Letters of Credit – the fraud exception

Publication | November 2017

Introduction

English law vigorously upholds the principle of autonomy in relation to letter of credit (LoC) and demand guarantee transactions, as demonstrated in a number of recent cases. Only where there is fraud will English courts provide relief from paying out against an otherwise complying presentation or demand. In taking this approach, the English courts seek to avoid interfering with obligations that are considered to be “the lifeblood of international commerce”. However, financial institutions entering into letter of credit transactions should be aware that not all jurisdictions follow the autonomy principle as strictly and should take steps to mitigate the risks of being trapped between different approaches.

What is a LoC?

LoCs are a common method of payment for parties in different jurisdictions engaging in the international trade of goods. A LoC is a written commitment by a bank to make payment to a beneficiary on the satisfactions of certain conditions. The buyer of the goods (the applicant for the credit) requests a bank (the issuing bank), which is usually a bank in the applicant’s jurisdiction, to open a LoC in favour of the seller of those goods (the beneficiary of the credit). Often, the issuing bank also arranges with another bank located in the jurisdiction of the seller (the confirming bank) that the latter bank will make the payment to the seller. The payment is made upon the presentation by the seller to the confirming bank of certain documents identified in the LoC. These documents might include documents confirming title to the goods and bills of lading identifying the goods which have been transported or, in the case of a standby LoC, simply a written demand by the beneficiary without the need for any further documents. The confirming bank is itself entitled to compensation from the issuing bank upon presentation to it of the same documents.

In this way, the obligation of both the issuing bank and confirming bank to pay is separate, and independent, from the beneficiary’s obligations in its underlying contract with the seller. The banks pay strictly in accordance with the terms of the LoC and do not need to concern themselves with whether or not the buyer and seller have met their contractual obligations to each other. A dispute over the sale of the goods does not impinge on the effectiveness of the LoC.

The fraud exception

The only exception to this principle recognised under English law is a fraud affecting the documents presented by the beneficiary (for example if they have been forged) or, in the case of a standby LoC, if the beneficiary had no honest belief in the validity of its demand. This exception arises, and the English courts will grant an injunction restraining the issuing/confirming bank from making payment, only in narrow and exceptional circumstances. To prove that a demand under a standby LoC is fraudulent, the applicant for an injunction (for example a buyer of the goods who alleges that the goods sold were defective) must show that the seller knows that the demand is fraudulent, or that the circumstances around the demand are such that the only reasonable interference is that the demand is fraudulent. The difficulty in meeting this threshold is demonstrated in the Court of Appeal’s decision in National Infrastructure Development Co Ltd v Banco Santander SA [2017] EWCA Civ 27 (NIDCO v Santander).

NIDCO v Santander concerned demands under four standby LoCs issued by Santander in favour of National Infrastructure Development Company Limited (NIDCO), a corporate vehicle of the government of Trinidad and Tobago, for carrying out public infrastructure works. The standby LoCs were security for payment obligations in a construction contract between NIDCO, and a contractor, Constructora OAS Limited (OAS). A dispute arose between NIDCO and OAS and OAS ceased construction work claiming non-payment and commenced arbitration against NIDCO. NIDCO subsequently made a demand under the standby LoCs, the terms of which required NIDCO to confirm that payment “is due and owing … by [OAS]”. OAS sought and obtained an injunction from a court in Brazil (where Santander had a subsidiary) restraining payment by Santander under the standby LoCs. The standby LoCs were governed by English law and contained English jurisdiction clauses, and NIDCO subsequently sought summary judgment in the High Court against Santander for payment of the sums.

Santander argued that the fraud exception should be engaged because

  • NIDCO’s certification that the sums were “due and owing” was false and that NIDCO could have had no honest belief it was true as no damages had yet been liquidated or awarded by the arbitral tribunal;
  • NIDCO was claiming approximately USD 35m when it was only entitled to USD 31m in security and it was fully aware of this;
  • There was potentially an equitable jurisdiction in English law to prevent unconscionable demands under LoCs, in addition to the fraud exception, and;
  • There should be a stay of execution pending further order in light of the Brazilian injunction which prevented Santander from making payment.

The Court dismissed this argument and granted summary judgment in favour of NIDCO.

In the Court of Appeal, Santander argued that there was no evidence that personnel at NIDCO had considered whether sums were presently “due and owing” or would become “due and owing” at some future date. The court dismissed this argument, however, finding that: “No doubt lawyers can have a debate as to whether a current entitlement to claim damages for repudiation entitles one to say that the amount of such damages is due and owing … but it borders on the absurd to say that the only realistic inference from the fact that business did not have (or may not have had) that debate is that they could not have believed in the validity of their demands.”

The end result of NIDCO v Santander was that the English courts required Santander to satisfy the LoC demand even though the Brazilian courts had granted an injunction forbidding payment. We examine the consequences of this further below.

Unconscionable demands

Although the English courts continue to resist efforts to extend the fraud exception to cover unconscionable demands, other jurisdictions such as Australia (where the unconscionable conduct ground has been incorporated into statute) and Singapore have been willing to do so. Similarly, in NIDCO v Santander, the Brazilian court granted an injunction restraining Santander from making payment on exactly the same facts which the English courts dismissed with the words: “the facts and matters put forward as evidence of fraud to my mind just do not amount to fraud at all”.

These differences in approach can give rise to real difficulties for banks involved in LoC transactions, especially given LoCs commonly do not include any express choice of governing law or jurisdiction. The contractual relationships between the various parties (for example, between the applicant and the issuing bank, the issuing bank and the confirming bank, and the confirming bank and the beneficiary) are often governed by different laws and subject to different jurisdictions.

To take an example, in the absence of an express choice of governing law, an LoC between a Brazilian applicant and a locally-based bank is likely to be governed by Brazilian law, but if an English-based confirming bank steps in and confirms the credit in favour of the beneficiary, the confirming bank’s relationships with the issuing bank and the beneficiary are both likely to be governed by English law (see Bank of Baroda v Vysya Bank Ltd [1994] 2 Lloyd’s Rep 87). As demonstrated in NIDCO v Santander, a Brazilian court may be more willing than an English court to grant an injunction restraining an issuing bank from making payment to a confirming bank. That might leave a confirming bank in the unfortunate position of being ordered by the English court to pay the beneficiary, knowing that the issuing bank is prevented under the Brazilian injunction from reimbursing it. Or, possibly even worse, it may be bound by two contradictory rulings in two jurisdictions, so that it will inevitably breach at least one of them.

Conclusion

As noted, the drafters of LoCs generally refrain from including governing law and jurisdiction clauses. This is because the LoC typically includes an express provision subjecting it to the terms of the International Chamber of Commerce’s “Uniforms Customs and Practice for Documentary Credits” (UCP), a body of rules on the issuance and use of LoCs which applies to over 100 countries. In doing so, drafters put their faith in the idea that the UCP provides for standardisation that transcends the differences that may arise through the application of different national laws. NIDCO v Santander shows that this is often not the case. Significantly, the UCP is silent as to governing law.

Given the varying approaches of different laws and jurisdictions to issues such as the motivation behind a beneficiary’s presentation of documents, good commercial practice suggests it would be prudent to include an express choice of governing law and jurisdiction in LoCs, even where they refer to the UCP. This would mitigate the risks of finding themselves trapped between contradictory judgments.


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