Illegality Distinct Exception

Should the law recognize illegality as distinct exception to the autonomy principle of letters of credit? If so, in what circumstances should the exception apply?


This discussion will consider whether illegality should be a distinct exception to the autonomy principle of letters of credit. The fraud exception already applies, which in many ways is a type of illegal contract; however illegality in a contract is much vaster than this both in the common law and in statute. Illegality basically means any contract that breaches a statutory or common law position. In order to fully comprehend illegality one must first explore the basic requirements of a contract because the key principle in contract law is that if all three elements of agreement, consideration and intention are present then the contract is complete. Once the contract in a credit agreement is complete then the courts uphold that any credit note passed is autonomous and the creditor cannot use the courts to be voided. Once the basics have been explored then some basic principles concerning the autonomy of letters of credit will be discussed. Then the principle of good faith, along side illegality will be discussed. Then a case study of the fraud exception will be discussed to illustrate how the courts in the UK are reluctant to use the fraud exception and the vastness of illegality would be used even less. This discussion will conclude by examining the previous exploration and determine whether illegality should be a distinct exception and even if it should would the courts use it effectively or ignore it as with the fraud principle.

Basics of a Contract:

Contracts are usually upheld by courts as they represent the freedoms between individuals concerning business dealings. Also the elements of a valid contract are so tightly defined that to override them would make a mockery of an individual's right to deal. In order to determine if there is a valid contract there has to be three elements which are; agreement; consideration; and intention. The first element that will be dealt with is the notion of agreement between the two parties. This element contains the ingredients of offer and acceptance. A valid offer must be clearly communicated by writing, mouth or act in order to allow the other person or group of persons to decline or accept. In relation to sales of goods there is no requirement for the agreement and offer to be in writing, as with the sale of property; however the offer has to be certain in its terminology and must be clearly distinguishable from an invitation to treat. In respect to certainty of terms both parties must make their intentions clear, as the courts will not enforce a vague agreement or an incomplete agreement; in addition it has to be more than a wish to enter negotiations, which the individual does not want to be bound.

The second element of a valid contract is consideration, which is defined as an indication that the promisor intended to be bound, and has the capacity to be bound. Consideration must be of some value, where there is a right, interest, profit or benefit to one party and a detriment to the other. There must be sufficient detriment to one party to be valid consideration. Consideration must come from the promisee, i.e. the person who has provided consideration can only enforce the promise; however the consideration does not need to be adequate, i.e. the consideration of the individual but does not need to be equal to the consideration of the other party. The law leaves it to the two parties to determine the amount of consideration, it may be very little; however there is no consideration if the terms are vague; and there is no consideration if it is not sufficient. Insufficient consideration includes performing a duty imposed by law or a duty owed to a contract of another's. Therefore consideration is an important part of a valid contract, however in relation to sales of goods it is usually executed consideration - a price paid for a promise, i.e. a price paid for the goods received.

Intention is the final element of a valid contract, which is the intention to be legally bound by the contract. In relation to the sales of goods it is not a complex scenario because once the money is received and the individual had the intention to sell the item, then the goods must be delivered to the buyer. The only way that intention can be omitted if it is proved that the party did not seek to be included to enter legal relations; however the passing of money and retaining it equates to a legal contract, the only way not to enter a contract is to reject the offer of the buyer and return the price of the goods.

If all these elements are in the contract along with good faith then the contract is complete and must be honored or a breach of contract law may be present. Good faith is present within all types of contracts whereby it refers to the honest intent to act without taking an unfair advantage over the other person within the contract. Therefore the only method to discharge a contract is through actions in breach, frustration, fraud etc. In respect to business dealings between companies these principles are stricter because it is assumed that the bargaining power is equal as they are both knowledgeable in the workings of contracts. In English law the aim to ensure that contracts between parties are upheld and the courts will always find an avenue to ensure that a contract is upheld. In respect to the autonomy of the letters of credit this rule is stricter because the contract is complete and performance has occurred. The following case will illustrate how the courts will infer certainty of contracts in English law even if the grounds are shaky.

Stocznia Gdanska SA v Latvian Shipping Co is a case that deals with an appeal dealing with the validity of restitution; however this case's argument is based upon an argument that there was a total failure of consideration. However consideration the House of Lords argued was defined from the actions of the shipbuilders, i.e. had they acted on the contract and were funds expended? The contract was for design, construction and delivery and as the shipbuilders had acted on this has consideration been fulfilled? In this case the House of Lords argued yes because it is was not just a contract of the mere sale of a ship, but the design and construction; whereby once this design and construction has been initiated then there can be no total failure of consideration. In the case of Stocznia Gdanska SA, when considering whether there has been a breach of the contract by the failure of total consideration, the courts rather than specifically considering the contract words is focuses on the intent and actions of the parties in conjunction with the written contract. In the purposes of justice the court considered the whole contract, its wording and the actions of each of the parties; therefore resulting in a decision by the court that is balanced and ensuring that one party is not penalised because the other party does not want to fulfil its obligations. Whereby the party claiming that there is total failure of consideration purports that there is no evidence of total consideration because this party has not acted or has be put at a detriment in respect to the contract. The court rather considered the actions of the other party, the shipbuilders, and determined if there was any consideration on their part and if there is then there cannot be a total failure of consideration. Therefore this case illustrates the English courts adherence to contracts over the possibility that the requirements are not available. If one takes this thinking and applies it to the problem at hand where a contract is performed it is highly unlikely the courts will overturn it because it will affect certainty of contracts. Yet there are cases of injustices and it is necessary for the courts to become involved and rescind a letter of credit, such as in the case of fraud and illegality because these cases are going against equitable and statutory principles. In order to fully understand this autonomy of letters of credit will be explored in the next section.

