The obligation on an issuer to pay claims made on it under a letter of credit is a key factor in the smooth running of international trade. Two recent High Court cases have considered the limited nature of the fraud exception to that obligation. To be able to refuse payment under the fraud exception, the issuer must demonstrate that the beneficiary could not honestly believe in the validity of the demand. Trainee Solicitor Thomas Fardon explores the details.
So what is a letter of credit?
A letter of credit is a commitment, usually given by a bank or other financial institution, that payment to a third party will be made on occurrence of a specified condition, such as a breach of contract or delivery of relevant documents. In exchange for the commitment, the issuer will require strict terms to be met, such as providing documentary proof that the exact goods that were contracted for were actually supplied to the buyer. Letters of credit therefore are an essential tool in international trade to provide comfort that contracts will be honoured. Because of this, there are very limited exceptions to an issuer’s obligations to pay under the letter of credit. One important exception is the right to refuse a claim made fraudulently. This exception has been reviewed in two recent cases.
The first case involved invoices issued by a drilling company to a Venezuelan company under a contract governed by Venezuelan law. A letter of credit was issued by a bank in favour of the drilling company as security for payment of the invoices. After a dispute between the parties, the underlying contract was held to be null and void by arbitrators, who found that provisions contained within the contract (requiring that the invoices should be paid first and disputed later) contravened the Venezuelan civil code. The drilling company sought to be paid under the letter of credit issued by the bank, certifying that the Venezuelan company was due to pay under the contract. The High Court ruled that the presentation was invalidly made. The drilling company’s director knew that the certificate was false because the underlying contract had been declared void and therefore the company was not liable to pay. The fraud exception applied, allowing the bank to refuse payment.
The same principle was applied by the High Court in a second case involving a company used by the government of Trinidad and Tobago to implement public infrastructure works. This time with a different outcome. The company entered into a contract with a Brazilian contractor, which received letters of credit by way of performance security from a bank. When a dispute arose between the two companies, the bank attempted to resist the demand for payment of the claimant company relying on the fraud exception. It argued that the claimant company could not certify that such sums were “due and owing” from the contractor, as they consisted of damages that were yet to be awarded by a tribunal. The High Court ruled that it was irrelevant whether, as a matter of law, the sums demanded are “due and owing”. What counted was that the beneficiary had an honest belief that the sums are “due and owing”. In this case the fraud exception did not apply. The company honestly believed in its entitlement despite that entitlement being subject to a tribunal’s final determination. The bank had to pay up accordingly.
The recent cases confirm the limited scope of the fraud exception. To resist payment under a letter of credit, an issuer needs to be able to demonstrate that the claim is made fraudulently, the fact the payment may be in dispute is not enough for the bank to be able to rely on the exemption.