Letters of credit (LoCs) are established on the basis of commercial policy and efficiency

concerns, which require banks to promptly honour the instrument. Banking institutions serve
a crucial role in facilitating payment transactions between parties involved in transactions of
significant monetary value, as these transactions are based on documentation and involve
substantial amounts of money.1 In the event of a delay in payment by a bank, there is a
potential risk to the reputation of the country. Additionally, such delays may contribute to a
rise in occurrences of international commercial fraud. 2 Such frauds are carried out through
the implementation of fraudulent practices in collaboration with financial institutions or
maritime service providers.3 The exponential expansion of this phenomenon poses a
significant risk to the economic stability of a nation. Nevertheless, the extent of government
intervention and control in this domain remains highly constrained.4

RESEARCH QUESTION

In this research paper, the researcher will endeavour to address the subsequent questions.

What is the meaning of a letter of credit?

How does Letter of Credit works?

What are the benefits and drawbacks of using a letter of credit?

What are the laws governing the LoC in India

RESEARCH METHODOLOGY

1
Susmitha P Mallaya, “Documentary Credit and Money Laundering: An Overview”, 48 Chartered Secretary 72
(2018).
2
H. Rayan and Charlers W.Mooney, Letters of Credit Supporting Debt Instruments (Practicing Law Institute,
U.S.1986)
3
Van Houtee, H, The Law of International Trade, (Sweet & Maxwell, London, 2002)
4
Susmitha P Mallaya, “Documentary Credits in International Trade Law”, 33 Cochin University Law Review 20
(2009)
 The methodology employed in this study is the doctrinal approach. No surveys were
conducted in the course of this study; rather, data was acquired from primary sources,
including acts and laws, as well as secondary sources, such as journals, books, and blogs. It
is imperative to note that the knowledge is derived from sources that are both reliable and
adhere to legal standards.

HYPOTHESIS

The advantages of a letter of credit plainly outweigh the disadvantages. Due to the
complexities of international trade, it has been difficult to establish a single unified law on
documentary credits despite the existence of numerous foreign regulations.

HOW DOES LETTER OF CREDIT WORKS?

PARTIES INVOLVED IN LETTERS OF CREDIT

“Documentary credit transactions are fundamentally predicated on a sequence of transactions

encompassing four distinct parties, each of whom maintains independent contractual
relationships.

Parties Involved

The bank which

The bank issuing the
Buyer (applicant for Seller (the beneficiary makes payment (the
credit (the issuing
the credit) under the credit) intermediary bank or
bank)
paying bank)

The distinctive characteristic of this instrument is in the fact that banks execute payment to
the seller solely on the basis of the papers submitted to them by the party specified in the
credit. The financial institution responsible for issuing letters of credit, is obligated to fulfil
payment to the involved parties, regardless of any factual discrepancies that may be presented
by the parties involved in the underlying sale transaction 5. Given that the banker does not
possess a direct involvement in the fundamental contractual agreement between the parties
involved in the sale of commodities, it is not incumbent upon the banks to verify the factual
veracity of the documents submitted to them by the seller 6.They are bound to check only the
veracity of the documents mentioned in the credit instrument.7

DOCTRINE OF TRUST VIZ-A-VIZ FRAUD

Trust serves as the fundamental pillar underpinning all transactions within the realm of
commerce, encompassing banking institutions. It serves as the adhesive that fosters
intercorporate alliances.8 Trust is essential for corporate survival9.Fraud, being a longstanding
and widely recognized occurrence within the realm of commerce, is an indisputable verity. 10

The banker-customer relationship is characterized by the emergence of trust and confidence

when the banker acquires confidential information under specific circumstances. 11 The
concept of letters of credit operates under the principle of autonomy. 12 This principle places
an obligation on the banker to fulfil their duty of honouring the documents presented in
accordance with the credit, regardless of any sales agreement between the involved parties.
The presence of exclusivity, however, presents an avenue for unscrupulous individuals to
engage in transactions that lead to the perpetration of financial fraud. Fraud, as an
exceptional circumstance, has been duly acknowledged within the context of the
fundamental principle of autonomy in letters of credit transactions. In accordance with this
principle, banks retain the prerogative to withhold payment to involved parties upon
discovering the presence of falsified documentation. However, a mere suspicion is not
enough to deny payment based on fraud claims. The burden of proof must exceed
reasonable doubt to support such a claim.13”

5
Jacqueline D Lipton, “Documentary Credit Law and Practice in the Global Information Age”, 22 Fordham Int’l
L J 1972 (1999).
6
Richard Schaffer et.al., International Business Law and its Environment, (West Educational Publishing Co.,
U.S.A. 1999)
7
Supra Note 4
8
Catty Gunn, “Financial Fraud”, Banking World 21 (1984).
9
Lawrence E Mitchell, “Fairness and trust in Corporate Law”, (1993)
10
Supra note 9
11
Susmitha P Mallaya, “Banker’s duty of Confidentiality : Modern Trends”, 28 Cochin University Law Review
12
Uniform Customs and Practice of Documentary Credits (UCP 500), art.3 (a). The principle of autonomy is
codified under this provision.
13
Gian Singh Ltd. v. Banque de I’Indochine [1974] 2 All E.R.754.
In both common law and codified merchant practice, courts have universally recognized the
need for incontrovertible evidence of fraud and the bank's awareness of it before declining
payment.14

