Article by Edward L. Symons, Jr.
The Uniform Commercial Code emphasizes the concept of good faith to resolve confrontations between parties to commercial transactions. While good faith is frequently elaborated in the context of articles 2 and 9, as well as article 7, its use in the resolution of letter-of-credit disputes under article 5 has been either glossed over or ignored. The result is that courts have failed to perceive both the integrity of the structure of article 5 and the central role that good faith plays in the pattern of article 5 and letter-of-credit transactions.
The resulting confusion is serious, because letters of credit are now coming into widespread use as an effective commercial device. More small manufacturers and businesses are engaging in international trade, necessitating their use of letters of credit. Letters of credit are also becoming more common in domestic trade. Most important, however, is the dramatic development of "standby" letters of credit, used in both domestic and international transactions to guarantee performance of such disparate contractual promises as construction of roads, sewers, or buildings, payment of commercial paper, and maintenance of sophisticated communication, manufacturing, or other facilities in foreign countries. The spread of letters of credit into nonsale areas, moreover, has just begun. The only limits on their use are the creative abilities of those who use them. In short, letters of credit are being used in more ways, in more business transactions than ever before. The final, telling proof of the broadened interest in letter-of-credit law is the dramatic increase in the number of reported cases in the last five to ten years. In the great bulk of these cases the critical issue has been, under what circumstances may an injunction issue restraining a bank from making payment on its letter of credit?
The doctrinal theory necessary to answer this question has been obscured by the writings of highly respected practitioners who claim that the historic and proper standard for issuance of an injunction is proof of "egregious" or "gross" fraud, and nothing less, with the result that an injunction against the issuing bank should rarely, if ever, issue. The correlative concept of good faith, woven into the fabric of letter-of-credit law, is ignored. The egregious fraud standard is incorrect historically. It is also at war with the wording of article 5 of the Uniform Commercial Code (especially section 5-114), with the pervasive concepts of contract law and the Code, and with the sense of justice of the courts presented with the injunction issue. Nevertheless, the unrebutted repetition of the egregious fraud standard, together with the denigration of the relevance of good faith, has caused several courts to nod to such a standard.
While many of the recent cases reach a correct result, their language is seriously deficient because of the absence of a reasoned elaboration of the underlying doctrinal theory. This article posits that the less stringent, but still delimited, standard of ordinary or "intentional" fraud, in the sense of common law deceit requiring scienter, is the proper standard to be applied and the standard often in fact applied by the courts, despite the great variety of language in the reported opinions. Under the intentional fraud standard the letter of credit can continue to be preserved and encouraged as a valuable commercial instrument. At the same time, this standard will better protect the customer (and frequently the issuer in a standby letter-of-credit transaction) from the beneficiary's fraud by enforcing the duty of good faith, in the sense of subjective good faith or honesty in fact.
A review of pre-Code cases and commentary reveals that there was a wide disparity of opinion about the proper standard of review, with three being suggested. For purposes of categorization, they may be listed as the egregious fraud standard, the intentional fraud standard, and the breach of warranty or innocent misrepresentation standard. Interestingly, eminent pre-Code commentators opted for the third standard. Today all agree that this standard is incorrect. It destroys one major commercial purpose of the letter of credit—that of enabling the beneficiary of the letter to reallocate the risk of nonpayment for delivered goods that allegedly do not conform to the underlying sales contract. The UCC, in its critical section 5-114, rejects the breach of warranty standard. Rather, it opts for a "fraud" standard, without defining fraud.
The section 5-114 standard is generally acknowledged to be a codification of the leading pre-Code case of Sztejn v. J. Henry Schroeder Banking Corp. A careful review of Sztejn and other pre-Code cases, the wording and cross-references in section 5-114, and the pervasive standard of good faith in the UCC—defined in section 1-201(19) as "honesty in fact"—reveal that the middle ground standard, intentional fraud, is the proper interpretation of both the pre-Code cases and the UCC. This middle ground is, moreover, consistent with the pervasive contract and UCC standard of good faith, as that term is to be understood in the context of letter-of-credit transactions.
It must be emphasized that there is nothing strange or heretical about applying generic contract concepts such as good faith to the law of letters of credit. Just as the law of commercial paper is specialty contract law, that is to say, contract law with special doctrines superimposed to enhance special commercial needs, so the law of letters of credit is contract law with special doctrines superimposed to enhance other special commercial needs. To the extent that there is no resulting detriment to the special commercial needs of the letter-of-credit transaction, application of generic contract principles assuring basic honesty in commercial dealings should be acknowledged. Therefore, the legal isolation of the bank's undertaking in the letter-of-credit transaction should not be emphasized blindly, with the concomitant danger of disregarding the relevance of ordinary rules of contract law, such as good faith, embodied in the UCC.
Before elaborating on these conclusions, as background for those not familiar with letters of credit, there follows an introduction to the rudiments of letters of credit—their commercial setting, the commercial values they represent, and the development of their use in commerce.
About the Author
Edward L. Symons, Jr. Associate Professor of Law, University of Pittsburgh School of Law. B.A. 1963, Cornell; J.D. 1969, Pittsburgh.
Citation
54 Tul. L. Rev. 338 (1980)