Update on standby letters of credit - Kotonou v National Westminster Bank plc [2010] EWHC 1659

September 2010

Contacts

Introduction

Standby letters of credit (SLC), as distinct from documentary credits, have largely evolved to meet the difficulties American banks face in granting third party guarantees. Although they are often encountered in trade transactions, they are also used in financing transactions, as a means of securing deposits, or as security for syndicated loan transactions.1 Unlike guarantees, documentary credits and performance bonds, they are not often the subject of judicial scrutiny.

In order to escape the characterisation of a guarantee, SLC will generally emphasise that the liability for making payment is a primary liability arising on production of conforming documents rather than on proof of a third party’s defaulting performance. It was to reinforce that position that the ICC’s contractual and codified rules UCP 6002 , which impose a document based liability on an issuer, was extended to cover SLC. However, as the term “standby” might suggest, the underlying intention is that payment against the production of documents should generally be contingent. In a trading context, that will usually mean a counterparty’s non-performance within a stipulated timeframe. Unless dealing with parties with US related banking sensitivities, it may be advisable to incorporate expressly into the SLC more appropriate uniform rules such as ISP 983. The ISP 98 are specifically tailored for SLC.

As SLC impose a primary payment obligation on the issuer, the inconvenient English law guarantee requirement for personal signatures as stipulated by the Statute of Frauds 1677 is avoided. For a beneficiary, the advantages of SLC are that they provide an autonomous third party security payment mechanism in the event of a counterparty’s default. The disadvantage for the provider is that they can be expensive and that payment obligations can be isolated from a counterparty’s unmeritorious, albeit not dishonest, conduct.

Footnotes
  1. Mahonia v JP Morgan [2004] EWHC 1938
  2. The Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication No. 600 (UCP 600)
  3. The International Standby Practices ISP 98, ICC Publication No. 590 (ISP 98)

Background

The recent decision in Kotonou v National Westminster Bank plc has been the subject of comment both in relation to a creditor’s duty to call in security and as an illustration of an abuse of process involving a collateral attack on findings made in earlier proceedings. The case also involved judicial consideration of the status of SLC.

Mr Kotonou controlled Olympic Resources & Services plc (ORS). In order to obtain a loan to ORS from National Westminster Bank plc (Nat West), Mr Kotonou procured a third party to provide a SLC issued by Barclays Bank plc (Barclays). Nat West failed to call on the SLC before it lapsed which resulted in Mr Kotonou having to provide a personal guarantee. ORS went into liquidation and a demand was made on the personal guarantee. Mr Kotonou, having succeeded in setting aside his personal guarantee on the grounds of misrepresentation, commenced separate proceedings against Nat West both in a personal capacity and as an assignee of ORS’ causes of action. One of the claims in these proceedings was that Nat West had owed and breached a duty both to ORS and Mr Kotonou to make a call on the SLC before it lapsed. This in turn raised the issue of the status of a SLC.

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Decision

Mr Kotonou sought to contend that as the SLC was almost the equivalent of cash, Nat West had held it as a bailee of cash and had been under an obligation to apply it towards ORS’ liabilities. Nat West sought to argue that the SLC was more in the nature of a guarantee than of cash or a negotiable instrument and it was under no duty to make a call. The Judge disagreed with both submissions commenting:

“It seemed to me that the rights (and any possible duties) of Nat West under the standby letter of credit were not the same as the rights and duties of a bailee of cash. It also seemed to me that there were differences between the rights of Nat West under the letter of credit and the rights it would have had under a traditional contract of guarantee in respect of the debts of ORS, even a guarantee given by a bank.”

The Judge consulted and recorded the views expressed in the leading textbooks as follows:

Benjamin’s Sale of Goods, 7th ed: “…first demand guarantees and performance bonds served the same functions as standby credits”; Gutteridge and Megrah’s Law of Bankers’ Commercial Credits, 8th ed: “a standby credit is a guarantee of the obligations of a party under a contract which operates in a similar manner to a performance bond or first demand guarantee”; and Jack, Documentary Credits, 4th ed: an "independent guarantee ….(with) an autonomous obligation of the person providing it.”

The Judge expressed his conclusions as follows:

“In one sense, the liability of Barclays is secondary to the liability of ORS. In another sense, the liability of Barclays is autonomous and arises on Nat West producing conforming documents as specified in the letter of credit. A call on the letter of credit can only be made between 30th September 2000 to 30th December 2000. The rights under the letter of credit cannot be assigned or transferred by Nat West. The rights under the letter of credit are not the same as cash or bank notes. The obligations of Barclays under the letter of credit are clearly defined and some matters which might provide a defence to liability under a traditional guarantee will not fall to be considered. Nat West holds the letter of credit as a security for payment of the underlying debt due from ORS to Nat West.”

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Conclusion

The references made in some of the cited text books characterising SLC as guarantees are perhaps unfortunate given the requisite formalities for such instruments. Accordingly, the Judge’s conclusion that SLC are autonomous and fall outside traditional guarantees is a welcome if somewhat unsurprising one. It is another decision which would suggest that in a commercial and e-trading context the Statute of Frauds should be repealed.

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