"Fraud in the Transaction": Enjoining Letters of Credit during the Iranian Revolution Source: Harvard Law Review, Vol.

93, No. 5 (Mar., 1980), pp. 992-1015 Published by: The Harvard Law Review Association Stable URL: http://www.jstor.org/stable/1340425 . Accessed: 17/07/2011 08:49
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"FRAUD IN THE TRANSACTION": ENJOINING LETTERS OF CREDIT DURING THE IRANIAN REVOLUTION
No financial instrument is more vital to international commerce than the letter of credit. Letters of credit assure payment in transnational sales contracts1 and, especially in the Middle East, serve as performance guarantees.2 In 1978, American contractors were contingently liable for millions of dollars in guarantee letters of credit payable to the Government of Iran.3 The Iranian Revolution put that money at risk. The ensuing litigation, detailed in Part I of this Note, turned on the controversial role of fraud in letter of credit law, examined in Part II, and showed problems inherent to these letters of credit, analyzed in Part III. At stake was the future of the letter of credit as a guarantee device.4
I. FRUSTRATION OF CONTRACT: THE IRANIAN REVOLUTION DISRUPTS AMERICAN AGREEMENTS

A letter of credit is an engagement by an issuer (usually a bank) to a beneficiary, made at the request of a customer, which binds the bank to honor drafts up to the amount of the credit upon the beneficiary's compliance with certain conditions specified in the letter of credit.5 The customer is ultimately liable to reimburse the bank.6 The traditional function of the letter of credit is to finance an underlying customerbeneficiary contract for the sale of goods, directing the bank to pay the beneficiary for shipment.7 A different function is
1 See,

e.g., W.

HAWKLAND,

TRANSACTIONAL LETTERS

GUIDE

TO THE UNIFORM IN THE

COM-

MERCIAL CODE 79I (I964). 2 See B. KOZOLCHYK, ? I.02[3], at 24 (I966);

COMMERCIAL

OF CREDIT

AMERICAS

cf. Regulation of Standby Letters of Credit: Hearings on S. 2347 before the Senate Committee on Banking, Housing, and Urban Affairs, 94th Cong., 2d Sess. 9 (I976) (letter from Arthur Burns, Chairman, Federal Reserve Board,on widespread use of guarantee letters of credit) [hereinafter cited as Proxmire Hearings]. I See, e.g., Brower, The Iranian Letter of Credit Litigation, in DOING BUSINESS IN HIGH RISK COUNTRIES ii8 (J. Olson ed. 1979). 4 Are letters of credit worth the paper they're written on?, THE ECONOMIST, March 24, I979, at I37. The international markets are sensitive to challenges to the validity of letters of credit. See Proxmire Hearings, supra note 2, at II2 (statement of Alvin Zises, President, Prulease, Inc.). 5See U.C.C. ? 5-IO3(I)(a). All cites to the U.C.C. are to the 1978 version. 6 See id. ? 5-II4(3). 7 See B. KOZOLCHYK, supra note 2, ? I.OI[3]. See generally 3 NEW YORK LAW
REVISION
(I955)

COMMISSION, cited

STUDY

OF THE UNIFORM STUDY].

COMMERCIAL

CODE

I569,

I578

[hereinafter

as SCHLESINGER

992

i980]

LETTERS OF CREDIT

993

served by the "standby" letter of credit, which directs the bank to pay the beneficiary not for his own performance but upon the customer's default, thereby serving as a guarantee device.8 Standbys were the focus of the Iranian letter of credit litigation. In connection with government contracts, American companies posted performance guarantees, plus repayment guarantees where the government made advance payments. The Iranian Government could call the guarantees at any time by stating, without particulars, that the underlying contract had been breached. Iranian banks acted as guarantors with each guarantee backed by a letter of credit from an American bank, payable to the guarantor upon certification that the government had called on the guarantees.9 In agreeing to procure these standbys, payable upon demand without notice, the contractors relied on the Imperial Government's interest in maintaining future commercial relations to deter unwarranted calls on the guarantees. But the Iranian Revolution disrupted performance of many foreign contracts, and the rise to power of the xenophobic Islamic Government inspired fears that punitive and unwarranted calls would be made. Given the practical impossibility of suing in Iran, the contractors feared they would be left without an adequate remedy at law if the Iranians called on the stand8 See I2 C.F.R. ?? 7.ii60(a), 208.8(d)(I), 337.2(a) (I979) (definitions of standby letters of credit by the Comptroller of the Currency (Dep't of the Treasury), the Federal Reserve System, and the Federal Deposit Insurance Corporation). See generally Verkuil, Bank Solvency and Guaranty Letters of Credit, 25 STAN. L. REV. 7i6,

72 I-24

(,973).

9See, e.g., United Technologies Corp. v. Citibank, 469 F. Supp. 473, 475-76 (S.D.N.Y. I979); American Bell Int'l, Inc. v. Manufacturers Hanover Trust Co., N.Y.L.J., Mar. 29, 1979, at 7, col. 6 (N.Y. Sup. Ct. Mar. 26, I979), aff'd mem., 70 A.D.2d 830, 4i8 N.Y.S.2d 55I (I979); Brower, supra note 3. Whether the contractors could have bargained for other guarantee arrangements is open to question. Compare Gibbs & Hill, Inc. v. Chemical Bank, No. 03637/79, slip op. at II-I2 (N.Y. Sup. Ct. June 7, I979) (suggesting that these terms were negotiable), and BUSINESS INTERNATIONAL, OPERATING IN IRAN 87 (I978) (same), with id. at 8i (suggesting that these terms were mandatory under Iranian law.). The defendant American banks tried to distinguish between the government of Iran as beneficiary of the guarantees and the Iranian banks as beneficiaries of the credits, arguing that although a government demand on the guarantees might be improper, the resulting call on the standby letters of credit by the Iranian bank could not be fraudulent. Brief for Defendant at 9 n.2, American Bell Int'l, Inc. v. ManufacturersHanoverTrust Co., 70 A.D.2d 838, 4I8 N.Y.S.2d 55I (i979). With one exception, see Watkins-Johnson Co. v. Wells Fargo Bank, No. C79-OI2I SAW, slip op. at s (N.D. Cal. Feb. 27, I979) (alternate holding), courts apparently ignored this distinction. This Note will therefore treat the Iranian banks and the Iranian government as one entity with respect to the letters of credit. If the two were not considered to be the same entity, government actions probably could not constitute "fraud in the transaction" concerning the letters of credit.

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bys.10 Anticipating future demands"1 on the credits, at least twenty-three contractors by January I980 sued to enjoin American banks from honoring demands on their standby letters of credit. 12 The contractors could not rely on the impossibility of performing their contracts as a ground for enjoining payment on the letters of credit, for it is a fundamental principle of letter of credit law that the letter of credit is independent of the underlying contract.13 Problems in the performance of the underlying contract between customer and beneficiary do not affect the letter of credit commitment from bank to benefici10 Some contractors asserted that suits against Iran on the underlying contracts would be barred in the United States by the Foreign Sovereign Immunities Act (FSIA), 28 U.S.C. ?? I602, I604 (I976). See Continental Supply, Ltd. v. The Provisional Gov't of Iran, No. Ca-3-79-o2I7-D (N.D. Tex. Feb. 23, I979) (temporary restraining order). Subsequent opinions stated that the FSIA would permit such suits against Iran, see American Bell Int'l v. Islamic Republic of Iran, 474 F. Supp. 420, 423 (S.D.N.Y. I979), although service of process may remain troublesome, see Electronic Data Sys. Corp. Iran v. Social Security Organization of Iran, No. Ca-3-79-2i8-F, slip op. at 7-I2 (N.D. Tex. June 2I, I979). The FSIA would also govern any attempt to attach the letters of credit, a line of attack apparently unused in the Iranian letter of credit litigation. It is not clear whether a letter of credit can be attached. See Sisalcords Do Brazil, Ltd. v. Fiacao Brasileira De Sisal, S.A., 450 F.2d 4I9 (5th Cir. I971), cert. denied, 406 U.S. gig United Bank Ltd. v. Cambridge Sporting Goods, 4i N.Y.2d 254, 26i & n.4, (1972); 360 N.E.2d 943, 949 & n.4, 392 N.Y.S.2d 265, 27I & n.4 (1976); Tueta v. Rodriguez, I76 So. 2d 550 (Fla. Dist. Ct. App. i965). See also Justice, Letters of Credit: Expectations and Frustrations (pt. 2), 94 BANKING L.J. 493, 494-95 (I977). I One court dismissed a case in which no demand had been made for lack of a case or controversy. Harris Corp. v. Bank Melli Iran, No. 79-560 (N.D. Ill. Mar. 22, I979). The case is easily distinguishable, as co-defendant Continental Illinois Bank & Trust offered the plaintiffs three days' notice before paying on the credits, essentially the same relief won by other contractors after litigation. See note 28 infra. 12 See Note, Enjoining the International Standby Letter of Credit: The Iranian Letter of Credit Cases (ig80) (forthcoming in the Harvard International Law Journal). Most suits were brought in New York state and federal courts; others were brought in Michigan, Illinois, Texas, and California. None of the defendant national banks attempted to use I2 U.S.C. ? 9I (I976) to defend against injunctions by state courts. See Crocker Nat'l Bank v. Superior Court, 68 Cal. App. 3d 863, I36 Cal. Rptr. 48i (Ct. App. I977) (statute bars state court injunction against national bank payment on a letter of credit), cert. denied, 434 U.S. 984 (I978). But cf. Third Nat'l Bank v. Impac Ltd., 432 U.S. 3I2, 323-24 (I977) (statute does not bar state court injunction against mortgage foreclosure by a national bank); Garfinckle v. Superior Court, 2I Cal. 3d 268, 274 n.5, 578 P.2d 925, 928-29 n.5, I46 Cal. Rptr. 208, 2I2 n.5 (I978) (questioning validity of Crocker after Impac). 13 See Venizelos, S.A. v. Chase Manhattan Bank, 425 F.2d 46i, 464-65 (2d Cir. to (2); INTERNATIONAL CHAMBER OF COMMERCE, UNIFORM I970); U.C.C. ? 5-II4(I) CUSTOMS AND PRACTICE FOR DOCUMENTARY CREDITS, General Provision and Definitions ? c (I974) [hereinafter referred to without cross-reference as U.C.P.]; SCHLESINGER STUDY, supra note 7, at I654.

