Legal Case Summaries

Article

Note: To secure its design and commission of an evaporation and crystallization system for use in the potash mine of K+S Potash Canada General Partnership (Beneficiary), Veolia Water Technologies, Inc. (Applicant), as successor of HPD, LLC (Original Applicant), obtained a USD 14,600,000 standby letter of credit issued by Société Générale (Issuer) in favor of Beneficiary. The standby was subject to ISP98. Following the collapse of a steel frame supplied by Applicant supporting a crystallizer in the mine(the Incident), Applicant and Beneficiary entered into a “Reservation of Rights Agreement” (Reservation Agreement) whereby Applicant obtained a second standby letter of credit for USD 15,000,000 in favor of Beneficiary, issued by Issuer and subject to ISP98. Beneficiary “believed” Applicant was responsible for the Incident and clause (b) of the Reservation Agreement provided that Beneficiary could draw on the second standby if Beneficiary determined “reasonably and in good faith, that the cause of the Incident [was] attributable to [Applicant]”, a term not stated in the second standby.

Subsequently, Applicant initiated arbitration against Beneficiary alleging compensation owed to it for work performed following the Incident. Beneficiary, in turn, filed a “statement of claim” with the Court of Queen’s Bench alleging that Applicant owed it CAD 180,000,000 in damages arising from the Incident. After it received notification that Beneficiary had demanded payment on the first standby and intended to draw on the second, Applicant sought an injunction to prevent Beneficiary from drawing on both standbys. The trial court dismissed Applicant’s claim on the basis that Applicant failed to show fraud by Beneficiary, having not even alleged fraud. Moreover, the trial court rejected Applicant’s argument that it was “seeking to do no more than oblige [Beneficiary] to comply with the contractual preconditions” for drawing on the standbys. In rejecting that claim, the trial court summarized Applicant’s position as “attempting to draw a false distinction between (a) a dispute about whether there had been a breach in performance under the Contract and (b) a dispute about whether [Beneficiary] had satisfied conditions specified in the Contract and the [Reservation Agreement] in relation to when the Letters of Credit could be accessed.” Applicant appealed. The Court of Appeal for Saskatchewan, Richards, Ottenbreit and Schwann, JJ., affirmed.

The appellate court began by discussing the law of letters of credit, distinguishing between commercial and standby credits, while noting the independence principle and the fraud exception. The appellate court also reviewed the law for restraining payment under an LC as provided in Bank of Nova Scotia v. Angelica-Whitewear Ltd., [1987] 1 SCR 59 [Canada] (requiring a strong prima facie case of fraud in addition to a balance of equities regarding (a) the strength of the claimant’s case; (b) irreparable harm; and (c) the balance of convenience). On appeal, Applicant argued that the Angelica-Whitewear standard should not apply as Applicant sought to restrain Beneficiary from demanding payment, not Issuer from paying. Thus, the appellate court framed the issue as whether an LC applicant could enjoin a beneficiary from demanding payment on the basis that “the draw would breach an agreement between the beneficiary and the applicant as to the circumstances in which a draw” could be made.

Noting the dearth of Canadian cases on point, the appellate court turned to English authorities, specifically Sirius International Insurance Co. (Publ) v. FAI General Insurance Ltd., [2003] EWCA Civ 470 [England].¹ The appellate court summarized the English Court of Appeal’s holding in Sirius as “recogniz[ing] that a court may enjoin a beneficiary from drawing on a letter of credit where there is a term in the underlying agreement that restricts the circumstances in which the beneficiary can make a draw.” The appellate court also cited Simic v. New South Wales Land and Housing Corporation, [2016] HCA 47 [Australia],² which reached a similar holding in that the independence principle (or autonomy principle) should not prevent a party who procured a performance bond in favor of a beneficiary from claiming that a demand is not in accord with particular contractual conditions thus warranting enjoining the demand.

The appellate court stated that “given the importance of letters of credit in the commercial world, and the weight of the English authorities, it would seem an applicant should be obliged to establish a strong prima facie case that the beneficiary is expressly disentitled from making a draw before an injunction will issue.” Although appearing to endorse the approach taken in the above cases and others, the appellate court did not “formally decide” to do so. Instead, the appellate court noted that, even if it adopted such an approach, “[Applicant] would still be unable to secure the injunction” it sought.

