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The impact of transaction fraud: strategies for the international letter of credit.

In this era of intense competition and globalization, even small and medium-sized firms are encouraged to enter foreign markets. With a foreign trade deficit of over $170 billion, it is apparent that the U.S. consumer has a tremendous appetite for imported goods. Simultaneously, more and more U.S. firms are attempting to avoid intense competition in many domestic markets by seeking lucrative foreign markets for their goods.

These import-export transactions, which are facilitated and financed through the use of the international letter of credit, play an important role in managing the foreign trade deficit.|8,18~(*) Regardless of the specific nature of the business transaction, either import or export, this form of financing is of tremendous importance to world commerce.|23~ In fact, the international letter of credit is required by the government in many countries to handle the payment side of export transactions.|21~

However, international letters of credit are not without risk and require careful management. In this article, the principles, concepts, and controversies surrounding it are explored. First, its purpose is explained. Second, three important legal issues are described. Third, significant litigation is summarized that characterizes the confusion and interpretation difficulties surrounding these legal issues. Further, the strategic implications of these issues are developed and explained as they pertain to the various parties to the letter of credit transaction: buyers (importers), sellers (exporters), and financial institutions (issuers).

The executive making the import or export decision must know how importers (buyers) can be protected from fraud in international sales contracts and how exporters (sellers) can be assured of payment on those contracts.|4,8,13,18~ The financing of international sales contracts through the international letter of credit is central to these issues.

The International Letter of Credit

The international letter of credit is issued by a financial institution (most often a bank) at the request of a buyer (importer). The bank promises to pay a specified amount of money to the named seller (exporter) upon the presentation of one or more documents stipulated in the letter of credit.|5~ These required documents are usually the commercial invoice, and an insurance policy or certificate.|2,19~

There are primarily two types of letters of credit: revocable and irrevocable. The revocable letter can be declared invalid by the buyer for a number of reasons. The irrevocable letter of credit, once issued to and accepted by the seller, is not subject to alteration of any kind without the express consent of the seller. The irrevocable letter is most commonly used and, without exception, is preferred by exporters throughout the world. With the exception of paying cash in advance, the irrevocable letter provides the exporter with the highest level of assurance that payment will be made.|12~ Therefore the irrevocable letter of credit is the subject of this article.

The international letter of credit is mainly used to expedite the international sales transaction by providing the seller/exporter with a payment guarantee. Upon receipt of an acceptable letter, the seller can process and ship the order, confident that the maker of the letter (usually a bank) will produce payment when the proper documents are presented. The seller is relieved of the necessity of trusting the buyer, and the buyer is rewarded with prompt delivery of goods. The financial institution is remitted a fee by the buyer for granting the letter of credit |2~.

The financial institution, as maker of the letter, has no direct involvement in the sales transaction and has no interest in what is actually bought or sold. When the proper documents are presented, payment is made to the seller and the bank's role ends. However, difficulties can arise when either the buyer or the seller violates one or more conditions of the sales contract |9,22~. To grasp the controversy surrounding this situation and its strategic implications, three legal principles governing letters of credit are described below: the independence principle, the strict compliance principle, and fraud in the transaction.

The Independence Principle: The international letter of credit transaction is independent of the sales transaction. The contract negotiated between the buyer (importer) and the seller (exporter) is both physically and legally separate from the international letter of credit contract established with the financial institution by the buyer.|9,16,17~ This independence principle is designed to protect the financial institution from being thrust into controversies and potential litigation that can develop from the breach of the sales contract. |7,18~ Therefore, the independence principle provides the foundation for dependability and trust that the seller requires in order to complete the sales transaction.

The Strict Compliance Principle: The execution of the letter of credit requires the seller to provide the bank (not the buyer) with certain documents. As mentioned previously, the most commonly required documents are the commercial invoice, the bill of lading, the consular invoice, and some form of proof of insurance. Under the requirements for a given letter of credit, the seller creates the legal obligation for payment simply by presenting the required documents. Therefore, the strict compliance principle means that the bank must honor a letter when the required documents are produced, i.e., when the seller strictly complies. The degree of completion or the quality of the sales contract between the buyer and seller should be of no consequence to the payor bank.|4,7,18~

