Documentary Credit World

Readers of Documentary Credit World will have read its comprehensive report (June 2023 DCW 15) on the decision of the English commercial court in Celestial Aviation Services Ltd v. UniCredit AG (London Branch).₁ The case will be heard by the court of appeal and the purpose of this article is to draw attention to one issue in the case concerning application of Regulation 28(3) of the UK Regulations introduced in response to Russia’s invasion of Ukraine in early 2022. The issue is whether or not this regulation rendered illegal the payment by UniCredit Bank of demands made under standby letters of credit which the bank had confirmed. The claimants – Celestial Aviation Services, Beneficiaries of the standbys – said such payment was lawful because the regulation did not apply, whilst the defendant bank argued payment would be unlawful because the regulation did apply.

Background dates and definitions

Because of the longevity of the various instruments involved, it is important to keep in mind a number of events and their dates. Between 2005 and 2014, Celestial entered into various leases of aircraft to Russian carriers.₂ For purposes of this article I shall concentrate on the lease dated 21 December 2005 (“the Lease”). Years passed and subsequently, by way of providing security for the performance of the Carrier ’s (Lessee’s) obligations under the Lease, Celestial sought the security of a standby LC. In due course, a standby was issued by Sberbank, a Russian bank, on 21 August 2017. This was confirmed by the London branch of UniCredit, a German bank, on 23 August 2017 (I shall refer to this confirmation as “the UniCredit Standby”). There are two further crucial dates: On 1 March 2022, Regulation 28 came into force; On 2 March 2022, Celestial made its demand.

For Celestial, what seems to have happened was that, having entered into various leases during 2005 and 2014 and with the international situation worsening in 2014, it became increasingly aware that its lessees may have more difficulty meeting their obligations under these leases and so it sought security by obtaining standbys.₃ It seems Celestial considered the standbys issued by Sberbank did not provide adequate security and required confirmation by UniCredit. Without confirmation of the standbys, it may be that Celestial would not have extended its existing leases nor entered into any new leases.

Accordingly, the odd situation here concerns the effect of a Regulation, not on the financing of the contract for the initial supply of the aircraft but rather, on the realisation of the security provided many years later in the event of there being default under that contract.

The Regulations
The relevant wording of the Regulation:

28. Financial services and funds relating to restricted goods and technology
(3) A person must not directly or indirectly provide financial services or funds in pursuance of or in connection with an arrangement whose object or effect is -

(a) the export of restricted goods to, or for use in, Russia;
(b) the direct or indirect supply or delivery of restricted goods to a place in Russia;

It was accepted that the aircraft fell within the Regulations’ definition of “restricted goods”.

The approach of the judge

The judge in paragraph 106 set out his approach to understanding application of the regulation as involving the following elements:

(1) a person provides financial services [or] funds;
(2) in pursuance of or in connection with;
(3) an arrangement whose object or effect is the supply of restricted goods to, or for use in, Russia, or to a Russian person.

As to element (1), the judge accepted there was “a provision of funds” by discharge of the payment obligation under the UniCredit Standby. As to element (3), he accepted that the Leases amounted to a relevant “arrangement”. This left what he termed the “critical dispute” focusing on element (2), namely whether a payment by UniCredit under its Standby was “in pursuance of or in connection with the supply of aircraft under the Leases”.

The judge’s conclusions

From the judge’s conclusions, I have emphasised relevant wording in italics:

(2) [Regulation 28], as would normally be expected, operated prospectively and not retrospectively. It therefore looked to the time at which financial assistance ₄ was provided to the relevant party. Here, the issuance of a letter of credit to enable the supply of aircraft to a Russian party after the date on which the Regulation came into force [1st March 2022] would plainly come within the prohibition, as both parties accepted.”
(3) That is not, however, this case. Here, the aircraft had been supplied long before the prohibition came into effect, at a time when it was perfectly lawful to make such a supply. Likewise, the provision by UniCredit of financial services to the Russian lessees was made when they issued the Letters of Credit which served as a mechanism for the satisfaction of the payment obligations of the lessees; and again, at the time of the provision of the services, that provision was perfectly lawful.

