Suspension of Payment under Letters of Credit (II)

(I) Conditions for Prohibiting Payment under a Letter of Credit

1. There must be fraud. The constituent elements of fraud in letter of credit transactions should include: (1) The fraudster must have committed acts of creating false impressions, concealing the truth, or using the operational mechanism of the letter of credit to commit fraud. This generally includes: forging or altering documents required by the letter of credit, and fraud committed by the beneficiary in the underlying contract; (2) The defrauded party makes a mistaken expression based on the false circumstances. For example, being deceived by the seller's fraud causes the buyer and/or issuing bank to mistakenly agree to an acceptance, or collusion between the buyer and seller causes the issuing bank to mistakenly agree to an acceptance; (3) The fraudster has the subjective intent to commit fraud; (4) The fraudulent act has caused or will inevitably cause property damage to the defrauded party.

2. There must be material fraud. Overly frequent judicial intervention in letter of credit business will inevitably shake the principle of independence and abstraction of letters of credit to a certain extent, damaging the established international trust in letters of credit. Therefore, most countries adopt a strict approach, insisting that payment under a letter of credit can only be stopped when the fraud reaches a material level.

We can examine and confirm material fraud from two aspects. First, analyzing from the result of the fraudulent act: if achieving the goal of one party signing the underlying contract is impossible and substantial losses are incurred, this constitutes material fraud. Second, analyzing from the fraudulent documents: forging or altering critical documents constitutes material fraud. So-called critical documents are those that directly affect the realization of the parties' purpose in signing the underlying contract.

For example, acts of advancing the date of bills of lading (advance bills) or antedating bills of lading are common in international trade. Do they constitute material fraud? Generally, the bill of lading is a critical document in letter of credit settlements. However, if the seller advances or antedates the bill of lading to facilitate negotiation and financing, the quality and quantity of the goods comply with the contract, and there are no abnormal market changes that affect the expected purpose of the underlying contract parties, then it does not constitute material fraud. But if the subject matter of the underlying contract has a temporal nature, the buyer purchases goods to meet specific market demands within a particular period, and the seller, due to delays, advances or antedates the bill of lading, significantly impacting the buyer's expected contractual purpose, then such alteration of the bill of lading constitutes material breach, and thus material fraud.

3. The material fraud must occur during the period of the beneficiary's responsibility. Generally, to prohibit payment under a letter of credit, the beneficiary must have participated in or led the material fraud; that is, payment stoppage can only be directed at the fraudster. However, in multi-link, long-distance, cross-border international trade, situations often arise where the seller has nothing to do with the fraud, which is orchestrated by a third party. For example, if the beneficiary has delivered the goods to the carrier, and the carrier steals or substitutes the goods without the beneficiary's knowledge, the applicant's expected purpose for the underlying contract will certainly not be realized. Can a payment stoppage under the letter of credit be applied? Applying it would be unfair to the beneficiary-seller, but not applying it would harm the applicant-buyer.

Courts around the world handle this differently. The author believes that in such cases, the decision to stop payment should no longer be based on the principle of fault, but rather according to the agreement between the buyer and seller in the underlying contract regarding the period of risk for the subject matter. For example, if the underlying contract uses trade terms like DES or DEQ, according to the ICC's Incoterms, the risk is only transferred to the buyer when the goods are placed at the buyer's disposal at the agreed port of destination. Since the fraudulent act (e.g., carrier theft/substitution) occurs during the seller's risk responsibility period, the seller should bear the legal consequences of the carrier's fraud, and prohibiting payment under the letter of credit should be permitted.

Conversely, if the underlying contract uses trade terms like FOB, CFR, or FCA, the risk is transferred to the buyer when the goods pass the ship's rail at the port of loading or upon delivery to the carrier, and the seller no longer bears responsibility afterward. Therefore, payment under the letter of credit cannot be stopped. Consequently, as long as material fraud occurs during the beneficiary's period of responsibility, regardless of whether the beneficiary actually participated in it, stop-payment on the letter of credit is justified.

4. The interests of bona fide third parties must not be harmed. The negotiability of letters of credit makes them a tool for financing, which is one reason for their vitality. To maintain this negotiability, it is necessary to protect the bona fide holders of instruments issued under letters of credit during circulation. This includes parties such as the assignee of the instrument, confirming bank, negotiating bank, and paying bank, who have paid value for the instrument without knowledge of fraud, dishonor, or defenses against their rights.

Article 13 of China's Negotiable Instruments Law clearly states: "The obligor on an instrument may raise defenses against the holder who has a direct creditor-debtor relationship with him and fails to perform the agreed obligations. The obligor on an instrument shall not use the defenses against the holder based on the defense grounds between himself and the drawer or prior parties." This is the legal basis for protecting bona fide third parties. Furthermore, stopping payment under a letter of credit aims to achieve the protection of innocent parties, including bona fide third parties, by preventing fraudsters from obtaining illegal gains. This is also required by the purpose of stop-payment. Only when rights claimed by bona fide third parties are lawfully excluded can payment under the letter of credit be prohibited.

Only when the application for stopping payment under a letter of credit meets all the above four conditions can the court order a prohibition on payment. However, typically, the legal concept of prohibiting payment under a letter of credit can only be used after the case is concluded and it is substantively determined that the beneficiary should not possess the instrument right under the letter of credit.

(II) Conditions for Suspending Payment under a Letter of Credit

Overall, to warrant payment suspension, the basic conditions for prohibiting payment must exist. However, the author believes that the primary requirement is met when the first three conditions for a prohibition on payment are substantially fulfilled. That is, as long as evidence can prove that the beneficiary committed material fraud, a ruling to suspend payment can be made. The key here is the extent of "proving." Most countries have relatively strict requirements for "proving."

China should also adopt strict standards to prevent an applicant inclined to refuse payment from abusing their rights, harming the legitimate interests of relevant parties, and affecting bank credit. What does "strict standard" mean? It depends on the specific circumstances of each case, making a definitive list difficult. It should be the result of a comprehensive analysis and comparison. It means being reasonably certain that the applicant is not acting out of hyper-sensitivity or malice, and that they have a greater likelihood of prevailing than the beneficiary.

As for the evidentiary requirement for excluding bona fide third parties, it should not be overly strict. It is difficult for the applicant to easily possess evidence regarding whether the third party knew the beneficiary was using the letter of credit for fraud, whether they acted in bad faith, whether they paid value, or whether they were grossly negligent, as these are determined by the interaction between the third party and the beneficiary. If an applicant court cannot impose suspension measures without having evidence that a third party is not bona fide, then effectively, payment cannot be stopped whenever a third party is involved. Such an approach would effectively grant rights to third parties who lack legitimate interest, essentially protecting fraud.

This contradicts provisions in China's Negotiable Instruments Law regarding parties who knowingly acquire an instrument fraudulently, those who knew of defenses between the obligor and prior holders at the time of acquisition, and those who acquired en instrument through gross negligence, as such parties do not enjoy instrument rights. The author suggests that when an instrument is suspected of being involved in fraud, the holder should bear the burden of proof for the legality of their holding. Therefore, when the court can prove the beneficiary committed material fraud but was unable to confirm the holder's legal right under the instrument, a ruling to suspend payment under the letter of cold be issued, allowing the court to notify the third party within a fixed period to provide evidence of their legal holding for timely review and legal processing, achieving the purpose of punishing illegality and protecting legality.

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