M J Antony: Honouring letters of credit

OUT OF COURT

Three Indian banks lose case in Supreme Court due to late detection of fraud.

A letter of credit is often referred to as the life blood of international commerce. Apart from the domestic laws, the rules are set by global documents like the Uniform Customs and Practice for Documentary Credit as published periodically in the International Chambers of Commerce Publication. In view of recurring disputes over negotiation of letters of credit, revocation and injunctions, the Supreme Court of India also had occasions to deal with the law regarding letters of credit. One of the latest instances was the dispute between three Indian banks and United Bank of Switzerland (UBS AG vs State Bank of Patiala). The other two banks involved were the Federal Bank Ltd and the United Western Bank.

The facts were similar in all the three cases. The Indian banks feared huge fraud by certain companies, but appeared to have taken late action. For instance, State Bank of Patiala issued an irrevocable letter of credit at the request of its client, Hamco Mining & Smelting Ltd to UBS. The beneficiary of the letter of credit was Frobevia SA. The contract was for the import of tin ingots by Hamco. Later, the maturity date was extended. Upon the production of the relevant documents, UBS made payment under the letter of credit to Frobevia. Shortly thereafter, the Indian banks wrote to UBS alleging that the two above companies, in connivance with other group companies of Hamco, had been perpetrating huge frauds on several banks in India. Goods were not even shipped in certain cases. Therefore, the Indian banks put the Swiss bank "on caution" and advised it not to negotiate the export bills of these companies.

The dispute started in 1999, when the Swiss bank demanded remittance of the entire amount which was due on the extended date. The Indian banks pointed out the "on caution" letters and rejected the repeated demand for reimbursement of the Swiss bank. The latter invoked the Uniform Custom & Practice for Documentary Credit 500 (UCP 500). When the dispute reached the Bombay High Court, it passed an order in favour of the Indian banks. Therefore, the Swiss bank moved the Supreme Court, where it won.

The observations made by the Supreme Court are notable as they are made after a review of the leading cases on this issue. It said that "international commerce operates on trust and relies to a large extent on arrangements between banks on behalf of their respective clients, giving rise to UCP 500, which governs the letter of credit in this case." In these cases, the fraud was detected after the letter of credit had been negotiated and, therefore, could not be set up "even as a plausible defence" by the Indian banks, the judgement said.

In a leading case, Oil & Natural Gas Commission Ltd vs SBI Overseas (2000), the Supreme Court laid down that an unconditional bank guarantee must be given effect to even when there is a dispute between the parties. Unless there is a plea relating to fraud, the court does not have the jurisdiction to grant unconditional leave to defend.

In yet another decision of the Supreme Court, Federal Bank Ltd vs V M Jog Engineering Ltd (2001), it was observed that in the case of a bank guarantee or letter of credit, the courts should not issue an order of injunction restraining encashment of the document on the ground of breach of the main contract between the buyer and the seller. A contract of bank guarantee or letter of credit is independent of the main contract and the only exceptions are when fraud was committed by the seller or where encashment results in irretrievable damage. The court went on to explain that where the negotiating bank makes payment to the seller after obtaining confirmation from the issuing bank about the genuineness of the letter of credit, bill of exchange or other related document and seeks reimbursement from the issuing bank, the encashing bank cannot be restrained by injunction from obtaining reimbursement.

Similarly, in Dwarikesh Sugar Industries vs Prem Heavy Engineering Works (1997), the court while dealing with a bank guarantee, held that the principle of undue enrichment was not applicable to encashment of bank guarantees.

Applying these principles to the UBS case, the Supreme Court said that if the alleged fraud had been detected earlier and the Swiss bank had been intimated earlier and put on caution prior to making payment, the Indian banks might have had a case which could be heard in the appropriate forum. But the fraud was detected after the letter of credit had been negotiated. Therefore, there was no "triable" issue, as held by the Bombay high court. Thus though the Indian banks have lost their case, the principles laid down by the court would stand good in international commerce.