i980]

LETTERS OF CREDIT

995

ary. But there are exceptions to this independence principle. Under article 5 of the Uniform Commercial Code, a customer may enjoin payment to a beneficiary who complies with the terms of the credit when there is "fraud in the transaction."14 The contractors argued that since they had not breached their contracts it would be a "fraud in the transaction" for Iran to certify breach in order to draw on the letters of credit; in addition, they maintained that during Iran's revolutionary turmoil parties not authorized by the new government could seize control of the credits and make nonauthentic and fraudulent demands on the credits.15 The "fraud" rule may be the most controversial and confused area of article The Iranian litigation brought the rule before the courts 5.16 in cases apparently similar, but actually disparate, and best divided into three categories for the purposes of Part II's analysis. 17
14 U.C.C. ? 5-II4(2). Letter of credit law in the Iranian litigation derived from two sources. All of the letters of credit stipulated that the parties were governed by the U.C.P. To the extent required by common choice of law rules, article 5 governs letters of credit issued by domestic banks. See Gewolb, The Law Applicable to International Letters of Credit, II VILL. L REv. 742, 753-54 (I966). New York's nonuniform addition, 62-I/2 N.Y. U.C.C. ? 5-Io2(4) (McKinney i964) provides that the U.C.C. does not apply to a letter of credit which incorporates the U.C.P.; however, because the U.C.P. is silent on fraud as a defense to a demand on a credit, ? 5-II4(2) governs such actions even in New York. See United Bank, Ltd. v. Cambridge Sporting Goods Corp., 4i N.Y.2d 254, 360 N.E.2d 943, 392 N.Y.S.2d 265

(I976).

California's non-uniform version of U.C.C. ? 5-II4(2), CAL. COM.CODE? 5II4(2) (West i964), does not provide for an injunction against the issuing bank's honor of a demand on the credit. However, California law does permit an injunction against the beneficiary's demand for honor, which may be functionally equivalent. See Steinmeyer v. Warner Constr. Corp., 42 Cal. App. 3d 5I5, ii6 Cal. Rptr. 57 (I974).

15 Brower, supra note 3, at I20. See also note 35 infra. The contractors also claimed that since the guarantees were payable to the "Imperial Government of Iran," payment to any successor government either would not conform to the requirements of the letter of credit or would be fraudulent. But the courts noted that the Islamic Republic of Iran had been recognized by the United States, and therefore would succeed under principles of international law to the rights and duties of the predecessor government. See, e.g., KMW Int'l v. Chase Manhattan Bank, 6o6 F.2d IO, i6-I7 (2d Cir. I979); American Bell Int'l, Inc. v. Islamic Republic of Iran, 474 F. Supp. 420, 423-24 (S.D.N.Y. I979); RCA Global Communications DISC, Inc. v. Imperial Iranian Supreme Commander's Staff, No. 3985/79, slip op. at 48 (N.Y. Sup. Ct. Apr.
i8, I979).
16 See generally American Bell Int'l, Inc. v. Islamic Republic of Iran, 474 F. BANK CREDITS AND ACCEPTANCES Supp. 420, 424 (S.D.N.Y. I979); H. HARFIELD, 82-83 (5th ed. I974); Harfield, Enjoining Letters of Credit Transactions, 95 BANKING L.J. 596, 596-605 (I978). 17 Of the 23 suits, some were consolidated and others were settled. See Comment, supra note I2. This Note discusses cases with significant holdings on the merits.

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A. Standby Letters of Credit Guaranteeing Repayment of Advances on Contracts Stopped in Midperformance by the Revolution As part of a $280 million contract to upgrade Iran's telecommunication systems, the Iranian Government had advanced American Bell International $38 million. In return, American Bell had arranged a repayment guarantee from Bank Iranshahr in Iran and a standby letter of credit from Manufacturers Hanover Trust in New York. The revolution led to defaults, first by the Iranian Government and later by American Bell. American Bell sued to retain the advance payment by enjoining payment on its standby letter of credit. In American Bell International, Inc. v. Manufacturers Hanover Trust Co. ,18 the court refused to grant an injunction. It construed "fraud in the transaction" narrowly as requiring American Bell to show "active, intentional fraud" by the Iranian Government19 - impossible to do before any demand had been made. When the Iranians subsequently did make a demand on the repayment guarantees and letters of credit, American Bell sued and lost again: "On the evidence before us, fraud is no more inferable than an economically rational decision by the government to recoup its down payment, as it is entitled to do under the consulting contract and still dispute its liabilities under that Contract."20 Neither opinion offered much guidance as to the meaning of "fraud in the transaction."21 B. Standby Letters of Credit Guaranteeing Performance of Contracts Stopped in Midperformance by the Revolution Stromberg-Carlson had arranged for performance guarantees and standby letters of credit as part of a $5.5 million contract to install advanced telecommunication equipment. By the time the revolution disrupted performance in early February I979, Stromberg-Carlson had shipped all and installed most of the equipment. Fearing a demand on its guarantees
18 N.Y.L.J., Mar. 29, I979, at 7, col. 6 (N.Y. Sup. Ct. Mar. 26, I979), aff'd mem., 70 A.D.2d 838, 4i8 N.Y.S.2d 55I (I979). 19 N.Y.L.J., Mar. 29, I979, at ii, col. 2. 20 American Bell Int'l, Inc. v. Islamic Republic of Iran, 474 F. Supp. 420, 425 (S.D.N.Y. I979). 21 Id. at 424 ("A demand . .. may ... be considered fraudulent if made with the [W]e goal of mulcting the party who caused the Letter of Credit to be issued..... need not decide this thorny issue of law."); American Bell Int'l, Inc. v. Manufacturers Hanover Trust Co., N.Y.L.J., Mar. 29, 1979, at 7, col. 6 (N.Y. Sup. Ct. Mar. 26, i979), aff'd mem., 70 A.D.2d 838, 4i8 N.Y.S.2d 55I (1979).

i980]

LETTERS OF CREDIT

997

and standby letters of credit, the company sought limited relief in the form of an injunction requiring its Iranian bank to give ten days' notice of any demand on the guarantees before drawing on the back-up letters of credit. In StrombergCarlson Corp. v. Bank Melli Iran,22 the court granted a limited injunction, finding "a serious risk that a fraudulent or nonauthentic demand could be issued." Therefore, the court held, "Although the modest relief requested would require reading a notice requirement into the provisions of the bank guarantee, 'the fluid and precarious circumstances now prevailing in Iran justify deviation from what would otherwise be a strong reluctance' to do so."23 Yet, as in American Bell, the opinion failed to specify what would constitute a "fraudulent" demand.24 When a demand was actually made on a performance guarantee in a similar situation, the contractor was denied an outright injunction in Balfour, MacLaine International Ltd. v. Manufacturers Hanover Trust Co.25 The Balfour court, however, mechanically relied on the independence of credit from contract without any serious consideration of the "fraud in the transaction" exception. C. Standby Letters of Credit Guaranteeing the Performance of Contracts in which the Customer's Duty to Pe4orm Never Matured KMW International arranged a $350,000 performance guarantee and standby letter of credit as part of a $3.5 million contract to ship telephone poles. KMW's duty to perform was to mature upon opening of a letter of credit in KMW's favor by the Iranians, which they failed to do. When KMW sued to prevent a demand on its letter of credit, the district court
467 F. Supp. 530, 532 (S.D.N.Y. I979). Stromberg-Carlson sued to enjoin both repayment and performance guarantees. 23 Id. at 532 (footnote omitted) (quoting Transcript at 35, Harris Int'l Telecommunications, Inc. v. Bank Melli Iran, No. 79-802 (S.D.N.Y. Feb. 22, I979) (hearing and order granting preliminary injunction) (io-day notice required of both bank and beneficiary)). See also Cubic Int'l Sales Corp. v. Continental Ill. Nat'l Bank & Trust, No. 79-o88o-RMT (C.D. Cal. Apr. i8, 1979) (hearing and order granting injunction) (io-day notice required of beneficiary before presentation of demand); Pan Am. World
Airways, Inc. v. Bank Melli Iran, No.
79-II90
22

(S.D.N.Y.

