Common Legal Disputes and Typical Cases of Forfaiting

I. Concepts Related to Forfaiting

1. Basic Definition

Forfaiting is a trade finance business based on underlying settlement instruments like letters of credit. It combines trade settlement and financing features, involves indirect financing where financial credit intervenes in the trade finance chain, and belongs to the category of trade finance products. According to ICC Publication No. 800, the Uniform Rules for Forfaiting (URF) (adopted by the ICC Banking Commission in Lisbon in April 2013), forfaiting is traditionally defined as the without recourse discounting of trade-related receivables. This definition includes three key elements: without recourse, discounting, and receivables.

2. Applicable Financial Instruments

The subject matter of a forfaiting transaction is a receivable, i.e., a payment claim. As forfaiting merely governs the transfer of the payment claim without altering its nature, its universality means the URF can be widely applied to all trade finance instruments, including bills of exchange, promissory notes, documentary credits, and invoice financing. The most common is forfaiting under documentary credits.

3. Classification

(1) By Transaction Party

Based on the parties involved, forfaiting business includes primary market, secondary market purchase, and resale transactions. The primary market refers to the market where the initial forfaiter purchases the payment claim from the initial seller. The initial forfaiter is typically a commercial bank, and the initial seller is usually the creditor of the payment claim, such as the beneficiary of a letter of credit. The secondary market refers to the market where a buyer purchases the payment claim from the initial forfaiter or another seller.

(2) By Transaction Direction

Purchase business refers to a financial institution (e.g., a bank) buying, without recourse, the matured but not yet due payment obligation confirmed by the issuing bank/confirming bank. Resale business refers to a financial institution (e.g., a bank) transferring the purchased, not yet due payment claim to another forfaiter.

(3) By Transaction Subject Matter

The subject matter of forfaiting is the payment claim. Since forfaiting only involves transferring the payment claim, its types are numerous based on the nature of the claim. These mainly include forfaiting under domestic letters of credit, forfaiting under international letters of credit, invoice financing forfaiting, and document financing forfaiting. Among these, forfaiting under letters of credit accounts for the highest proportion.

II. Causes of Action and Adjudication Approaches in Forfaiting Disputes

Currently, there is no separate cause of action for forfaiting disputes. As forfaiting is a business involving the transfer of payment claims, disputes typically arise from underlying transaction disputes, involving multiple legal relationships and parties. Judicial practice shows that causes of action for forfaiting disputes include financial loan contract disputes and letter of credit financing disputes. Courts adjudicate based on legal frameworks including: the Supreme People's Court Provisions on Several Issues Concerning the Trial of Letter of Credit Dispute Cases (hereinafter, the "L/C Judicial Interpretation"), the Administrative Measures for Domestic Letters of Credit (PBOC & CBRC Announcement [2016] No. 10), the Commercial Bank Forfaiting Business Guidelines (Banking Association Issuance [2019] No. 156) (hereinafter, the "Forfaiting Business Guidelines"), Uniform Customs and Practice for Documentary Credits (UCP600), and the Uniform Rules for Forfaiting (URF800). The adjudication approaches include:

1. Examination Primarily Based on the Letter of Credit Legal Relationship

The underlying transaction for forfaiting is the letter of credit, and the further underlying transaction is the trade background. The letter of credit, as a specialized and widely used trade finance instrument, has its own complete set of transaction rules and international practices. Therefore, adjudicating forfaiting disputes also requires adherence to letter of credit rules, such as the principle of independence (Article 5 of the L/C Judicial Interpretation), the fraud exception principle (Articles 8 and 9 of the L/C Judicial Interpretation), and the exception to the fraud exception principle (protecting bona fide third parties, Article 10 of the L/C Judicial Interpretation). For details, refer to the separate article Typical Cases and Key Adjudication Points in Letter of Credit Disputes.

2. Protection of Bona Fide Third Parties

As a financial instrument enhancing the liquidity of payment claims, forfaiting involves long transaction chains, multiple parties, and multi-layered nested transactions. If the rights and interests of bona fide third parties cannot be protected, transaction security is undermined, and the liquidity-enhancing function of forfaiting is weakened. Therefore, courts tend to protect the legitimate rights and interests of bona fide third parties, especially on issues of entitlement, specifically embodied in the "exception to the fraud exception principle" for letters of credit.

