The autonomy principle remains unscathed and, absent fraud, a bank will be required to pay against a properly presented letter of credit (L/C) according to lawyers.

In this article, reproduced with permission from Mayer, Brown, Rowe & Maw LLP, the law firm looks at the case and appeal in England of Sirius International Insurance Company (Publ) -v- FAI General Insurance Limited and Others [2004] UKHL 54

Autonomy principle

The parameters of the autonomy principle underlying L/Cs had been under scrutiny in the first instance and Court of Appeal decisions in Sirius International Insurance Company (Publ) -v- FAI General Insurance Limited and Others (see article below; Letters of Credit - recent developments, 13 June 2003).

Those expecting the House of Lords to deliberate on this further as a result of the appeal to their Lordships heard on 8 and 9 November 2004 will have been disappointed with the judgment handed down on 2 December 2004. Their Lordships considered that the autonomy principle was irrelevant to the matters to be decided.

Unusual case

Sellers and banks have long relied on the principle that a L/C entitles a seller to receive payment from the bank under that credit without the bank being concerned as to any underlying dispute between buyer and seller.

The Sirius case did not involve the usual importer/exporter or buyer/seller relationship but rather Sirius as fronting reinsurer and FAI as retrocessionaire. The case concerned the interrelationship between a L/C issued in favour of Sirius and terms agreed between Sirius and FAI in a letter (the "Side Letter") that restricted Sirius' ability to draw against the letter of credit.

Tomlin Order

Because the L/C was due shortly to expire and because a costly arbitration was due to commence, the parties had agreed to a Tomlin Order. The schedule to that Order set out terms intended to prevent the arbitration going ahead and to preserve the funds under the L/C while the parties resolved the issue of entitlement to those funds. Both the Court of first instance (Jacob J) and the Court of Appeal (May, Carnwath LJJ and Wall J) considered the autonomy principle in this context.

The Court of Appeal considered both the construction of the Tomlin Order and Side Letter and the application of the autonomy principle.

Obligation to pay

The Court of Appeal held that the principle remained effective and a bank would be obliged, absent fraud, to pay on the L/C if a demand was presented. However, where the receiving party had expressly agreed (as Sirius had done in the Side Letter) not to draw down unless specified conditions were met they would not be entitled to request payment under the L/C.

In his judgment, May LJ remarked that, had it been necessary to do, so he would have agreed with Jacob J that the Court would have granted an injunction restraining Sirius from drawing down on the L/C. This was, however, not an issue before the Court of Appeal.

Decision not needed

By contrast, the House of Lords held that issues relating to the autonomy principle did not fall to be decided. Instead, the appeal should be decided on the basis of the correct contextual interpretation of the Side Letter and the schedule to the Tomlin Order.

(Sirius was held to be entitled to the proceeds of the L/C on the basis that one of the conditions required by the Side Letter had been satisfied by the terms of the schedule to the Tomlin Order.)

Unscathed principle

The autonomy principle remains unscathed and, absent fraud, a bank will be required to pay against a properly presented L/C. However, the Court of Appeal's judgment, insofar as it determined issues that were not later considered by the House of Lords, means that a party may be restrained from demanding payment under a L/C if to do so breaches the conditions for payment agreed separately between, what would usually be, the buyer and seller.

Any such separate agreement is a matter between the parties alone and a bank presented with a valid demand should generally make payment on the letter of credit. Where the bank has actual notice of a fettering agreement the prudent course will be to take legal advice.

December 2004
Copyright © 2004 Mayer, Brown, Rowe & Maw.

Sirius International Insurance Co Ltd v FAI General Insurance Ltd [2003] EWCA Civ 470A.

13 June 2003

Letters of Credit - recent developments Mayer, Brown, Rowe & Maw LLP

The decision by the Court of Appeal recognises the importance of the autonomy of letters of credit, but also provides a warning that a party who binds itself only to draw on such credit in specified circumstances, will not be entitled to the proceeds of the letter of credit if those circumstances do not arise.

Background

A Lloyd's syndicate wished to reinsure its liabilities. Due to the concerns of the syndicate as to the financial stability of a proposed reinsurer, FAI General Insurance Ltd ("FAI"), Sirius International Insurance Company ("Sirius") became the reinsurer, on the basis that while it wrote the policy, FAI would pay Sirius should it, Sirius, be called on to make a payment.

