The 'autonomy principle' applying to letters of credit - and the restricted use of the fraud exception - has been applied by the Court of Appeal ("CA") in Petrosaudi Oil Services (Venezuela) Ltd v Novo Banco S.A. & Others .
In doing so, the CA has provided comfort to enterprises depending on standby letters of credit to guarantee payment where invoices between the trading parties are at risk of dispute and/or non-payment.
Letters of credit
Letters of credit are sometimes referred to as 'the lifeblood of commerce'. Where payment under a principal contract for goods or services is at risk of non-payment, the beneficiary instead receives payment as credit from the other party's issuing bank on amounts due. This shifts the burden of risk for non-payment from the seller to the buyer, giving comfort to and ensuring that the seller can continue providing goods or services and confidence to the buyer that those goods or services will continue to be supplied.
Under English law, a letter of credit creates an obligation on an issuing bank to make a payment on demand, provided that the conditions contained exclusively in the letter of credit are met. The letter of credit is autonomous of the underlying agreement and as such, any dispute between the buyer and seller under the principal contract is not of concern to the issuing bank, it need only confirm that the documents presented to it are in good order. This is known as the 'autonomy principle' and is subject only to limited exceptions, one of which being the fraud exception which exempts a bank from paying out against a fraudulent demand for payment.
In 2010, Petrosaudi Oil Services (Venezuela) Ltd ('POS') entered into a contract under Venezuelan law for the supply of oil rig drilling services with PDVSA Servicios S.A. ('PDVSA'), a Venezuelan state entity (the 'Principal Contract'). The Principal Contract contained terms that payment should be made on production of an invoice and that any dispute be addressed post-payment (a 'pay now argue later' clause). Additionally, given concerns surrounding the payment history of PDVSA, an English law standby letter of credit was issued by Banco Espirito Santo S.A. (later transferred to Novo Banco S.A.) ('the Bank') in POS's favour.
A dispute arose in relation to the rate used to calculate sums due under invoices issued by POS. Arbitrators appointed to deal with the dispute concluded that the 'pay now argue later' clause contravened Venezuelan law, which prevents payments being made by state entities prior to the verification of invoices. While the arbitrators had authority to examine disputes under the Principal Contract, they declared it appropriate for the English Courts to determine whether presentation could be made under the standby letter of credit.
POS made presentations to the Bank under the standby letter of credit demanding payment for invoices totaling circa 130m USD. PDVSA sought an injunction preventing payment, contending that any claim for payment under the letter of credit was fraudulent as a consequence of the arbitrator's prior decision and that, under the fraud exception, the Bank should not make payment. The fraud allegation stemmed from the requirement under the letter of credit that PDVSA was certified to be 'obligated to pay' the amount claimed. POS opposed this view, asserting that the presentation for payment had complied with the terms of the letter of credit and was not fraudulent, and sought a declaratory judgment that the Bank was liable to pay.
The High Court held that the effect of Venezuelan law and the arbitrators decision meant that there was no 'obligation to pay' a disputed sum under the standby letter of credit. The fraud exemption was deemed to apply and the Bank was restrained from paying out under the standby letter of credit, the High Court stating that the recovery of the disputed payment should be made through arbitration. POS appealed to the CA.
Allowing the appeal, the CA ordered that payment under the standby letter of credit should be made by the Bank to POS.
The court determined that the essential question was whether PDVSA was 'obligated to pay' the invoices per the requirement of the letter of credit. The meaning of those words had to be considered in the particular context in which they appear including the fact that they form part of a contract (the letter of credit) which is separate from the drilling contract, with a different party and governed by a different law. On the facts of this case, the meaning of that term must mean that the obligation to pay has accrued even though PDVSA may be precluded from discharging the liability by virtue of Venezuelan law.
As the requirements of presenting the required documents in the requisite form were met, the Bank should meets its obligations in making payment to POS unless any exception preventing this existed. Had the presentations for payment under the letter of credit be made fraudulently, the obligation for the Bank to make payments to POS would be removed.
The CA held that POS had been entitled to genuinely believe that PDVSA were 'obligated to pay' and that in doing so and making representations to the Bank for payment, the director who gave the representations to the Bank had not acted fraudulently. Christopher Clarke LJ, while agreeing with the interpretation of POS in respect of the letters of credit, commented that different minds may take different views on their construction. In doing so, this would not automatically render a party fraudulent.
This decision reaffirms the importance of the autonomy of letters of credit in supporting the mechanics of commerce. Banks issuing letters of credit can focus solely on whether the documentation presented conforms to the requirements of the letter of credit rather than becoming concerned with any underlying dispute in a principal contract between parties.
An obligation for payment under a letter of credit governed by English law cannot be avoided easily. The CA recognised the important commercial function they play in business. Further, the narrow application of the fraud principle protects a party seeking to claim under a letter of credit honestly and with a genuine belief in their right of presentation.
This document is for informational purposes only and does not constitute legal advice. It is recommended that specific professional advice is sought before acting on any of the information given.