Fraud and the Flaws in the Letter of Credit System

Since there is credit involved in this type of transaction, fraudulent activities are not far behind because of the opportunities this process presents. In the letter of credit cycle, venues for fraudulent opportunities can be observed to be present. The possibilities of fraud taking place can be easily compared with the likelihood of fraud to take place in credit card transactions. As explained in an article in the Hong Kong Industrialist (2008, 34): “Despite the availability regulations and scrutiny of the banks, there is inevitably weaknesses in the L/C system.

It is not uncommon for fraudsters to exploit the Independence Principle and the Compliance Principle. After all, the bank only examines the document, but not physically examines the goods at the port”. Banks do not physically examine the goods at the port because in this system, they function according to the provided documents. The only checks made are in the capacity of the buyer to pay the bank back. Although it is technically the issuing bank that made the payment, the goods are of no use to them; as the representative bodies of credit, their concerns are in the transaction and not in the goods.

This shows how the fundamentals of letters of credit, the Independence Principle and the Strict Compliance Principle, are highly depended on and these banks run these principles in expectation that the goods being traded lie in the respective good faiths of the buyer and the seller. Given that the letter of credit merely facilitates business by ensuring that a transaction will take place through the banks of the contracting parties, the tendency is that some entities may take advantage of the weaknesses of the system and do not deliver what is initially agreed to.

According to Blodgett and Wilson (1993), fraudulent activities may be enacted by either buyer or seller. A buyer may execute fraud in which he can claim that a transaction is taking place when in fact it is not happening. A buyer can execute fake transactions from an issuing bank and can also forge documents. At the same time, a seller can deliver goods that do not comply with the agreement with the buyer.

Although letters of credit are contractual in nature, the documents do not necessarily spell out liabilities should fraud take place; letters of credit, in essence, are independent of the sales agreement between the buyer and the seller since they are basically enacted by the banks acting in behalf of the buyer and the seller. If a letter of credit is approved and that the buyer has already paid the issuing bank the dues of the credit, the delivery of the goods do not have anything to do with the transaction anymore despite the letter of credit serving as the receipt of payment of the sale of the goods.

Should the seller has sent the customer worthless goods, the letter of credit does not have enough capacity to make a case out of the situation other than serving as the proof of payment; the issuing bank, in this regard, albeit being the initial paying party, is deemed irrelevant to such turn of events. This can be further complicated especially in international transaction cases. The buyer, who most likely bought the goods in a foreign jurisdiction, does have the option to pursuit the case in that venue although this can cause more challenges because of the complexity of the system.

As a receipt and validation of payment, the transaction already appears legit as it is. A typical letter of credit example cited by Blodgett and Wilson (1993) is the case between Sztejn v. Schroder Banking Corporation; the former purchased bristles from an Indian company and Schroder Banking Corporation was contracted by Sztejn for an irrevocable letter of credit with the Indian seller as the beneficiary.

However, the seller sent goods that do not meet the initially agreed products; since Schroder approved the transactions as provided by the documentation sent by the Indian company in the shipment, Sztejn therefore cited that transaction fraud had taken place. This led the company to challenge the honour of the letter of credit issued by the bank. Based on this example, the risk in this arrangement is that buyers or even sellers may identify the banks as the liable points of fraud since these are the agencies that approve the documentation and processes the transactions.

As previously mentioned, the letter of credit cycle involves the banks to execute the transactions, from the issuance and the transfer of credit, to the payments to the seller, and then the debit from the buyer. The risk here is that the transaction can actually take place without having to check on what is being transacted about since the letter of credit in itself facilitates, implements and concludes the business. Hence, a buyer and a seller can actually finalise a transaction with a shake of their hands should the letter of credit is established as the main processing point of the sale.

The sales agreement somehow takes a backseat since payment becomes an important point in the process, and much is emphasised on the security of the payment because in international trading scenarios, not all contracting parties have the capacity to see through the entire process. With the banks acting as the processing and the validating parties, there is that sense of confidence that the transaction would be handled well although the banks have nothing to do with the sales and the goods.

As a result, fraudulent transactions can easily take place but the lines of liability are not defined especially when it comes to identifying what is fraudulent in the process in the first place. The question of fraud, therefore, can be because the letter of credit transaction, in isolation, may not be fraudulent. Since it is only the documents that move the fraud usually gets exposed once the letter of credit transaction is already concluded. Hence, the fraud is can be identified in the transaction of the sales which, in the context of letters of credit, does not really have anything to do with the letter of credit itself.