Mar. 30,

1979)

(20-day

notice required of beneficiary before presentation of demand); RCA Global Communications DISC, Inc. v. Imperial Iranian Supreme Commander's Staff, No. 3985/79 (N.Y. Sup. Ct. Apr. i8, 1979) (order granting preliminary injunction). 24 Stromberg-Carlson Corp. v. Bank Melli Iran, 467 F. Supp. 530, 532 n.5
(S.D.N.Y.
25

1979) ("The 'fraud' exception

...

has been liberally construed ....").

No. 2080I/78 (N.Y. Sup. Ct. July i6, I979) (order denying preliminary injunc-

tion).

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granted an injunction in KMW International v. Chase Manhattan Bank, 26 ruling that letters of credit should not be honored "where there is a considerable danger that the transaction will be frustrated by . . . fraud, supervening illegality,

insurrection or war. 27 The Second Circuit reversed, finding nothing in the law "which excuses an issuing bank from paying a letter of credit because of supervening illegality, impossibility, war or insurrection."28 It is noteworthy, however, that the Second Circuit denied relief in part because no demand had yet been made on KMW's letter of credit.29 In fact, no case in the Iranian litigation has involved an actual demand on a performance guarantee and standby letter of credit where the obligation to perform had never matured.30 It is not clear what effect these Iranian cases will have on letter of credit law.31 Although the courts did not explicitly analyze the meaning of "fraud in the transaction," the scarcity of precedent dealing with breaches in the independence principle makes these cases important authority. On the other hand, the Iranians called on the credits in few cases, which may make the Iranian litigation sui generis. Nevertheless, two important conclusions may be drawn. First, the cases strengthened the integrity of the letter of credit by denying injunctions despite the impossibility of per26 No. 79-io67 (S.D.N.Y. Mar. 9, I979) (hearing and order granting preliminary injunction), rev'd, 6o6 F.2d IO (2d Cir. I979). 27 Slip op. at 2I. 28 6o6 F.2d IO, i6 (2d Cir. 1979). However, on the basis of "general equitable powers," the court directed Chase to give KMW three days' notice before paying on any demand. Id. at I7. The remedy was tied loosely to U.C.C. ? 5-II2 and U.C.P. article 8(d), which give the issuer (not the customer) three days or a "reasonable time," respectively, to decide whether to honor or dishonor demands. 29 6o6 F.2d at i6. 30 See also Balfour, MacLaine Int'l Ltd. v. Manufacturers Hanover Trust Co.,

N.Y.L.J.,

Jan. 25, I979, at

ii,

col. 3 (N.Y.

Sup. Ct. Jan

I9,

1979),

where,

as in

KMW, Balfour, MacLaine's duties to perform had not matured when it lost on its first try to enjoin payment on a performance guarantee letter of credit. The Iranians subsequently fulfilled the conditions which triggered Balfour, MacLaine's contract duties. See Transcript at i8, Harris Int'l Telecommunications Corp. v. Bank Melli Iran, No. 79-802 (S.D.N.Y. Feb. 22, I979) (hearing and order granting preliminary injunction). Therefore, subsequent Balfour, MacLaine decisions are properly analyzed under the second category above. See p. 997 & note 22 supra; cf. Werner Lehara Int'l, Inc. v. Harris Trust & Savings Bank, No. G79-684 CAi (W.D. Mich. Jan. 2, ig80) (In KMW-type contract, Werner Lehara before shipment extended its guarantee letter of credit but Iranians let their payment letter of credit expire; no demand had been made; held, no injunction against payment on the credit.). 31 See generally Olson, Letter of Credit Obligations in Iran Unclear, Legal Times Wash., Apr. 2, I979, at 8, col. I; Olson, Contractors Still Face Uphill Iran Credit Fight, Legal Times Wash., Aug. 20, I979, at I5, col. I.

i980]

LE77ERS OF CREDIT

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forming underlying contracts.32 More significantly, KMW and dicta in American Bell apparently go further and allow a beneficiary to draw on a letter of credit even if the beneficiary himself has rendered performance of the underlying contract impossible.33 That conclusion would overrule four decades of letter of credit law.34 Second, the Iranian litigation involved a new problem under letter of credit law which the Uniform Commercial Code was inadequate to handle. The complaint of American contractors that unauthorized parties might draw on the credits was not a problem of "fraud in the transaction." It was a wrong beneficiary problem, created by the characteristics of the standby letter of credit.35 The Code gave the courts no guidance at all on the latter; the Code's treatment of the former requires a more thorough analysis than that given by the courts. II. FRAUD IN THE TRANSACTION: PROBLEMS IN THE RELATIONSHIP BETWEEN THE LETTER OF CREDIT AND THE UNDERLYING CONTRACT Letter of credit law prior to the Uniform Commercial Code descended from the "Law Merchant" - an amalgam of commercial customs which developed independent of contract law for the convenience of merchants.36 Both pre-Code case law and article 5 embody a customary allocation of risks primarily geared to the traditional function of the letter of credit: the financing of contracts for the sale of goods across long distances.37 Absent the use of a letter of credit, a seller who
See p. ioio & note 87 infra. This conclusion rests on the assumption that the Iranian Government was treated as the beneficiary. See note 9 supra. 34 See pp. I002-07 infra. 35 American banks assured the courts that only demands bearing proper telex codes would be received as genuine demands on the credits, and that therefore there was no unauthorized demand problem. See, e.g., RCA Global Communications DISC, Inc. v. Imperial Iranian Supreme Commander's Staff, No. 3985/79, slip Op. at 48-49 (N.Y. Sup. Ct. Apr. i8, I979) (order granting preliminary injunction). But this answer is not wholly satisfactory, because the wrong party may seize control of the banks. Bank of America received cables from "The Revolutionary Interim Supervisory Council" in February I979, representing itself as the new management of Bank Markhazi. The cables were contradictory, implying that various factions gained control of bank policy at different times. Affidavit of Michael G. Dowling at 5, Harris Int'l Telecommunications, Inc. v. Bank Melli Iran, No. 79-802 (S.D.N.Y. Feb. 22, 1979) (hearing and order granting preliminary injunction). 36 See generally Trimble, The Law Merchant and the Letter of Credit, 6i HARV. L. REV. 98I (I948); see also Bartholomew, Relations Between Banker and Seller under Irrevocable Letters of Credit, 5 MCGILL L.J. 89 (I959). 37 See B. KOZOLCHYK, supra note 2, ? I.OI[3]. See generally SCHLESINGER
32
33

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ships to a distant customer on credit risks losing his goods in return for a damage claim in a foreign jurisdiction. If the customer pays in advance, he risks losing his cash in return for a long-distance suit. The letter of credit provides a satisfactory allocation of these risks. A customer-buyer will have his bank issue a letter of credit to the beneficiary-seller, payable, for example, upon presentation to the bank of invoices, bills of lading, and documents of insurance covering the goods. The seller can demand payment once he has the required documents; the bank, once it receives the documents and pays on the credit, is entitled to reimbursement from the customer in exchange for the documents. The customer then has the documents necessary to take possession of the goods.38 A letter of credit transaction therefore comprehends three separate commitments: (i) the customer-bank contract, binding the bank to issue the letter of credit on behalf of the customer and obligating the customer to reimburse the bank; (2) the letter of credit commitment,39 binding the bank to pay the beneficiary upon the latter's compliance with the terms specified in the credit; and (3) an underlying contract between customer and beneficiary, which the letter of credit is issued to facilitate.40 One can therefore describe a traditional letter of credit as an instrument ensuring that neither buyer nor seller has both goods and cash at the same time. Unwilling to sell on credit, the seller instead receives the bank's irrevocable commitment and is thereby assured of payment.41 Unwilling to pay on
STUDY, supra note 7, at I578 (I952 draft of U.C.C. article 5 concentrated on letters of credit associated with sales of goods.) Use of the letter of credit other than in the context of sales developed only after World War II. See Note, Recent Extensions in the Use of Commercial Letters of Credit, 66 YALE L.J. 902 (I957). U.C.C. article 5, however, applies principles of letter of credit law without distinguishing between traditional and standby letters of credit, and post-Code cases have held that principles from traditional letter of credit law are equally applicable to standbys. See, e.g., Pringle-Associated Mortgage Corp. v. Southern Nat'l Bank, 57i F.2d 87I, 874 (5th Cir. 1978). See generally Barclays Bank D.C.O. v. Mercantile Nat'l Bank, 48i F.2d I 2 24, I 230-3 I (5th Cir. I9 73). 38 See J. WHITE & R. SUMMERS, HANDBOOK OF THE LAW UNDER THE UNIFORM COMMERCIAL CODE ? i8-i, at 602 (I972). 39 An irrevocable letter of credit commitment from bank to beneficiary, see note 4I infra, is not contractual because no consideration passes from beneficiary to bank; nor can it be analyzed as an offer, as the credit once opened remains in force despite the bank's objections or even counteroffers from the beneficiary. See B. KOZOLCHYK, supra note
40 2,

? 23.03[I].

