Established fraud is the main accepted international exception to the autonomy principle and the absolute detachment of demand guarantees from their underlying contracts. For a long time it has been a question of doubt and uncertainty as to whether illegality in the underlying contract was also an exception. Another question often asked was whether it was an exception to the autonomy principle, if the demand guarantee itself and/or its underlying contract was contrary to the law, good morals or public policy. In determining whether or not these grounds will constitute an exception to the autonomy principle of the demand guarantee, one needs to distinguish clearly between instances where the demand guarantee itself is against the law, good morals or public policy; and where the underlying contract is illegal, or against the good morals or public policy.

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Trade Finance 101
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Illegality in Trade
Finance
An exception to the autonomy principle.
Andrea Frosinini

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1. What if the demand guarantee itself is “illegal”?
Established fraud is the main accepted international exception to the autonomy principle and the
absolute detachment of demand guarantees from their underlying contracts. For a long time it has been a
question of doubt and uncertainty as to whether illegality in the underlying contract was also an exception.
Another question often asked was whether it was an exception to the autonomy principle, if the demand
guarantee itself and/or its underlying contract was contrary to the law, good morals or public policy. In
determining whether or not these grounds will constitute an exception to the autonomy principle of the demand
guarantee, one needs to distinguish clearly between instances where the demand guarantee itself is against the
law, good morals or public policy; and where the underlying contract is illegal, or against the good morals or
public policy.
If a contract goes against the law, good morals or public policy, it is illegal and, consequently, void in terms of the
general principles of the law of contract. If it is the letter of credit or demand guarantee itself that is contrary to
the law, good morals or public policy, i.e., the law of the country that applies to the guarantee/credit, or the law
of the country where the guarantee/credit is to be performed, it will likewise not be enforceable. A demand
guarantee/letter of credit itself may be illegal where the issuing of the guarantee/credit is prohibited, this being
the case where it is against a specific statute to issue a demand guarantee/letter of credit in favour of
Beneficiaries from certain countries deemed to be a foreign enemy of the State, or where the outbreak of a war
renders the Beneficiary a foreign enemy. A demand guarantee/letter of credit itself may also be illegal because of
a supervening prohibition. A supervening prohibition may take place where at the time of issuing of the
guarantee/credit was lawful, but by the time of payment it has become illegal for the bank to pay by reason of a
government or judicial order. The position doesn’t change where the order against payment of the demand
guarantee/letter of credit comes from a foreign government or court, provided it is the Government, or a court in
the country where the bank’s payment obligation shall be performed or the country whose law is the proper law
of the credit/guarantee.
Where the demand guarantee is governed by the law of one country, but the court of another country, that is not
the place of performance, makes an order prohibiting payment under the guarantee, courts are not obliged to
recognise the order made by other courts. In such an instance, if the demand guarantee/letter of credit is valid
under its proper law and the law of the place of performance, courts will enforce it and ignore the illegality
resulting from the foreign court order. The defence of illegality applies to the demand guarantee/letter of credit
as it would to any other contract that is found to be illegal. Where the demand guarantee/letter of credit itself is
illegal, and the underlying contract legal, the principle of autonomy does not come into play and no difficulty
arises as a result of that principle. The situation may also arise where the demand guarantee/letter of credit
itself, as well as the underlying contract are illegal under the same prohibition. In such cases, illegality of the
demand guarantee/letter of credit is not affected by the autonomy principle because the guarantee/credit is
illegal in itself rather than through illegality in the underlying contract.
The position becomes uncertain in the situation where the illegality is in the underlying contract only, this being
the situation where the prohibition that makes the underlying contract illegal, does not directly affect the
demand guarantee/letter of credit. Where the underlying contract is illegal, it is important to establish whether
such illegality also extends to and influence the demand guarantee/letter of credit itself. If so, there might be
instances where the principle of autonomy will have to be infringed. Just as with the fraud exception, there are
two conflicting policy considerations that arise in these circumstances: on the one hand, the policy in favour of
preserving the sanctity of demand guarantees and letters of credit, on the other hand, there is the policy against
enforcing any transaction entered into in furtherance of an illegal purpose. The first policy presses for maximum
autonomy of demand guarantees and letters of credit, and the second policy requires the Principle of autonomy
to be infringed in certain circumstances.
