Opinion ID: 1625318
Heading Depth: 1
Heading Rank: 11

Heading: fraud in the transaction

Text: The primary issue in this case is the interpretation of fraud in the transaction in R.S. 10:5-114. Under that provision, the issuing banks must honor EAB's drafts unless the documents presented by EAB were ... forged or fraudulent or there is fraud in the transaction. R.S. 10:5-114(2). The plaintiffs do not dispute the validity of the documents submitted by EAB. Therefore, the only issue is whether there was fraud in the transaction. If such fraud is found to exist, a court is empowered, under R.S. 10:5-114(2)(b), to enjoin the issuing banks from honoring drafts under the credit. There is more than one transaction involved when letters of credit are issued. The first is the contract between the customer and the issuing bank, present in all cases; the conventional case involves a sale and delivery of goods; the standby case involves a contract or performance, or a loan by the beneficiary bank to a borrower, secured by the customer's letter of credit. If the credit secures a loan by the beneficiary bank, that loan is the underlying transaction. The plaintiffs maintain that transaction should be interpreted in its broadest sense. It is their position that by not qualifying transaction, the drafters intended it to be given a very general and expansive interpretation. More specifically, they claim that if a fraud is practiced that would ultimately cause a loss to the customer, injunction will lie against honor regardless of who perpetrated the fraud. Furthermore, they contend that transaction must be understood to include the underlying transaction between the limited partners and C.I., Ltd. Plaintiffs maintain that by not giving transaction a general meaning, lending banks would be permitted to launder fraud, thereby damaging the integrity of the judicial system. The intervenors advocate a restrictive interpretation of transaction. They claim that an injunction may be properly issued only when fraudulent documents are issued, or when the beneficiary commits active fraud against the investors who obtained the letters of credit. The U.C.C. was adopted in Louisiana in an effort to harmonize the commercial law of Louisiana with that of the other states. [4] We should, therefore, examine the jurisprudence of other states interpreting R.S. 10:5-114(2). [5] The most frequently cited case on the fraud in the transaction exception in U.C.C. 5-114(2) is Sztejn v. Henry Schroder Banking Corp., 177 Misc. 719, 31 N.Y. S.2d 631 (Supr.Ct.N.Y.1941). Although Sztejn arose before the drafting of the U.C.C., most commentators and courts agree that Sztejn was the impetus for the fraud exception. Sztejn involved a commercial letter of credit issued by J. Henry Schroder Banking Corporation in favor of Transea, an Indian corporation which sold bristles. The New York plaintiff, Sztejn, and his co-adventurer, Schwartz, had contracted to purchase bristles from Transea. They obtained a letter of credit from Schroder Banking Corporation in order to pay for the bristles. The letter of credit provided that Transea could draw on it upon presentment of an invoice and a bill of lading. After placing fifty cases on a ship bound for the United States, Transea presented a bill of lading and an invoice to the Chartered Bank of India, a correspondent bank of J. Henry Schroder Banking Corporation. The documents represented that fifty crates of bristles had been shipped, but in fact the crates contained cow hair and rubbish, according to the plaintiff's petition. Plaintiff sued to enjoin the Chartered Bank of India from honoring Transea's drafts. The defendant, Chartered Bank of India, filed a motion to dismiss for failure to state a cause of action. Accepting the plaintiff's allegations as true, the New York court denied the motion to dismiss. The court concluded that J. Henry Schroder Banking Corporation had received notice of an active fraud by Transea before presentment of the draft for payment. The court reasoned that: In such a situation, where the seller's fraud has been called to the bank's attention before the drafts and documents have been presented for payment, the principle of the independence of the bank's obligation under the letter of credit should not be extended to protect the unscrupulous seller. 