Fraud in the Transaction: The independence and strict compliance principles primarily protect the right of the seller to payment under the terms of the international letter of credit, thereby eliminating the need for the seller to trust the buyer in the international transaction. However, suppose an unscrupulous seller negotiates a sales contract and intentionally ships worthless goods to the buyer. Upon presentation of the proper documents, the bank (or other issuer of the letter of credit) makes payment to the seller. This is a classic case of fraud in the transaction.|9,20,22~

According to the independence and strict compliance principles, the letter of credit was executed properly and legal action in a foreign jurisdiction appears to be the buyer's only recourse. Obviously, this is not a viable course of action for the buyer.|15~ Another course of action available to the buyer under these circumstances is provided in Section 5-114(2) of the U.S. Uniform Commercial Code that governs letters of credit:

..., an issuer (bank) acting in good faith may honor the draft (letter of credit) or demand for payment despite notification from the customer (buyer) of fraud, forgery or other defect not apparent on the face of the documents but a court of appropriate jurisdiction may enjoin such honor.

Used in this sense, "enjoin" essentially means "prevent." According to the Uniform Commercial Code of the United States, the buyer can legally prevent the issuer (bank) from honoring the explicit terms of the letter.

Note that, just as an unscrupulous seller can take advantage of the letter of credit, the unscrupulous buyer can behave similarly. In order to avoid or delay payment, the buyer can claim fraud in the transaction when, in fact, none exists. For obvious reasons, the focal point of international letter of credit litigation has been on determining the scope of "fraud in the transaction," since it creates a legal path through both the independence and strict compliance principles.|1,9,16~ Thus, the potential for differing interpretations of fraud has serious strategic implications for all parties to international transactions.

Case Examples

The difficulty with "fraud in the transaction" lies in determining the degree of fraud necessary to prevent payment under the letter of credit.|9~ A review of recent court cases in the U.S. indicates a trend toward broadening the interpretation of fraud in the transaction.|8,9,18~ If this trend continues, then all patties to the international trade transaction must re-evaluate the usefulness of the international letter of credit. Several important legal cases provide evidence of the broadening interpretation of fraud in the transaction.

Sztejn v. Schroder Banking Corporation: The most famous case on this subject is Sztejn v. Schroder Banking Corporation.|20~ Sztejn was a buyer (importer) of bristles from an Indian seller (exporter), Transea Traders, Ltd. As the buyer and as the bank's customer, Sztejn contracted for an irrevocable letter of credit with Schroder Banking Corporation. Transea Traders was the beneficiary of this letter.

In lieu of genuine merchandise, "Transea filled fifty crates with cowhair, other worthless material, and rubbish." The seller dispatched this rubbish on a steamship and, in order to meet the requirements of the letter of credit, produced documents describing the goods as bristles.

The court ruled that the attempt to draw on the letter of credit was such "egregious" or extreme fraud that proper grounds existed for denying payment and the letter of credit was not honored. However, there appears to be continuing confusion regarding transaction fraud even though the courts are quick to cite Sztejn as the legal precedent for later cases.|1,8,16,18~ This is because the boundary is not clearly drawn between the transaction fraud and the independence and strict compliance principles.|17~

Roman Ceramics Corporation v. Peoples National Bank: In this case, the buyer was Michter's Distillery, Inc.|18~ It contracted with the bank for a $65,000 irrevocable letter of credit with Roman, seller of decanters, as the beneficiary. Any unpaid decanter invoices were to be submitted with drafts on the letter. However, to comply further with the terms of the letter of credit, such an invoice was to be certified as unpaid.

Although it appeared that Roman's documents were in order, the court agreed with the bank that it need not pay this "irrevocable" letter of credit. The court enjoined or stopped payment because of the bank's notice that, contrary to the certification, the decanter invoices were previously paid. The court stated that, in order to constitute fraud in the transaction (and enjoin payment), the seller must engage in "active" fraud of this type. However, one of the judges vigorously disagreed with the majority decision by stating that there was no fraud in the transaction and by questioning its impact on banks. The dissenting judge compared the cases of Roman, Sztejn, and Intraworld Industries, Inc. v. Girard Trust Bank:|10~

In Sztejn the court enjoined honor of a draft drawn on a letter of credit because the beneficiary had intentionally failed to ship any of the goods ordered by the buyer. It is this kind of egregious fraud that the court in Intraworld pointed to in concluding that an injunction is proper only if the beneficiary has no bona fide claim to payment.