The appellate court then proceeded to review the contract underlying the first standby. Under clause 12(e) of that contract (reprinted below), Beneficiary could draw on the standby if (i) Applicant defaulted on any obligation thereunder and (ii) Applicant failed to cure the same within “any applicable cure period” as defined thereunder. Applicant argued that Beneficiary failed to satisfy these preconditions and thus, it ought to be prevented from demanding payment. The appellate court disagreed, however, citing an affidavit from a vice-president of Beneficiary which provided that Beneficiary had concluded that Applicant was responsible for damages arising from the Incident based on a report produced by third-party investigators. The affidavit also made clear that Applicant had made no effort to cure during the two years following the Incident.

In discussing whether Beneficiary could be restrained in drawing on the second standby (were the court to adopt the Sirius approach), the appellate court looked to clause 6(b) of the Reservation Agreement (reprinted below). As mentioned, that clause required, among other conditions, that Beneficiary had to determine “reasonably and in good faith, that the cause of the Incident [was] attributable to [Applicant]” before demanding payment. Applicant argued that under the Reservation Agreement, and a “Change Order 45” agreement, executed concurrently, Beneficiary agreed to “not draw under the [LC]” until a “final determination” of costs owed to Beneficiary was made pursuant to the Reservation Agreement. The appellate court noted, however, that nothing in the Reservation Agreement required that such a determination be made by a court or arbitral tribunal. Moreover, another clause in the Reservation Agreement conflicted with Applicant’s argument by providing that “[Beneficiary] shall reimburse [Applicant] for all sums which [Beneficiary] draws under the [LC] for losses, costs or damages which are subsequently determined in accordance with the Contract not to be [Applicant]’s legal responsibility.” (Emphasis added). Thus, the Change Order 45 was limited to amounts paid under it, and by providing for subsequent reimbursement, nothing in the Reservation Agreement expressly prevented Beneficiary from demanding payment prior to a formal adjudication. Accordingly, the appellate court declined to consider the issues of irreparable harm or the balance of convenience as Applicant failed to demonstrate a strong prima facie case of fraud warranting enjoining Beneficiary from drawing on the standbys.

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Legal Analysis:

Comment: Although the court did not formally adopt the approach taken in Sirius, the implications of that approach warrant comment. Reprinted here are the comments offered regarding the Sirius case, summarized in the 2003 Annual Survey:

Roger Fayers, Barrister (UK), first raised the issue of this case and the implications of fraudulent draws in A New Slant on Autonomy of LCs in England, Documentary Credit World, November/December 2002, p.32. He wrote:

“(T)he significance of this recent judgment is that if the principal can point to the express agreement of the beneficiary not to draw except under certain conditions and he can show that those conditions have not been met, why should he not be able to go to the court for an injunction? Why should he not say: ‘Here there is a negative covenant not to draw unless certain conditions are met. The beneficiary knows the conditions are not met and that he is not entitled to draw. The court should always enforce such a covenant, either on the well-known principle that it is only making a man refrain from doing what he has agreed not to do or on the basis that by drawing the beneficiary will ex hypothesi know he is acting fraudulently and the court should intervene to prevent his fraud?’ An English court would agree with him.”

Editor’s Comment:[Regarding the Sirius case]

1. The judge’s suggestion that there could be an agreement that a party can agree not to draw down an LC unless certain conditions are met requires some consideration. Certainly, the applicant and beneficiary could so agree. Were they to do so in the underlying contract and were the conditions not reflected in the LC, however, the failure of the conditions to be met would not interfere with the rights of any nominated bank or of the issuer to be reimbursed. Nor would it interfere with the rights of a transferee beneficiary who did not have notice of the conditions.

2. Where the condition is expressed in the LC but is non documentary, then it will be disregarded under UCP500 Article 13 (Standard for Examination of Documents)…ISP98 Rule 4.11 (Non-Documentary Terms or Conditions) [as well as UCP600 Article 14(h)].

3. [However], it may be wondered whether the failure to comply with this term of the underlying contract constitutes LC fraud so as to justify injunctive relief against the beneficiary. The answer must depend on the circumstances and the condition. The test is the same in either event: there must be material fraud so serious as to establish that there is no colorable basis for the drawing.

