Fraud Exception Principle

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This article was originally published on February 7, 2021 and has been updated to reflect recent legal developments.

This article is provided for general informational purposes only and does not create, nor shall it be construed as creating, a lawyer-client relationship between Alburo Alburo and Associates Law Offices (or any of its lawyers) and the reader. For advice on specific legal concerns, you are encouraged to engage the services of a qualified lawyer. You may also directly consult Alburo Alburo and Associates Law Offices for proper guidance tailored to your situation.

The views and information presented herein are based on the laws, rules, and jurisprudence prevailing at the time of writing. They do not take into account subsequent legal developments and should not be relied upon as a substitute for professional legal advice.

AT A GLANCE:

A letter of credit is a commercial instrument developed to address the unique needs of certain commercial transactions. (The Hongkong & Shanghai Banking Corp., Limited v. National Steel Corp., G.R. No. 183486, February 24, 2016)

In the realm of commercial transactions, a letter of credit stands as one of the most reliable financial instruments used to facilitate trade. It provides security to sellers while assuring buyers that payment will only be made upon compliance with agreed conditions.

The nature and function of a letter of credit have been explained by the Supreme Court in the case of The Hongkong & Shanghai Banking Corp., Limited v. National Steel Corp., G.R. No. 183486, February 24, 2016.

Letter of Credit, defined

Nature of a Letter of Credit

A letter of credit generally arises out of a separate contract requiring the assurance of payment of a third party. In a transaction involving a letter of credit, there are usually three transactions and three parties.

As explained in The Hongkong & Shanghai Banking Corp., Limited v. National Steel Corp., the process generally unfolds as follows:

Once the seller ships the goods, he or she obtains the documents required under the letter of credit. He or she shall then present these documents to the issuing bank which must then pay the amount identified under the letter of credit after it ascertains that the documents are complete.

The issuing bank then holds on to these documents which the buyer needs in order to claim the goods shipped. The buyer reimburses the issuing bank for its payment at which point the issuing bank releases the documents to the buyer.

The buyer is then able to present these documents in order to claim the goods. At this point, all the transactions are completed. The seller received payment for his or her performance of his obligation to deliver the goods. The issuing bank is reimbursed for the payment it made to the seller. The buyer received the goods purchased.

The Independence Principle

Central to letters of credit is the Independence Principle, which provides that the obligation of the issuing bank to pay is separate from the underlying contract between the buyer and seller.

The so-called “independence principle” assures the seller or the beneficiary of prompt payment independent of any breach of the main contract and precludes the issuing bank from determining whether the main contract is actually accomplished or not. Under this principle, banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any documents, or for the general and/or particular conditions stipulated in the documents or superimposed thereon, nor do they assume any liability or responsibility for the description, quantity, weight, quality, condition, packing, delivery, value or existence of the goods represented by any documents, or for the good faith or acts and/or omissions, solvency, performance or standing of the consignor, the carriers, or the insurers of the goods, or any other person whomsoever. (Philippine National Bank v. San Miguel Corp., G.R. No. 186063, January 15, 2014)

The independence principle liberates the issuing bank from the duty of ascertaining compliance by the parties in the main contract. As the principle’s nomenclature clearly suggests, the obligation under the letter of credit is independent of the related and originating contract. In brief, the letter of credit is separate and distinct from the underlying transaction (Philippine National Bank v. San Miguel Corp., G.R. No. 186063, January 15, 2014)

Exception: The Fraud Exception Principle

However, is there an exception to the Independence Principle? Yes.

Despite the strict application of the Independence Principle, the law recognizes a narrow but vital exception—fraud.

In Transfield Philippines, Inc. v. Luzon Hydro Corporation, Australia And New Zealand Banking Group Limited and Security Bank Corporation, G.R. NO. 146717, November 22, 2004, the Supreme Court articulated what is known as the Fraud Exception Principle:

Most writers agree that fraud is an exception to the independence principle. Professor Dolan opines that the untruthfulness of a certificate accompanying a demand for payment under a standby credit may qualify as fraud sufficient to support an injunction against payment. The remedy for fraudulent abuse is an injunction. However, injunction should not be granted unless: (a) there is clear proof of fraud; (b) the fraud constitutes fraudulent abuse of the independent purpose of the letter of credit and not only fraud under the main agreement; and (c) irreparable injury might follow if injunction is not granted or the recovery of damages would be seriously damaged.

Thus, the “Fraud Exception Principle” is the exception to the Independence Principle. It provides that the untruthfulness of a certificate accompanying a demand for payment under a standby letter of credit may qualify as fraud sufficient to support an injunction against payment.

Under the fraud exception principle, the beneficiary may be enjoined from collecting on the letter of credit if the beneficiary committed fraud by substituting fraudulent documents even if on their face the documents complied with the requirements.

This principle refers to fraud in relation with the independent purpose or character of the Letters of Credit and not only fraud in the performance of the obligation or contract supporting the letter of credit.

Alburo Alburo and Associates Law Offices specializes in business law and labor law consulting. For inquiries regarding legal services, you may reach us at info@alburolaw.com, or dial us at (02)7745-4391/ 09175772207/ 09778050020.

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