The fraud rule in letters of credit according to Sztejn (small business opportunities)
By Nicolai Nielsen
Stejn is the landmark case in American law dealing with fraud in letter of credit transactions. It was so important that the court’s findings became codified in the Uniform Commercial Code (UCC), but throughout the common law jurisdiction Sztejn has been praised and followed.
Sztejn had bought bristles from an Indian company named Transea Traders, Ltd. To effectuate payment to the seller Transea, Sztejn opened a letter of credit with Schroder. The beneficiary presented the required documents and drew a draft to the order of Chartered Bank, which presented the draft to Schroder requesting payment. However, instead of shipping the contractually agreed upon goods, Transea had filled 50 crates with rubbish. Plaintiff, Sztejn filed a suit for judgment asking the court to declare the letter and draft thereunder void and furthermore asked the court to enjoin the issuing bank, Schroder, from accepting the draft.
The court assumed that the plaintiff’s allegations were true, namely that Transea was engaged in a scheme to defraud the plaintiff and that Chartered Bank was not an innocent holder of the draft. Particularly taking into consideration that Sztejn would be defrauded if Schroder paid Chartered Bank under the draft, the court ruled in Sztejn’s favor.
One important aspect of the decision is the position of Chartered bank. Justice Shientag showed little mercy for Chartered Bank, ruling “where the draft and the accompanying documents are in the hands of one who stands in the same position as the fraudulent seller” no hardship will be caused when enjoining the issuing bank from payment.
The posture of the presenting bank led justice Shientag to a further comment:
“If it had appeared from the face of the complaint, that the bank presenting the draft for payment was a holder in due course, its claim against the bank issuing the letter of credit would not be defeated even though the primary transaction was tainted with fraud.”
In this regard justice Shientag followed established law regarding the treatment of holders in due course of negotiable instruments.
Sztejn established the determining factors of the fraud rule in letter of credit transactions. Cognizant of the fact that the independence principle is one of the tenets of letter of credit transactions, the independence principle will only be disregarded in the case of fraud. Mere allegations of fraud however are not enough to obtain an injunction. Rather, the fraud needs to be proven. A payee under a draft, who is a holder in due course, will receive payment, regardless of the fraud committed by the drawer.
A holder in due course does not exist with sight payment or deferred payment letters of credit.
Sztejn remains a seminal decision whose echo can still be felt in Article 5 of the UCC.
