Letter of Credit Security and the “Autonomy Principle”
In commerce, parties often provide security in the form of letters of credit. A party (the “promisor”) may provide security for performance of its obligations under a commercial transaction (“underlying contract”) with the other party (the “promisee”) by procuring a letter of credit (“LOC”) from a bank. The LOC would stipulate that a certain amount of money is to be released by the bank to the promisee/beneficiary if the promisor defaults in the underlying contract. There would therefore be two different relationships at play: 1) that between the promisor and promisee in the underlying contract and 2) that between the bank and the beneficiary under the LOC.
In such an arrangement, the LOC is governed by strict rules, namely the “autonomy of documentary credits principle” (or simply the “autonomy principle”), which requires the bank to honour a demand by the beneficiary upon the latter advising that a default has occurred in the underlying contract (and satisfying all requirements for the demand). The autonomy principle holds that this must occur regardless of any dispute between the parties in the performance of the underlying contract. An exception to this principle exists where the beneficiary is found to have committed fraud in seeking release of the funds.
Last week, Madam Justice Slawinsky of the Alberta Court of Queen’s Bench issued her decision in Café Can Cun Co Incorporated v. Halcor Development Corporation (“Café Can Cun”). We acted for the respondent landlord, Halcor Development Corporation. The landlord took the position that the applicant tenant had defaulted on its 10-year lease by not paying rent and by abandoning the premises. The landlord therefore demanded that money secured under a certain LOC (the “BMO LOC”) be released to it. The tenant had previously sought and obtained an ex parte (without notice to the landlord) interim injunction order precluding release of the BMO LOC money before the landlord made its demand to the bank. The apparent basis for seeking the interim order was that the landlord committed “fraud” by advising the bank that the tenant was not entitled to a reduction of the amount secured under the BMO LOC. (A discussion of the allegations is beyond the scope of this brief article. The reader is directed to the hyperlinked decision for a description of said allegations.)
The issue before the Court in Café Can Cun was whether the interim injunction should be continued. In short, the landlord completely denied, with cause, that there was any fraud in any manner or form. And no evidence was suggestive that there was any. The judge agreed that a strong prima facie case of fraud was not made out. To establish such a case, the Court emphasized, an applicant must show that there was some kind of deceit or moral wrongness. The case needs to be made that the beneficiary has no right to release of the money. Having found that no fraud had been committed, the Court found, applying the autonomy principle, that the bank was not to be restrained in any way from releasing the money under the BMO LOC. Madam Justice Slawinsky accordingly set aside the interim injunction and dismissed the tenant’s application.
It is critical to note that a finding of a strong prima facie case of fraud is a necessary, but not sufficient, ground for an injunction to be issued. It is only one of a 3-part test that an applicant needs to satisfy in order to obtain an injunction against release of LOC money. An applicant is also required to show that it would suffer irreparable (that is non-monetarily compensable) harm. The tenant in the case at hand could not show the Court that it would suffer such harm if the interim injunction was not continued. That was thus a further reason why the tenant’s application was not successful. The third and final prong of the 3-part test requires an applicant to establish that the “balance of convenience” favours the granting of the injunction. The Court found that this element was not met by the applicant because it could not be shown that the applicant would suffer more harm than the respondent if the injunction was not continued than would befall the respondent if it was continued.
The key takeaway is that LOCs are governed by the autonomy principle. Release of money under such instruments cannot be stopped unless there is evidence of fraud. The autonomy principle is integral to the worldwide documentary credit system, which allows for security regarding contractual performance and immediacy of payment.
Invitation for Discussion:
If you would like to discuss this blog in greater detail, or any other business matter, please do not hesitate to contact Mohamed Amery.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.