Sztejn v. J. Henry Schroder Banking Corp.
177 Misc. 719, 31 N.Y.S.2d 631, 1941 N.Y. Misc. LEXIS 2434 (1941)
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Rule of Law:
An issuing bank may be enjoined from honoring a letter of credit, despite the presentation of facially conforming documents, when there is active fraud in the underlying transaction by the seller, the bank has been given notice of the fraud prior to payment, and the party presenting the draft for payment is not a holder in due course.
Facts:
- Sztejn and his partner, Schwarz, contracted to purchase a quantity of bristles from Transea Traders, Ltd. (Transea) in India.
- To facilitate payment, Sztejn and Schwarz arranged for J. Henry Schroder Banking Corporation (Schroder) to issue an irrevocable letter of credit in favor of Transea.
- The letter of credit stipulated that Schroder would pay drafts drawn by Transea upon presentation of specific documents, including an invoice and a bill of lading, covering the shipment of bristles.
- Transea intentionally shipped fifty crates filled with cowhair, rubbish, and other worthless material instead of the contracted-for bristles.
- Despite the fraudulent shipment, Transea obtained facially conforming documents, including a bill of lading from the steamship company that described the merchandise as bristles.
- Transea drew a draft under the letter of credit and delivered it, along with the fraudulent documents, to The Chartered Bank of India, Australia and China (The Chartered Bank) for collection.
- The Chartered Bank presented the draft and documents to Schroder for payment.
- Before Schroder accepted or paid the draft, Sztejn notified Schroder of Transea's fraud.
Procedural Posture:
- Sztejn, the plaintiff, filed a lawsuit in the New York Supreme Court, a trial-level court, seeking to restrain payment under a letter of credit.
- The defendant, The Chartered Bank, filed a motion to dismiss the complaint for failure to state a cause of action.
- The court is now ruling on The Chartered Bank's motion to dismiss.
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Issue:
Does the independence principle, which obligates an issuing bank to pay upon presentation of facially conforming documents under a letter of credit, preclude a court from enjoining payment where there is active fraud in the underlying transaction and the party presenting the draft is not a holder in due course?
Opinions:
Majority - Shientag, J.
No. The independence principle does not extend to protect a fraudulent seller where the bank has notice of the fraud before payment and the presenting party is not a holder in due course. While a letter of credit is generally independent of the underlying sales contract, this principle is intended to insulate the bank from disputes over the quality of goods, not to compel it to honor drafts in a transaction known to be fraudulent. The court distinguished a mere breach of warranty from active, intentional fraud, such as shipping worthless rubbish. Because Schroder received notice of Transea’s fraud before paying the draft, and because the complaint alleges The Chartered Bank is merely an agent for collection and not a holder in due course, the court has the authority to enjoin payment to prevent the consummation of a fraudulent scheme.
Analysis:
This case established the landmark 'fraud in the transaction' exception to the independence principle governing letters of credit. It draws a critical distinction between a mere breach of warranty (where the bank must pay against conforming documents) and intentional fraud that vitiates the entire transaction (where payment can be enjoined). This decision balances the need for commercial certainty inherent in letters of credit with the fundamental legal principle that courts will not knowingly assist in the perpetration of fraud. The ruling protects buyers from egregious seller misconduct while carefully preserving protections for innocent third parties who take drafts as holders in due course.
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