Letters of credit: Another one does NOT bite the dust

The strength of the letter of credit as a payment mechanism lies in the fact that its beneficiary, the seller of goods, is entitled to be paid as long as it provides to the bank the documents specified by the letter of credit. The bank has an absolute obligation to pay, irrespective of any contractual disputes between the buyer and the seller. Issues as to whether the goods actually meet the agreed upon specifications or any other claim of non-performance cannot be used by the purchaser to avoid paying the seller. It is thus said that the letter of credit is a separate contract, autonomous from the contract on which it is based, e.g. the contract of sale. One of the very few exceptions to this principle of autonomy is a fraud committed by the beneficiary of the letter of credit.

English law is often used between the parties to an international sale of goods, particularly where one or both parties are domiciled in a member country of the Commonwealth. The jurisprudence of English courts is therefore of some importance to those involved in international commerce. The recent case discussed in this blog entry confirms that the fraud exception is to be interpreted narrowly under English law.

In the case of Alternative Power Solutions vs. Central Electricity Board et al., [2014] UKPC 31, the Judicial Committee of the Privy Council (the “JCPC”) clarified the legal principles that are to be applied where the fraud exception is invoked in order to prevent the seller from drawing on the letter of credit. The JCPC’s judgement confirms that the fraud exception will only be available in very exceptional circumstances.

In 2010, Alternative Power Solutions (“APS”) won a tender process launched by the Central Electricity Board of Mauritius (“CEB”) for the supply of 660,000 compact fluorescent light bulbs. The ensuing contract provided that CEB had the right to inspect the merchandise prior to shipment. Disputes between the parties were to be arbitrated. An irrevocable letter of credit was issued by the Standard Bank and notified to CEB. Importantly, there was no requirement for any certificate of inspection or similar document to be presented to the bank in order for the letter of credit to be paid.

Differences of opinion arose between the parties in respect of the identity of the manufacturer of the light bulbs, the modalities of the inspection and the port of shipment. CEB applied for an injunction to restrain Standard Bank from paying under the letter of credit. At the hearing, APS’ representative indicated that it had no objection to an inspection being carried out in accordance with the terms of the contract and that no shipment would take place unless the inspection was carried out to the satisfaction of the buyer. Standard Bank indicated that it would not make payment until shipment was effected. The purchaser therefore withdrew its application; however the bulbs were shipped without the inspection having taken place. It was far from clear that the representative of the seller who made the representation before the court was aware of this at the time he made the representation.

CEB sought to draw an inference from APS’ conduct that it had no intention to provide the light bulbs it had agreed to provide and was acting fraudulently in order to defraud it of the purchase price. For a second time, CEB filed for, and this time obtained an interim (provisional) injunction prohibiting Standard Bank from making any payment under the letter of credit. A few months later, the court made the interim injunction interlocutory, confirming that APS had no right to draw on the letter of credit. The Court of Appeal of Mauritius confirmed the lower court’s decision.

The JCPC reversed the Court of Appeal’s judgement, quashing the injunction. The JCPC agreed with the lower courts’ judges that an injunction should only be granted to restrain a bank from paying under a letter of credit where the fraud exception applies and the bank is aware of the fraud. However, the test to determine whether the exception applies was incorrect. The test applied by the judge at first instance was whether CEB had raised “a serious prima facie arguable case that there might be an attempt to defraud” by APS. He held that the issue of fraud must ultimately be decided by the court or, in this case, the arbitrator.

The JCPC, after canvassing a number of previous court cases, determined that the tests to decide on the availability of the fraud exception at trial and at the injunction stage are not quite the same. At the interlocutory stage of the proceedings, i.e. before the injunction becomes final, the correct test, according to the JCPC, is whether it is “seriously arguable that on the material available [to the court], the only realistic inference is that the beneficiary of the letter of credit could not have honestly believed in the validity of its demands [for payment]”. An interlocutory injunction can only be granted if this test is met. The JCPC then clarified that “the expression “seriously arguable” is intended to be a significantly more stringent case then “good arguable case”, let alone “serious issue to be tried.”

Here, it was not suggested before the lower courts that any of the documents presented to Standard Bank were forgeries or that any of them contained, to the knowledge of APS, any material express misrepresentation. Given that conclusions regarding CEB’S allegation of fraud depended upon a thorough analysis of the true contractual position between the seller and buyer, such conclusions could not form a proper basis for the grant of an injunction against Standard Bank. Also, that the latter was aware of a contractual dispute between the seller and buyer and indeed, even made party to the court proceedings, had no bearing on its obligation to honour the terms of the letter of credit.

While this case is a fine specimen of semiological hair splitting by the English judiciary, it offers a lesson to be learned. Namely, if as a purchaser of goods paid through a letter of credit you have specific requirements that you consider to be a pre-condition to payment and these can be objectively documented on paper, then include them in the documents that must be presented to the bank to trigger payment. Do not count on the courts to take your word that the seller is not adhering to the terms of the deal.

For more information on the above, please call/email Martin Aquilina at maquilina@hazlolaw.com or at 1.613.747.2459 x 308