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We have previously written about letters of credit, which are common to financing transactions and are an essential form of security in the banking world.  The Supreme Court of Canada recently revisited the law surrounding such instruments, particularly how fraud can impact their enforceability.

The case of Eurobank Ergasias S.A. v. Bombardier Inc. concerned a complicated procurement transaction for the supply of aircraft by Bombardier to the “Hellenic Ministry of Defence” (“HMOD”).  As part of the transaction, Bombardier agreed under a separate contract to pay liquidated damages if it did not subcontract certain of its obligations to Greek companies.  This requirement, in turn, was secured by a “Letter of Guarantee” issued by Eurobank in favour of HMOD.  A further letter of credit was issued by the National Bank of Canada in favour of Eurobank, again at the request of Bombardier (a customer of the National Bank).  As the Supreme Court of Canada summarized, “The plan for the interlocking letters of credit was straightforward: should HMOD call on Eurobank to honour the Greek Letter of Guarantee, Eurobank would be entitled to call on the National Bank to reimburse it” under the second letter of credit, referred to in the decision as the “Letter of Counter-Guarantee.”

A dispute arose between Bombardier and HMOD, which went to an arbitral tribunal for resolution.  Before the arbitral award was issued, HMOD demanded payment from Eurobank under the Letter of Guarantee.  Once it learned that HMOD had demanded payment, Bombardier sought interim relief from the arbitral tribunal, which ordered HMOD to “abstain from demanding payment under the Letter of Guarantee” pending issuance of its final award.  Bombardier also sought an injunction in the Superior Court of Quebec to prevent payment under both that Letter of Guarantee and the Letter of Counter-Guarantee.  Notwithstanding this, HMOD eventually made a final demand for payment and asserted that Eurobank would be subject to legal measures if it refused to pay.  Eurobank paid and then demanded payment from National Bank under the Letter of Counter-Guarantee.

At trial, the judge held that HMOD had obtained payment under its Letter of Guarantee fraudulently, and Eurobank’s conduct had also been fraudulent because it was aware that its payment to HMOD resulted from fraud. The Supreme Court of Canada was tasked with determining when a bank will not be permitted to honour a demand for payment under a letter of credit because of fraud.

What is a Letter of Credit?

As the Court explained, a letter of credit is generally issued by a bank at its customer’s request.  The beneficiary of the letter is entitled to demand payment from the bank so long as the demand “conforms to the requirements set out in the letter of credit.” There are two general types of letters: the first are known as “documentary letters of credit,” which are usually used to “facilitate payment in a transaction ‘as a means of moving money from one jurisdiction to another,’” while “standby letters of credit” effectively serve as a guarantee.  Standby letters of credit “secure performance of a contractual obligation” and are often issued “to ensure that the beneficiary will be paid what they believe they are owed under an underlying contract.”  In other words, the risk of non-payment under the underlying contract is moved to the bank that issues the letter of credit.  

Letters of Credit have historically been known by other terms, such as demand guarantees and standby credits; however, at least in this case, the Court found little difference between these descriptors from a legal standpoint.

Principles of Autonomy and Strict Compliance Underlie the Law of Letters of Credit

In Eurobank, the Court outlined the two key principles of the law governing letters of credit: autonomy and strict compliance.  Autonomy refers to a letter of credit as “an independent obligation of the issuing or confirming bank” (see also Bank of Nova Scotia v. Angelica-Whitewear Ltd.).  In other words, it is “an autonomous contract between the issuing bank and the beneficiary,” governed by its own terms and independent of the contract between the bank and its customer or the beneficiary and that customer.  As the Court observed, a dispute involving the underlying contract (for example, between the beneficiary and the customer) does not generally justify a bank’s refusal to make payment under the letter of credit.

Strict compliance means that, before issuing payment under a letter of credit, a bank must ensure that the beneficiary’s demand strictly conforms with the letter’s terms.  In other words, the bank must ensure that the beneficiary provides it with documents “that correspond to the requirements stated in the letter of credit.”  It is not enough for the beneficiary’s demand to “substantially” comply with those requirements – the demand must strictly comply, although in appropriate cases, it is possible “to overlook immaterial discrepancies.”

What is the “Fraud Exception?”

The law recognizes only one exception to the issuing bank’s obligation to pay on demand: when the beneficiary of the credit commits fraud that is “sufficiently brought to the knowledge of the bank before payment.”  The standard set for such fraud is “high.”

What is Meant by “Fraud”?

As the Court explained, for the fraud exception, “fraud” does not mean fraud in the “criminal sense.”  In the context of letters of credit, it refers to the “effect on the demand for payment by the beneficiary.”  The Court pointed out that a demand for payment by a beneficiary who knows it has “no right to be paid under the underlying contract” may constitute fraud.  

When Will the Fraud of a Third Party Be Deemed to Constitute Fraud of the Beneficiary?

The Supreme Court confirmed that the fraud exception continues to apply in cases involving an interlocking series of letters of credit, such as the Eurobank case.  As the Court explained, the fraud of a third party to a letter of credit will not generally “engage the fraud exception.” However, where a beneficiary is aware of fraud “and proceeds to call for payment when it knows that the conditions of payment are not met,” the fraud of the third party will also constitute the fraud of the beneficiary.  In other words, the beneficiary must not only know about the third party’s fraud but must participate in it (for example, by improperly “honouring a demand for payment”).

Ultimately, the Supreme Court of Canada dismissed the appeal, finding that the fraud exception was applicable.  The Court concluded that Eurobank “knew of and participated in fraud” by HMOD and, therefore, “for the purposes of the fraud exception,” had to bear responsibility for it.

Contact the Legal Team at Milosevic & Associates in Toronto for Effective Representation in Commercial Litigation Matters Involving Fraud

Have you been wronged by civil fraud? Milosevic & Associates can help. Our skilled litigation lawyers are highly experienced at untangling complex fraud cases. We’ll work tirelessly to recover your losses and achieve a just outcome. Call 416-916-1387 or contact us online for a consultation.