FRAUD AND LETTERS OF CREDIT

The “definition of the term 'fraud' may be determined from diverse judicial constructions of
both common law principles and equity principles which was subsequently acknowledged in
India through the enactment of the Contract Act.15 The term ‘fraud’ was given a meaning of
dishonesty or deceit in Beauman v. A.R.T.S. Ltd..16

The aforementioned definition of fraud shall possess limited utility in the context of a letter
of credit, for it is imperative to acknowledge that within such transactions, acts of fraud may
be perpetrated by both the buyer and the seller, employing both documentation and tangible
goods as instruments thereof. While it is indeed possible to establish fraud in relation to
documents, proving fraud in relation to goods can present significant challenges.17

It is evident that the judiciary, in its general disposition, has adopted a restrictive
interpretation of the term “fraud”. The courts have only acknowledged the existence of
fraud in cases involving egregious behaviour on the part of the parties, causing a profound
perturbation in the judicial conscience. The justification for this restrictive interpretation is
that a broader rule would undermine the inherent certainty of letter of credit transactions.

WIDER INTERPRETATION OF FRAUD

There are two wider interpretation of term fraud. One can be characterized as a violation of
the standard contractual agreement, while the other can be classified as an intentional act
of fraudulent.18

The customer's right to seek an injunction against payment is contingent upon demonstrating
a breach of contract that aligns with the established standards of the underlying contractual

14
Himadri Chemicals Industries Limited v. Coal Tar Refining Co (2007) 8 SCC 110.
15
s.17., The Indian Contract Act, 1872 (Act 9 of 1872)
16
[1949]1 KB 550
17
Ross Cranston, Principles of Banking Law (Oxford University Press, New York, 2002)
18
Michael Stern, “The Independence Rule in Standby Letters of Credit”, 52 University of Chicago Law Review
218 (1985)
agreement.19 The intentional fraud standard adheres to the traditional "egregious fraud"
criterion, as evident from the observation. It is imperative to ensure that a beneficiary, who
submits valid documentation in support of a letter of credit, is withheld from receiving
payment solely in cases where their own misconduct has directly contributed to the
generation of said documents.20”

However,“courts insist on a limited definition and are unwilling to expand it. In Roman
Ceramics Corporation v. Peoples National Bank21, for instance, the district court enjoined
payment after concluding that the beneficiary was aware that the invoices covered by the
letter of credit had been paid. However, the issuing bank attempted to obtain payment by
falsifying this fact. While implementing the definitions of fraud in the transaction, the court
noted that the circumstances that justify the injunction are limited to the beneficiary's
fraud.22 Hence, in foreign country's egregious fraud has traditionally been observed in letter
of credit transactions..”

MAJOR ELEMENTS OF FRAUD RULE23

Major Elements of Fraud Rule

Fraud is the only reason to discontinue letter of credit payments; breach of

warranty is not.

Fraud must be demonstrated to stop letter of credit payments.

Payment must be provided per credit terms, even if fraud is established, if a holder
in due course or a presenter with similar status makes demand for payment

19
Harv. L. Rev ,“Fraud in the Transaction Enjoining Letter of Credit during the Iranian Revolution”, 992 (1980).
20
Stephen H.Van Houten, “Letters of Credit and Fraud: A Revisionist View”, 62 Canadian Bar Review 371
(1984).
21
Roman Ceramics Corp. v. Peoples Nat. Bank, 517 F. Supp. 526 (M.D. Pa. 1981)
22
Mark S. Blodgett and Donald O Mayer, “International Letters of Credit: Arbitral Alternatives to Litigating
Fraud”, American Business Law Journal 443 (1998).
23
Ross P. Buckley & Xiang Gao, “The development of the fraud rule in Letter of Credit Law: The Journey so far
and the road ahead”
 INDIAN LEGISLATURE ON LETTERS OF CREDIT

In the Indian context, it is noteworthy to mention that there exists no distinct legislation that
directly governs transactions involving letters of credit. Generally, they are based on law
governing contract and the banks are not regulated by any policy decisions by the
government. In India, banks adhere to the Universal Customary Practices (UCP), a widely
recognized soft law that is universally accepted.24 The Reserve Bank of India, in its capacity
to regulate credit transactions, provides instructions in accordance with this practice. A
significant portion of the instructions align with the practice advocated by the International
Chamber of Commerce, specifically the principles of Universal Customary Practices. The
banking system harbours immense potential for perpetrating substantial fraudulent
activities, primarily through the discounting of letters of credit bills and manipulation of
accounting systems. This observation highlights the dearth of effective oversight in the realm
of banking-associated financial fraud.25