31 N.Y.S.2d at 634. In spite of its decision in favor of the plaintiff, the court was careful to leave the independence principle intact: It is well established that a letter of credit is independent of the primary contract of sale between the buyer and the seller. The issuing bank agrees to pay upon presentation of documents, not goods. This rule is necessary to preserve the efficiency of the letter of credit as an instrument for the financing of trade. One of the chief purposes of the letter of credit is to furnish the seller with a ready means of obtaining prompt payment for his merchandise. It would be a most unfortunate interference with business transactions if a bank before honoring drafts drawn upon it was obliged or even allowed to go behind the documents, at the request of the buyer and enter into controversies between the buyer and the seller regarding the quality of the merchandise shipped. If the buyer and the seller intended the bank to do this they could have so provided in the letter of credit itself, and in the absence of such a provision, the court will not demand or even permit the bank to delay paying drafts which are proper in form.... Of course, the application of this doctrine presupposes that the documents accompanying the draft are genuine and conform in terms to the requirements of the letter of credit.... (Citations omitted). 31 N.Y.S.2d at 633-34. The Sztejn court, in determining whether the customer could stop the issuing bank from honoring the draft, determined that the underlying transaction was fraudulent and that the Chartered Bank (presenting the draft for payment on behalf of Transea) was in no better position than the fraudulent Transea. Sztejn was a commercial letter of credit case which involved active fraud on the part of the beneficiary. The bank (Chartered) that presented the draft for payment was merely the correspondent for the issuing bank, not a holder in due course, but an agent of the seller-beneficiary charged with fraud. The court refused to allow a sellerbeneficiary to profit from its own fraudulent conduct. The Sztejn holding was applied to standby letters of credit in Shaffer v. Brooklyn Park Garden Apartments, 311 Minn. 452, 250 N.W.2d 172 (Minn.1977). In Shaffer, two purchasers of units in a limited partnership had letters of credit issued in favor of the limited partnership as part of their capital contribution. The letters of credit provided they could be drawn on only after presentment of a promissory note and a certification by the partnership that the investors had failed to meet payment of authorized loans which are payable. 250 N.W.2d at 175. The letters of credit were subsequently transferred to Wayzata Bank & Trust Company as security for loans to the partnership. The partnership experienced financial difficulty and Wayzata Bank & Trust Company attempted to draw on the letters of credit. In compliance with the letters of credit, Wayzata presented notes and certifications by the partnership that the investors had failed to meet payment of authorized loans which are payable. The investors sued to enjoin Wayzata from drawing on the letters of credit, claiming that the certifications were false. The court found that an injunction was proper because plaintiffs sought the injunction on the basis of fraud in the documentation. The court reasoned that: ... [W]here injunctive relief is sought, the fraud alleged must be in respect to the documents presented and not as to the underlying transaction. The allegations of fraud made by [the plaintiff-investors] is appropriate for injunctive relief since it concerns the certifications by [the partnership] presented by Wayzata. 250 N.W.2d at 180. Another standby letter of credit situation was faced in O'Grady v. First Union National Bank, 296 N.C. 212, 250 S.E.2d 587 (1978). In that case, the attachment of a letter of credit to a note it purported to secure, but which had been substituted for the original note and which omitted the signature of one endorser was interpreted by the court as a case involving fraudulent documentation which would give rise to injunctive relief. Plaintiffs before us interpret the case as involving fraud in the underlying transaction. In Colorado National Bank of Denver v. Board of County Commissioners of Routt County, 634 P.2d 32 (Colo.1981), Routt County sued to enforce a standby letter of credit issued in its favor by a land developer, apparently as security for the developer's promise to build certain roads in a proposed subdivision in the mountains. The development was apparently abandoned, and the land remained raw, undeveloped mountain property for which there was no market and for which the county had no plans to improve. The issuing banks refused to honor the drafts and the county sued the banks. The banks resisted by claiming that the county's recovery would constitute a windfall. They alleged that such a windfall recovery fell within the fraud in the transaction exception. The Colorado Supreme Court upheld the county's right to collect under the letters of credit, rejecting the bank's fraud claim. The court relied on the independence principle and refused to allow the issuing bank to litigate the performance of the underlying contract. According to the court: The Bank cannot litigate the performance of the underlying performance contracts. `[P]erformance of the underlying contract is irrelevant to the Bank's obligations under the letter of credit.' ... Likewise, the question of whether the beneficiary of the letter of credit has suffered any damage by the failure of the bank's