Established fraud of which the bank has knowledge is basically the only accepted exception and the first to
acknowledge that the autonomy principle were not absolute. Initially, there was some hesitation and uncertainty
as to whether illegality in the underlying contract was also a distinct exception to the autonomy principle. So far,
nobody has recognised an illegality exception to the autonomy principle and courts have indicated that such an
exception exists, neglecting to indicate to what extent illegality can provide the basis for a defence to a claim. It is
still argued whether there is a further exception where the demand guarantee/letter of credit is tainted by
illegality in the underlying contract. Illegality in the underlying contract may be a defence under the law to an
issuing bank in refusing to make payment under a letter of credit, as illegality is a separate ground for non-

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payment under a letter of credit. There is no indication that illegality generally is a defence under a letter of
credit, though it does perhaps show that established fraud is not necessarily the only exception. Before illegality
could operate as a defence, or a ground for restraining payment by the bank, it had to be clearly established and
known to the bank, like in case of fraud. The reason for letting the “underlying illegality” ‘work through to the
letter of credit, then it is hard to picture a form of “underlying” illegality that would not be allowed to affect the
letter of credit. Where the common purpose of the parties to a contract is to break the law of a foreign country,
the contract is unenforceable on the grounds of public policy. The next question to be answered is what the legal
position is if only one of the parties had an unlawful purpose.
A plaintiff who had contracted for a purpose that was illegal under the law, cannot enforce the contract in law,
because to permit him to do so would be contrary to public policy. It is also contrary to the public policy to
enable the claimant to enforce a contract that entered into for a foreign illegal purpose known only to himself,
than it would be to enable him to enforce such a contract where the purpose is known to both parties to it. It is to
be decided whether illegality as opposed to fraud is also a possible basis upon which the autonomy principle may
be infringed. If a Beneficiary is as a matter of public policy precluded from utilising a letter of credit to benefit
from his own fraud, it is hard to see why he has to be allowed to use courts to enforce part of an underlying
transaction that would be unenforceable on the grounds of illegality if no letter of credit were involved, however
serious the material illegality involved. Whether enforcement is permissible, at least arguably, depends on the
gravity of the illegality alleged. Although on the pleaded case that appears to be considerable, the uncertainty of
this area of law is such that this is an issue which ought to be determined by reference to the evidence before the
court at trial and not merely on assumptions derived from the pleaded defence. Moreover, the fact that the bank
has no clear evidence of illegality at the date when payment is to be made, would not prevent it having a good
defence on that basis, if such clear evidence is to hand when a court is called upon to decide the issue.
In certain instances the illegality of the underlying contract can taint the letter of credit and thereby render it
unenforceable. The defence is therefore struck and on the assumed facts there is at least a strongly arguable case
that the letter of credit cannot be permitted to be enforced against the defendant bank. The decision whether
enforcement is permissible at least arguably depended on the gravity of the illegality alleged and the uncertainty
of this area of the law is such that this is an issue which ought to be determined by reference to the evidence
before the court at trial. The autonomy principle of a letter of credit does not prevent it from being tainted by
illegality of the underlying contract and, in other words, illegality in the underlying contract could constitute a
defence to the enforcement of a letter of credit. Whether enforcement is permissible under the letter of credit
depends on the gravity of the illegality alleged. It would be incredible that a party to an illegal transaction would
be permitted to enforce a letter of credit that was a vital part of such transaction. The impregnability of letters of
credit may not be superseded on public policy grounds where there is an unlawful underlying contract, if the
nature of the underlying illegal purpose is relatively trivial. Under the law, letter of credit obligations are subject
to an “illegality” defence and, furthermore, an illegal defence could also be based on a Beneficiary’s complicity in
the Applicant’s procurement of a letter of credit to facilitate. It is now recognised that illegality in the underlying
contract to a commercial letter of credit is a defence that a dishonouring issuer may raise against a complicit
Beneficiary.