Regarding the judiciary in India, there was a lack of implementation of any innovative
measures in this aspect. The authorities exhibit a degree of caution when it comes to
intervening in matters pertaining to letters of credit, preferring to adhere to the prevailing
principles observed in foreign jurisdictions, particularly those rooted in common law
traditions. Perhaps their intention is to exercise restraint in intervening in commercial
disputes related to letters of credit, taking into account the economic value of this instrument
and the involvement of banking institutions in these transactions. 26 However, the judiciary has
acknowledged that these principles should not be regarded as inviolable. Consequently, when
adjudicating cases pertaining to letters of credit, they have acknowledged fraud as a notable
exemption to the principle of autonomy of the letters of credit, drawing inspiration from
English legal precedents.27

In instances where there exists a significant disagreement between the involved parties and
a prima facie indication of fraudulent activity is evident, the courts intervene, albeit
adhering strictly to the established English precedents. 28 In the Indian legal system, it is

24
State Trading Corporation of India Ltd. v. Jainsons Clothing Corporation (1994) 6 SCC 597.
25
Susmitha P Mallaya, “An Appraisal of Fraud Rule Exception in Documentary Credit Law with special
Emphasis on India”, KULR 83 (2016).
26
United Commercial Bank v. Bank of India (1981) 2 SCC 766.
27
Hindustan Steelworks Construction Ltd. v. Tarapore & Co. (1996) 5 SCC 34.
28
U.P. Co-op Federation Ltd v. Singh Consultants and Engineers (P) Ltd. (1988) 1 SCC 34.
 imperative to provide concrete evidence of fraudulent activities, as a mere accusation of
fraud does not meet the threshold required to invoke the fraud exception.29

Furthermore, it is within the purview of the courts to consider the inclusion of any
supplementary justifications within the framework of the fraud exception. 30 In the case of
BSES Ltd. v. Fenner India Ltd31., it is noted that the court chose not to accept the assertion
that the presence of "lack of good faith" or "enforcing with an oblique purpose" should be
considered as additional grounds to establish the exception to the fraud rule. Therefore, it is
incumbent upon this court to meticulously scrutinize each case presented before it, with the
sole purpose of determining whether said case can be classified under any of the categories
pertaining to the rule of fraud.

It becomes apparent that a significant obstacle encountered within the Indian context
pertains to the challenging task of substantiating concrete evidence of fraudulent activities
in documentary credit transactions32. The court may adopt a rigid approach in deciding cases
pertaining to matters concerning documentary credit.

SUGGESTION

 According to“the American Institute of Certified Public Accountants (AICPA), the

implementation of a robust anti-fraud policy is imperative, encompassing four key
components: prevention, detection, deterrence, and response. In line with this perspective, it
is worth considering the adoption of analogous measures in India, leveraging the expertise
of esteemed institutions such as the Institute of Chartered Accountants and the Institute of
Cost and Works Accountants of India.
 It is imperative to implement a robust regulatory framework that specifically targets the
prevalent issue of fraudulent activities pertaining to documentary credit within the banking
sector. The current situation can be predicated upon robust governmental policy measures in
the interim.

29
General Electric Technical Services Company Inc. v. Punj Sons (P) Ltd., AIR 1991 SC 1994.
30
I.T.C. Limited v. Debts Recovery Appellate Tribunal (1998) 2 SCC 70.
31
A.I.R. 2006 SC1148.
32
Ram Chandra Singh v. Savitri Devi (2003) 8 SCC 319
 In addition, it is imperative to facilitate the arrangement of diverse workshops and
specialized training initiatives for both bank employees and customers who depend on this
instrument for their commercial transactions.
 The promotion of the digital iteration of this instrument should be accompanied by robust
cyber security measures. At the international level, the international communities have
established a novel legal framework pertaining to the utilization of electronic transport
documents. The primary objective of this framework is to foster the advancement of
electronic methods for asserting the transferability of rights and liabilities.33”

CONCLUSION

In“the realm of international trade, while documentary credit may be deemed the most
dependable financial instrument, its credibility within the business community may diminish
if fraudulent transactions remain unregulated. The economic advantages of fair use extend to
the overall national economy, with a particular emphasis on the banking sector. However, the
law governing documentary credit, especially, fraud rule is a very confusing area.

The presence of soft law regulations in this domain provides an avenue for unscrupulous
individuals to engage in fraudulent endeavours. From a governmental standpoint, there exists
a deficiency in adequate regulation and efficient policy-making to tackle these concerns and
protect the interests of both financial institutions and consumers. The cautiousness exhibited
by Indian courts in invoking the fraud rule in documentary credit transactions can be
attributed to the sensitivity of this document in the area of financing both national and
international trade.

However, in the absence of a proactive role, there will be an escalation in the prevalence of
fraudulent transactions within this domain. Hence, it is imperative for the judiciary to
implement suitable measures aimed at mitigating the adverse impact of documentary credit
fraud, while simultaneously preserving the trustworthiness of traders engaging in commercial
transactions through this instrument, until such time that a comprehensive legislative
framework is established in India.”

33
Caslav Pejovic, “Documents of title in Carriage of goods by Sea: Present Status and Possible future
directions”, [2001] Journal of Business Law 461.