled to its satisfaction on the plea that the goods are not up to the contract or do not correspond with the description. The bank is not entitled to withhold payment after its obligation to pay has arisen merely because an allegation of fraud has been made against the seller. As Browne L. J. emphasized in the case of Edward Owen that it was not enough to allege fraud. If that was possible in law, all that a buyer had to do to stop payment under an irrevocable letter of credit was to allege fraud against the seller. It is very easy to allege fraud whenever there is a dispute as to quantity or quality of the goods. But that cannot be the ground on which the bank will be entitled to refuse payment. As Lord Denning has emphasized that the rule, in the case of a confirmed irrevocable credit in respect of contract for the sale of goods, is that the confirming bank is in no way concerned with disputes between the buyer and the seller as to the contract of sale which underlies the credit and it is a strict rule. In order to come within the exception, the buyer must not only allege but clearly establish that the documents that were presented by the beneficiary were forged or fraudulent."

33. The Apex Court had an occasion to deal with the similar proposition in the case of UP Cooperative Federation Ltd. v. Singh Consultants and Engineers (P) Ltd. (1988) 1 SCC 174, wherein the court re-emphasized the principle that the letter of credit must not be interfered with by the courts as the restraint on encashment of the same has major implications upon the international commerce as well as it hinders the autonomous nature of the transaction. The court has held that the Bank is required to just look into the correctness and appropriateness of the documents and if the same are found to be in order, the other consideration of the main underlying contract does not affect the encashment of the letter of the credit. The relevant paras of the Judgment are noteworthy:

"44. The modern documentary credit had its origin from letters of credit. We may, therefore, begin the discussion with the traditional letter of credit. Paul R. Verkuil in an article [Bank Solvency and Guaranty Letters of Credit, Standford Law Review V. 25 (1972-73 at p. 719)] explains the salient features of a letter of credit in these terms:

The letter of credit is a contract. The issuing party- usually a bank-promises to pay the 'beneficiary'-traditionally a seller of goods-on demand if the beneficiary presents whatever documents may be required by the letter. They are normally the only two parties involved in the contract. The bank which issues a letter of credit acts as a principal, not as agent for its customer, and engages its own credit. The letter of credit thus 'evidences-irrevocable obligation to honour the draft presented by the beneficiary upon compliance with the terms of the credit.

45. The letter of credit has been developed over hundreds of years of international trade. It was most commonly used in conjunction with the sale of goods between geographically distant parties. It was intended to facilitate the transfer of goods between distant and unfamiliar buyer and seller. It was found difficult for the seller to rely upon the credit of an unknown customer. It was also found difficult for a buyer to pay for goods prior to their delivery. The bank's letter of credit came into existence to bridge this gap. In such transactions, the seller (beneficiary) receives payment from issuing bank when he presents a demand as per terms of the documents. The bank must pay if the documents are in order and the terms of credit are satisfied. The bank, however, was not allowed to determine whether the seller had actually shipped the goods or whether the goods conformed to the requirements of the contract. Any dispute between the buyer and the seller must be settled between themselves. The Courts, however, carved out an exception to this rule of absolute independence. The Courts held that if there has been "fraud in the transaction" the bank could dishonour beneficiary's demand for payment. The Courts have generally permitted dishonour only on the fraud of the beneficiary, not the fraud of somebody else.

34. From the above discussion, it can be conveniently said that there is no res integra that the letter of credit is an independent contract and the courts are in trend of not to interfere with the encashment of the letter of credit unless the case falls within the purview of exceptions laid down by the Apex Court. Now, I shall go ahead with the discussion on exceptions which empowers the court to interfere on the encashment of letter of credit.

Exceptions : Case of Fraud and Special Equities

35. The first exception which has been carved out by the courts are the case of fraud of egregious nature meaning thereby that the said fraud must be the fraud of gross nature which shakes the conscience of the court and the said fraud must be known to the parties including party representing as well as to the bank. Under the said circumstances, if the said fraud is established, the court can interfere with the bank guarantee. The legal proposition on the fraud has been laid down in the same case of UP Cooperative Federation Ltd (Supra) which has been elaborated by his Lordship Jagannath Shetty (as his Lordship then was) by stating the following:

"The wholly exceptional case where an injunction may be granted is where it is proved that the bank knows that any demand for payment already made or which may thereafter be made will clearly be fraudulent. But the evidence must be clear, both as to the fact of fraud and as to the bank's knowledge. It would certainly not normally be sufficient that this rests on the uncorroborated statement of the customer, for irreparable damage can be done to a bank's credit in the relatively brief time which must elapse between the granting of such an injunction and an application by the bank to have it discharged."

36. Under those circumstances, it was also held that the plea of fraud must be in the nature of an egregious nature as to vitiate the entire underlying transaction of the bank guarantee. It is fraud of the beneficiary and not the fraud of somebody else that would make the Court to grant the Order of injunction as asked for. If the bank detects with the minimal investigation, the fraudulent action of the seller, the payment could be refused.