See, e.g., Venizelos, S.A. v. Chase Manhattan Bank, 425 F.2d 46i, 464-65 (2d Cir. I970); H. HARFIELD, supra note i6, at 3I-32. 41 See Pringle-Associated Mortgage Corp. v. Southern Nat'l Bank, 57i F.2d i87I (5th Cir. I978). Today almost all letters of credit are irrevocable, meaning that the bank may not withdraw its engagement to the beneficiary. See H. HARFIELD, supra

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LETTERS OF CREDIT

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credit, the customer pays in advance of receiving the goods, but only upon receipt of documents which indicate that the goods have been shipped.42 The need to achieve these characteristics and protect the allocation of risks they represent produced the cardinal rule of letter of credit law: the "independence principle," which holds each commitment in a letter of credit transaction to be independent of the others.43 The independence of the bank-seller commitment from the underlying customer-seller contract protects the seller because the customer cannot interfere with the bank's promise to pay.44 The independence of the bank-customer credit agreement from the underlying sales contract protects the bank by requiring repayment from the customer if the documents are in order, irrespective of problems in the underlying contract.45 The bank can thus issue an inexpensive letter of credit because it merely processes documents.46 But because the customer's only assurance of the seller's performance lies in the documents presented to the bank, the customer's obligation to reimburse the bank depends on the bank's strict observance of the credit's documentary conditions for payment and is independent of the buyer's liability to the seller on the underlying contract.47 Pre-Code authority, however, did modify the independence principle in two types of cases involving attempts by a party to gain the benefit of a credit or a-contract without discharging his own obligations in the transaction. A customer was not able to accept conforming goods from the seller and deny his bank reimbursement on the credit because the documents were
note i6, at 40-44. But see Beathard v. Chicago Football Club, Inc., 4I9 F. Supp.
II33
42

(N.D.

Ill. I976).

See S. MENTSCHIKOFF, COMMERCIAL TRANSACTIONS 595 (I97o); Llewellyn, Some Advantages of Letters of Credit, 2 J. Bus. U. CHI. I, 5, 9-IO (I929). 43 See pp. 994-95 & note I3 supra. 44 Foreign Venture Ltd. Partnership v. Chemical Bank, 59 A.D.2d 352, 399
N.Y.S.2d II4 (I977); Frey & Son, Inc. v. E.R. Sherburne Co., I93 A.D. 849, i84 N.Y.S. 66i (I920); see H. HARFIELD, supra note i6, at 72-73 & n.2; SCHLESINGER STUDY, supra note 7, at i654-56.
45

See, e.g., Asociacion de Azucareros de Guatemala v. United States Nat'l Bank,

423 F.2d 638, 64I (gth Cir. I970); Laudisi v. American Exch. Nat'l Bank, 239 N.Y. 234, I46 N.E. 347 (I924); Benecke v. Haebler, 38 A.D. 344 (I899). See generally Kozolchyk, The Legal Nature of the Irrevocable Commercial Letter of Credit, I4 AM. J. COMP. L. 395, 398-400 (I965).
46 See Harfield, "A Plague on Both Your Houses" (Alternate Approaches to the Regulation of New Uses of Bank Credit), 59 J. COM. BANK LENDING 27, 39-40 (I977); Harfield, Article 5 - Trade Without Tears, or Around Letters of Credit in I7 Sections, I952 WIS. L. REV. 298, 299-300. 47 See International Banking Corp. v. Irving Nat'l Bank, 283 F. I03 (2d Cir. Portuguese Am. Bank v. Atlantic Nat'l Bank, 200 A.D. 575, I93 N.Y.S. 423 I922); (I922); H. HARFIELD, supra note i6, at 73 & n.3.

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improper.48 And, more important for the Iranian litigation, the seller-beneficiary of a letter of credit could not wholly fail
to perform
-

ship nothing

and still demand payment on

the credit because his documents were proper. This latter exception to the independence principle was enunciated in the landmark case of Sztejn v. J. Henry Schroder Banking Corp.49 In Sztejn, the seller was under contract to ship fifty crates of bristles, but instead shipped fifty crates of garbage. The court held: Wherethe seller'sfraudhas been called to the bank'sattention before the drafts and documents have been presented for payment the principleof the independenceof the bank's obligation under the letter of credit should not be extended to
protect the unscrupulous seller .... Although the bank is

not interestedin the exact detailed performance the sales of contract,it is vitally interestedin assuringitself that there are some goods represented the documents.50 by The Sztejn case inspired section
5-II4(2)

of the Code:5'

48 See Royal Card & Paper Co. v. Dresdner Bank, 27 F.2d 79I (2d Cir. I928); Courteen Seed Co. v. Hong Kong & Shanghai Banking Corp., 245 N.Y. 377, I57 H. FINKELSTEIN, LEGAL ASPECTS OF COMMERCIAL LETTERS OF N.E. 272 (I927); CREDIT I95-97 (I930). If the independence principle applied in these cases, the customer's acceptance of the goods should not affect the customer's liability to the bank. This pre-Code exception is not covered by article 5. Therefore pre-Code case law should continue to govern. See U.C.C. ?? I-Io3, 5-I02(3). 49 77 Misc. 7I9, 3I N.Y.S.2d 63I (Sup. Ct. I94i). A few cases before Sztejn had hinted at the existence of this exception. See, e.g., Old Colony Trust Co. v. Lawyers' Title & Trust Co., 297 F. I52 (2d Cir.), cert. denied, 265 U.S. 585 (I924); Maurice O'Meara Co. v. National Park Bank, 239 N.Y. 386, 40I-02, I46 N.E. 636, 64I (I925) (Cardozo, J., dissenting). See generally H. FINKELSTEIN, supra note 48, at I7' & n. 70. In light of the drive for international uniformity in letter of credit law illustrated by the U.C.P., it is interesting to note that pre-Sztejn English decisions also alluded to such an exception. See Societe Metallurgique d'Aubrives & Villerupt ii v. British Bank for Foreign Trade, [I922] Lloyd's List L.R. i68 (K.B.), cited in Sztejn, 177 Misc. at 722, 3i N.Y.S.2d at 635; Ellinger, The Tender of Fraudulent Documents Under Documentary Letters of Credit, 7 MALAYA L. REV. 24, 36 (I965). See also H. GUTTERIDGE & M. MEGRAH, THE LAW OF BANKERS' COMMERCIAL CREDITS I34 (4th ed. I968). Sztejn was explicitly adopted as the law of England in Edward Owen Engineering Ltd. v. Barclays Bank Int'l Ltd., [1978] I Lloyd's List L.R. i66 (C.A.). See also Etablissment Eseffka Int'l Anstalt v. Central Bank of Nigeria, [1979] I Lloyd's List L.R. i6i (C.A.); R.D. Harbottle (Mercantile) Ltd. v. National Westminster Bank Ltd., [i977] 2 All E.R. 862 (Q.B.). Though there has been some discussion of Sztejn-like situations in Europe, little positive law evolved. See B. KOZOLCHYK, supra note 2, ? I4.03. 50 177 Misc. at 722-23, 3i N.Y.S.2d at 633-35. 5I See United Bank Ltd. v. Cambridge Sporting Goods Corp., 4i N.Y.2d 254, 259, 360 N.E.2d 943, 948, 392 N.Y.S.2d 265, 270 (1976); Justice, supra note io. But cf. Harfield, supra note i6, at 605 ("Section 5-II4 contains a new gene[:] .. .. 'fraud in the transaction."'). See also Harfield, Code Treatment of Letters of Credit, 48

CORNELL L.Q.

92,

I03-04

(I962).

1980]

LE77ERS OF CREDIT

I003

Unless otherwiseagreedwhen documentsappearon their face to comply with the terms of a creditbut a requireddocument does not in fact conformto the warranties made on negotiation or transfer of a document of title . . . or of a certificated
security . . . or is forged or fraudulent or there is fraud in the transaction

(a) the issuermust honorthe draft or demandfor payment if honor is demandedby a holder in due course . . . and (b) in all other cases as against its customer, an issuer acting in good faith may honor the draft or demand for payment despitenotification fromthe customerof fraudor forgery or other defect not apparenton the face of the documentsbut
a court of appropriate jurisdiction may enjoin such honor.52 Sztejn and later section

For four decades, legal analysts have tried to reconcile first with the independence prin5-II4(2) ciple.53 There would be no conflict if Sztejn and the Code permitted an injunction only for forged or fraudulent documents,54 for every letter of credit implicitly requires the documents presented to be genuine.55 But the phrase "fraud in the transaction" is not obviously so limited, and its meaning is not clarified anywhere in article 5 or its official comments. Trying to avoid resolution of mercantile disputes over the

52 U.C.C. ? 5-II4(2) (emphasis added). 53 See generally 55 HARV.L. REv. 878 (I942); Analysis and Interim Report of the State Bar of California, in CALIFORNIA SENATEFACT FINDING COMMITTEE ON
JUDICIARY, 6TH PROGRESSREPORT TO THE LEGISLATURE, THE UNIFORM COMMERCIAL CODE 337 (I96I) [hereinafter cited as CALIFORNIA REPORT], quoted in CAL.