The first italised words indicate that the judge clearly sees the financial assistance from the UniCredit Standby as being finance to enable the aircraft to be supplied and as being provided at the time of its issuance (or rather at its confirmation) in 2017. But this, I think, does not properly take account of a particular feature of the standby viz it exists only to function if and when a demand is made upon it. Actually, as a practical matter, until then it functions perfectly well simply by its very existence because, if there is no default under the contract it is supporting, there will be no need to make a demand. So long as there is no demand, there is no liability to make any payment at all. Nevertheless, the standby will have served its purpose.

Because the judge’s summary of the elements to application of regulation 28(3) does not include looking at when the obligation to pay actually arises, I think this is flawed. Where he does refer to it, he understates the position. In saying “All that remained to be done, – which I infer he means
‘Actually, not very much’ – as at the time the prohibition in Regulation 28 came into effect, was for
the obligation undertaken long before to be fulfilled”, he is conflating the obligation a confirming
bank undertakes with the performance of that obligation. To explain why in the context of this
particular case this distinction is important, I refer to English law.

English law

This was the governing law of the UniCredit Standby and so it is in accordance with English law principles of construction that the incorporated UCP600 provisions are to be interpreted. Similarly, English law will determine the question of when the obligation of a bank confirming a standby letter of credit arises and its effect.

The relevant UCP provisions seem to reflect there being a distinction between a bank entering into an obligation to confirm and the actual performance of that obligation. UCP600 Article 2 refers to a confirmation as constituting the bank’s “definite undertaking” but this is “[p]rovided that the stipulated documents are presented to [the bank]” according to UCP600 Article 8. UCP600 Article 15(b) then provides: “When a confirming bank determines that a presentation [of documents] is complying, it must honour or negotiate and forward the documents to the issuing bank.”

There is no indication in the judgment of the Lessee having defaulted in making any payment prior to 2022 nor of Celestial having made any demand before then. This is not surprising as the Lessee had use of the aircraft and would have been earning revenue sufficient to meet its payment obligations.

Since the UCP provisions are not conclusive, it will be by analogy to the position with regard to the functional equivalent of the standby in England, the demand guarantee, that I believe an English judge would look to determine the confirming bank’s obligation and when it arises. And this seems to be quite clear. It is set out in Nelson Enonchong’s The Independence Principle of Letters of Credit and Demand Guarantees (my emphasis added in italics):

3.67 Demand is a condition precedent
...

Under a demand guarantee, the demand is a condition precedent to the issuer ’s liability. The reason is that the issuer agrees to pay only if a demand that complies with the requirement of the instrument is made. Therefore the issuer is not liable unless and until a complying demand is made”.

The position has also been stated judicially in similar terms in Britten Norman Ltd (in liq) v. State Ownership Fund of Romania (my emphasis):

“[u]ntil a demand was made, [the issuer] was under no actual liability to [the beneficiary]. Its liability was only a potential liability when the demand was made in conformity with the terms of the letter of guarantee, [the issuer ’s] potential liability crystallised into an actual liability.”₅

As applied in this case

If this be English law, then the next question is how does English law apply as respects the UniCredit Standby and Regulation 28(3)? Paragraph (3) requires that the “funds” (the payment of the UniCredit Standby) be paid either in pursuance of or in connection with the “arrangement” (the Lease). There are two parts to providing the answer.

Analysis of Regulation 28(3)

The first part relates to UniCredit’s obligation and, more importantly, when it arose. The judge concluded in paragraph 126(3) that “the provision of financial services₆ to the Russian lessees was made when they issued the letters of credit which served as a mechanism for the satisfaction of the payment obligations of the lessees”. (my emphasis)

Had such a provision been made when UniCredit “confirmed” the standby, it would have involved UniCredit making a payment on 23 August 2017 and, since this was well before Regulation 28(3) came into effect on 1 March 2022, clearly it would be lawful. But UniCredit did not make any payment in 2017. And it did not do so because it was not until 2022 that it had any obligation to make a payment. I think the proper analysis is that UniCredit’s obligation to pay only arose when Celestial made a demand and it did not make its demand until 2 March 2022, by which time Regulation 28(3) had come into force.

This only gets UniCredit halfway home, however. There is still the second part, which the judge considered to be the “critical dispute”, concerning the application of Regulation 28(3) to the payment UniCredit did make on 2 March 2022 and the relationship between that payment and the Lease.