4. If the condition were similar to the one suggested in this case, namely that the beneficiary could not draw on the LC without the permission of the applicant, none of these observations would change. If the condition were unexpressed, it could not affect the LC obligation unless the drawing were fraudulent. If it were expressed and non-documentary, it would be disregarded. If it were expressed and documentary, the banks would require that there be compliance with the condition. ISP98 Rule 4.10 (Applicant Approval) suggests that the issuer cannot waive such a condition. The only different consideration which may impact the analysis of this type of condition would be whether the applicant by withholding consent is itself acting in a manner that is either in bad faith, inequitable, or fraudulent, thereby defeating any claim that it might have to relief.

Excerpts of Standbys and Underlying Contracts:

First Standby: “We SOCIETE GENERALE hereby authorize you to draw on us in respect of irrevocable standby letter of credit No. 02502-1087236PEE (‘Credit’), for the account of the Applicant up to an aggregate amount of [$14,600,000 USD] available by your drafts at sight, accompanied by your signed certificate stating that:

‘We are entitled to draw on this Credit under the Design Supply and Commissioning Contract dated December 11th 2012 issued to the Contractor (HPD Project Number 530021#0##).’

…

This Credit is issued in connection with the Contract between K+S Potash Canada GP (“Beneficiary”) and HPD, LLC (“Applicant/Contractor”) dated 11th of December 2012.

We agree with you that all drafts drawn under, and in compliance with the terms of this Credit will be duly honored, if presented at the counters of SOCIETE GENERALE…(FRANCE) Attention: International Guarantees Department on or before 5:00 p.m. (ET) on 1st of December 2013.

…

This Credit shall be governed by the International Standby Practices - ISP98 published by International Chamber of Commerce”

Second Standby: “We SOCIETE GENERALE hereby authorize you to draw on us in respect of irrevocable standby letter of credit No. 02502-1148368PEE (‘Credit’), for the account of the Applicant up to an aggregate amount of USD 15,000,000.00 (Fifteen Million United States dollars) available by your drafts at sight, accompanied by your signed certificate stating that:

‘We are entitled to draw on this Credit under the Reservation of Rights Agreement between K + S Potash Canada GP, Veolia Water Solutions & Technologies North America, Inc. and Veolia Water Solutions & Technologies SA dated December 20th, 2016.’

…

This Credit is issued in with the Reservation of Rights Agreement between the Beneficiary, the Applicant and Veolia Water Solutions & Technologies SA dated December 20, 2016.

We irrevocably agree with you that all drafts drawn under, and in compliance with the terms of this Credit will be duly honored, if presented at the counters of SOCIETE GENERALE…(France) at or before 5:00 p.m. (ET) on June 30, 2018.

This Credit shall be governed by the International Standby Practices - ISP98 published by International Chamber of Commerce.”

Contract Clause 12(e):“Without limiting the rights and remedies of [Beneficiary], [Beneficiary] may draw upon the Letters of Credit if [Applicant] defaults in any of its obligations under this Contract and fails to remedy the default within any applicable cure period provided for in the Contract including, without limitation, the obligation to make the deliveries contemplated by and in accordance with the dates specified in the Contract Documents. If any Letters of Credit will expire before the expiry of any such cure period, then [Beneficiary] may draw upon the Letters of Credit prior to their expiry without waiting for the expiry of any applicable cure period.”

Reservation Agreement Clause 6(b): “Subject to Section 6(c) below and without limiting the rights and remedies of [Beneficiary], [Beneficiary] may draw upon the Letter of Credit for any losses, costs or damages which are recoverable under the Contract, that are suffered or incurred by [Beneficiary] as a result of, or arising out of the Incident or any related impacts of the Incident and exceed the insurance proceeds received or reasonably expected to be received by [Beneficiary] pursuant to the Builder’s Risk Policy, if [Beneficiary] determines, acting reasonably and in good faith, that the cause of the Incident is attributable to [Applicant] or its Personnel, in whole or in part, and such losses, damages or costs are not covered under the Builder’s Risk Policy.”

[MJK]

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The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of the ICC or Coastline Solutions.