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Standby letters of credit

23 March 2017

A recent case has explored when a bank will be relieved of its duty to make payment under a letter of credit in a situation where the payment terms of the underlying contract are subject to a dispute under foreign law proceedings. This case also clarified points regarding the fraud exemption and the certification required from the presenter in a demand for payment. Below, we will explore these points and highlight the potential impact of this case.

The case

The case of Petrosaudi Oil Services (Venezuela) Ltd v Novo Banco SA (1) PDVSA Servicos SA (2) PDVSA Services BV (3) [2017] EWCA Civ 9) concerned an English law letter of credit where the underlying contract (for oil drilling services) was governed by Venezuelan law. A dispute arose between the parties to the underlying contract which affected invoices totaling $129m and had been referred to arbitration. Whilst the final outcome of the arbitration was awaited, the arbitrators had made a ruling that the key payment term of the contract (which stated that invoices were deemed accepted and due for payment if not disputed within 15 days) was void. Despite this ruling, the beneficiary of the letter of credit, Petrosaudi Oil Services (Venezuela) Ltd ("POS") submitted a demand for payment requesting $129m from the bank.

What should the bank do?

Under an English law letter of credit, the bank's obligation to make payment is a separate and independent obligation from the underlying contract to which it relates and the performance (or non-performance) of the obligations set out in that contract. Once a demand for payment has been made by the beneficiary of the letter of credit in the required format, the bank must fulfil its obligation to make payment, unless the fraud exemption applies.

In this case, the demand documents were presented in the required format and included a statement that 'the applicant is obligated to the beneficiary to pay the amount demanded under the drilling contract…'. The bank was not relieved of its obligation to make payment simply because of the existence of the ongoing dispute between the parties. Accordingly, the bank stated its intention to make the payment.

At this point the other contract party ('PDV') sought an injunction to restrain the bank from making payment on the basis of the fraud exemption. The parties agreed a holding position (where the bank would not pay) pending the trial at which the impact of the arbitration ruling on the fraud exemption could be considered in full.

Impact of the foreign law arbitration

For the fraud exemption to apply, a bank is entitled to withhold payment where it is clearly established or obvious that the beneficiary was involved in a fraud relating to the transaction and where the bank knew of the fraud. The Court's view was that the fraud element would be satisfied in this case if the beneficiary had no honest belief in the statement that PDV were 'obligated to pay' or that it was made without caring whether it was true or false.

During the first instance hearing, the Court concluded that the effect of the ongoing foreign law arbitration proceedings was to remove the contractual obligation on PDV to make payment of the invoice until such time as the arbitration proceedings were concluded. This brought into question whether PDV was obligated to pay the debt for the purposes of the demand for payment, and if not, whether the presenter had been fraudulent in submitting its demand to the bank.

The fraud exemption

On appeal, the Court of Appeal closely examined the wording in the demand for payment. It clarified that the statement 'obligation to pay' did not require PDV to be under an immediate obligation to discharge a liability. Instead, the Court took the view that the statement could include the situation where PDV had a liability to pay but was not currently entitled to make payment while the overseas arbitration procedure was ongoing. Accordingly, POS had been entitled to submit the demand for payment.

The element of dishonesty is a crucial requirement for the fraud exemption. The errant party must be 'conscious of the falsity of what he was saying' or have 'no honest belief in, or a reckless indifference to, its truth'. The appeal judge expressed some disquiet at the conclusion of fraud reached in the previous hearing. He recognised that it is possible to have more than one interpretation of a point of law and that an incorrect legal representation would not necessarily equate to fraudulent behaviour.

In conclusion, the Court did not believe any fraud had occurred. The presenter was entitled to certify that payment was due and submit the demand to the bank.

The function of letters of credit - confirmed

The judgment in this case serves as a reminder that the function of letters of credit is to 'reverse the risk of non-payment from the payee to the payor'. It noted that, in this case, the availability of the letter of credit was of critical importance to the underlying transaction.

Points for banks to check when considering an English law demand for payment:

  • Do the demand documents comply with the requirements set out in the letter of credit? If so, the bank is under an obligation to pay unless the fraud exemption applies.
  • Is the bank aware of fraud? The fraud exemption applies if the bank is aware that there has been a forgery of documents or that the request for payment is made fraudulently.
  • Is the fraud obvious or clearly established? There is common law commentary to the effect that it is not enough to suspect fraud, it must be 'established' or 'obvious'. The case of POS has demonstrated that an incorrect representation of law in a demand document does not necessarily equate to fraudulent behaviour.
  • Should the bank withhold payment if there is a dispute between the parties to the underlying contract and fraud has not been established? No. An underlying dispute will not affect the bank's obligation to pay.

The obligation to pay can be indirectly affected by proceedings only if they give rise to a situation where the beneficiary chooses to behave fraudulently.

Letters of credit are often for significant sums and a payment in error or a failure to pay when due can carry reputational as well as legal risks. If you have any concerns about whether a payment is required in any given situation we would recommend that you take advice and would be pleased to help you.

NOT LEGAL ADVICE. Information made available on this website in any form is for information purposes only. It is not, and should not be taken as, legal advice. You should not rely on, or take or fail to take any action based upon this information. Never disregard professional legal advice or delay in seeking legal advice because of something you have read on this website. Gowling WLG professionals will be pleased to discuss resolutions to specific legal concerns you may have.

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