Autonomy of Letters of Credit:

Letters of Credit are basically agreements for one party to pay a repayable to sum to another, once the letter of credit has been properly completed then it is binding for the party to pay this sum of money, i.e. extend credit to the other party. In other words, as with a contract to exchange goods etc once it has been completed and has all valid elements the court will uphold the validity of the contract and its performance; therefore to have a letter of credit presupposes that a valid contract is in place, which is at the heart of this discussion. There is one exception, other than the lack of a valid contract, which is the presence of fraudulent information being forwarded to the creditor. This means that if the information that the creditor is given wrong and the person who is lending the money knows this then it is fraud and will fulfill the fraud exception to stop the credit note being held valid. UK law does not provide any specific statute to confirm this but is enshrined within common-law principles. This exception is very similar to the notion of utmost good faith in insurance law in principle the use of it is very limited therefore limiting the working of justice, i.e. if there is a legal principle that is rarely or never used makes it null and void. This may seem to be counterproductive to the other approaches to fraudulent contracts; however it seems to be indicative of the UK's approach of upholding valid contracts over the invoking justice. The problem with just relying on the fraud exception is that it does not deal with other aspects of illegal contracts that contain all three of the requisite requirements of a valid contract. Also how can a letter of credit be justly upheld if it breaches a statutory or common law principle? The answer is that it cannot and to uphold it makes a mockery of the legal system and contract law because injustice is deemed to be okay it someone contracts it to be so. The following section will consider the notion of good faith, which this essay would argue should be another element of good faith linking it with the principles of illegality.

Good Faith and Illegality:

Good faith is basic to a valid contract in most jurisdictions; however in English law it has been greatly ignored, except in insurance law where it has been put in statute but phrased as utmost good faith. Therefore this discussion will briefly go over the principle of good faith in insurance law and then illustrate how in other types of contracts it is not used, but in the US it is a basic principle as the next section's case study will illustrate Then it will consider illegality and illustrate if the principle of good faith was utilized then this would be an exception to the principle of the autonomy of letters of credit. Utmost good faith refers specifically to insurance law; whereby the insured must disclose all the material facts otherwise the insured can vitiate the contract. The concept of good faith is present within all types of contracts whereby it refers to the honest intent to act without taking an unfair advantage over the other person within the contract. In the area of insurance law it is essential for the insuree to notify the insurer of all applicable information because this will effect if the policy can be made and the amount of the policy. This is because the insuree is in the position of power as they know all the information and their duty is to disclose it. If one looks at the relevant notion of a valid contract, if the elements of a valid contract are not present then the contract is void. This principle relies on validity and if a contract is illegal should it not also means that any thing that is received from the contract is rescinded, i.e. a letter of credit. The first type of illegality that will be considered are contracts that are immoral, i.e. if the contract is known to be for an immoral purpose it is void. Contracts that are for illegal purposes are also held to be void. Any contract that is contrary to a statute is also void; however the case of St John Shipping Corporation v Joseph Rank Ltd held that a court should not hold a contract is prohibited by statute unless this intention is clear. The case of Taylor v Bhail held that any contract that is tainted by an illegal purpose is not enforceable. Also in the interests of justice an innocent party can claim restitution. Finally the case of Tinsley v Milligan holds that in property law illegality can only discharge an equitable interest where this illegality must be relied upon to prove the claim. Therefore there are many held instances of illegality in contracts and the question is why do these principles apply distinctly to the autonomy of the letters of credit? The answer seems to be confusing, i.e. relying of the fact that the contract has in part been performed. This seems to be unfair and against theses principles, even if an illegality exception was in a very narrow form such as equitable interests in property would be better than none at all. Yet this seems to be the approach of the UK courts as the following case study of the fraud exception of the principle of the autonomy of the letters of credit will illustrate.

