Questioning the stalwart of payment methods

In 1978 Kerr J famously said that irrevocable obligations assumed by banks are the “lifeblood of international commerce”. The accuracy of this description was tested recently before the English Court of Appeal. The court remained unwilling to depart from the principle that if a compliant demand is made under a standby letter of credit, an issuing bank must pay, subject to only very limited exceptions.

A key purpose of the widespread use of letters of credit to finance commodity transactions is the comfort it gives to the seller that it will receive payment. In two English law cases decided this year, banks sought to avoid their payment obligations under a standby letter of credit (SBLC), without success.

In the first case, National Infrastructure Development Co Ltd v Banco Santander2, the bank was appealing against summary judgment given in favour of the beneficiary (NIDC) of four SBLCs. The bank raised several arguments on appeal, including one that the demand for payment was fraudulent.

The SBLCs provided that the presentation of a demand would be conclusive evidence that the amount claimed was “due and owing” to NIDC by its contractor. The bank argued that NIDC did not believe in the validity of its claim, because a claim for damages for premature abandonment of the underlying contract was not a claim in law that money was “due and owing”. The Court of Appeal held that this argument was misconceived:

1. The beneficiary’s belief that payment was “due and owing” should activate payment. The test is not whether the demands were decided by a tribunal or otherwise to be correct in law.
2. An ongoing arbitration concerning the underlying contract did not mean NIDC’s demands were dishonest.
3. It could not be fraudulent to make a demand that one was entitled to make.

The Court of Appeal concluded that there was no evidence of fraud and the bank had to honour the demand for payment.

Fraud claim

In the second case, Petrosaudi Oil Services (Venezuela) Ltd v (1) Novo Banco SA (2) PDVSA Servicos SA (3) PDVSA Services BV3, the beneficiary, Petrosaudi, appealed the English Commercial Court’s decision that its demand for payment had been fraudulent. The court had held that Petrosaudi was not entitled to call for payment of invoices under the SBLCs issued by the bank, because the underlying invoices were disputed. The underlying contract contained a “pay now, argue later” clause, but this conflicted with a provision of Venezuelan law, which governed the contract. Venezuelan law required completion of a verification procedure authorising the bank to pay, or an arbitration award to the same effect. The court had held that Petrosaudi’s certification under the SBLC was fraudulent as, under Venezuelan law, the bank had no present obligation to pay.

Petrosaudi appealed. The issue in dispute was whether it had been open to Petrosaudi to certify that the counterparty was “obligated to pay”, and thus demand the payment from the bank, when the sums were in dispute. The Court of Appeal allowed Petrosaudi’s appeal:

1. The meaning of the words “obligated to pay” had to be considered in the context of the certificate to be tendered under the SBLC. The SBLC was separate to the underlying contract, made with a different counterparty, and had a different governing law (English law).
2. According to the underlying contract, the counterparty was obligated to pay Petrosaudi. This obligation was not immediately dischargeable due to the provision of Venezuelan law, but the obligation existed nevertheless.
3. The SBLC did not require the award of a tribunal or evidence that Venezuelan law had been complied with. The SBLC was governed by English law.

Reinforcing the law

These decisions reinforce the English law principle that exceptions to the rule that an issuing bank must pay under an SBLC are limited and difficult to prove. If you have concerns about the reliability of your counterparty, requiring them to provide an SBLC from a reliable bank and governed by English law remains a good way of securing payment.

If you are the beneficiary of a SBLC, you should insist that it contains clear wording to the effect that presentation of a demand by you will be conclusive evidence that the amount claimed will be “due and owing”. In order to rely on the strength of these decisions, you should also ensure that English law governs the SBLC, even if it does not govern the underlying contract.

Sarah Taylor is a partner of HFW, located in the London office. She can be contacted on +44 (0)20 7264 8102, or sarah.taylor@hfw.com.