The lifeblood of commerce: letters of credit and the "autonomy" principle reaffirmed

The lifeblood of commerce: letters of credit and the "autonomy" principle reaffirmed

Letters of credit (also known as “standby letters of credit” or “standby L/Cs”) are a crucial tool in many commercial transactions.  They are used when, for example, a supplier requires a payment obligation owed to it by a buyer (aka the “borrower”) to be guaranteed by a strong and creditworthy entity, e.g. a bank.  A typical standby L/C works as follows:

  • the borrower asks its bank to issue (for an agreed fee) the standby L/C in favour of the supplier under facility documentation made between the bank and the borrower;
  • the supplier can call upon the standby L/C if the borrower does not pay the relevant invoice amount when due;
  • the bank pays the unpaid invoice amount upon presentation of documents specified in the standby L/C – crucially, this payment obligation from the bank is separate and independent  from performance of the underlying supplier-borrower contract; and
  • the borrower provides reimbursement to the bank under the aforementioned facility documentation.

The key feature of a standby L/C is the creation of a standalone payment obligation on the bank which is divorced from the underlying contract.  Put another way, the conditions to the bank’s payment are contained exclusively in the terms of the standby L/C itself.  The bank will pay the supplier if these conditions are satisfied.  This principle is called the “autonomy of the credit”.

This principle means that the recipient of a standby L/C can effectively treat that credit as “cash” so long as it complies with the conditions to payment.  Accordingly, it is critical to borrowers’ and suppliers’ confidence in these instruments that the “autonomy” principle is upheld and that issuing banks honour their payment obligations.

The fraud exception is one of the very limited exceptions to the “autonomy” principle. Fraud occurs “where the [supplier], for the purpose of drawing on the credit, fraudulently presents to the confirming bank documents that contain, expressly or by implication, material representations of fact that to his knowledge are untrue” (United City Merchants (Investments) Ltd v Royal Bank of Canada [1983] 1 AC 168).

Two recent Court of Appeal cases (National Infrastructure Development Co Ltd v Banco Santander SA [2017] EWCA Civ 27 and Petrosaudi Oil Services (Venezuela) Ltd v Novo Banco SA and others [2017] EWCA Civ 9) have reaffirmed the “autonomy” principle and reiterated that the fraud exception is very narrow in its application.

In National Infrastructure Development:

  • a bank (“X”) issued a letter of credit to a company (“Y”) in relation to a contract between Y and another party (“Z”).  That letter of credit was governed by English law and subject to English jurisdiction clauses;
  • Y asserted that Z had abandoned the underlying project contract and made a demand on X;
  • Z argued it was not required to pay because Y had given a false notification to X by recklessly claiming that amounts under the contract were due and owing when that was not the case; and
  • instead Z claimed that the amounts were not yet due and owing, that the “fraud” exception applied, and that X did not have to pay Y as a result.

This argument was dismissed on summary judgment. Z had failed to show that it had a “real prospect” of succeeding at trial of being able to prove that Y had claimed under the letter of credit fraudulently.  X should therefore make payment to Y under the letter of credit.

In Petrosaudi:

  • a company (“A”) provided services to an entity (“B”) and a bank (“C”) issued a letter of credit governed by English law to A in respect of B’s payment for those services
  • there was a dispute over payment and B refused to pay invoices issued by A;
  • an arbitration tribunal was established to resolve the dispute under an arbitration clause in the underlying contract;
  • A made a presentation of documents to C under the letter of credit certifying that B was obliged to pay under the underlying contract; and
  • C confirmed its intention to pay and B sought an injunction preventing C from making the payment.

The underlying contract stated that B must pay any disputed invoices.  The arbitration tribunal had imposed some restrictions on the payment of the sum in dispute, but the Court of Appeal still held that the underlying sum was due and payable under the terms of the underlying contract, with the result that C should pay A pursuant to the letter of credit.

Head of Banking & Finance, Jonathan Porteous comments: “Both these cases illustrate that the English courts are extremely keen to ensure that the fraud exception to the “autonomy” principle remains a narrow one, and that standby letters of credit are honoured by banks as part of finance transactions wherever possible.”

Contact our experts for further advice

Andrew Dodds

Search our site