UK: Standby Letters Of Credit, Complying Demands And The Fraud Exception – Court Of Appeal Restores Certainty And Commercial Common Sense

Last Updated: 10 February 2017
Article by Celia Gardiner and David Williams

In two appeals on the validity of demands under standby letters of credit (SBLCs) and the application of the fraud exception, the Court of Appeal has ruled in each case that:

  • the beneficiaries were entitled to demand payment under the SBLCs;
  • they had not acted fraudulently in issuing the demands; and
  • there was no basis for restraining the relevant banks from paying against the demands.

The appeal court provided very useful clarifications around these issues in Petrosaudi Oil Services (Venezuela) Ltd. v. Novo Banco S.A. [2017] EWCA Civ 9 (the Petrosaudi Appeal) and National Infrastructure Development Co. Ltd. v. Banco Santander S.A. [2017] EWCA Civ 27 (the Santander Appeal).

KEY PRINCIPLES

SBLCs are used mainly to provide the beneficiary with credit support in the event of non-performance by its counterparty under an underlying contract. Applicants of SBLCs are liable to their issuing banks for amounts paid out under the credit, and are therefore watchful against unfair and fraudulent demands by beneficiaries.

Under the well-known "autonomy principle", an issuing bank's duty to pay against an apparently complying presentation/demand is independent of the underlying contract and any disputes between the parties to that contract. The fraud exception – if there is fraud in opening the credit or a fraudulent demand by the beneficiary – is one of very few exceptions to the autonomy principle.

The key issue in both the Petrosaudi Appeal and the Santander Appeal was whether the beneficiaries were entitled to serve demands under the SBLCs and whether they were fraudulent in making those demands.

THE PETROSAUDI APPEAL

The Background

Petrosaudi Oil Services (Venezuela) Ltd (Petrosaudi) provided oil rig drilling services to PDVSA Servicios S.A. (PDV) under a Venezuelan law contract (the Drilling Contract). An English law governed SBLC was issued in favour of Petrosaudi as credit support for PDV's payment of Petrosaudi's invoices.

The Drilling Contract provided that if PDV disputed an invoice it had to tell Petrosaudi within a set time or it would be deemed to have accepted the invoice on a "pay now, argue later" basis. At arbitration, this arrangement was held invalid under Venezuelan law (which set out a prescribed process for approving invoices issued to a state entity, such as PDV, before that entity had to pay).

PDV failed to pay certain invoices and Petrosaudi issued a demand to the bank under the SBLC certifying that "... the Applicant is obligated to the Beneficiary to pay the amount demanded under the Drilling Contract ...".

The High Court trial

Taking into account the Venezuelan arbitration rulings, the trial judge held that disputed invoices issued under the Drilling Contract were not immediately payable to Petrosaudi until either PDV approved those invoices or there was an arbitration award in respect of the invoices. The court held that, at the time of the demand, the sums claimed under the SBLC had to be due for immediate payment, not at some defined or undefined point in the future. Therefore, according to the judge, in certifying that the applicant was "obligated to pay" Petrosaudi the sums claimed under the SBLC, the signatory of Petrosaudi's demand either knew that the demand was false or was reckless as to its falsity. The fraud exception was therefore established and the bank should not pay under the SBLC.

The Court of Appeal's decision

At appeal, the leading judgment of Christopher Clarke LJ focused on the meaning of "obligated to pay" in the certifying statement in Petrosaudi's demand. The phrase, he said, was capable of more than one meaning and had to be considered in context – it was part of the demand under the SBLC, which was a separate contract from the Drilling Contract. He noted that there were different types of debt obligation, for example:

  • a contingent debt which arises and becomes payable on the occurrence of the contingency;
  • a debt payable only after a period of time has elapsed; or
  • (as in the case of the Drilling Contract) a debt due and payable by a debtor now, but for which the debtor has some excuse or restriction against immediately discharging it.

Although the effect of the Venezuelan arbitration rulings was that PDV did not have an obligation immediately to pay the invoices under the Drilling Contract, PDV still had an existing liability to pay them.

Petrosaudi was therefore entitled to make the demand under the SBLC. Its certificate in the demand that the applicant was "obligated to pay" was, "in essence, a representation of law" on which "different legal minds may obviously take different views". It was not fraudulent "in any sense". The bank was obliged to pay the amounts demanded.

THE SANTANDER APPEAL

In the Santander Appeal, National Infrastructure Development Co. Ltd. (NIDCO), of Trinidad and Tobago, and Brazilian contractor Construtora OAS (OAS) had entered into a contract for OAS to build a major highway in Trinidad (the Construction Contract). The Construction Contract was subject to Trinidad law, with dispute resolution by arbitration in Trinidad. Banco Santander S.A. (Santander) issued SBLCs at the request of OAS as a performance and retention "guarantee" under the Construction Contract. The SBLCs were English law governed, and the English courts had jurisdiction to settle disputes arising in relation to them. The terms of the credit provided that presentation of a demand would be "conclusive evidence that the amount claimed is due and owing to you [NIDCO] by the contractor [OAS]".

OAS abandoned the project and went into insolvency in Brazil. Following this, NIDCO terminated the Construction Contract and presented demands under the SBLCs to Santander stating that the relevant sums were "... due and owing to us by the contractor ...". In granting summary judgment for NIDCO, the High Court had held, among other things, that NIDCO was entitled to issue these demands and they were not fraudulent.

The Court of Appeal's reasoning

On appeal, Santander argued that NIDCO's demands under the SBLCs were not valid and were fraudulently made. The sums demanded included unliquidated damages for OAS walking away from the Construction Contract and, the bank submitted, such sums could not be "due and owing" unless and until the level of those damages had been determined by judicial process or by agreement.

In the leading judgment, Longmore LJ clarified that it was NIDCO's belief in the validity of its demands that was relevant, not whether the demands were correct as a matter of law. As a general principle, establishing the fraud exception required "particularly cogent evidence".

He also considered the meaning of the phrase "due and owing" in NIDCO's demands against their contractual background. The Construction Contract required the SBLCs to cover any losses NIDCO suffered due to OAS's non-performance of that contract. The SBLCs stipulated that demands should state that a sum was "due and owing" by OAS. NIDCO was therefore entitled to include sums relating to OAS's non-performance of the Construction Contract as "due and owing" when issuing its demands. The court stated clearly that "it cannot be fraudulent to make a demand one is entitled to make". The bank was therefore obliged to pay against the demand.

Conclusions

In our earlier article " Recent cases on standby letters of credit – does the issuing bank have to pay?" we took the view that while the High Court decision in the Santander case was sound, the judgment in the Petrosaudi case was not clear cut – views supported by the Court of Appeal's rulings in the Santander Appeal and the Petrosaudi Appeal.

Both appeal court decisions underscored the essential commercial utility of letters of credit – international transactions which might otherwise not have taken place due to high levels of risk proceeded because letters of credit were made available to provide the respective parties with some level of comfort.

The Court of Appeal adopted interpretations of the phrases "due and owing" and "obligated to pay" which were most apt in the specific contexts in which they were used, and which made "commercial good sense", as Christopher Clarke LJ put it in the Petrosaudi Appeal.

In each case, the appeal court's affirmation of the fundamental autonomy principle was unequivocal. The courts will generally strive to enforce a bank's payment obligations under a letter of credit, and will interfere with those obligations only where the high threshold for establishing the fraud exception (or one of the other very limited exceptions) has clearly been met.

Law stated as at 31 January 2017

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