If there is evidence of illegality in the underlying transaction to a letter of credit, then presumably the facts
proving that defence would have to be clearly established, just as fraud must be. This issue has not been settled
authoritatively yet. Before illegality could operate as a defence, or a ground for restraining payment by a bank, it,
like fraud, has to be clearly established and known to the bank. If the legality of the payment is merely doubtful,
it might be that the bank would not be restrained. The problem arises when illegality is clearly proved at trial,
but it is not clear at the time documents are presented for payment: the mere suspicion of illegality will not be
enough. If all that can be shown is that the underlying contract is arguably illegal, the court will not grant an
injunction restraining payment. Apparently, the consequence of this high standard of proof is that, in practice,
the illegality exception will be successful only in very exceptional cases for, just as with the fraud exception, it
will not be easy for banks to use it as an excuse not to pay under a letter of credit. Where there is an unlawful
underlying transaction defence may not be engaged where the nature of underlying illegal purpose is relatively
trivial, at least where the purpose is to be accomplished in a foreign jurisdiction. Whether enforcement would be
permissible under the letter of credit depended on the gravity of the illegality alleged. It appears that for the
illegality exception to apply, the illegality must be sufficiently serious. However, it is not clear what test must be
applied in order to determine whether the illegality was sufficiently serious.

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It appears that for the illegality exception to apply, this must be sufficiently serious, but it will often be difficult to
decide whether the illegality is in fact sufficiently serious. In extreme cases, where the illegality relates to an
illegal underlying transaction for the illegal sale of arms and ammunition or illegal drugs, where of course the
term illegal refers to illegality as provided for in the relevant country, it will be easy to establish that illegality is
sufficiently serious. For the fraud exception to the autonomy principle to succeed, several cases have consistently
required clear evidence of the fraud as it was sometimes expressed to be clear evidence of fraud at the time of
presentation of the documents. These cases did not intend restricting the time by which the evidence of fraud
had to be available to the extent of ignoring evidence of fraud that came to light after presentation of the
documents, but before hearing the case. The point was rather that the bank would have to reach a decision on
whether or not to pay soon after presentation of the documents. Usually it would only refuse payment in the
light of compelling evidence available to it at that stage. However, if the bank refused to pay on a suspicion of
fraud and is later sued, and before the case is heard, acquired evidence, this evidence should be admissible.
Another unresolved issue is what state of mind the Beneficiary and the issuing bank must be in at the time of
presentation. In the situation where neither knew of the illegality, but the issuing bank rejected on the grounds
of non-conformity and at the trial it becomes clear to have been wrongful, it then becomes important to establish
whether the issuing bank can still defend on the ground of illegality. Knowledge of fraud on the part of the
Beneficiary is vital for the fraud exception to arise at all. It has also been suggested that knowledge of illegality
should be treated differently, unless the state of mind of one or both parties is a precondition for illegality to be
available as a defence.
Whereas in cases where the underlying contract is said to be illegal, the illegality is likely not practised on either
the Applicant or the bank. As long as an offence is to be committed through the use of a letter of credit, a court
must prevent the Beneficiary from benefiting from it as long as he was a participant in the offence and the bank
had no prior notice of the illegality. The reliance on the public policy rule that a dishonest person should not
benefit from his crime is to ensure that Beneficiaries are suitably deterred. Even where the strange nature of the
terms of a letter of credit might have put the bank on enquiry that something may not be entirely right, there is
nothing to prevent the bank from refusing to pay. The analogy with fraud means that before the defence of
illegality can be relied on, it must be shown that the Beneficiary was privy to the illegality and that it is not
enough for the bank to claim that it has suspicions that the underlying contract was illegal. It must be able to
show that the bank had more than plain suspicion and that not only was the underlying contract illegal, but the
letter of credit was essential to achieving the illegal purpose or cannot be separated from the illegal purpose.