COM. CODE? 5II4, Comment 6 (West I964); Harfield, supra note i6; Note, Letters of Credit: Injunction As A Remedy For Fraud in U.C.C. Section 5-114, 63 MINN. L.
REv. 487, 50I-o8 (I979). 54 What distinguishes a "fraudulent document" from a "forged document" or "fraud

in the transaction" is unclear. An example of a "forged document" the drafters probably had in mind is a bill of lading created out of whole cloth by the beneficiary instead of by a carrier. A bill of lading properly issued by a carrier but altered by the beneficiary would have been a "fraudulent document." See Mentschikoff, Letters of Credit: The Need for Uniform Legislation, 23 U. CHI. L. REv. 57I, 6I3 (I956). Dean Mentschikoff was Associate Chief Reporter of the Code and a prime defender of article 5. See Panel Discussion on the Uniform Commercial Code: Report of the New York Law Revision Commission - Areas of Agreement and Disagreement, I2 Bus. LAW. 49, 64-65 (I956) (statement of Henry Harfield) [hereinafter cited as Panel Discussion]. Some post-Code decisions seem to have used the term "fraudulent documents" when actually concerned with performance of the underlying contract represented in the documents. See, e.g., Shaffer v. Brooklyn Park Garden Apartments, 3II Minn. 452, 250 N.W.2d I72 (I977); O'Grady v. First Union Nat'l Bank, 296
N.C. 2I2, 250 S.E.2d 587 (I978).
55 See Sztejn v. J. Henry Schroder Corp., I77 Misc. 7I9, 72I, 3i N.Y.S.2d 63I, 634 (Sup. Ct. I94i); Harfield, supra note i6, at 6oI-o5 (Sztejn properly viewed as forged documents case); Note, supra note 53, at 50I (narrow view of Sztejn limits case to forged documents).

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HARVARD LAW REVIEW

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quality of performance of underlying contracts in the context of actions to enjoin letters of credit,56 theorists have attempted to interpret section 5-II4(2) in ways which leave the independence principle intact.57 Yet apart from the logical difficulties inherent in these attempts,58 the legislative history of section 5-II4(2) indicates that "fraud in the transaction" was meant to embody an exception to the independence principle and provide for injunctive relief based solely on the beneficiary's misperformance of the underlying contract.59 The early drafts of the fraud section provided for injunctions against payment where the seller's performance of the underlying contract was so poor as to amount to failure of consideration or fraud.60 When the I952 Official Draft limited grounds for
56

See pp. Ioo8-og & notes 82-83 infra.

57 See Bossier Bank & Trust Co. v. Union Planters Nat'l Bank of Memphis, 550 F.2d I077 (6th Cir. I977); Shaffer v. Brooklyn Park Garden Apartments, 3II Minn. 250 452, 250 N.W.2d I72 (I977); O'Grady v. First Union Nat'l Bank, 296 N.C. 2I2, S.E.2d 587 (I978); H. HARFIELD, supra note i6, at 82-83 ("fraud in the transaction"

refers to the letter of credit transaction). But see note 58 infra. See also Harfield, supra note i6, at 6I3-I4 (customer asserts derivatively only those defenses available to the bank). 58 It is not clear how "fraud in the letter of credit transaction," see note 57 supra, can be distinguished from "forged or fraudulent documents." See American Bell Int'l,
Inc. v. Islamic Republic of Iran, 474 F. Supp. 420, 424 (S.D.N.Y. I979); Note, supra

note 53, at 503. Compare Harfield, supra note i6, at 605-o6 (transaction must be "so intimately related to the independent letter of credit contract as to be an implied term of that contract") with id. at 6o8 ("The 'entire transaction' must be infected."). Both formulations appear to conflict with the independence principle. 59 In general, it is unclear whether there can be a "legislative history" of a statute written by parties with no legislative power and subsequently passed by 49 different jurisdictions, many of which did their own studies on the Code. See generally J. There is, however, a real legislative WHITE & R. SUMMERS, supra note 38, at 9-Ii. history for article 5. The Code professed to codify existing letter of credit law, which was almost exclusively a product of New York courts. See Funk, Letters of Credit: U.C.C. Article 5 and the Uniform Customs and Practice, ii How. L.J. 88 (i965). Though other states generated studies of the Uniform Commercial Code, the New York Law Revision Commission was unmatched in its examination of article 5. Indeed, it was argued at the time that one of the purposes of article 5 was to spread what had been a New York specialty to the rest of the country: "Well, the only argument I have ever heard in favor of [article 5] is the Chicago argument. Chicago says that the only people who are objecting to that article are the New York lawyers, who are the only ones who know anything about [the letter of credit], and they don't want the hinterlands to learn anything about it." Colloquoy with William Emblidge, Buffalo attorney, in NEW YORK LAW REVISION COMMISSION, STUDY OF
THE UNIFORM COMMERCIAL CODE: STENOGRAPHIC REPORTS OF PUBLIC NEW HEARINGS ON THE CODE HELD AT BUFFALO, SYRACUSE AND ALBANY, YORK I5 (I954).

See generally Panel Discussion, supra note 54, at 66 (statement of Henry Harfield). 60 ALI CODE OF COMMERCIAL LAW art. IV, ch. I, ? 22 (I948); U.C.C. ? 4-II6 (I949 version); U.C.C. ? 5-I20 (I950 version). But cf. McLaughlin, The Letter of Credit Provisions of the Proposed Uniform Commercial Code, 63 HARV. L. REv.
I373, I378 (I950) (criticizing this provision).

i980]

LE77ERS OF CREDIT

I005

injunctive relief to "forged or fraudulent documents,"'61it was criticized in the New York Law Revision Commission's study of article 5: is not inflexible. The existing rule [on injunctive relief] Even in the absence of forgery and fraud, extraordinary
circumstances may justify issuance of an injunction.
. .

. The

Code . . . leaves us in doubt on the questionwhetherextraorshortof fraudor forgerymay ever justify dinarycircumstances or the issuanceof an injunctionagainst presentment honor of drafts.62 documentary One "extraordinary circumstance" which the study envisioned as justifying enjoining payment on a letter of credit was defective contractual performance when the customer was deprived of legal remedy because the beneficiary was an instrumentality of a hostile foreign government.63 Since lack of legal remedy is a prerequisite for a preliminary injunction in any action, the study's criticism is important for section 5-II4(2) its conclusion that the beneficiary's actions with respect to the underlying contract alone may justify an injunction.64 The comments of the study on the "fraud" section of article 5 were adopted by the New York Law Revision Commission in its report to the state legislature.65 The draftsmen of the Code responded to the New York Law Revision Commission by rewriting article 5.66 New York attorneys found the revised
61 U.C.C. ? 5-III (I952 version). Even this language, however, could be read to See Comment, Letters of Credit encompass conduct in the underlying transaction. Under the Proposed Uniform Commercial Code: An Opportunity Missed, 62 YALE
L.J. 227, 254 (I953). 62 SCHLESINGER 63 Id. at i657. STUDY,

supra note 7, at i656-58

(footnotes omitted).

64 What constitutes lack of a remedy at law is not clear. See Note, supra note 53, at 490 & n. I7. It may encompass the insolvency of the customer, see Dynamics Corp. of America v. Citizens & S. Nat'l Bank, 356 F. Supp. ggI (N.D. Ga. I973), the financial collapse of the beneficiary, see Shaffer v. Brooklyn Park Garden Apartments, 3II Minn. 452, 250 N.W.2d I72 (I977), and lack of remedy against the bank, see 20 U.C.C. REP. SERV. 7i6 (D. Mass. I976), rev'd sub nom. Interco, Inc. v. Schwartz, Interco, & Son, Inc. Inc. v. First Nat'l Bank, Co., 22 U.C.C. REP. SERV. 472 (Ist Cir.
I977);

Frey

v. E.R.

Sherburne

65 NEW YORK LAW

YORK LAW REVISION REVISION

66i, 664 (I920). I93 A.D. 849, 854, i84 N.Y.S. REPORT TO THE LEGISLATURE RECOMMISSION,

LATING TO THE UNIFORM COMMERCIALCODE app. IV, at 435 (I956).

