Review：《U.S. Sanction Laws and the LC Independence Principle - Part 1》

　　Ⅳ.Price Must be Paid: How Deep Should Banks Dig into the Underlying Transaction?

　　As mentioned above, banks may become targets of sanction schemes if they were found guilty of knowingly aiding or facilitating North Korea’s sanctionable activities. The regulations issued by OFAC encourage or require banks to conduct additional investigation into the underlying commercial transactions of the LCs. However, if banks dig too deep into the background transaction, the independent nature of LCs would be destroyed. Consequently, the global commercial payment system would be jeopardized greatly.

　　Fortunately, banks can defend themselves by showing their lack of constructive knowledge. Constructive knowledge is presumed by law if banks can obtain the knowledge through reasonable due diligence. Thus, if banks can show that they have practiced reasonable due diligence, they may have a better chance to be off the hook.

　　It may not be "sufficiently reasonable" if foreign banks just follow their normal due diligence program. That is especially true when the underlying transactions involve sensitive parties, goods, or geographic areas. An enhanced due diligence scheme is necessary.

　　1.Know Your Customs’ Custom (“KYCC”)

　　Pursuant to the Patriot Act 2001, the Financial Crimes Enforcement Network (“FinCEN”) proposed the Know Your Customer (“KYC”) requirements in 2004. Accordingly, banks shall use reasonable diligence to ensure and retain the identity and associated risks when maintaining a business relationship with a customer or client.

　　However, because numerous participants are involved in the underlying transactions of LCs, some parties are not the direct customer of Banks. Banks may act as the issuing bank, negotiating bank, confirming bank, advising bank, accepting bank, discounting bank, reimbursing bank, or paying bank. Usually, the applicant of an LC is the customer of the issuing bank, but it is not necessarily the customer of the negotiating bank or the paying bank. Conversely, the beneficiary is usually the customer of the negotiating bank, but the issuing bank may have no business relationship with the beneficiary.

　　The transferrable LC makes things more complicated. By transferring the credit, the beneficiary transferred its LC right to a third party. Sometimes, Banks have no clue of who is the ultimate payee of the LC.

　　Thus, the traditional KYC program is not sufficient to mitigate the risk of a potential violation of the sanction laws. Before providing financial services and honoring their LC undertakings, banks should screen every relevant participant of the underlying transaction to know the identity of the customer’s customer.

　　2.Higher Risk Goods

　　When the LC is dealing with higher-risk goods (for example, weapons, nuclear material, or semi-conductors, etc.), FFIEC's BSA/AML MANUAL requires banks to pay more attention to the documents than merely applying the “on-their-face” examination.^[1]Particularly, red flags should be raised when the goods appear to be over or undervalued, double invoiced, partially shipped, or use fictitious goods names.

　　3.Sensitive Geographic Places

　　The following map shows areas where North Korean STS transfers commonly occur:^[2]

　　[source:https://home.treasury.gov/system/files/126/05142020_global_advisory_v1.pdf]

　　As the map shows, most of the North Korean STS practices occurred in the areas of the East China Sea, the Yellow Sea, and the Sea of Japan. Thus, if the shipping documents show that the goods are shipped from the neighboring ports of those areas, more attention should be paid.

　　In sum, the enhanced internal compliance and the sanction clause may burden the banks and their clients. However, in considering the more and more strict U.S. sanction against North Korea, those are the price that must be paid.

　　Ⅴ.Banks’ Defenses Against Claims of Wrongful Dishonor

　　According to UCP, ISP 98, URDG 758, and other LC rules and laws, the issuing bank must honor the LC if the presented documents comply with the stipulation in the credit.^[3]The confirming banks have the irrevocable obligation to honor or negotiate a complying presentation if they add confirmation to the LC.

　　Consequently, if banks dishonor the LCs because they found the underlying transaction is sanctionable under U.S. sanction laws, they could be sued by the beneficiary, the applicant, the transferee of a transferrable LC, or other stakeholders. Banks may raise the following defenses against the claims of dishonor:

　　1.Fraud Exception

　　The fraud exception to the Independence Principle is well established by case laws. Under the fraud exception, banks can ask the courts to issue injunctive orders to stop payment. Basically, the fraud exception allows the banks to dishonor under very rare circumstances.

　　However, the threshold to successfully raise the fraud exception defense is very high. Also, the required elements of the fraud exception are different in different countries.

　　In 3Com Corp. v. Banco do Brasil, S.A., the U.S. court held that dishonor due to fraud is proper where a draw has no basis in fact and represents a fraud in the transaction, or where a drawdown would amount to an outright fraudulent practice by the beneficiary.^[4]

　　Besides, the fraud exception is a “narrow one” because of the need to protect the smooth operation of international commerce. ^[5]

　　The English courts take the same position regarding the narrow interpretation of the fraud exception. They will not restrain the payment unless the fraud and the applicant’s knowledge of the fraud are “very clearly established”.^[6]

　　According to the holdings of the U.S. and U.K. courts, if banks can prove the lack of “colorable basis” to draw on the LC or the draw request “amount to an outright fraudulent transaction”, they can obtain the courts' order to dishonor the credit. Thus, the nominated banks have two methods to invoke the defense based on the fraud exception: to prove the lack of transaction basis of the draw or to prove the intention to defraud.