It appears that another requirement that will have to be complied with before the illegality exception will be
applicable, is that the letter of credit must be so “closely related“ or “connected” to the illegality in the underlying
contract that it is tainted by it. At present, it is not certain with what criteria the court is going to determine
whether in a particular case there is a sufficiently close connection between the letter of credit and the illegality
of the underlying contract. The tests advanced this far do not seem to be entirely satisfactory. In many cases of
illegality, it is often virtually impossible to claim that the letter of credit is not significant to the underlying illegal
transaction. If illegality in the underlying contract is a defence under a commercial and a standby, then it should
follow that illegality is also available as a defence under a demand guarantee, given that the two types of
transactions are so closely related. If illegality is a defence under a demand guarantee, this could have important
results. In any such transaction where the Principal wishes to prevent payment, consideration ought to be given
as to whether the underlying contract to the demand guarantee can be shown to be an illegal transaction. If so,
then this might provide a useful ammunition in the attempt to prevent payment being made when a seemingly
unjustified demand is made.

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2. Illegality and the UNCITRAL convention
The United Nations Convention on Independent Guarantees and Stand-by Letters of Credit, “UNCITRAL
Convention”, specifically provides for an illegality exception. Article 19(2)(b) of the UNCITRAL Convention
clearly provides for an exception to the autonomy principle of demand guarantees and standbys if the underlying
contract is illegal. The article specifically states that this illegality exception will only be accepted where the
underlying obligation of the Principal/Applicant has been declared invalid by a court or arbitral tribunal. Article
20 of the Convention makes specific provision both for measures similar to an injunction, preventing payment
and for attachment or freezing orders to be available to the court where there is a “high probability” shown by
“immediately available strong evidence”; the court “may issue a provisional order” or similar. Article 20(3)
specifically provides that where the underlying obligation of the Principal/Applicant has been declared invalid
by a court, or arbitral tribunal, unless the undertaking indicates that such contingency falls within the risk to be
covered by the undertaking, or where the undertaking, a demand guarantee or a standby, is used for a criminal
purpose, the court may issue an injunction preventing payment or issue an injunction. The only problem is that
before the court may issue an injunction or payment may be withheld, the underlying contract must first have
been declared invalid by a court, or by an arbitral tribunal, both of which might take a long time to achieve. In the
meantime the bank might still pay as there is no injunction preventing it from paying and the Beneficiary might
also utilise and spend the money obtained. Also, if the bank pays in the meantime, it will be entitled to be
reimbursed by its customer, i.e. the Principal of the demand guarantee. If this happens, clearly there will be no
need to apply for these types of injunctions and the Principal’s/Applicant’s best option would be to try and claim
damages, if that is allowed in the specific jurisdiction’s law of contract, especially when it relates to a contract
that has been found to be illegal. It is also not certain whether this declaration of invalidity by a court should be
an order dealing specifically with the underlying contract, be final or from a court having jurisdiction over the
underlying contract.
It seems that if the demand guarantee/standby is used for a criminal purpose, the court may immediately issue
an injunction preventing payment or issue an injunction, without a prior court or arbitral tribunal having made a
declaration on the matter. It is not clear whether the sentence “use of the undertaking for a criminal purpose”
relates to a case where the payment on the undertaking itself would violate criminal law, or where the payment
of the underlying obligation would violate criminal law. However, at this point it seems that the exact
interpretation of the illegality exception as provided for in the UNCITRAL Convention is problematic and consists
of mere speculation.

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3. Conclusion.
It seems to be settled law that a contract that is contrary to the law, good morals or public policy is
illegal, and consequently, void in terms of the general principles of the law of contract in each separate
jurisdiction. If it is the commercial or standby/demand guarantee itself that is contrary to the law, good morals
or public policy, i.e. the law of the country which applies to the guarantee/credit or the law of the country where
the guarantee/credit is to be performed, it will likewise not be enforceable. Where the demand guarantee/letter
of credit itself is illegal, and the underlying contract legal, the principle of autonomy does not come into play and
no difficulty arises as a result of that principle. Recent cases are in favour of accepting illegality in the underlying
contract as an exception to the principle of autonomy of letters of credit and demand guarantees.
