Article

Note:Agnew, a syndicate at Lloyd's, sought to reinsure its liabilities. Applicant, FAI General Insurance Co., an insurance company, was proposed as reinsurer but deemed not strong enough by Agnew. The policy was set up in a manner that Sirius International Insurance Corp., another insurance company, ultimately became the reinsurer and Applicant was to pay Sirius in the event that a payment was ever required by the policy. In the terms of the business, Sirius "fronted" the policy and "retroceded" it to Applicant.

To effect the payment to Sirius, Applicant obtained a standby LC issued by Westpac Bank for US$ 5 million in favor of Sirius as Beneficiary. By the terms of a collateral agreement between the two parties not reflected in the LC terms, Sirius would pay claims presented by Agnew only with Applicant's prior approval. Furthermore under this collateral agreement, drawings on the LC would only occur if: 1) Applicant had agreed that a claim should be paid but had not otherwise provided funds to do so, or; 2) Agnew obtained a judgment or binding arbitration award against Sirius obliging payment. The existence of the LC was kept confidential by the parties and disclosed to Agnew.

Agnew subsequently made a claim on the reinsurance policy, and its validity was challenged by Applicant. Sirius entered into a tripartite agreement with Agnew and the broker that arranged the insurance acknowledging that Agnew could reasonably assert the validity of the claim, and the broker would fund Agnew's losses with a loan until proceedings against Applicant for the funds were concluded.

Sirius instituted arbitration against Applicant, which progressed until Applicant's parent became insolvent and provisional liquidators were appointed. By local law, the arbitration proceedings were stayed. Sirius applied for a removal of the stay, but the application was compromised by a later legal order, by which Applicant conceded that it was indebted to Sirius, and Sirius was instructed to draw on the LC and deposit the proceeds into escrow pending a hearing on entitlement to the funds. The position and arguments of the parties in respect to the LC were thereby preserved, notwithstanding the drawing. The matter came before the High Court of Justice Chancery Division Companies Court, Jacob, J., for determination of preliminary matters, including entitlement to the escrow funds. He awarded summary judgment in favor of Sirius.

Sirius argued that LCs are autonomous of underlying agreements and give an independent right to the beneficiary to require the bank to pay. Sirius relied on UCP500 Article 3 for support that LCs are a "separate transaction from the sales or other contracts on which they may be based and banks are in no way concerned with or bound by such contracts ...". Furthermore, even if there was a recognizable covenant, this did not provide a ground for Applicant to enjoin payment, but rather one to sue for damages after the draw.

Applicant argued that the collateral agreement establishing conditions to any drawings on the LC should be enforced as a negative covenant on the principle that "it is only making a man refrain from doing that which he has agreed not to do." Applicant further argued that since the conditions of the collateral agreement were not satisfied, the court should prevent Sirius from drawing on the LC (or, as was the case following the legal order, collecting the LC proceeds from escrow). Since there was an express provision in the underlying contract regarding conditions for a draw, Applicant urged that this situation was not the "normal case of 'pay now, argue later'" that is a tenet of LCs.

While the court noted the "vital importance" of the autonomy of LCs, it observed that it did not follow that independence was "undermined in the very special case where a party expressly agrees not to draw down unless certain conditions are met." The court likened the LC arrangement to a cash account arranged by Applicant with a contract between Applicant and Sirius controlling its disposition. In that scenario, the court would undoubtedly enforce the negative covenant between the parties:

"Cash, like a letter of credit, is autonomous, perhaps even more so, but people can agree not to touch identified pots of it, if that is what they want to do. If such an agreement is made, there is no reason why the law should not enforce it."

Notwithstanding the collateral agreement limiting Sirius' rights to draw on the LC, the court determined that one of the conditions to the drawing was in fact satisfied and that Sirius was entitled to the escrow funds. While the funding agreement with Agnew and the broker was not a binding arbitration award or judgment obliging Sirius to pay the reinsurance claim, Applicant's subsequent admission to an outstanding debt to Sirius served as an agreement in substance to pay Sirius for the claim. According to the court, all parties knew that there was a back-toback arrangement in place and that the acknowledged debt represented funds that would inure Sirius for the reinsurance claim. "The truth is that [Applicant] got the benefit of Sirius fronting the deal. The price of that was the provision of the letter of credit. The letter of credit was properly drawn down. It was there to meet just the eventualities that happened."

Comment:

Roger Fayers, Barrister (UK), first raised the issue of this case and the implications of fraudulent draws in the DCW (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:

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) and ISP98 Rule 4.11 (Non-Documentary Terms or Conditions).

3. In either case, 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.

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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 ICC or the other partners in DC-PRO.