COMMISSION, list omitting 5). ON UNIFORM in response as NEW STATE LAWS, ASSOCIATION COMMERCIAL Law Revision to New York any MEMORANDUM mention OF QUESTIONS problem

But cf. NEW

RELATING from TO

ARTICLE 5 PREPARED BY CONSULTANTS OF THE LAW REVISION COMMISSION 36

(I954)

(a nonexclusive on article

of the "fraud"

a list of

questions

66 See COMMITTEE CITY OF NEW (examining cisms) YORK, cited changes

OF THE BAR OF THE CODE 57, 6i

(I962)

REPORT ON THE UNIFORM

made

Commission

criti-

[hereinafter

YORK BAR REPORT];

cf.

J.

WHITE

& R. SUMMERS,

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HARVARD LAW REVIEW

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Code, including the rewritten fraud section, in "substantial compliance" with the Commission's criticisms,67 and a subseby the Code's Permanent quent defense of section 5-II4(2) Editorial Board appeared to include the Commission's "extraordinary circumstances" within the ambit of the section.68 Thus it was understood that under the Code the beneficiary's misperformance of the underlying contract alone could provide grounds for injunctive relief; the silence of the Code as to the exact standard for injunctive relief should be interpreted as leaving the matter to judicial development.69 indicate that two Decisions interpreting section 5-II4(2) of conduct will justify injunctions against paydifferent types ment on a letter of credit. In one category, the seller disturbs the documents. Example: the contract calls for shipment by June i. Shipment actually occurs June 2, but the seller alters the documents to indicate earlier shipment. That produces "forged or fraudulent" documents.70 In the other category, the seller so egregiously misperforms his duties under the underlying contract as to essentially destroy it. Example: the seller ships garbage or grossly nonconforming goods, yet obtains bills of lading from an innocent carrier and claims payment on the letter of credit. The seller has committed a "fraud in the transaction."71 These two types of conduct are often confused
supra note 38, at iO (New York Law Revision Commission had great effect on the Code). Note, however, that this 67 NEW YORK BAR REPORT, supra note 66, at 6i. report's comments on current ? 5-II4 do not mention the addition of the crucial phrase "fraud in the transaction" or the Schlesinger Study's ruminations on injunctive relief, see p. I005 supra. Moreover, the response issued by the Code draftsmen to the Law Revision Commission's criticisms does not expressly mention the "fraud in the transaction" issue. U.C.C. pt. II, at I55 (I954 version) (subcommittee reports). 68 PERMANENT EDITORIAL BOARD, REPORT No. 2, VARIATIONS TO CODE U.C.C. (I964). The justification was in response to CaliforIN ADOPTING STATES ? 5-II4(2) nia's decision to omit the crucial phrase "but a court of appropriate jurisdiction may enjoin such honor." The California legislature apparently deleted the phrase because of procedural problems in serving process or asserting jurisdiction over the beneficiary, whose rights would be harmed by such an injunction even though he was not before the court. Report of Professors Harold Marsh, Jr. and William D. Warren, in CALIFORNIA REPORT, supra note 53, at 494, reprinted in CAL. COM. CODE ? 5II4, Comment 6 (West i964). 69 See U.C.C. ? 5-Io2(3), Comment 2. 70 See Merchants Corp. of America v. Chase Manhattan Bank, 5 U.C.C. REP. SERV. I96 (N.Y. Sup. Ct. I968); Siderius, Inc. v. Wallace Co., 583 S.W.2d 852, 862-63 (Tex. Civ. App. 1979). 71 See United Bank Ltd. v. Cambridge Sporting Goods Corp., 4i N.Y.2d 254, 360 N.E.2d 943, 392 N.Y.S.2d 265 (1976) (shipment of mildewed and rotten boxing gloves instead of new boxing gloves); cf. Edgewater Constr. Co. v. Percy Wilson (I976) Mortgage & Fin. Corp., 44 Ill. App. 3d 220, 233, 357 N.E.2d I307, I3I7-i8 (Jiganti, J., specially concurring) (court will look to underlying contract if fraud is alleged).

i980]

LE77ERS OF CREDIT

I007

on the ground that the beneficiary's evil intent in each situation has produced misrepresentations in the documents.72 This is not so. Indeed, analysis indicates that neither misrepresentation nor evil intent is required to justify injunctive relief. A bill of lading is merely a representation of a representation. It only shows what the carrier was told he was carrying.73 There can be a misrepresentation only if the beneficiary alters an accurately transcribed bill of lading after the carrier issues it. If the bill of lading or other document has been altered, an injunction should be based not on the discrepancy between document and performance but by this tampering with the document,74 which would make it "forged or fraudulent" within the meaning of section 5-II4(2).75 Furthermore, if any alteration of the documents justifies an injunction, the intent of the beneficiary should be irrelevant. For example, if a seller ships the requisite goods, and documents are issued which erroneously represent different goods, the beneficiary's alteration of the documents to cure the documentary error and draw on the credit will still justify an injunction. The documents do not in fact meet the requirements of the letter of credit,76 and actual performance of the underlying contract does not justify payment when the documents are improper.77 Once alteration of documents has been shown, the only way the court can determine that the tampering cures rather than creates a misrepresentation is to examine performance of the underlying contract - forbidden by the independence principle.78
72 See West Va. Hous. Dev. Fund v. Sroka Dev. Fund, 4I5 F. Supp. II07, (W.D. Pa. I976); Note, supra note 53, at 499-500.

III4

73 A carrier who has no reason to know of the seller's misrepresentations in a straight bill of lading is not liable for the misdescriptions in the lading. See G.A.C. Commercial Corp. v. Wilson, 27i F. Supp. 242, 247-48 (S.D.N.Y. i967); 49 U.S.C. ? IOI (I976); U.C.C. ? 7-203, Comment. The carrier may be liable for unknowing misdescriptions in an order bill of lading. See 49 U.S.C. ? I02 (I976). See generally J. WHITE & R. SUMMERS, supra note 38, at 742-49. 74 Such a case also might arise if the beneficiary alters a third-party certificate of quality which is required by the credit, see Banco Espanol de Credito v. State Street Bank & Trust Co., 409 F.2d 7II (ist Cir. i969), or if the beneficiary's nonconforming invoice is rejected and the beneficiary then alters it, see Courtaulds N. America, Inc.

v. North Carolina Nat'l Bank, 528 F.2d 802, 8o6-o7 (4th Cir. I975). 75 See p. I003 & note 54 supra. But cf. United City Merchants (Investments) Ltd. v. Royal Bank of Canada, [I979] i Lloyd's List L.R. 267 (Q.B.) (beneficiary does not

lose right to payment if carrier alters documents).

76

See p. I003 & note 55 supra.

" See, e.g., Equitable Trust Co. v. Dawson Partners, [I927] 27 Lloyd's List L.R. 49 (I926); North Am. Foreign Trading Corp. v. General Elecs. Ltd., 67 A.D.2d 890,
4I3 N.Y.S.2d
REV. I4, I5-26

700 (I979) (mem.); Davis, Commercial Letters of Credit, 5 SYDNEY L.

(I965).

78 See McLaughlin, supra note 6o, at I378; Campbell, Guaranties and the Suretyship Phases of Letters of Credit, 85 U. PA. L. REV. I75, 28i (I936).

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On the other hand, when the beneficiary performs so badly as to destroy the underlying contract, there may be no misrepresentation at all. If the seller ships rubbish in crates marked "bristles," properly issued bills of lading truthfully represent the shipment of boxes marked "bristles," but the seller has nevertheless committed a "fraud in the transaction." What justifies the injunction here is not the discrepancy between documents and performance but the destruction of the underlying contract itself.79 For example, if the seller ships goods and obtains bills of lading, then hijacks the goods at the same time as he demands payment, the bills of lading accurately represent the initial shipment of goods. Nevertheless, the seller's conduct warrants an injunction because he has deprived the customer of the goods as surely as if he had initially shipped rubbish.80 The beneficiary's intent should be irrelevant in such a case. Given the destruction of the underlying contract it is inconceivable that a customer without adequate legal remedy would have to pay on a letter of credit because the seller shipped empty crates through negligence rather than "active, intentional fraud. 81 What degree of misperformance constitutes destruction of contract is not clear from the cases. A line must be drawn between a breach of warranty, which does not constitute destruction of the underlying contract, and shipment of worthless goods, which does constitute destruction and justifies an injunction.82 The standards of article 2 governing contract breakdowns have not been used in article 5 cases, since adjudication of mercantile issues in injunction actions would vitiate one purpose of the letter of credit - to ensure that the beneficiary has his payment in hand while such disputes are
79See Intraworld Indus. Inc. v. Girard Trust Bank, 461 Pa. 343, 359, 336 A.2d 3r6, 324-25 (I975) ("[T]he circumstances which will justify an injunction against honor must be narrowly limited to situations of fraud in which the wrongdoing of the beneficiary has so vitiated the entire transaction that the legitimate purposes of the independence of the issuer's obligation would no longer be served."). See also Shattuck & Guernsey, Letters of Credit - A Comparison of Article 5 of the Uniform Commercial
(i962). Code and the Washington Practice, 37 WASH. L. REV. 500, 529-30 & M. MEGRAH, supra note 49, at I33-34 80 But cf. H. GUTTERIDGE

