Canada: Saskatchewan Court Of Appeal Releases Important Decision On Letters Of Credit As Security For Contractual Obligations

Last Updated: May 10 2019
Article by Caroline J. Smith

The Saskatchewan Court of Appeal recently released a decision of note to any business that uses or provides letters of credit as security for contractual obligations, or is considering doing so: Veolia Water Technologies, Inc v K+S Potash Canada General Partnership (Veolia). In Veolia, the Saskatchewan Court of Appeal held that the beneficiary of a letter of credit can draw on it to reimburse itself for certain losses even though liability for those losses is still being litigated.

USE OF LETTERS OF CREDIT AS SECURITY FOR CONTRACTS

Letters of credit are sometimes used to secure performance under contracts for construction or sale of goods, especially high-value contracts involving companies based outside of Canada.

A letter of credit is a promise by a bank (the issuer) to pay a specified amount of money to a third party (the beneficiary) on behalf of its customer (the applicant). Payment is made only if the conditions specified in the letter of credit are met. For example, a purchaser of goods may provide a letter of credit to the seller as security for payment; that letter of credit may require the seller to provide proof of delivery of the goods to the issuer in order to draw on the letter of credit.

Though the use of letters of credit as security for contractual obligations is intended to avoid litigation, disputes sometimes arise regarding whether payment should be made. It is important for any business that is party to a contract using a letter of credit as security to understand how courts resolve those disputes.

OPTIONS FOR DISPUTES REGARDING PAYMENT UNDER LETTERS OF CREDIT

Applicants who wish to block or challenge a payment under a letter of credit have two main options.

One is to target the issuer by applying for an injunction prohibiting the issuer from paying the beneficiary, or if payment has already been made, suing the issuer. However, an applicant's injunction or lawsuit against an issuer can succeed only if the applicant can prove that the conditions for payment in the letter of credit were not met, or that the issuer made the payment knowing that the beneficiary's demand was fraudulent. A beneficiary's demand is fraudulent if the beneficiary committed fraud in the underlying transaction or forged a document needed to satisfy a condition of payment.

The other option is to target the beneficiary. This is the option the applicant attempted to exercise in Veolia.

SUMMARY OF THE VEOLIA CASE

In Veolia, the beneficiary (KSPC) and the applicant (Veolia) were parties to a contract under which Veolia was to design, supply, and commission an evaporation, clarification, and crystallization system for KSPC's potash mine (the Contract). A frame supporting a crystallizer supplied by Veolia failed (the Incident). In order to recoup its losses from the Incident, KSPC made demands on two letters of credit supplied by Veolia. Veolia objected to those demands because Veolia and KSPC were still litigating Veolia's alleged liability for the Incident.

Veolia supplied Letter of Credit #1 to KSPC pursuant to the Contract, which required Veolia to supply a letter of credit that KSPC could "draw upon...if [Veolia] defaults in any of its obligations under this Contract and fails to remedy the default within any applicable cure period..." Letter of Credit #1 provided that the issuer would pay KSPC if it received a certificate signed by KSPC stating that "We are entitled to draw on this Credit under the [Contract]."

Letter of Credit #2 was supplied pursuant to a reservation of rights agreement between Veolia and KSPC relating to the Incident (the Reservation of Rights Agreement). The Reservation of Rights Agreement required Veolia to supply another letter of credit that KSPC could draw on "for any losses, costs or damages which are recoverable under the Contract, that are suffered or incurred by KSPC as a result of or arising out of the Incident...if KSPC determines, acting reasonably and in good faith, that the cause of the Incident is attributable to Veolia or its Personnel[.]" Letter of Credit #2 stated that the issuer would pay KSPC if it received a certificate signed by KSPC stating that "We are entitled to draw on this Credit under the Reservation of Rights Agreement[.]"

Veolia applied for an injunction to prevent KSPC from drawing on either letter of credit, arguing that KSPC was not entitled to draw on them because there was a dispute regarding whether Veolia was liable for the Incident, and no court or arbitral tribunal had yet decided the issue. The Saskatchewan Court of Appeal held that Veolia was not entitled to an injunction. The terms of the Contract and the Reservation of Rights Agreement did not obviously prevent KSPC from making the demands in the circumstances—they did not state that a court or arbitral tribunal must decide Veolia's liability before KSPC could make demands on the letters of credit.

In reaching its decision, the Saskatchewan Court of Appeal commented that the scope for court intervention in disputes between applicants and beneficiaries may be broader than in disputes between applicants and issuers. In addition to cases where the conditions in the letter of credit are not met or where the beneficiary's demand is fraudulent, the Saskatchewan Court of Appeal noted that a court might intervene between an applicant and beneficiary in a case where the beneficiary is obviously not entitled under the terms of the underlying contract to make the demand. However, it was unnecessary to decide this point in Veolia given that the underlying contracts did not obviously prevent KSPC's draws, so a court will have to decide in a future case whether this should be the law.

GUIDANCE FOR APPLICANTS, BENEFICIARIES, AND ISSUERS

Veolia provides a good reminder to companies using or considering using letters of credit to secure contractual obligations that it can be difficult to prevent a beneficiary from receiving payment under a letter of credit. Courts can issue injunctions to block wrongful demands in a narrow set of circumstances, but it is important to note that injunction applications must be brought promptly. Therefore, if a disputed demand has been made or is about to be made, the applicant, beneficiary, and issuer should consult legal counsel as soon as possible. Additionally, the Saskatchewan Court of Appeal has opened the door to potentially widen the circumstances in which a court may block a demand to include circumstances where the contract clearly does not allow the beneficiary to make the demand. Both applicants and beneficiaries should therefore ensure that their contract clearly delineates the circumstances in which the beneficiary may make a demand under a letter of credit.

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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