According to Article 10 of the L/C Judicial Interpretation, if the issuing bank, the nominated or authorized party of the issuing bank, the confirming bank, the negotiating bank, or other parties make payment, accept, or negotiate in good faith, then payment under the letter of credit is not affected even if fraud exists. Since forfaiting is essentially the transfer of a payment claim without changing its nature, forfaiting under a letter of credit still involves payment, acceptance, and negotiation. If the relevant parties act in good faith, their rights and interests are protected.

III. Common Disputed Issues and Typical Cases

1. When Payment to the Beneficiary is Made via Forfaiting, Does it Constitute Negotiation or Assignment of Rights?

Article 2 of the Forfaiting Business Guidelines issued by the China Banking Association on July 4, 2019, states: "Purchase business refers to a bank buying, without recourse, the matured but not yet due payment obligation confirmed by the issuing bank/confirming bank." Therefore, whether payment to the beneficiary via forfaiting constitutes an assignment of rights or letter of credit negotiation is disputed.

The author believes that forfaiting merely enhances the liquidity of the payment claim without altering its nature. Payment, acceptance, and negotiation under a letter of credit remain aspects of the payment claim. Therefore, forfaiting encompasses both assignment and negotiation. Some courts also hold that assignment under forfaiting and negotiation under a letter of credit are not mutually exclusive; payment under forfaiting can constitute negotiation under the letter of credit.

2. When Payment to the Beneficiary is Made via Forfaiting, Is There an Obligation to Notify the Debtor of the Assignment?

Article 546 of the Civil Code states: "If the creditor assigns the claim without notifying the debtor, the assignment shall not be effective against the debtor." The essence of forfaiting business is the assignment of a claim. Whether it is subject to the notification obligation for assignment of claims is disputed.

The author believes forfaiting is a special type of assignment. The beneficiary is the creditor, and the applicant is the debtor. As forfaiting's essence is to enhance the liquidity of payment claims, its financial nature and industry practice mean that when conducting forfaiting (assignment of the not-yet-due claim under a letter of credit), the debtor (applicant) is typically not notified. If Article 546 of the Civil Code were strictly applied, requiring the beneficiary in the primary market to notify the applicant for the forfaiting to be effective, it would contradict industry practice and undermine forfaiting's fundamental financial instrument attributes. Therefore, the principle that special law prevails over general law should be applied, prioritizing forfaiting-specific rules (though forfaiting lacks special laws at the same hierarchy as the Civil Code, only having departmental regulations and international practices, which are of lower hierarchy). In some cases, courts do not directly address whether the Civil Code's notification obligation applies but judge the validity of the forfaiting transaction based on the relevant contractual agreements.

3. If the Underlying Transaction is False, Does the Forfaiting Purchasing Bank Constitute Negotiation in Good Faith?

Article 8 of the L/C Judicial Interpretation lists circumstances constituting L/C fraud: the beneficiary forging documents or submitting documents containing false information; the beneficiary maliciously failing to deliver goods or delivering worthless goods; the beneficiary and applicant or a third party colluding to submit false documents where no real underlying transaction exists. Therefore, a false underlying transaction constitutes L/C fraud.

Regarding false underlying transactions, the validity of contracts and allocation of liability in trade financing like forfaiting can be referenced in related series articles: Common Disputes and Adjudication Points in Import/Export Bill Purchase Business, Common Disputes and Typical Cases in Domestic Guarantee for Offshore Loan, Determination of Authenticity of Trade Background and Validity of Loan Contracts, Common Disputes and Adjudication Points in Independent Guarantee Business - Entered Cases, Common Disputes and Adjudication Points in Commercial Factoring Business, Typical Issues and Adjudication Points in Bill Disputes.

