The utilization of Letters of Credit (LOC) in cross-border transactions is a well-established practice for payment facilitation and risk mitigation, especially in situations where trust or a relationship between parties is yet to be established. However, caution must be exercised when adopting LOC for payment due to the potential risks associated with fraud. To illustrate this, we will examine a significant case in the evolution of LOC payments—the SZTEJN case.
In 1941, the SZTEJN case, building upon the judgment in the Old Colony case, offered an interpretation of the fraud exception rule. The buyer and seller had entered into a contract for the sale of bristles. Despite the documents submitted to the negotiating bank accurately describing the bristles specified in the letter of credit, the seller delivered goods that were fraudulent—cowhair, other worthless material, and rubbish, designed to mimic genuine merchandise and defraud the plaintiff. SZTEJN sought an injunction from the court, which, upon review, determined that the seller’s actions constituted fraud. The court held that the principle of independence under the letter of credit should not extend to protect an unethical seller. Consequently, the plaintiff sought a judgment declaring the letter of credit and draft void, along with injunctive relief to prevent the payment of the draft, a decision supported by the court.
The SZTEJN case still echoes in modern scenarios, as evidenced by a recent incident involving a Brazilian company and a Chinese counterpart. The agreed payment term was LOC for home appliance orders. During the negotiation of certificates and coordination of testing for the new items, the LOC was nearing expiration. Despite the client’s request to cancel the order, the factory insisted on a delivery schedule and shipped empty boxes (equivalent to rubbish) without client approval. The factory submitted documents describing home appliances to the bank and received payments. While constituting LOC fraud, the Brazilian company failed to seek injunctive relief promptly, leading to the payment being drawn by the factory. Subsequently, legal action had to be taken against the factory in China.
Key Takeaways:
- Commence with Test Orders: Initiate with test orders for new items rather than large quantities initially. This approach allows for the identification and resolution of potential challenges in production, certification, printing, shipping, payment stages, and local market acceptance before committing to larger orders.
- Consider Alternatives to LOC: While LOC is favored for bank guarantees, consider alternatives like Telegraphic Transfers (T/T) for new items. This approach helps to predict and mitigate losses in case the new item doesn’t perform as expected.
- Promptly take injunction: If discrepancies, such as goods being shipped without approval or mismatches in weight/dimensions described in documents, are identified, take immediate injunctive relief. Suspend payment until the discrepancies are verified, as recovering payment post-LOC honor can be both cumbersome and expensive.
- Proactive Communication in Disputes: Canceling orders after placement can be challenging and may lead to cooperation failure. In case of disagreements, proactively tackle the issues rather than evading them, fostering a constructive relationship between parties.
