Article

Factual Summary:

To secure their obligations upon becoming "names" of an insurance syndicate, the applicants procured standby letters of credit in favor of the insurance syndicates. The applicants later came to believe that they had been defrauded and delivered evidence to the issuers, but did not seek injunctions preventing any drawings. Upon consider-ing the applicants' evidence of fraud, the issuers dishonored drawings under the standbys under the fraud exception. The beneficiary filed suit in an English court for wrongful dishonor. The issuers, in their pleadings, stated that their customers had evidence of fraud, but failed themselves to plead fraud as a defense to the dishonors. Instead, the issuers asked the applicants to join in the action or to seek an injunction against honor in the English courts. The applicants refused to do so.

The English court provided the issuers with the opportunity to amend their pleadings to assert fraud. The issuers warned the applicants that they would not do so, but the applicants again refused to join the action. The English court issued judgments in favor of the beneficiary. The issuers then brought this action in Canadian courts to obtain reimbursement from the applicants.

While engaging in settlement negotiations, the parties requested that the court decide the issue of whether the applicants could assert the issuers' failure to raise a fraud defense in the English action as a defense to this action.

Legal Analysis:

1. Fraud: Issuer Dishonor:The Canadian court noted that in the case of fraud, the beneficiary either had to seek an injunction or convince the issuer that there was "clear and obvious" fraud. The court concluded that the latter would be a tougher standard to meet. The court then stated that the issuers, in these instances, must have concluded that there was "clear and obvious" fraud because they dishonored the drawings, even though other Canadian decisions had upheld issuer's decisions to honor under the exact same evidence.

The court then noted the difficulty the issuers faced in determining whether there had been fraud. The subsequent litigation over the issue was expected to consume months of time. Because the court considered bankers "ill equipped" to determine issues of fraud, it felt that the standard of "clear and obvious" fraud would have to be extremely difficult to meet to protect bankers in such situations. The court noted that if an issuer had merely dishonored to do its customer a favor and help it in its battle with the beneficiary, it had done a disservice to the integrity of the letter of credit as a payment mechanism. Moreover, the issuers' actions in favor of their customers could now severely harm them in their rights to reimbursement.

2. Fraud: Right to Reimbursement: Having concluded that the issuers must have been convinced of the fraud in this case, the court turned to issue of whether the issuers could subsequently change their minds about the fraud and decide to honor/or not raise the fraud defense in litigation. The court ruled that an issuer could not so change its mind without, at the least, giving such notice to the beneficiary and applicant.

3. Fraud: Issuer Dishonor: The court next turned to the issue of whether an applicant, after declining to seek an injunction, but convincing an issuer to dishonor on the basis of fraud, had an obligation to intervene in subsequent litigation between the issuer and beneficiary. The issuers argued that the fees charged for letters of credit do not reflect any intention on the part of the issuers to wage the legal battles of the applicants. Indeed, the issuers here had failed to assert such a defense, in part, because the litigation costs would have been enormous to prove such fraud. The court rejected this argument, and noted that the issuers should revise their fee structures to reflect such a risk. Under the court's rationale, in the wrongful dishonor action, the funds at stake were the issuers' and, accordingly, the issuers had the duty to defend that action. While it certainly may have been in the applicants' best interests to intervene, the court refused to find a duty to do so.

4. Reimbursement: The issuers next argued that, under the reimbursement agreements and general principles of indemnity, the applicants were bound by the English decision to indemnify the issuers. The court noted that for the general principles of indemnity to apply under Canadian law, the issuers would have had to have given the applicants an opportunity to defend the English action. The issuers, in this case, had only requested that the applicants be joined or file for an injunction. The issuers had not asked the applicants to aid the defense by supplying witnesses, documents, or strategies. As such, the issuers had failed to provide the applicants with an opportunity to defend the charges, and the principles of indemnification under Canadian law did not apply.

5. Fraud: Estoppel: The issuers next argued that the applicants should be estopped from asserting the defense based on their failure to join the English litigation. The court found that the applicants had been put on notice of issuers' intentions not to assert the fraud defense and had chosen to sit "on the sidelines and watch." The court further found that the English litigation essentially involved the money and interests of the applicants. Additionally, the applicants would have been in a far better position than the issuers to plead and prove a fraud defense in that litigation. As such, the court decided "reluctantly" that the applicants were estopped from asserting that the issuers failed to raise a fraud defense in the English action as a defense to this action based on their conduct.

6. Res Judicata: Additionally, the issuers had argued that the applicants were bound by res judicata. The court, again pointing to many of the same findings it made regarding the estoppel issue, concluded that the applicants and the issuers shared an identical interest in the English litigation. Had the issuers won that case, the applicants would have been relieved of any reimbursement liabilities. As such the court found the applicants to be "privies" of the issuers in that litigation and assigned to them a duty of reasonable diligence. As the applicants had not acted reasonably diligent and failed to join the litigation to properly raise the fraud defense, the court found them bound by res judicata to the English decision which determined that the letters of credit must be properly honored.

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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.