The letter of credit system, as should be noted, also gives credit options to buyers and sellers. Generally, there are two main types of letter of credit: irrevocable and revocable. As the latter is the most used, allegations of fraud can be initially challenged especially as at the initial point of the transaction it is already declared whether the letter of credit is irrevocable or not. At the same time, because of the irrevocable nature of the letter of credit, this can be a point of scrupulous behaviour for the buyers which, ironically, prefer this form of credit as a means of assurance that the goods sold are going to be paid for.

This is why in cases such as Sztejn v. Schroder Banking Corporation, the letter of credit cannot be challenged because the allegation that there was fraud in the transaction will be usually questionable; as Blodgett and Wilson explained (1999): “The conduct of the seller here, however questionable, is not the kind of fraud that would justify the grant of an injunction against the honour 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 honouring 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. ” This demonstrates how the system can be flawed because as there is an assurance of a transaction, the processes pertaining to the sales agreement are overlooked.

In exchange for the conveniences provided by the tool, there are the “shortcuts” in the entire trading process which is why a business deal can be easily reached without the nuisances. A buyer can easily buy the goods without having to immediately pay the seller, and at the same time, the seller is guaranteed that the sales will be paid because it is a financial institution that would make the direct payment to the seller through the seller’s bank. The irrevocable letter of credit further guarantees the payment thus further establishing the deal between the two parties.

An important point raised from the above-mentioned excerpt from Blodgett ad Wilson (1999) can be seen in how letters of credit, in itself, are protected; the author mentioned “the role letters of credit play in modern commerce” thereby further emphasising how it is important that such tool can be used to facilitate trade. It can be gathered that the lack of liability assigned to the letter of credit system and its agencies, the banks, demonstrate how this document only functions to initiate and conclude transactions, but the actual transacting parties and the objects of transaction are not protected.

It is now important to look at the functions of the banks involved in the system; as previously mentioned, at least two banks are involved in the processing of the documents, and these are the banks on behalf of the buyer and the banks in behalf of the seller. The letter of credit comes from the issuing bank as contracted by the buyer and, the payment transaction takes place between the issuing bank and the seller’s banks.

The seller’s bank includes the advising bank, the entity that validates the letter of credit, and the confirming bank which confirms the letter of credit on behalf of the seller; it is possible that a single bank acts as the advising and the confirming banks. Based on these assigned functions, these banks enact the processes and ensure that the letter of credit pushes through, and at both ends, payments are made; after the validation the funds are transferred to the seller’s bank, and in the end, the issuing bank debits the amount from the buyers.

With the banks taking care of the processing of payments, they merely act as agencies. Should a principal role is played, such as the issuing bank and the advising bank executing their functions, their roles end once their part in the process is finished (Cranston, 1997). This is why it is possible that should disputes and errors take place, these agencies do not need to resort to law because there are no definite laws that govern these arrangements other than the presence of regulations that basically oversee the transaction (Cranston, 1997).

Through this, it can be gathered that technically, as the processing agents, banks do not have anything to do with the sales of the goods despite their critical roles in the process. Apparently, this brings to mind the current and ongoing credit crisis that has been taking place in the United States which has created a significant impact to the country’s major banking and financing system which in turn, other countries and economies have been affected.

Basically, the credit crisis stems from the sub-prime lending agreement in the United States which would enable credit to be more available to the people without having to look at the financial capacity of the potential loaners. Evidently, the establishment of the sub-prime lending system would facilitate buying thereby playing an important role in the nation’s economy and the real estate industry. However, as can be seen in the events that have been taking place, this system is evidently flawed; most people cannot pay their loans and as a result, assets would devalue and become useless. Many industries outside this sphere have been affected.

This comparison with the weaknesses of the letter of credit system can be initially related to how letters of credit is seen as an important facilitating tool of trade but evidently, the system can eventually victimise more businesses. What is interesting is that since letters of credit can enable fraudulent behaviour from either the seller or the buyer, when it comes to the examination of the case in the context of law, letters of credit and its agencies, the banks, seem to be protected. In a sense, the letter of credit system has been designed as such in order to create fewer inconveniences in the trade transactions.