customer to perform as agreed is of no concern.... Further, a bank cannot challenge the utilization of funds paid under a letter of credit.... (Citations omitted) . . . . . Fundamentally, `fraud in the transaction,' as referred to in section 4-5-114(2), must stem from conduct by the beneficiary of the letter of credit as against the customer of the bank. See generally White and Summers, Uniform Commercial Code & sect; 18-6 (2d ed. 1980). It must be of such an egregious nature as to vitiate the entire underlying transaction so that the legitimate purposes of the independence of the bank's obligation would no longer be served. Intraworld Industries, Inc. v. Girard Trust Co., supra; New York Life Insurance Co. v. Hartford National Bank & Trust Co., 173 Conn. 492, 378 A.2d 562 (1977); Sztejn v. Henry Schroder Banking Corp., supra; Werner v. A.L. Grootemaat & Sons, Inc. [80 Wis.2d 513, 259 N.W.2d 310 (1977)] supra. `[I]t is generally thought to include an element of intentional misrepresentation in order to profit from another....' West Virginia Housing Development Fund v. Sroka [415 F.Supp. 1107 (1976)], supra. This fraud is manifested in the documents themselves, and the statements therein, presented under the letter of credit. Dynamics Corporation of America v. Citizens & Southern National Bank [356 F.Supp. 991 (1973)], supra; Shaffer v. Brooklyn Park Garden Apartments, 311 Minn. 452, 250 N.W.2d 172 (1977).... 634 P.2d at 39-40. The Colorado Supreme Court noted that the issuing bank did not even argue that there was fraud in the transaction between the developer (customer) and the county (beneficiary) and agreed with the trial court's decision to exclude all evidence beyond the four corners of the letters of credit, the demands thereunder, and the Bank's replies. 634 P.2d at 40. Finally, in Cappaert Enterprises v. Citizens and Southern International Bank of New Orleans, 486 F.Supp. 819 (E.D.La. 1980), plaintiff, Cappaert Enterprises, sued to enjoin a Kuwait bank from collecting under a letter of credit which was issued to secure a loan. The letter of credit was obtained by a joint venture comprised of Cappaert and United Fisheries of Kuwait. A dispute developed between Cappaert and United concerning performance of the joint venture agreement. Cappaert sued to enjoin the Kuwait bank from drawing on the letter of credit, claiming that United had committed a fraud against it. The district court concluded that Cappaert's claim of fraud in the transaction was without merit. The court relied heavily on the principle of independence between the letter of credit and the underlying transaction. According to the court: The accuracy of Cappaert's allegation that United Fisheries acted fraudulently in its role as a joint venturer is immaterial to the resolution of this issue, for impropriety in the underlying agreement is irrelevant to an interpretation of the letter of credit.... 486 F.Supp. at 826. As illustrated in the foregoing cases the independence principle is a strong influence in the decision of cases throughout the country. Adherence to that basic principle is necessary in order to protect the commercial utility of letters of credit. Nevertheless, the jurisprudence and literature recognize and illustrate the need to extend the meaning of fraud in the transaction at least a step beyond fraudulent documentation. The strongest reason for such an extended interpretation is to deny rewarding fraudulent conduct by letter of credit beneficiaries. One author writes: Notwithstanding dictum to the contrary in some of the cases, the holding of the court in NMC Enterprises, Inc. v. Columbia Broadcasting System, Inc . that fraud in the underlying transaction is sufficient to justify relief is the better rule. Since the issuer's obligation on a letter of credit is generally completely independent of the underlying transaction, the customer who obtains a letter of credit assumes the risk that payment may be made when the beneficiary has not properly performed the underlying contract. Moreover, the beneficiary may have required the letter of credit in part to assure that a dispute regarding performance of the underlying contract would not delay payment. By obtaining a letter of credit, however, the customer should not be required to assume the risk of making payment to a beneficiary who has engaged in fraudulent conduct in the underlying transaction. Furthermore, a rule that precludes injunctive relief where the fraud is in the underlying transaction will compensate the beneficiary for wrongful acts in situations where the customer will not have an effective legal remedy for the fraudulent conduct and thus tend to encourage fraud, a policy that should be avoided. As the court said in Dynamics Corp. of America v. Citizens & Southern Nat. Bank, there is as much public interest in discouraging fraud as in encouraging the use of letters of credit. While fraud in the underlying transaction should be sufficient to