“in pursuance of or in connection with”

This phrase used in Regulation 28(3) is a broad expression and resembles the standard wording used both in statutes and contracts to express the linkage between event X with event Y. To some extent this is always a matter of first impression and the connection must be sufficient; sufficiency being viewed in the context of the particular case. The judge accepted that in the cases that have arisen the courts have usually given it the widest meaning. Nevertheless, in this case, he refused to read it broadly. Accordingly, he held that the regulation had no application and did not prohibit UniCredit from honouring Celestial’s demand.

Comments to the contrary

First, the judge was clearly influenced by what he saw as the independent nature of the various obligations involved. He focused, too, on Celestial’s supply of the aircraft and he was also conscious of the time gap between their supply under the Lease in 2005 and, as he described it, issuance of the UniCredit Standby years later in 2017.

Closely related to this, which he did say was of importance, is the autonomy principle, establishing a standby’s independence from the underlying contract (here, the Lease). Nobody can doubt that an essential element arising from the relationships involved with a letter of credit (commercial or standby) is the insulation of the security of payment provided by the bank from the transaction between the parties which it is supporting. This is a consequence of the instrument’s special function in international trade.

Nevertheless, as English judges have recently concluded, the autonomy principle does not carry all before it. It is interesting that two further exceptions to the principle, the underlying contract exception and the illegality exception, both emanate from the construction of other documents, of a contract and of a Regulation.

In a case involving the underlying contract exception, May LJ rejected the claimant’s bold submission that simply because the letter of credit was autonomous it could not then be affected by conditions as to its draw which had been expressly agreed with the other party to the underlying contract.₇

As to the illegality exception, there are passages to the same effect in the two Mahonia decisions.₈

In the first, Colman J, in summary proceedings held there was an arguable defence of illegality sufficient to go to trial and observed that an issue arising in a letter of credit case “is not a matter which can be resolved simply by postulating the separate nature of the letter of credit” without addressing the proper construction of the relevant legislation in the entire context. He also said it would “be wrong in principle to invest letters of credit with a rigid inflexibility”. The case then proceeded to trial before Cooke J, who, having carried out a fuller investigation of the facts, came to a different conclusion, holding that the letter of credit had not played a part in the illegal scheme. However, he did agree with Colman J’s analysis of illegality preventing enforcement of a letter of credit, adding that he would “not have held that the “autonomy” of letters of credit required a different conclusion”.

Whilst the judge here did address the wording of Regulation 28(3), I think his incorrect analysis of the UniCredit Standby led him, when reconciling the conflicting considerations involved, to give too much weight to autonomy. But despite autonomy prying the credit and the contract apart, as a practical matter, the two can never be entirely disconnected. And in Shanghai Shipyard Co Ltd v. Reignwood International Investment (Group) Ltd,₉ Popperwell LJ gave two sound examples of their having to retain some connection. As applied to this case, Celestial would have to refer to the Lease in order to make its written demand specifying which obligation the Lessee was in default. Similarly, in the event of there being any dispute with the Lessee as to Celestial’s entitlement to make that demand or in that amount, the Lease and its terms would have to be referred to in the ultimate accounting between the parties.₁₀

Furthermore, just turning things around and asking the rhetorical question: If confirmation of the UniCredit Standby was not made pursuant to or connected with the Lease, then just what was it made in pursuance of or in connection with? Standbys (and demand guarantees) do not just spring out of thin air. There must always be an underlying obligation for which they provide security and, other than for payment of rentals due under the Lease (or for loss arising from breach of some other obligation under the Lease), there is no evidence of any other form of financial assistance that had been provided. In short, autonomy and connection are not necessarily mutually exclusive.

There is another more general point to make. The judge was also aware of there being some odd results from rendering illegal in 2022 a payment in respect of aircraft supplied so long ago. It left Celestial not only without payment of the defaulted rental but also out of possession of its now- embargoed aircraft. This said, that such a situation can arise from the working mechanism of a standby letter of credit (or demand guarantee) is certainly unfortunate, but it is not necessarily commercially disastrous. And here it may not be for two reasons: (a) the UK Treasury’s overall sanctions scheme seems to have allowed for there being just such unfair situations by providing that applications can be made for licences to permit payments to be made;₁₁> and (b) Celestial, as lessors, will almost certainly have hull insurance covering loss of their aircraft.

We now await the court of appeal’s decision which will not be until 2024.

* Roger Fayers, Barrister (UK), is a former legal advisor in the Department of Trade and Industry and a DCW
Editorial Advisory Board member.

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