Canada: Letters Of Credit: When Not To Pay

Last Updated: November 15 2016
Article by Kirsty Barnes and Catherine Phillips

Most Read Contributor in Canada, October 2018

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. Below we will highlight the potential impact of this case, including, the scope for foreign law proceedings to impact on a bank's obligation to pay and recommend the key points to check in respect of an English law letter of credit which is subject to an alleged fraud.

The case

The case of Petrosaudi Oil Services (Venezuela) Ltd v Novo Banco SA (1) PDVSA Servicos SA (2) PDVSA Services BV (3) [2016] EWHC 2456 (Comm), 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 claimant submitted a demand for payment under the letter of credit. The claimant sought confirmation that it was entitled to make a presentation under the letter of credit and receive the $129M in payment 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 is required to 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 obligations to make payment simply because of the existence of the ongoing dispute between the parties. Accordingly, the bank stated its intention to make 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.

The Court concluded that:

  • the effect of the interim foreign law arbitration ruling was to remove the contractual obligation on PDV to make payment of the invoice until the arbitration proceedings were concluded;
  • the meaning of the statement ' pay' in the demand was 'obligated to pay now';
  • the presenter (the beneficiary's global counsel) would have considered the correct interpretation of the term 'obligated'. Either the presenter had made the statement in the demand for payment without believing it to be true, or he had been reckless as to its falsity, by 'wilfully shutting his eyes to the obvious'.
  • the fraud exemption applied and the bank was not required to make payment.

What if there was no dishonesty?

The Court considered what would happen if a demand for payment was made which the beneficiary believed to be true, even if it contained a statement of fact that was incorrect. It noted that 'proof of falsity at trial in a case where there was an honest belief that the presentation was compliant on its face at the time would not give the bank a defence' to making payment i.e. the element of dishonesty is a crucial part of the fraud exemption.

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'.
  • 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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