justify injunctive relief, mere failure to properly perform the underlying contract does not constitute fraud .... (Emphasis added). Hawkland & Holland, UCC Series § 5-114.09 (Art 5). In the case before us, the underlying transaction is the loan transaction between EAB and C.I., Ltd. If the beneficiary EAB was guilty of fraud with respect to the plaintiffs (investors/customers), it should not be permitted to profit from that fraud. If the banks want an instrument which will be paid without question upon demand, with no recourse by parties upon whom responsibility lies, other means are available. Our holding is consistent with the cases cited by the parties as well as those found by our research. In all of the cases where letters of credit have been enjoined, the courts have found that either the documents were defective or the beneficiary was guilty of fraud. [6] For example, in Sztejn, the customer sought to enjoin the payment of a draft, presented by the agent of the fraudulent beneficiary, at a time after the issuing bank had notice of the fraudulent shipment by the beneficiary. Under the foregoing interpretation of fraud in the transaction, it must now be decided whether such fraud occurred in this case. In accordance with our interpretation of R.S. 10:5-114(2), our analysis will be limited to the loan transaction and the conduct and knowledge of the beneficiary, EAB. There is more than one measure of fraud in the various jurisdictions in the United States. Cases and writers have called Sztejn an example of egregious fraud, and some have required egregious fraud in the transaction before according relief to the customer. ( KMW International v. Chase Manhattan Bank, 27 UCC Rep 203, 606 F.2d 10 (CA2 1979); Colorado National Bank of Denver v. Board of County Commissioners of Routt County, supra). Cases and authorities have distinguished egregious fraud from intentional fraud, and have advocated intentional fraud as the better standard to afford injunctive relief to the customer. Hawkland & Holland UCC Series § 5-114:09 (Art 5). Civil Code provisions defining fraud and the rights of the fraud victim establish standards for commercial transactions in Louisiana and would seem to require the same results reached in most of the fraud cases involving letters of credit. Fraud is a misrepresentation or a suppression of the truth made with the intention either to obtain an unjust advantage for one party or to cause a loss or inconvenience to the other. Fraud may also result from silence or inaction. C.C. 1953. Fraud does not vitiate consent when the party against whom the fraud was directed could have ascertained the truth without difficulty, inconvenience, or special skill. The exception does not apply when a relation of confidence has reasonably induced a party to rely on the other's assertions or representations. C.C. 1954. Error induced by fraud need not concern the cause of the obligation to vitiate consent, but it must concern a circumstance that has substantially influenced that consent. C.C. 1955. Fraud committed by a third person vitiates the consent of a contracting party if the other party knew or should have known of the fraud. C.C. 1956. Fraud need only be proved by a preponderance of the evidence and may be established by circumstantial evidence. C.C. 1957. The party against whom rescission is granted because of fraud is liable for damages and attorney fees. C.C. 1958. Plaintiffs maintain that EAB obtained knowledge of fraudulent practices in its investigation of C.E., Inc. and C.I., Ltd. The trial court agreed with plaintiffs and found that the entire letter of credit transaction was permeated with fraud; the court also found that EAB had notice of the fraud. Such findings, if supported by the evidence, would warrant injunctive relief under our interpretation of R.S. 10:5-114. The trial court relied on several factual findings in reaching its determination that fraud in the transaction occurred. The first finding relied on by the trial court was that the principals of C.E., Inc. made oral representations to the plaintiffs that C.I., Ltd. was going to invest directly in real estate. Contrary to these representations, C.I., Ltd. invested primarily in other partnerships. These representations have no relevance to the conduct of EAB since they were not written and it was not shown that EAB knew about them. Secondly, the trial court found that EAB had knowledge of cash flow problems at C.E., Inc. This finding is supported by the testimony of Devito and the December 17, 1981 memo which placed the loan on hold. In spite of this knowledge, it is undisputed that EAB had received a significant number of positive recommendations concerning C.E., Inc.'s ability to pay its debts. It cannot be said that EAB's knowledge that a cash flow problem had existed constitutes fraud. According to the trial court, the PPM misrepresented that C.E., Inc. could fund five million dollars of capital to C.I., Ltd. The