(discussing Dutch case in which seller shipped goods, obtained bills of lading, and then simultaneously drew on the credit and attached the goods; the court upheld payment to the seller; European commentators criticized the result). 81 But see American Bell Int'l, Inc. v. The Islamic Republic of Iran, 474 F. Supp.
420, 425 (S.D.N.Y. r979); American Bell Int'l, Inc. v. Manufacturers Hanover Trust Co., N.Y.L.J., Mar. 29, I979 (N.Y. Sup. Ct. Mar. 26, I979), aff'd mem., 70 A.D.2d 5I3-I5. 830, 4I8 N.Y.S.2d 55I (i979); Note, supra note 53, at 499-500, 82 United Bank Ltd. v. Cambridge Sporting Goods Corp., 41 N.Y.2d 254, 360 N.E.2d 943, 392 N.Y.S.2d 256 (I976). See also Campbell, supra note 78, at 273, 28I.

i980]

LETTERS OF CREDIT

I009

adjudicated.83 The proper standard should be found by referring to the function of the letter of credit. As opposed to payment for goods in advance, or a sale of goods on credit, a letter of credit ensures that neither customer nor seller ever has both cash and goods. An injunction is warranted at that point on the spectrum between substandard goods and worthless goods where the seller has effectively retained the goods while receiving the cash. This interpretation of "fraud in the transaction" compels division of the Iranian cases into the three categories described in Part I. In the first category,84 the letters of credit were issued in return for the Iranian government's advance payments. Those payments were the "underlying contracts." If no advances had been made, a demand on the credits would have been a "fraud in the transaction" because the contractors would have to pay on the credits without realizing anything from the underlying contracts. But advances had in fact been made in the American Bell cases. Therefore American Bell's underlying contract had not been destroyed when the Iranians demanded payment on their letters of credit, and the courts were correct in denying American Bell injunctive relief. By the same analysis, however, the courts incorrectly decided the third category of Iranian cases, which involved letters of credit guaranteeing performance of contracts in which the customer's duty to perform had never matured. In KMW International v. Chase Manhattan Bank,85 the underlying contract was an agreement to ship telephone poles, conditioned upon the customer, KMW, receiving financing from the beneficiary, Iran. KMW did not receive that financing. The Second Circuit failed to realize that Iran's failure to pay vitiated the underlying contract just as the beneficiary had destroyed the underlying contract in Sztejn. For the Iranians to demand payment should have been "fraud in the transaction" within the meaning of section 5-II4(2). 86
83 See Report of Professors Harold Marsh, Jr. and William D. Warren, in CALIFORNIA REPORT, supra note 53, at 494, quoted in CAL. COM.CODE? 5II4, Comment 6 (West I964); Harfield, supra note i6, at 598; pp. 998-IOOI supra. In practice, however, the seller often must litigate without cash in hand because the customer can often easily obtain a temporary restraining order against payment on the credit. 84 See p. 996 supra. 85 6o6 F.2d IO (2d Cir. I979). 86 Unreported cases from the Cuban Revolution present similar problems and support this conclusion. See, e.g., St. Paul Fire & Marine Ins. Co. v. Bankers Trust Co., N.Y.L.J., Nov. i8, I960 at I4, col. I (N.Y. Sup. Ct. Nov. I5, I960) (customer St. Paul was liable on letters of credit securing its borrowings of bonds from a Cuban bank; the Revolutionary Government nationalized the Cuban bank and the borrowed

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In the second category of Iranian cases, the letters of credit guaranteed contract performance, but the contractors had begun work on the contracts. Because work and payment had started on these contracts, the value of the underlying contracts may have been impaired rather than destroyed, in which case no injunctions should have issued. Yet even if the underlying contracts had been destroyed, they were aborted not by the Iranian Government but by the supervening disruption of the Iranian Revolution, an unforseen calamity attributable to neither party. This was not a "fraud" problem; it was an impossibility problem. By not issuing injunctions, the Iranian letter of credit cases settled a conflict among the few existing precedents by establishing that it is not "fraud in the transaction" for a beneficiary to draw on a letter of credit when supervening impossibility disrupts the underlying contract.87 The impossibility problem is significant because it shows the limits of the fraud analysis enunciated above. Contract destruction not attributable to the beneficiary is rare in the
bonds, then drew on the letters of credit; held, "[the independence] principle must yield where, as here, the drawing of drafts upon the letter of credit would be tantamount to a fraud upon the plaintiff"). 87 Compare Dynamics Corp. of America v. Citizens & S. Nat'l Bank, 356 F. Supp. 99i (N.D. Ga. I973), and Nadler v. Mei Loong Corp., I77 Misc. 263, 30 N.Y.S.2d 323 (Sup. Ct. I94i) (risk that goods shipped may never arrive due to impending Pacific war justifies injunction), with Grob v. Manufacturers Trust Co., 177 Misc. 45, 29 N.Y.S.2d 9r6 (Sup. Ct. I94I) (letter of credit pays seller on shipment; therefore customer bears risk goods will not arrive even when risk stems from impending Pacific war). Nadler was specifically rejected, and Grob endorsed, in United Technologies Corp. v. Citibank, 469 F. Supp. 473, 480 (S.D.N.Y. I979). Cf. Rosenfeld v. Banco Internacional, 27 A.D.2d 826, 278 N.Y.S.2d i6o (i967) (beneficiary was paid despite misdescription in bills of lading which led to government seizure of goods). Dynamics, not usually cited as an impossibility case, is an example of a decision ostensibly based on the beneficiary's "misrepresentation" where the court actually worried about the underlying contract. But see Note, Guaranty Letters of Credit: Problems and Possibilities, I6 ARIz. L. REv. 822, 848 (I944). Beneficiary India called on letters of credit guaranteeing performance of a multi-shipment contract when that contract was interrupted by an arms embargo associated with the 1971 India-Pakistan War. Though the letters of credit were issued with each shipment, the terms of the credits, see 356 F. Supp. at 994 n.2, show the letters of credit were not limited to guaranteeing the quality of individual shipments but rather guaranteed performance of the entire contract. Such performance was indubitably interrupted, and it was no misrepresentation for India to certify that "Dynamics Corporation of America has failed to carry out certain obligations," id. By contrast, courts are apparently united in not withholding payment from the beneficiary where the underlying contract has merely been frustrated rather than rendered impossible. See, e.g., American Steel Co. v. Irving Nat'l Bank, 266 F. 4I (2d Cir. I920) (wartime regulation prevented customer's resale of goods shipped by beneficiary), cert. denied, 258 U.S. 6I7 (I922); Mid States Mortgage Corp. v. National Bank, 77 Mich. App. 65I, 259 N.W.2d 175 (1977) (housing project financed by letter of credit failed due to a third party's default).

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traditional letter of credit transactions that produced the Sztejn rule and section 5-I I4(2). In a traditional letter of credit, catastrophic disruption of the underlying contract before the goods are shipped prevents the beneficiary from obtaining the documents needed to trigger payment on the credit. Insurance on the goods usually protects the customer from catastrophic disruption of contract after shipment.88 But there were no insurable goods underlying the letters of credit payable to Iran. The difference between standby and traditional letters of credit creates both this impossibility problem and other difficulties unique to standby letters of credit. III. FAILURE OF THE UNIFORM COMMERCIAL CODE:
PROBLEMS IN STANDBY LETTERS OF CREDIT

Letter of credit law embodies a traditional allocation of risks associated with financing a sales contract. But risks change when the letter of credit is used in nontraditional ways. Since the Second World War, letters of credit have been used as surety devices, serving in the role of performance bonds and bid guarantees.89 While commentators have long recognized that this change in role increases risks to banks,90 the Iranian letter of credit cases show that standby letters of credit may increase risks to customers as well.91 In a traditional letter of credit transaction, the customer pays for the beneficiary's performance, for example, shipment of goods. The documents which fulfill the conditions of the credit indicate that the seller has performed before either issuer or customer pays. For that reason the letter of credit is better for the customer than payment in advance. But under a standby letter of credit the customer pays upon a breach in his own performance. The documents are reduced to the beneficiary's assertion of the customer's breach. Because the documents no longer describe the beneficiary's performance the bank's inspection of the documents no longer polices the ben88 ed.

See J.

O'HALLORAN,

THE

ABC OF

COMMERCIAL

LETTERS

OF CREDIT

9 (7th

I973).

89 See p. 992 & note 2 supra. 90 Compare Verkuil, Bank Solvency and Standby Letters of Credit: Lessons from the USNB Failure, 53 TUL. L. REv. 3I5 (I979), and Naegele, Unsound Banking Practices - A Paper Dealing with Standby Letters of Credit and Other Bank Guar-

antees, in
IST

SENATE

COMM.

ON BANKING,

HOUSING

& URBAN AFFAIRS, REGULATION

94TH CONG., Print

SESS.,

COMPENDIUM

OF MAJOR ISSUES IN BANK

647 (Comm.