　　Where North Korea's deceptive shipping practices are involved, it is difficult and maybe impossible for the banks to fulfill the above-mentioned burden of proof. The fraud exception is not very helpful.

　　2.Illegality Exception and “Social Contract”

　　The illegality exception is more controversial than the fraud exception. In the U.S., the UCC article 5 expressly states that fraud and forgery are exceptions to the Independence Principle without mentioning the illegality exception. Based on that, some scholars argue that the U.S. law does not recognize the illegality in the underlying transaction as an exception because of the absence of express provision.

　　Some disagree with that view and argue that the UCC does not expressly exclude the availability of the illegality exceptions.

　　All of the above-mentioned debates are based on the illegality of the “underlying contract”. However, the real issue is whether the banks' honor of the LC is illegal. Thus, the illegality of the underlying contract is irrelevant.

　　If the honor of the LC will break the law, banks have the implied liability of not to honor them. By issuing an LC, banks do not have the immunity to act beyond the law. Although banks have promised to honor the LC obligation, they have the higher-level undertaking to do business legally under the “Social Contract” they have made as a member of the society.

　　Ⅵ.Sanction Claus

　　In recent years, Banks have used sanction clauses more and more often.

　　A typical sanction clause of LC intends to give Banks the discretion whether or not to honor their LC undertakings. Some argue that sanction clause is a necessary tool to mitigate the risks of being punished by the government or being sued by the customers.

　　1.the Enforceability

　　However, the enforceability of the sanction clauses is in great controversy. Some argue that the sanction clause is not enforceable because it is a non-documentary condition. Section 14-h of UCP 600 provides that “If a credit contains a condition without stipulating the document to indicate compliance with the condition, banks will deem such condition as not stated and will disregard it.” ⁷Accordingly, the sanction clauses should be disregarded as a non-documentary condition.

　　In 2014, ICC issued Guidance Paper on the Use of Sanctions Clauses in Trade Finance Related Instruments Subject to ICC Rules (“2104 GP”). In this Guidance Paper, ICC recommended banks refrain from using sanction clauses in LCs. In 2020, ICC changed its position and issued an addendum to the 2014 GP. In this addendum, ICC emphasized that sanction clauses should not be used “routinely”. ICC also stated that “Clauses should refrain from including unparticularized references to laws generally."⁸ The addendum includes several recommended samples of the sanction clause. One is as bellow:

　　“[notwithstanding anything to the contrary in the applicable ICC Rules or in this undertaking,] We disclaim liability for delay, non-return of documents, non-payment, or other action or inaction compelled by restrictive measures, counter-measures or sanctions laws or regulations mandatorily applicable to us or to [our correspondent banks in] the relevant transaction.”^[9]

　　In the author’s view, the recommended sample has no material difference from those denounced by the 2014 GP. The wording does not change the nature of a non-documentary condition.

　　2.Necessity and Helpfulness

　　Sanction clauses may not be helpful to Banks to win the case against their clients. Moreover, sanction clauses are not even necessary for that purpose. As discussed above, if the honor of the LC will lead to the violation of the law, Banks should stop the payment under their implied obligation. Banks should not be forced to violate the law, even in the world of LCs. With that being said, sanction clause is just an express disclaimer which says “I am not liable for not breaking the law.”

　　However, the use of the ICC-recommended sanction clause may be helpful to prove Banks’ employment of reasonable diligence to mitigate the risk of helping North Korea.

　　Ⅶ.Conclusion

　　In conclusion, although the Independence Principle prevents Banks from making any investigation beyond the presented documents, the sanction laws impose duties and liabilities upon Banks. In considering the harsh consequence, Banks should employ enhanced due diligence programs to determine whether the underlying transactions potentially violate the sanction laws. If Banks are sued for dishonoring LCs related to North Korea's sanctionable practices, they can invoke fraud and illegality exceptions as defenses.

　　Notes:

　　[1]See RISKS ASSOCIATED WITH MONEY LAUNDERING AND TERRORIST FINANCING

　　[2]Updated Guidance on Addressing North Korea’s Illicit Shipping Practices, Department of the Treasury, March 21, 2019

　　[3]See § 7a, UCP 600

　　[4]See 3Com Corp. v. Banco do Brasil, S.A., 171 F.3d 739, 747 (2d Cir. 1999)

　　[5]See Archer Daniels Midland Co. v. JP Morgan Chase Bank, N.A., No. 11 Civ. 0988 (JSR), 2011 WL 855936, at *5 (S.D.N.Y. Mar. 8, 2011)

　　[6]See Edward Owen Engineering Limited v. Barclays Bank International Ltd. [1978] QB 159.

　　[7]See § 14 h, UCP 600

　　[8]See Addendum to The Use Of Sanctions Clauses In Trade Finance-Related Instruments Subject To ICC Rules, ICC, May 2020

　　[9]See Id.