The district court was able to find fraud only after it had reviewed facts developed at an extensive trial and had answered some difficult questions of law. Although this kind of litigation is not appropriate, in my view, when the submitted documents conform on their face to the terms of the letter of credit and although the trial court defined "fraud in the transaction" too expansively, the court did have a fully developed record on which to base its judgement that the customer had committed fraud. The same is not true of the bank, and if the letter of credit is to have the desired effect, financial institutions should not be placed in the position of having to develop such a record.

The conduct of the seller here, however questionable, is not the kind of fraud that would justify the grant of an injunction against the honor of a letter of credit. In any event, because of the role letters of credit play in modern commerce, disappointed parties to the transactions underlying these letters should be compelled to resolve their disputes in a court of law. Equitable injunctions restraining banks from honoring letters of credit should be confined to narrowly limited circumstances so as to preserve the integrity and efficiency of this method of financing commercial transactions.|18~

Defining Fraud in the Transaction: In Rockwell International Systems, Inc. v. Citibank, the court ruled that "outright fraudulent practice" is the condition necessary to interrupt the payment flow under the international letter of credit.|17~ Further, in the case of Harris Corporation v. National Iranian Radio and Television and Bank Melli Iran, the court specifically sought a broad and flexible reading of transaction fraud and expressed it as "fraudulent utilization."|9~ However, in a recent California case, the court viewed fraud in the transaction in an entirely different light. In Ground-Air Transfer v. Weststates Airlines, the court was highly critical of any form of injunctive relief to prevent payment under a letter of credit. |6~

In each case, the difficulty in defining fraud in the transaction became a legal focal point. The ability to delay or even circumvent payment under a letter of credit is enhanced by broad interpretations of transaction fraud. In the future, all parties involved in international sales transactions will be influenced by this evolving characteristic of the international letter of credit. The resolution of this legal issue may also affect the balance of trade and general health of the U.S. economy. Management must therefore be attuned to the strategic implications of letter of credit litigation.

Strategic Implications

With the apparent broadening of the interpretation and application of the fraud exception to the international letter of credit, all parties to foreign trade transactions should be increasingly cautious. The issue of fraud in the transaction, as interpreted in recent court cases, undermines both the independence and strict compliance principles. Financial institutions are no longer certain that "strict compliance" with terms of the letter is sufficient to prevent litigation when the fraud exception is invoked. Similarly, the independence of the letter of credit transaction from the sales transaction is being threatened. The weakening of both principles has important strategic implications for buyers, sellers, and the financial institutions providing international letters of credit.

Predictable Outcomes of the Controversy: First, as financial institutions see themselves becoming involved in litigation over the issues of whether to honor the payment conditions for a letter of credit, more and more of them will decide to discontinue the service. Thus, international letters of credit will become harder to obtain. Second, in the attempt to avoid legal problems, the international letter of credit will become more legally detailed, increasing both time for preparation and complexity of interpretation. Third, as risk, required detail, and complexity increase, the cost of obtaining the international letter of credit will most certainly increase. Finally, as the issue of fraud in the transaction expands in legal popularity, there will be more litigation over international letters of credit. Some of the increase in fraud claims will be legitimate, resulting from uncertainties caused by recent court cases. In other situations, some buyers in international transactions may seek to use the legal confusion over the issue to delay or even escape payment to foreign sellers in legitimate transactions.

Implications for the Buyer: Since the buyer initiates and pays the cost of the international letter of credit, the buyer should be very concerned about the changes taking place. As letters become more expensive and harder to obtain, buyers will find it increasingly difficult to engage in international trade. To ensure the ability to obtain a letter of credit in a timely manner, the buyer must cultivate a strong, long-term relationship with at least one financial institution granting international letters of credit.|14~ This is critically important for the buyer with a high level of risk in foreign transactions. Without such a relationship, one lawsuit involving the buyer in a payment dispute could result in the inability to secure another letter of credit.

In their relationship with the financial institution providing the letter of credit, buyers will be expected to accept more risk. Therefore, buyers will need to be more diligent in screening sellers and avoiding fraud. This in turn will force several changes in the relationship between buyers and sellers. First, buyers should use more objective criteria to evaluate the reputation of sellers than ever before. Second, buyers will naturally tend to be more loyal to sellers with proven reputations and less likely to deal with unknown sellers. This increase in seller/supplier loyalty will then lead to a third change. Buyer sensitivity to price will almost certainly be less for the goods of those sellers with the best reputations. In effect, the price elasticity of demand will decrease for those sellers with the best reputations, since they represent the least risk in terms of letter of credit litigation.