Sirius required a letter of credit (L/C) in support of this arrangement. This was eventually issued by Westpac in January 2000. Sirius and FAI had agreed terms (set out in a letter dated September 1999 and accepted in October 1999) that restricted Sirius' ability to draw against the L/C. Those terms were, namely, that Sirius would not make any payment under the reinsurance without FAI's prior agreement in writing and that there would be no draw down of the letter of credit unless FAI agreed that Sirius should pay a claim but had not placed them in funds, or the syndicate obtained a judgment or binding arbitration award against Sirius which they were obliged to pay ("the Conditions").

Tomlin order

By the time the L/C had been issued the syndicate had made a claim against Sirius. The ensuing wrangling between the parties led to an arbitration and a compromise under a Tomlin order. The agreement in the schedule to that order included a provision that the L/C should be called on and the proceeds paid into an escrow account pending resolution of the dispute between Sirius and FAI as to which of them was entitled to those proceeds.

Amongst other things, Jacob J at first instance considered the effect of the Conditions. He held that although the autonomy of a letter of credit was an important principle, it was not undermined where a party had expressly agreed not to draw down unless conditions were met and there was no reason for the court not to enforce such an agreement. He also ruled on the construction of the schedule to the Tomlin Order; by Sirius and FAI agreeing that FAI was indebted to Sirius and by placing a figure on that indebtedness, the first alternative condition of the September letter had been fulfilled (namely that FAI had agreed that Sirius should pay the claim but had not put them in funds to do so).

The Court of Appeal

Both parties appealed the decision; FAI on the ground of the construction of the Tomlin Order and Sirius on the decision pertaining to the autonomy of the L/C. The Court of Appeal held that the "indebtedness" paragraph of the schedule (referred to above) compromised the arbitration proceedings only and did not purport to determine questions arising out of the L/C. In particular, the schedule did not authorise Sirius to pay the syndicate, only that Sirius were authorised to prove in FAI's liquidation.

The Court of Appeal in considering the question of the autonomy of the L/C was faced with the following opposing arguments. Sirius submitted that they were entitled to draw on the L/C despite it being a breach of contract and that the court would have refused a restraining injunction, the terms of the underlying contract providing a remedy in damages only. FAI submitted that the autonomous nature of a letter of credit would not extend to permitting beneficiaries to draw down in breach of a promise not to and that the Court would grant a restraining injunction preventing breach of this negative covenant.

Principle of autonomy

The Court of Appeal considered the commercial reasons behind the principle of autonomy of L/Cs and that, absent fraud by the seller in presenting the documents to the confirming bank seeking payment, the court will not restrain a bank from making payment on a letter of credit payable according to its terms, nor prevent a beneficiary from seeking payment. Nor would the court prevent a beneficiary from drawing on a letter of credit despite a dispute relating to the underlying contract. By means of the autonomous nature of letters of credit, "banks are protected and the cash nature of letters of credit is maintained. There is no authority extending this autonomy for the benefit of the beneficiary of a letter of credit so as to entitle him as against the seller to draw the letter of credit when he is expressly not entitled to do so.".

This claim, May LJ observed, was not typical; the underlying transaction was not of the type usually supported by a letter of credit (such as a contract of sale), rather it related to an agreement regulating, between FAI and Sirius, the terms on which the L/C could be drawn against. This represented a restriction on Sirius and its security. While these restrictions were not incorporated into the letter of credit itself and would not prevent a bank from making payment on the L/C, as between the parties Sirius were not entitled to draw on the L/C if the express conditions of the underlying agreement were not fulfilled. Sirius were not, therefore entitled to the funds in the escrow account.

The effect of the decision

The unique facts of this case are likely to distinguish it from future decisions on letters of credit. The Court was careful to stress the importance of the autonomy of letters of credit in support of commerce and there has been no erosion of this principle (which is indeed enshrined in Article 3 UCP 500). However, this case demonstrates that the principle of autonomy cannot be used by a party to permit it to do that which it has expressly agreed not to do. While a bank may be obliged to pay under the terms of the letter of credit, the party that seeks such payment in breach of terms agreed with the other party, may find itself restrained by an injunction and facing a damages claim for breach of contract.

This article represents the views of the author and not necessarily those of the ICC or any of the other partners in DC-PRO.