37. The said legal proposition has been reiterated by the Supreme Court in the case of State Trading Corporation v. Jainsons Clothing Corporation, (1994) 6 SCC 597, the relevant paragraphs of the judgment are worth mentioning:

"8. The grant of injunction is a discretionary power in equity jurisdiction. The contract of guarantee is a trilateral contract which the bank has undertaken to unconditionally and unequivocally abide by the terms of the contract. It is an act of trust with full faith to facilitate free flow of trade and commerce in internal or international trade or business.

It creates an irrevocable obligation to perform the contract in terms thereof. On the occurrence of the events mentioned therein the bank guarantee becomes enforceable. The subsequent disputes in the performance of the contract does not give rise to a cause nor is the court justified on that basis, to issue an injunction from enforcing the contract, i.e. bank guarantee. The parties are not left with no remedy. In the event of the dispute in the main contract ends in the party's favour, he/it is entitled to damages or other consequential reliefs.

9. It is settled law that the Court, before issuing the injunction under Order 39, Rules 1 and 2, CPC should prime face be satisfied that there is triable issue strong prima facie case of fraud or irretrievable injury and balance of convenience is in favour of issuing injunction to prevent irremediable injury. The court should normally insist upon enforcement of the bank guarantee and the court should not interfere with the enforcement of the contract of guarantee unless there is a specific plea of fraud or special equities in favour of the plaintiff. He must necessarily plead and produce all the necessary evidence in proof of the fraud in execution of the contract of the guarantee, but not the contract either of the original contract or any of the subsequent events that may happen as a ground for fraud."

38. The Apex Court in the above decision of State Trading Corporation (Supra) has extended the exception from fraud to Special Equties. The law again was brought forward by yet another decision of Svenska Handelsbanken v. wherein an important point was discussed about the inter relation of fraud and irretrievable injury in the following words:

"We have already held that the contracts between the lenders and the borrower are not vitiated by any fraud much less established fraud and there is no question of irretrievable injury, therefore, there was no reason for the High Court to set aside the order of the trial court.

Against there is no case of any irretrievable injury either of the type as held in the case of Itek Corporation (supra) as there is no difficulty in the judgment of this country being executable in the courts in Sweden.

The High Court was not right in working on mere suspicion of fraud or merely going by the allegations in the plaint without prima facie case of fraud being spelt out from the material on record.

The High Court was also in error in considering the question of balance of convenience. In law relating to bank guarantees, a party seeking injunction from encashing of bank guarantee by the suppliers has to show prima facie case of established fraud and an irretrievable injury. Irretrievable injury is of the nature as noticed in the case of Itek Corporation (supra). Here there is no such problem. Once the plaintiff is able to establish fraud against the suppliers or suppliers-cum-lenders and obtains any decree for damages or dimunition in price, there is no problem for affecting recoveries in a friendly country where the bankers and the suppliers are located. Nothing has been pointed out to show that the decree passed by the Indian courts could not be executable in Sweden.

The High Court totally ignored the irretrievable injury which will be caused to defendant No. 12 in not honouring the bank guarantee in international market which may cause grievous and irretrievable damage to the interest of the country as opposed to the loss of money to the borrower/plaintiff. There was no question of defendant No. 4 not making any demand. The instalments for repayment of the loans had already been fixed and liable to be paid without demand by defendant No.4. Defendant No. 12 is under a duty to pay the instalments regularly on a fixed date without any demand to defendant No. 4."

39. On Similar lines, the following authorities are also noteworthy:

(i) Centax (India) Ltd. v. Vinmar Impex Inc. & Ors. 1986 (4) SCC

(ii) The Projects & Equipment Corporation of India Ltd. v. Onoda Engineering & Consulting Company Ltd. 43 (1991) DLT 42

(iii) Coronation Marketing Services Ltd. v. MMTC Limited & Anr.

61 (1996) DLT 61

(iv) Dwarikesh Sugar Industries Ltd. v. Prem Heavy Engineering Works (P) Ltd. & Anr. 1997 (6) SCC 450

(v) Mahatma Gandhi Sahakra Sakkare Karkhane v. National Heavy Engg. Coop. Ltd. & Anr. 2007 (6) SCC 470

(vi) Mountain Mist Agro India (Pvt.) Ltd. & Anr. V. Mr. S.

Subramaniyam IA 8979/2006 in CS(OS) 1643/2005

(vii) Fair Deal Agencies & Anr. V. Inner Mongolia Muwang Animal By Product Company ltd. & Ors. 150 (2008) DLT 623

(viii) P.V. Beverages Pvt. Ltd. v. Global Beverages AG & Ors. 148 (2008) DLT 68

From the above analysis of the authorities, one can say with certainty that there are two exceptions to the general rule that the court should not interfere with the encashment of the bank guarantee, first being fraud which must be of egregious nature or grossest of the proportion as distinguished from the ordinary fraud and second; being special equities / irretrievable injury. Both the exception are interdependent on each other meaning thereby that absence of fraud will not lead to irretrievable injury as held Svenska (Supra). Further, Fraud must not be merely pleaded but has to be established which is further subject to two qualifications that is clear evidence of the factum of the fraud and bank's knowledge about the fraud.

The author can also be reached at drgubbilegal@gmail.com


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