Three final implications relative to the buyer are worth mention. First, as always, the increased cost of obtaining and using the international letter of credit must eventually be passed on to the customer in the form of higher prices. In those markets where the customer is relatively price-sensitive, the buyer in the international transaction may be forced into avoiding the letter of credit. Second, the increased direct cost of the international letter of credit could very well result in a reversal of the decision to buy foreign made goods. If the cost of the international letter exceeds the price differential between foreign and domestically produced goods (all other factors being equal), then domestic goods will be substituted for imports. Finally, the buyer in the international letter of credit transaction must, at all costs, never be accused of claiming fraud in the transaction simply to delay or escape payment. Even the accusation may be enough to make it impossible to again secure the letter of credit. In this sense, the few unscrupulous business firms that would claim fraud for these purposes force the effects of their illegal and unethical behavior on all firms engaged in international trade.

Implications for the Seller: While several of these implications are applicable to the seller as well, four additional issues merit the seller's attention. First, in transactions involving the international letter of credit, the seller should (where possible) not do business with a buyer with a reputation for being difficult to please and/or with a poor payment history. This is sound business practice under any circumstances, but is even more important in the international transaction. Second, where the increased risk of late or no payment is substantial, the seller should generally seek alternate means of payment for goods. Of course, the ability to pursue either or both of these strategies is highly dependent upon the seller's competitive position. The hungry seller is apt to dictate few terms.

A third issue of interest to sellers concerns the general impact of the broadening fraud exception on the overall size of a given market. In the near future, foreign sellers may find their markets shrinking in the United States due to the higher cost of (and difficulty in obtaining) the international letter of credit. These conditions at the very least force a change in marketing strategy for the foreign seller. Since the impact of the fraud exception is likely to vary unevenly in a given market, sellers may be able to benefit from implementing the techniques of market segmentation. Specifically, it may be possible to identify portions of the overall market that are less affected by the fraud exception. Through the application of market segmentation and target marketing, a generally shrinking overall market could be replaced with one or more "target markets" that either do not rely on the international letter of credit or represent a very low risk in terms of payment disputes.

This leads to a fourth and final implication for the seller. If the issues of strict compliance, independence, and transaction fraud remain problematic with certain countries but not to others, the seller should alter the marketing strategy geographically. That is, the seller should attempt to shift market share from those countries with international letter of credit problems to those countries where the strict compliance and independence principles are deemed more important than the fraud exception.

Conclusion

With the exception of paying cash in advance for goods, the international letter of credit provides the greatest assurance to both parties in an international exchange that the sales contract will be successfully completed. Further, the importance of the international letter of credit is likely to increase dramatically in the future due to rapid growth in world trade. The European Community, the unification of Germany, and the breakup of the USSR all point to increasing opportunities for international trade. Yet, transaction fraud can undermine the power and value of the letter of credit by weakening both the independence and strict compliance principles. Should the international letter of credit be used or avoided?

The astute manager will heed the strategic implications described in this article. If the trend in litigation continues, international letters will dramatically increase in cost, and fewer financial institutions will provide them. At the same time, the formal structure of the letter will increase in detail and complexity, and it will take much more time to prepare them. In order to minimize the risk of using the letter of credit, the buyer in an international transaction should remember the following points:

1. Cultivate a strong, long-term relationship with at least one financial institution granting letters of credit.

2. Use objective criteria to evaluate the reputation of foreign sellers.

3. Be loyal to foreign suppliers with proven reputations.

4. Especially when dealing with "unknown" foreign suppliers, carefully weigh the cost differential between buying domestic and foreign-made goods.

5. If at all possible, avoid becoming involved in any form of litigation in a foreign jurisdiction.

The second, third, and fifth items in the above list apply equally well to the seller in an international transaction (just substitute "buyer" for seller or supplier). Additional items for the seller to remember include:

1. Avoid buyers with a reputation for being difficult to please.

2. Avoid buyers with an unknown or poor payment history.

3. Require an alternate payment method when the risk of using the international letter is considered too high.

4. Avoid foreign markets in which recent litigation unduly favors domestic buyers over foreign sellers.

The international letter of credit will continue to be the most important method of financing international trade between individual buyers and sellers if, with objectivity and diligence, the parties to the international transaction can avoid the problems associated with the fraud exception.

