Letters of credit and the fraud exception (Petrosaudi Oil Services (Venezuela) Ltd v Novo Banco SA and others)

lan C Williams, senior associate, and Andy McGregor, partner, both at RPC, examine the Court of Appeal’s judgment in the Petrosaudi Oil Services case concerning whether a bank was obliged to pay the claimant the sums due under a contract pursuant to a letter of credit.

Original news

Petrosaudi Oil Services (Venezuela) Ltd v Novo Banco SA and others [2017] EWCA Civ 9, [2017] All ER (D) 92 (Jan)

The Court of Appeal, Civil Division, in allowing the appellant company’s appeal, held that the appellant, Petrosaudi Oil Services (POS), had been entitled to call for payment of sums under a standby letter of credit (SBLC) for the account of the third respondent, PDVSA Services BV. POS had contracted with PDVSA regarding the provision of drilling services. Further, in the circumstances, the general counsel of POS had been entitled to sign a demand presented to the relevant bank under the SBLC.

What are letters of credit?

Letters of credit are an essential cog in the mechanics of international trade. In essence a letter of credit substitutes a bank’s credit-risk for that of the buyer of goods or a service. The letter of credit creates a payment obligation on the part of the bank to the seller that is independent of the underlying contract between the buyer and seller. This fundamental principle is referred to as the ‘autonomy of the credit’ or the ‘principle of autonomy’. The seller is paid upon the presentation of certain specified documents, for example, an invoice, as long as such documentation meets any requirements specified in the letter of credit. The use of letters of credit gives sellers the confidence to ship goods, or provide services, in the knowledge that they will receive swift payment from the bank. Buyers are given comfort that goods and services will be provided without delay.

What is the ‘fraud exception’ and did the courts apply it in the Petrosaudi case?

Under the principle of autonomy a bank must pay out under a letter of credit as long as certain requirements specified in the letter of credit are met. However, if these requirements are provided dishonestly or recklessly as to their truth then the fraud exception to the principle of autonomy (as opposed to the general fraud exception) will apply and payment can be withheld. The fraud exception is therefore a narrow one which will rarely apply and which should not undermine confidence in letters of credit.

In the Petrosaudi case the High Court decided at first instance that the fraud exception did apply and accordingly ordered the bank to withhold payment. However, this decision was overturned on appeal.

What were the facts of this case?

The claimant, POS, a Barbadian company, entered into a contract to supply oil rig drilling services to the second defendant PDVSA Servicios SA, a Venezuelan company (PDV). As required by this underlying contract, a standby letter of credit was issued in favour of POS by the first defendant, Novo Banco SA, a Portuguese bank, as security for payment of invoices issued by POS.

POS provided drilling services between July 2015 and June 2016 and rendered invoices to PDV totalling in the region of $129m. However, a dispute arose which, pursuant to a term in the underlying contract, POS and PDV entered arbitration to resolve.

Under the underlying contract:

  • if PDV did not dispute an invoice within 15 days of receipt it was deemed to have irrevocably accepted the invoice as being correct, due and owing, and
  • if PDV did dispute an invoice it nevertheless had to pay POS the disputed amount which would be repaid (with interest) should POS subsequently accept, or PDV provide that the amount was not payable (the ‘pay now, argue later’ clauses)

However, the underlying contract also provided that Venezuelan law was applicable to the performance of the contract and in two preliminary (partial) arbitral awards it was held that Venezuelan law rendered the ‘pay now, argue later’ clauses null and void.

PDV therefore contended that it had no obligation to pay the invoices until the dispute was resolved following a final arbitral award. POS disagreed and contended it was entitled to make a presentation under the letter of credit and receive full payment of the sums outstanding from the bank.

POS subsequently presented the invoices to the bank for payment. The letter of credit provided that POS had to certify that PDV was ‘obligated to the beneficiary to pay the amount demanded under the drilling contract’, which POS did. Accordingly, the bank gave notice that it considered that there had been a compliant presentation and stated its intention to pay out to POS.

What was the key issue to be decided in this case?

PDV contended that the effect of the preliminary arbitral awards was that it (and therefore the bank) was not obligated to make payment pending the outcome of the arbitration. The ‘pay now, argue later’ clauses did not alter the position as the arbitrators had found them to be null and void as a matter of Venezuelan law. Accordingly, POS could not have honestly certified in the presentation to the bank that PDV was obligated to make payment. To have made the presentation was therefore fraudulent within the meaning of the ‘fraud exception’ to the ‘autonomy principle’. Therefore POS was not entitled to any payment under the letter of credit at this time.

POS disagreed with this analysis and contended the presentation had been compliant with the terms of the letter of credit and that, even if this was not the position, there had been no fraud.

How did the courts decide this issue?

At first instance the High Court found that the certificate provided by POS that PDV was obligated to POS for the sums claimed in the presentation was false. No such sum was due and payable at the time of the presentation. The debt had to be claimed and adjudicated in arbitration—until and unless that happened there was no present debt due or payable at all. This would have been clear to POS in light of the preliminary arbitral awards and accordingly POS cannot have had an honest belief in the statement that PDV was ‘obligated’ or had made it recklessly, not caring whether it was true or false. The fraud exception to the principle of autonomy therefore applied and the bank was restrained from paying out to POS under the letter of credit.

The Court of Appeal overturned the decision at first instance. The Court of Appeal found that, contrary to the decision at first instance, the certificate provided by POS correctly stated that PDV was obligated to POS for the sums claimed in the presentation. The Court of Appeal agreed with the analysis of POS’s general counsel of the meaning of the certificate, which underpinned the presentation made to the bank under the letter of credit. The Court of Appeal in effect exonerated the claimant’s general counsel, taking the same view that he had of the legal position underpinning the presentation made to the bank by the claimant. Accordingly POS was entitled to provide the certificate. The fraud exception did not apply.

Did the bank have to pay out under the letter of credit?

Eventually, yes. The Court of Appeal ordered the bank to pay POS the amounts due under the presentation made to the bank by POS pursuant to the letter of credit.

Does this case change or extend the current legal position?

The case does not break new ground nor establish a new legal principle. However, the Court of Appeal’s decision provides a useful reminder that, absent clear evidence that the signatory acted fraudulently, the autonomy principle should be upheld. The decision also gives lawyers helpful comfort that the courts should not second guess honest representations of law.

What should banks who issue letters of credit take note of as a result of this decision?

The principle of autonomy means that a dispute arising from the underlying contract between buyer and seller is very unlikely to act as a bar to payment by a bank pursuant to the terms of a letter of credit. The fraud exception to the principle of autonomy is a narrow one. It is unlikely that a bank will be able to withhold payment under a letter of credit in line with the fraud exception unless there is clear evidence of fraud.

Interviewed by Susan Ghaiwal.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

First published on LexisPSL Banking & Finance. Click here for a free trial.

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