Article 10 of the L/C Judicial Interpretation states that if the negotiating bank accepts, pays, or negotiates in good faith, payment under the L/C is not affected even if fraud exists. However, the interpretation does not further define "good faith." The author believes whether it constitutes good faith can be understood by reference to the constitutive elements of a "bona fide third party" in civil law. Article 311 of the Civil Code defines a "bona fide third party" with two elements: "the transferee was in good faith when acquiring the real property or movable property" and "acquired it for a reasonable price." Therefore, whether it constitutes payment/negotiation in good faith requires meeting both conditions simultaneously:

(1) The Forfaiting Purchasing Bank was in Good Faith when Purchasing the Payment Claim under the L/C

This good faith comprises two layers of meaning. First, the purchasing bank did not know that the letter of credit involved fraud. Second, the purchasing bank was not grossly negligent, meaning it exercised due diligence and did not disregard obvious defects in the rights. As to the first layer, it is difficult for the purchasing bank to prove its lack of knowledge. Regarding the second, whether the purchasing bank exercised due diligence is highly contentious in practice, as the boundaries of such diligence are ambiguous and depend on judicial discretion.

Viewpoint 1: Defining the bank's duty of care by whether the presentation complies with the credit terms.

In Case 1, the court held that pursuant to Article 50 of the Administrative Measures for Domestic Letters of Credit, which provides: "Upon receipt of documents, the bank shall, based solely on the documents themselves, carefully examine all documents stipulated in the credit to determine whether they constitute a complying presentation. A complying presentation means a presentation that is in accordance with the terms and conditions of the credit, the applicable provisions of these Measures, international standard banking practice for document examination, and consistent within the documents and between the documents," and Article 51(1), which states that "banks shall examine documents on their face only," a bank is required only to conduct a formal review of whether the documents appear on their face to comply with the terms of the credit. It is not obligated to undertake a substantive review of the underlying transaction referenced in the documents.

Viewpoint 2: Banks should conduct necessary review of the authenticity of the trade background.

The author believes that according to Article 6 of the Forfaiting Business Guidelines: "Strengthen verification of the authenticity of the trade background. The purchasing bank in the primary market holds the first-hand information of the beneficiary and is responsible for conducting due diligence such as 'know your customer' and 'know your business,' reviewing the beneficiary's creditworthiness, and verifying the authenticity of the underlying trade background. The purchasing bank in the secondary market shall conduct necessary review of the transferred claim documents and trade background materials and pay attention to the credit risk of the issuing bank/confirming bank." Both primary and secondary market purchasing banks should conduct necessary review of trade background materials. If they fail to discover obvious falsehoods, it constitutes gross negligence, a failure to exercise due diligence, and thus not good faith.

(2) Did the Forfaiting Purchasing Bank Acquire the Payment Claim under the L/C for a Reasonable Price?

Where forfaiting is conducted by the beneficiary in the primary market, the forfaiting price is typically determined with reference to the prevailing bank loan interest rate for the corresponding period, and payment is made on a discounted basis. For example, in Case 1, the negotiating bank, Ping An Bank Shanghai Branch, paid a discounted amount of RMB 27,320,563.2 to Xulin Company under the forfaiting arrangement. In Case 2, the consideration paid by the forfaiting purchasing bank was RMB 9,876,819.44, being the letter of credit amount of RMB 10 million less a handling fee (0.23% per transaction) and interest (based on an annual financing rate of 2.45%). Since both the handling fee of 0.23% per transaction and the annual financing rate of 2.45% were consistent with prevailing industry rates for the period, the consideration paid by the purchasing bank was reasonable.

In Case 1, the court held that Ping An Bank Shanghai Branch had examined whether the sales contract, invoice, and goods receipt required to be submitted under the letter of credit in question appeared on their face to comply, and whether the letter of credit terms and documents appeared on their face to be consistent. After confirming that the documents complied, it made payment (the consideration) in accordance with the entrusted payment application, which was consistent with legal provisions. Xiangdian Company also failed to provide evidence proving that Ping An Bank Shanghai Branch colluded with the beneficiary Xulin Company to harm its interests. Therefore, the court held that Ping An Bank Shanghai Branch's negotiation constituted negotiation in good faith.

4. If the Underlying Transaction is False, Can Guarantee Liability under Forfaiting be Reduced or Exempted?

Under the letter of credit issuance business model, commercial banks typically require credit enhancement measures from the applicant to mitigate risk, such as obtaining a guarantee from a third party for the debts arising under the letter of credit. If a commercial bank pays the letter of credit beneficiary via forfaiting, whether it has fulfilled reasonable review obligations, and if the underlying transaction is false, whether the guarantor can thereby reduce or exempt guarantee liability, is disputed.