Case Study Fraud Exception - UK & US:

The given approach to fraud exception was defined by Lord Denning in United City Merchants v Royal Bank of Canada as that defined in the US Case Sztejn v Henry Schroder Banking Corp:

To this general statement of principle [of independence], ... there is one exception: that is, where the seller, for the purpose of drawing on the credit, fraudulently presents to the confirming bank documents that contain, expressly or by implication, material representations of fact that to his knowledge are untrue. Although there does not appear among English authorities any case in which this exception has been applied, it is well established in the American cases of which the leading or landmark is Sztejn v J Henry Schroder Banking Corp (1941) 31 N.Y.S. 2d 631.

Yet, as previously mentioned the courts take a non-interference approach to letters of credit, in order to interfere the fraud must reach a specified burden of proof and must actually involve beneficiary fraud. The standard of proof is very high where there must be clear and unequivocal proof that fraud has been committed. The case of RD Harbottle v Natwest defines this burden of proof as:

Except possibly in clear cases of fraud of which the banks have notice, courts will leave the merchants to settle their disputes under the contracts by litigation or arbitration as available to them or stipulated in the contracts. ... Otherwise, trust in international commerce could be irreparably damaged.

Therefore as with the exploration of the UK's approach to upholding the certainty of contracts the courts take a very enlightened principle and hinder it with such a high burden of proof that it basically makes it unusable. In addition the courts have added the actual necessity for there to be beneficiary fraud, which means that the fraud has to be committed by the beneficiary of the credit note, therefore if some fraud was involved by at the hands of a third party the creditor has to bear the weight of this fraud even if the fraud would have met the high standard of proof. This has been upheld in the United City Merchants Case. Therefore this seems to prove that the UK's adherence to contract certainty far outweighs the basic principles of justice, which leads one to believe that notion of utmost good faith is an exception to the rule of upholding the certainty of contract, especially in respect to contracts that are made by companies. This was stresses in the judgment of the RD Harbottle Case when the decision of imposing a high burden of proof was being justified in the nature of commercial certainty:

Otherwise, trust in international commerce could be irreparably damaged.

The USA, on the other hand, champions the fraud exception rule as to uphold fraudulent acts breaches the basic precepts of justice of a valid contract. The USA has enshrined this rule in statute, as well as has extended to types of fraud. The Sztejn Case as in the UK is the key case dealing with fraud exception; however it is not limited by a high burden of proof. It also is not limited to intentional and unequivocal fraud, i.e. it includes constructive fraud and egregarious fraud, but most interestingly the USA approach has a flexible standard that is indicative of the USA's adherence to justice in contracts whether on party is a company or not. This flexible standard is confirmed in the case of United Bank Ltd v Cambridge Sporting Goods Corp :

It should be noted that the drafters of section 5-114, in their attempt to codify the Sztejn case and in utilizing the term fraud in the transaction, have eschewed a dogmatic approach and adopted a flexible standard to be applied as the circumstances of a particular situation mandate. It can be difficult to draw a precise line between cases involving breach of warranty (or a difference of opinion as to the quality of goods) and outright fraudulent practice on the part of the seller.

Therefore this leads on to the conclusion that the approach of the UK is too entrenched in the belief that certainty in commercial contracts outweighs justice, which has created a lopsided and unfair system concerning letters of credit; especially when the fraud exception is based upon principles that promote justice as in the USA.

Conclusion - Illegality as a Distinct Exception:

In the interests of justice illegality should be a distinct exception; however the court reasoning with respect to the fraud exception does not seem to allow for this route of justice. It almost seems that justice contrary to the basic precept of upholding contracts, yet this is not true for other jurisdictions such as the USA. It almost seems that UK courts do not want to be involved in dismantling valid contracts, yet as this argument assumes how can there be a valid contract without good faith? The answer is there cannot be, yet as the UK courts rely on laissez faire principles when it comes to contract law, i.e. as little interference in valid contracts as possible they seem to refuse to become involved unless there is statute such as in respect to utmost good faith insurance law. Therefore in order for there to be justice there needs to the introduction through statute to ensure that there is an illegality exception and fraud exception to the principle of the autonomy of the letters of credit; otherwise the law surrounding illegal and fraudulent contracts is a mockery.


J G Barnes & J E Byrne, 2001, 'Letters of Credit: 2000 Cases', 56 Business LR 4

Gao and Buckley, 2003, A Comparative Analysis of the Standard of Fraud Required Under the Fraud Rule in Letter of Credit Law, Oxford University Comparative Law Forum 3

Charlesworth and Morse, 1999, Company Law, Sweet & Maxwell

Farrar et al, 1998, Farrar's Company Law 4th Edition, Butterworths

Jones & Sufrin, 2004, EC Competition Law, Oxford University Press

Keenan and Bisacre, 1999, Company Law (with Scottish supplement), Prentice Hall

K L Macintosh, 1986, 'Letters of Credit: Dishonour When a Required Document Fails to Conform to the Section 7-507(b) Warranty', 6 J L & Commerce 1(6)

Pillans and Bourne, 1999, Scottish Company Law, Cavendish

Sealy, 2001, Cases and Materials in Company Law, LexisNexis UK