PPM stated that C.E., Inc. would ... fund no more than $5,000,000 of working capital and/or negative cash flow ... (PPM, p. 24). The plaintiffs argue that the trial court found that EAB knew that C.E., Inc. could not fulfill its funding commitment. They claim that this knowledge constituted fraud. In addition to the above statement in the PPM regarding a capital commitment, the PPM also specifically described the risk of C.E., Inc. becoming unable to make funds available to C.I., Ltd. This risk is described on page 33 of the PPM as follows: There can be no assurance that the General Partner [C.E., Inc.] shall have funds available to it or shall be able to make funds available to the Partnership [C.I., Ltd.] in either case sufficient in amount to satisfy the obligations of the Partnership. At best, C.E., Inc.'s funding commitment was equivocal. Therefore, EAB did not obtain knowledge of fraud as a result of its review of the funding provisions in the PPM. According to the trial court, EAB learned from the first supplement to the PPM that C.I., Ltd. had made investments which did not fall within the primary investment objectives stated in the PPM. The PPM stated that C.I., Ltd. intended to invest primarily in existing Properties, such as apartment buildings and complexes, hotels, motels, office buildings and complexes and similar income producing properties. (PPM, p. 18). The PPM qualified the above representation in the following terms: It should be noted that although the Partnership currently intends to invest primarily in real property, the Partnership Agreement does not restrict the Partnership in any way from acquiring or investing in any other type of property or investment. (PPM, p. 18). The supplement to the PPM stated that C.I., Ltd. had made eight investments. The largest investment was the purchase of the Bourbon Orleans Hotel in New Orleans for $12,867,300. The majority of the remaining investments consisted of interests purchased in other partnerships. Contrary to the findings of the trial court, EAB cannot be held to have known that these investments were inconsistent with the representations stated in the PPM. The largest of these investments, the Bourbon Orleans Hotel, fell squarely within the primary investment objectives of the PPM. With regard to the other investments, the PPM clearly stated that no guarantees could be given regarding the types of investments to be made by C.I., Ltd. The trial court attached significance to the fact that the March, 1981 audit of C.E., Inc. was qualified due to the existence of outstanding payables and receivables with its affiliated partnerships. The audit report contained the qualification since the scope of the audit did not extend to the affiliated partnerships. Such a qualification, standing alone, is not evidence of fraud on the part of EAB. Devito testified at trial that most syndicators would not have even provided audited financial statements. The trial court found that since EAB knew that the proceeds of the EAB loan were to be used to pay off prior partnership loans, EAB had notice of an impropriety. The acknowledged reason for obtaining the EAB financing was to replace the Mercantile and FNB loans with lower interest financing. This purpose was legitimate and it was disclosed to the investors. [7] Therefore, EAB's knowledge of the proposed use of the proceeds was perfectly consistent with the interests of the plaintiff-investors. As a final indication of EAB's bad faith, the trial court relied on the fact that at the signing of the loan agreement on March 15, 1982, the representatives of C.E., Inc. changed the guarantee provisions in the loan agreement. The guarantee provisions provided that the bank would receive guarantees from C.E., Inc. and Robert Jackson. Prior to the amendment the agreement provided: The bank will only call on the Guarantees after having drawn under the Letters of Credit. On March 15, 1982, the C.E., Inc. representatives penciled in additional language. Following the change, the sentence stated: The bank will only call on the Guarantees after having drawn under the Letters of Credit, and only upon the failure or inability of the issuing bank to make payment under the terms of the Letters of Credit. Regardless of the amendment, EAB was required to first attempt to draw under the letters of credit. It is not certain what effect the change had on the guarantee provisions. However, the investors' rights were not prejudiced since their letters were the first means of recourse for EAB in either case. Based on our foregoing analysis of the facts relied on by the trial court, we find that there was no evidence of fraud or knowledge of fraud on the part of EAB. Therefore, the fraud in the transaction exception of R.S. 10:5-114(2) is not applicable to this case. The trial court's contrary holding was erroneous. Therefore, the court of appeal decision reversing the trial court in this respect must be affirmed.