* In addition to numerous court cases referenced in this article, many of the fundamental issues, principles, and concepts of letters of credit are presented in these sources: Harfield, H. (1974), "Bank Credits and Acceptances", 5th ed., New York: John Wiley and Sons; Note (1980), "Fraud in the Transaction: Enjoining Letters of Credit During the Iranian Revolution," Harvard Law Review, 93 No. 5, 992-1015; Harfield, H. (1978), Enjoining Letter of Credit Transactions," Banking Law Journal, 95 No. 7, 596-615; Uniform Commercial Code (1981), Article 5; Blodgett, Mark S. (1991), "Letters of Credit: Teaching An Integral Part of the International Component, Journal of Legal Studies Education, 9 No. 2, 369-378.

References

1. Blodgett, Mark S. (1991), "Letters of Credit: Teaching an Integral Part of the International Component," Journal of Legal Studies Education, 9 No. 2, 369-378.

2. Cateora, Philip R. (1987), International Marketing, 6th ed., Homewood, IL: Richard D. Irwin, Inc.

3. Czinkota, Michael R. and Ilkka A. Ronkainen (1988), International Marketing, Chicago, IL: The Dryden Press.

4. Dynamics Corporation of America v. The Citizens and Southern Bank (1973), 356 F. Supp. 991 (N.D.Ga.).

5. Eiteman, David K. and Arthur I. Stonehill (1984), International Business Finance, Reading, MA: Addison-Welsey Publishing.

6. Ground Air Transfer v. Weststates Airlines (1990), 889 F. 2d 1269 (1st Cir.).

7. Harfield, H. (1974), Bank Credits and Acceptances, 5th ed., New York: John Wiley and Sons.

8. Harfield, H. (1978), Enjoining Letter of Credit Transactions," Banking Law Journal, 95 No. 7, 596-615.

9. Harris Corporation v. National Iranian Radio and Television and Bank Melli Iran (1982), 691 F. 2d 1344 (11th Cir.).

10. Intraworld Industries v. Girard Trust Bank (1975), 336 A.2d 316 (Pa. Sup. Ct.).

11. ITEK (Corporation v. First National Bank of Boston (1984), 566 F. Supp. 1210 (D. Mass. 1983), Aff'd. 730 F. 2d 19 (1st Cir.).

12. Jain, Subhash C. (1987), International Marketing Management, 2nd ed., Boston: PWS-Kent Publishing Company.

13. Larson v. First Interstate Bank of Arizona (1983), 603 F. Supp. 467, 470 (D. Ariz.).

14. Maulella, Vincent M. (1989), "Uncorking the Letter of Credit for Quicker Export Collections," Corporate Cash Flow, 18 (February 2), 42-45.

15. Meyerowitz, Steven A. (1988), "Selling Abroad: Making Sure You Get Paid," Business Marketing, February, 68-76.

16. Note, (1980) "Fraud in the Transaction:...Revolution," Harvard Law Review, 93 No. 5, 992-1015.

17. Rockwell International System Inc. v. Citibank (1983), 719 F. 2d 583, 589 (2nd Cir.).

18. Roman Ceramics Corp. v. Peoples National Bank (1983), 517 F. Supp. 526 (M.D. Penn. 1981), Aff'd. 714 F. 2d 1207, 1218-19.

19. Rowe, Michael (1987), "Letters of Credit: How to Use Them In Your International Business Transactions," International Trade Forum, 23 (January/March 1), 4-7, 23-25.

20. Szetjn v. Henry Schroder Banking Corp. (1941), 177 Misc. 719, 31 N.Y. Supp. 2d 631, 633 (Sup. Ct. N.Y. Cty.).

21. Thornhill, William T. (1989), "How to Keep the Risks in Letters of Credit Under Control," Commercial Lending Review, 4 (Summer 3), 40-56.

22. Uniform Commercial Code (1981), Article 5.

23. Whitman, D. (1987), "International Law Coverage in Business Law Texts: Survey and Analysis," Journal of Legal Studies Education, 6 No. 1, 41-51.

Mark S. Blodgett is an Assistant Professor of Legal Studies at Georgia Southern University; Jerry W. Wilson is an Assistant Professor in the Marketing Department at Georgia Southern University, Statesboro, Georgia.
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Author:Blodgett, Mark S.; Wilson, Jerry W.
Publication:Review of Business
Date:Mar 22, 1993
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