Article

Factual Summary: Beneficiary was a non-profit corporation that provided repair warranties for new homes in British Columbia. To protect against default by Applicant of a five-year limited repair warranty covering the exterior stucco facing of a new residential building, Bank issued a clean performance standby LC for CA$75,000 in favor of Beneficiary. There were never any warranty claims made against Beneficiary regarding Applicant's building. Beneficiary was subsequently declared bankrupt and applicable local law precluded any new warranty claims against Beneficiary.

When Beneficiary's assignee for the benefit of creditors, or Trustee in bankruptcy, sought to draw on the LC, Applicant sought an injunction to prevent the drawing. By agreement, the Trustee agreed not to draw on the LC pending the outcome of the lawsuit. The trial court refused to issue an injunction, noting that there was "no basis in law" that would prohibit the Trustee from drawing on the LC. On appeal, reversed with one dissent.

Legal Analysis:

1. Successor By Operation of Law: The appellate court stated that "it matters not that the [Trustee in insolvency] is standing in the shoes of the true beneficiary of the letter of credit." The appellate court interpreted the applicable statute to provide that "a trustee has all the powers necessary to make demand and receive payment on a letter of credit of which the insolvent is the beneficiary."

2. Clean Letter of Credit: The appellate court noted that the LC was a "clean letter of credit" because it contained no express conditions for any draw, other than a demand for payment.

3. Standby LC: While recognizing that the LC was not denominated a "standby", the appellate court stated that "[w]hile no one used the expression 'standby letter of credit', everything about this tripartite transaction suggests that is precisely what the parties understood the Letter of Credit to be."

The appellate court noted that:

A standby letter of credit is any letter of credit intended 'to provide the beneficiary with protection against the risk of non-performance' by the account-party [quoting from] Kevin Patrick McGuinness, The Law of Guarantee, 2nd ed. (Scarborough: Carswell, 1996) at p. 786. It enables 'one party to a contract to obtain money from a bank when the other party has failed, or is alleged to have failed, to perform the contract or some aspect of it' [quoting from] Raymond Jack, Documentary Credits, 2nd ed. (London: Butterworths, 1993) at p. 260. A standby letter of credit is distinguishable from a conventional letter of credit, which generally serves as a payment mechanism in the international sale of goods.

4. Injunction; Fraudulent Drawing; Abuse; Clean Standby: On appeal, the trustee argued that it was entitled to draw down the entire amount of CA$75,000 available under the clean standby for Beneficiary's use when Beneficiary became insolvent for the benefit of Beneficiary's creditors without regard to the underlying contract between Beneficiary and Applicant. Applicant argued that the LC served only to secure its obligations under that agreement and was not a cash substitute, and that a drawing was not proper unless there was a default on the underlying warranty agreement. The appellate court framed the issue simply: "would a demand for payment by the [Trustee or Beneficiary] absent a breach of contract by the [Applicant] constitute an abuse of the autonomy principle that this Court should enjoin as a fraud in the transaction"?

The appellate court looked to the terms of the LC, the contract between insurer and builder, and the letter of receipt that was sent by the insurer on receipt of the LC and concluded that the LC was intended as security for the performance of Applicant's obligations under the contract. Accordingly, the appellate court concluded that a drawing on the LC where there was no breach of the underlying contract "would be an 262 abuse of the principle of autonomy within the concept of fraud. The chambers judge ought to have enjoined the respondent from making a demand on the Letter of Credit until such time, if any, as the appellant defaulted on its obligations under its contract ... ."

5. Fraud; Independence: The appellate court was concerned about whether the autonomy or independence principle prevented issuance of an injunction where there was fraud in regard to the transaction but not the documents. Reviewing the Canadian authorities, including the leading case of Bank of Nova Scotia v. Angelica-Whitewear, Ltd., 36 D.L.R. (4th) 161 (1987), the appellate court stated that "the making of a demand under a letter of credit, where there is no right to make such demand as between the beneficiary and the account-party, may constitute fraud sufficient to supersede the autonomy principle".

The court concluded that:

"[Beneficiary] did not receive cash or its equivalent. There was no agreement to provide cash. [Beneficiary] received a letter of credit it implicitly agreed in para. 1(d) of the Contract with Builder to draw down only in specific circumstances, namely breach by the appellant of its obligations under the contract. To draw down that letter of credit in any other circumstances comes within the exception to the autonomy principle for 'fraud in the transaction.'"

Recognizing the need for restraint in any exception to the independence principle, the court stated that in this case an exception is justified because a drawing would involve "a breach of the Contract with Builder going to the very reason why the appellant caused the Letter of Credit to be issued and to the circumstances in which the Letter of Credit could be drawn down -- that is, 'fraud in the underlying transaction of such a character as to make [a] demand for payment under the credit a fraudulent one'".

6. URDG: Although the undertaking was a letter of credit and not subject to the Uniform Rules for Demand Guarantees and did not require a statement of default, the appellate court noted that its conclusion was consistent with the ICC Uniform Rules for Demand Guarantees (URDG), Article 20, which it noted "requires a demand for payment on a standby letter of credit to include or be accompanied by a statement that the account-party is in breach of its obligations, and the respect in which it is in breach."

7. Drawing, Not Fraudulent: In dissent, Lowry, J.A., disagreed with the court's interpretation of the underlying contract as precluding a draw unless beneficiary had to pay claims under the warranty. The dissent interpreted the agreement to permit a draw at any time, to replace the security of the LC with cash at beneficiary's option. By this interpretation, the dissent concluded, there would be no fraud in the trustee drawing on the LC in this case.

Comments:

1. This decision is correct in its statement of the law regarding clean standbys. Even in the case of a clean standby, a drawing can be fraudulent. The proof of fraud in such a case is, however, difficult. In this case, it did not appear that the Trustee made any effort to claim that the drawing was based on any principle other than the one that insolvency law trumps all and that the Trustee should be entitled to seize all assets in sight without regard to entitlement. In such a situation where there was no arguable basis for a drawing on the LC, the appellate court properly reversed the trial court's decision to refuse injunctive relief.

2. The reference to the URDG was, to say the least, strange. Not only was the LC not subject to the URDG, but it did not contain any clause similar to the highly controversial requirement in URDG Article 20, inserting a required default statement. The reference hardly bolsters the court's conclusion and, quite the opposite, weakens it.

[JEB/jwb]

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