(1) If the Issuing Bank/Purchasing Bank is Not at Fault, the Guarantor Still Bears Liability Despite a False Underlying Transaction

Some courts hold that when an issuing bank honours a letter of credit or a negotiating bank pays via forfaiting, its duty regarding document examination is bounded by the documents under the letter of credit and does not extend to documents outside the letter of credit, such as the underlying contract. If the commercial bank examines documents in accordance with uniform rules such as the UCP, then even if the underlying transaction is false and the bank is not at fault, the guarantor must perform the guarantee obligation according to the guarantee contract.

(2) If the Issuing Bank/Purchasing Bank is at Fault, the Guarantor May Rescind the Guarantee Contract for a False Underlying Transaction

Some courts hold that a bank opening a letter of credit should adhere to the principle of good faith, fulfill the contractual agreement in handling the letter of credit, and complete necessary formal review obligations, thereby knowing or should have known that the underlying transaction was false with no genuine trade. If the issuing bank fails to identify obvious anomalies, such as affiliation between the applicant and beneficiary, commingling of personnel, overlapping office addresses, overlapping business scopes, or abnormal goods delivery methods, it constitutes a failure to perform necessary review obligations. This amounts to knowingly handling a letter of credit without a genuine underlying transaction background, contradicting the true intention of the guarantor when providing the guarantee and constituting fraud against the guarantor. Prior to the Civil Code, Article 30 of the Guarantee Law stipulated that the guarantor bears no civil liability if the creditor of the principal contract commits fraud. After the Civil Code, according to its Article 148: "If one party induces the other party to perform a civil juristic act against its true intention by means of fraud, the defrauded party has the right to request the people's court or an arbitration institution to rescind it." The guarantor may apply to rescind the guarantee contract.

5. Does an Issuing Bank's Bridging Payment under Forfaiting Constitute a Financial Loan, and the Validity of Overdue Interest and Penalty Interest Determination?

Buyer-paid interest forfaiting refers to, under a usance L/C, the issuing bank buying out the beneficiary's claim under the L/C and paying the full L/C amount to the beneficiary before maturity. The period from the buyout payment date to the maturity date of the relevant claim is the financing period. The financing interest rate and related fees are borne by the applicant.

The basic transaction model for buyer-paid interest forfaiting is: the seller and buyer sign a sales contract agreeing to use a bank's usance L/C as the settlement tool, but the seller bears the cost of the credit period. Thus, within the basic transaction framework, the seller effectively receives payment at sight. If the issuing bank makes a bridging payment for the L/C amount, it constitutes an overdue loan. Whether the overdue interest rate is reasonable needs to be assessed based on the contract terms and legal regulations.

(1) The Comprehensive Interest Rate on Bridging Payments Cannot Exceed 24%

According to Article 2 of the Supreme People's Court's Several Opinions on Further Strengthening Financial Adjudication (Fa Fa [2017] No. 22): "Strictly regulate usury according to law, effectively reducing the financing costs of the real economy. Where the borrower under a financial loan contract requests a reduction of the portion exceeding an annual interest rate of 24% on the grounds that the total of interest, compound interest, penalty interest, default interest, and other fees claimed by the lender is too high and significantly deviates from actual loss, such request shall be supported to effectively reduce the financing costs of the real economy." In Case 6, the court held that the Domestic Letter of Credit Issuance Contract clearly stipulated that bridging payments are to be treated as overdue loans, accruing compound interest at 0.5‰ per day from the bridging date, equivalent to an annual rate of 18%, which did not violate the law. In Case 7, the court held that the penalty interest rate Tianjing Company should pay to CITIC Bank Changchun Branch should be capped at an annual rate of 24%.

(2) Compound Interest on Overdue Interest for Bridging Payments is Not Supported

Case 7: The court held that regarding interest arising from bridging payments, whether compound interest is charged on penalty interest requires explicit contractual agreement; without such agreement, it is not supported. Case 8 held that if the bridging interest rate already includes a certain percentage added to the base loan interest rate, it has the nature of default liability and can be deemed overdue penalty interest. Claiming compound interest on top of that constitutes double punishment, violating the principle of fairness. Therefore, the claim by CITIC Bank for compound interest was not supported.