At this stage, it is possible to identify only a few requirements that will need to be satisfied before the illegality
exception will be applicable under the current law. First, the alleged illegality will have to be established clearly,
second, illegality will also have to be sufficiently serious, third, the Beneficiary must have been involved in the
illegality and last, the letter of credit/demand guarantee must be sufficiently connected to the illegality in the
underlying transaction. For the fraud exception to the autonomy principle to succeed, earlier cases have
consistently required that banks had to have a clear evidence of the fraud at the time of presentation of the
documents. Whereas later cases take the view that the earlier cases did not intend restricting the time by which
the evidence of fraud had to be available to the extent of ignoring evidence of fraud that came to light after
presentation of the documents, but before hearing the case. The point is rather that the bank should reach a
decision on whether or not to pay, soon after presentation of the documents. Usually it will only refuse payment
in the light of compelling evidence available to it at that stage. However, if the bank refuses to pay on a suspicion
of fraud, and is sued, and prior to the hearing of the case acquires evidence, such evidence should be admissible.
The illegality should relate to a criminal offence being committed: if the illegality is not linked to a criminal
element, it should be deemed that it is not sufficiently serious, but of a mere technical nature i.e. that it merely
contravenes a section of a specific Act that carries with it no possibility of a criminal prosecution by the
authorities concerned, and it should then not constitute an exception to the autonomy principle and the bank
should then have to pay despite the illegality. The parties should thereafter proceed against each other in terms
of the normal principles applicable to the law of contract. In instances where the underlying contract is tainted
by sufficiently serious illegality, it should be possible for the Principal to apply for an interdict to restrain the
bank from paying and/or the Beneficiary from making a demand or receiving payment under a demand
guarantee/letter of credit.
It has not been made clear what the duties and obligations of the banks are in relation to illegality in the
underlying contract. Banks should not be forced to determine whether payment under the guarantee/credit will
be used for an illegal purpose, because of the autonomy principle of demand guarantees and letters of credit, and
should therefore not have to look beyond the documents at the underlying contract. The duty of banks is only to
examine documents with reasonable care and if such examination does not disclose evidence of illegality, the
bank is entitled to pay and to be reimbursed by its customer, i.e., the Principal/Applicant. In the absence of clear
evidence of illegality, the bank is “bound” to pay. Thus, the availability of the illegality exception will not
necessarily put banks under any additional difficulty in the examination of documents. Where a bank is actually
aware of the illegality of the underlying contract, e.g., where it is evident from the information supplied by the
Applicant/Principal in the application form for the letter of credit/demand guarantee that certain foreign-
exchange regulations will be contravened by the bank if it complies with its payment instruction under the
credit/guarantee, the bank should refuse to honour it. Likewise, when the bank may obtain knowledge of the
illegality of the transaction by exercising reasonable care, it should similarly be under an obligation not to pay
out on the letter of credit/demand guarantee. Where the bank is neither actually aware of the illegality of the
underlying contract, nor able to become aware by exercising reasonable care, its payment under the letter of
credit/demand guarantee cannot be faulted. To place such a duty, i.e. obtaining knowledge of the illegality of the
transaction by exercising reasonable care, for instance by looking at the information applied on the application
form, on a bank makes sense and will not necessarily place an additional duty on the bank. If a reasonable
examination by the bank does not disclose evidence of illegality, the bank should be entitled to pay and to be
reimbursed by its customer. However, if the bank fails to fulfil such a duty, it should not be allowed to be
reimbursed by its customer.
The illegality defence is potentially more problematic than the fraud defence and it is often very difficult to
determine whether a specific underlying contract is indeed illegal, especially if it is against the public policy or

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good morals of a rather unfamiliar country and if illegality is proven, whether that illegality is serious enough to
justify the infringement of the autonomy principle. It will not be an easy task for a court to establish whether the
illegality is serious enough, which may vary from one country to another.
With fraud, the different jurisdictions often seem to have a more similar view that a specific action is of a
fraudulent nature, although they often disagree on the required standard of proof. In some cases, it is also
possible that there will be an overlapping of fraud and illegality. Until such time as courts continue to have such a
stringent approach to the fraud exception, parties will surely try the illegality exception thinking that courts will
be more lenient with it.