[hereinafter cited as COMPENDIUM], with H. HARFIELD, supra note i6, and Harfield, The Standby Letter of Credit Debate, 94 BANKING L.J. 293, 298-99 (I977). 91 See Note, Guaranty Letters of Credit: Problems and Possibilities, i6 ARIZ. L. REV. 822, 838 (1974).
I975)

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eficiary's performance of the underlying contract.92 The documents become trivial and the conditions of the credit become meaningless. As the standby letter of credit becomes more like an unconditional promise to pay, the credit becomes no better than "cash in advance" and increases risks to customers like the American firms in Iran: "[P]laintiffs gave a blank check to the Iranian Government." 93 The differences between traditional and standby letters of credit proved important in the Iranian litigation because these differences created for the American contractors the problem of the wrong beneficiary. Under a traditional letter of credit, the possibility that an unintended party will draw on the credit cannot, by itself, put the customer at risk. So long as the beneficiary has performed, the customer receives that performance no matter who tenders the documents. Under standby letters of credit, fulfillment of the conditions of the credit does not give the customer the beneficiary's performance of the underlying contract. Therefore customers are legitimately concerned that only the right party be in control of documents triggering the letters of credit - that only the right person can draw on the "blank check."94 During the revolutionary disturbances in Iran, it was possible for parties unauthorized by the new regime to make unwarranted demands on the cred92 See id.; Note, supra note 37, at gog. Of course, a beneficiary in a traditional letter of credit transaction can evade documentary protections. See H. HARFIELD, supra note i6, at 58-59. But absent intent to defraud, the beneficiary generally provides documents matching his performance in a traditional letter of credit - and the customer can require documents describing the contract in detail. See International Banking Corp. v. Irving Nat'l Bank, 283 F. I03, I05 (2d Cir. I922). If the beneficiary errs in performance, his documents will reflect the error, he will not collect on the credit, and the customer is protected. See p. iooi & note 47 supra. In standby letters of credit like those in the Iranian litigation, the documents match the beneficiary's perception of the customer's default. If the beneficiary misjudges a default, the documents he submits don't show that misjudgment, so the customer is not protected. But see Fidelity Nat'l Bank v. Dade County, 371 So. 2d 545, 546-47 (Fla. Dist. Ct. App. 1979). See also p. IOI4 & note 107 infra. 93 American Bell Int'l, Inc. v. Manufacturers Hanover Trust Co., N.Y.L.J., Mar. 29, 1979, at 7, col. 6 (N.Y. Sup. Ct. Mar. 26, 1979), aff'd mem., 70 A.D.2d 830, 4i8 N.Y.S.2d 55I (i979). 94 The customer has traditionally been protected against an unintended party fulfilling the conditions of the credit, because a letter of credit is not assignable unless it provides to the contrary. U.C.C. ? 5-Ii6(i); McGowan, Assignability of Documentary Credits, I3 LAW & CONTEMP. PROB. 666, 68I-82 (I948). But see Fidelity Bank v. Lutheran Mutual Life Ins. Co., 465 F.2d 2II, 2I3 (ioth Cir. 1972). Where there are questions about an individual's authority to draw on the credit, the independence principle has not precluded looking beneath the documents. Corporacion de Mercadeo Agricola v. Mellon Bank Int'l, 464 F. Supp. 88 (S.D.N.Y. 1978).

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its.95 The courts' improvised response was to direct the banks to give three to ten days notice before paying on the letters of credit, so that the contractors would have a chance to investigate the authenticity of any demand. 96 Yet this relief amounted to a modification of the letter of credit, which is prohibited by the Code without the consent of both customer and beneficiary.97 The Iranian letter of credit litigation forced courts interpreting the Code to confront what bank regulators have known for years: standby letters of credit are not the same as traditional letters of credit and should not be treated in the same way. Since I974, federal banking authorities have subjected standbys to bank lending limits because standbys can contain risks to banks greater than traditional letters of credit.98 As standbys also present a different allocation of risks to customers, a different interpretation of article 5 - or an amendment to it - is desirable. The Code was from its inception inadequate to handle standby letters of credit, even though it explicitly purports to cover them.99 Article 5 was a restatement of the law of letters of credit as the law stood in I952,100 years before litigation over standbys had brought the problems of these instruments to the fore.101
95 See p. 999 & note 35 supra. 96 See pp. 996-98 & note 3I supra. 97 U.C.C. ? 5-Io6(2); U.C.P. art. 3(c). The only comparable problem under a traditional letter of credit was theft of bills of lading - which after discovery concerned both the beneficiary, who wanted payment, and the bank, which had to pay the right drawer. The parties could freeze the entire transaction without preliminary judicial remedies. The description of events in Zervos v. S.S. Sam Houston, 427 F. Supp. 500 (S.D.N.Y. I976) provides an example. Limited notice relief may become a standard remedy imposed by courts on issuing banks for an allegation of fraud falling short of the standard necessary for a flat injunction. See Transamerica DeLaval, Inc. v. Citibank, No. 79-4Io8 slip op. at II-I2 (S.D.N.Y. Aug. I7, 1979) (a non-Iranian case by the KMW district judge), adjuring the issuing bank to "take the precaution of finding out whether the demand is acceptable, which means that informally you are going to give them [customer/plaintiff] the three days." 98 I2 C.F.R. ?? 7.II60, 208.8(d), 337.2 (i979). See Proxmire Hearings, supra note 2, at 20 (statement of Frank Wille, Chairman, FDIC); I20 CONG. REC. 29792 (I974) (excerpt from Federal Reserve Board Governor Holland's speech to the Robert Morris Associates), reprinted in COMPENDIUM, supra note go, at 690. But see note go supra. 99 But see Pringle-Associated Mortgage Corp. v. Southern Nat'l Bank, 57i F.2d 87I, 874 (5th Cir. 1978); H. HARFIELD, supra note i6, at I99; Murray, Letters-ofCredit in Nonsale of Goods Transactions, 30 Bus. LAW. II03 (I975); Harfield, Code, Customs and Conscience in Letter of Credit Law, 3 U.C.C. L.J. 7, 9 (I97i). 100The I952 Official Draft purported to be a restatement of existing law. SCHLESINGER STUDY, supra note 7, at I717. 101 The West Digests show that litigation concerning standby letters of credit was

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Ideally, an amendment to article 5 would modify the independence principle for standby letters of credit.102 The Code should provide that as to any letter of credit payable not upon evidence of the beneficiary's performance of the underlying contract, but rather upon evidence of the customer's default, the customer should be entitled: (i) to prior notice of any demand for payment on the credit, and (2) to enjoin payment upon a showing of any valid defense he has on the underlying contract. Under such a provision, standbys would still guarantee payment to the beneficiary by substituting the bank's solvency for the customer's, but would no longer put the customer at risk when the contract breaks down through no fault of his own. The standby would function more like the surety bond it replaces and would still retain the low-cost advantages of the letter of credit, since an issuing bank would still deal exclusively in documents and would remain privileged to pay on conforming documents unless enjoined. 103 As article 5 stands now, however, the only way the courts could relax the independence principle to accommodate standbys would be through expansion of the "fraud in the transaction" provision 104 While the drafters of this provision may in section 5-II4(2). have aimed it primarily at Sztejn-like cases of egregious misperformance within the context of a traditional letter of credit,105 their evident willingness to leave its content to judicial elaboration, combined with their failure to otherwise deal with the problems unique to standbys, would not make such an expansion unreasonable. 106 Carefully drafted letters of credit could provide increased protection to customers,107 and the Code allows parties to a credit to modify the independence principle. 108 But banks hesitate to deviate from standard forms. The Uniform Customs and Practice for Documentary Credits,109 frequently incorporated by reference into letters of credit,110 was drafted by bankers for bankers despite attempts by merchants to innegligible until the I970's; the standby letter of credit is not discussed in the "scope" section of the SCHLESINGER STUDY, supra note 7, at I570-80. 102 See Note, supra, note 53, at 5I3-I5; Note, supra note 9I, at 848-59.
103
104

See pp.

See p.

IOOI supra.
I377-78;

105 106
107

supra. I003-09 See generally McLaughlin, supra note 6o, at

Mentschikoff, supra note

54, at 633.

See U.C.C. ? 5-I02(3), Comment 2. See Note, supra note 9I, at 846-47. 108 See U.C.C. ? 5-II4(2) ("Unless otherwise agreed .... 109 See note i6 supra. 110 Harfield, Code Treatment of Letters of Credit, 48 CORNELL L.Q. (I962). But see Mentschikoff, supra note 54.

92,

96

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fluence the result,1ll and has been termed a "contract of adhesion."112 To leave further change to the market risks not only damage to the unwary customer but also haphazard judicial reaction that would affect letter of credit law with respect to both standbys, where change is needed, and traditional letters of credit, where it is not.
"I Mentschikoff, supra note 54, at 575 at I585-86. 112 See Funk, supra note 59, at 89-90.
n.20;

SCHLESINGER STUDY, supra note 7,