Factual Summary:

The beneficiary's real estate development company arranged for applicant reinsurer to secure performance bonds with a standby LC. The beneficiary attempted to draw upon the LC "on the eve of its expiry" though the bonds were not in default and no demand had been made on them. The applicant obtained an ex parte injunction enjoining the beneficiary from drawing upon the LC, but unintentionally represented in the initial injunction proceeding that the LC secured US $70,000 worth of bonds when it actually secured US $30,000,000. The applicant also failed to divulge that the LC was about to expire. After the injunction was issued, the applicant caused the LC to be renewed for another year as security for the beneficiary's bonds. The Superior Court continued the injunction pending the trial of the action or a further order.

Legal Analysis:

1. Fraudulent Drawing: The beneficiary argued that the "LC was an integral part of its security arrangements, and was going to expire...and [it] was draw down on it." The beneficiary also claimed "to be simply replacing one form of security with another...and that it would intend to retain the funds and invest them, and keep them as security for the other obligations." The court noted that since the LC was extended, the beneficiary "will remain in precisely the same position in relation to its security." For these reasons, the Superior Court continued in force the ex parte injunction preventing the beneficiary from drawing on the LC. It also stated that "The LC was given as a security. The essential nature of security is that it cannot be realized, except if there is a default in the obligation it secured. For the [beneficiary] to do so constitutes a 'fraud' in the sense that term is used in cases regarding LCs".

In continuing the injunction in force, the court indicated that it was critical that "the [beneficiary] could only draw down the LC on the basis of it having to make a payment to a bondholder. There is no question that there has been neither a default on any bond, nor any demand for payment by a bondholder. The [applicant's] errors, while material, are not fatal to the continuation of the injunction".


It is possible that the standby in question was poorly drafted in that it did not provide for a drawing in the event that it had not been replaced or renewed prior to its expiry in the event that it was still required for the underlying transaction. Whatever the case, it appears that there was a practical solution since the court signifies that the expectations of the parties are fulfilled by the renewal of the standby.

What is troubling about this opinion, however, is the court's repeated reference to 'the essential nature of a security" in deciding whether or not the drawing is appropriate. While the essential nature of a security may have some relevance to the question of whether a drawing was fraudulent, it is rather low in the list of matters to be considered. At the very top of the list is the terms and conditions of the standby itself. Do they link a drawing to default. If not, then the non-renewal of a standby need have no relationship to a default. The next step, so to speak, would be to examine the underlying agreement and to determine what was intended. Was it the intention of the parties that the standby be in place to assure performance throughout the transaction? Only if there were no answers at these levels would some general principle regarding security be of any interest. Unfortunately, the opinion provides no answer to these questions.

The worry is that the court may posit result based on its mistaken premise that the standby is a default undertaking. It is not. Default is only relevant if the drawing document is linked to default. It need not be. Should the court begin with the incorrect premise, it could then reason that since the LC is a standby, the drawing can only occur in the event of a default. To do so would confuse the function use of the standby in some transactions (as a performance mechanism to be drawn on in the event of a "default") with the essential nature of a standby.



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.