When can a bank avoid paying under an irrevocable letter of credit?

It is an essential characteristic of a letter of credit that it is an autonomous contract, and that its performance is independent of the underlying transaction to which it relates. So, when can a bank avoid paying under an irrevocable letter of credit?

The judge in this Australian Supreme Court case1 concluded that there are at least three circumstances where a bank does not have to pay:

• in the case of fraud;
  
  
• where it is clear from the underlying contract that there would be no call on the credit where there was a bona fide dispute; or
  
  
• where there was unconscionable conduct under certain sections of the Trade Practices Act (which are broadly similar to sections 9 and 11 of the Fair Trading Act 1986 of New Zealand).

Fraud

The first exclusion was not relevant to this case.

Negative stipulation

The court did not agree that the second exclusion was applicable in this case, but noted that English courts have expressed strong reluctance to exercise it. This is because although restraining the beneficiary from breaching the underlying contract does not directly interfere with the autonomy of the payment obligation, the effect of intervening is to break down the separation between the underlying contract and the independent financing contract. However, the court noted that there is a solid line of authority in Australia for the view that an injunction is available in such circumstances.

(We note that New Zealand courts appear to be taking their lead from English decisions, rather than following Australia, in this regard).

Unconscionable conduct

In this case, there was a dispute as to amounts owing to the supplier. Notwithstanding the dispute, the beneficiary provided to the bank a certificate representing that the full amount was due. It also certified that demand for payment had been made and had remained unsatisfied.

The court decided that the conduct of the beneficiary was unconscionable within the meaning of section 51AC of the Trade Practices Act because the amount referred to in the certificate was false, and the statement about demand was misleading (in fact demand was made on the same day as the certificate).

The wording in the Trade Practices Act is broadly consistent with New Zealand's Fair Trading Act and therefore it is possible that the analysis used in this Australian decision could equally apply to a similar case in New Zealand under the Fair Trading Act.

Construction of the letter of credit

Finally, the judgment contains some interesting observations on the construction of the relevant document, notably:

• Where a letter of credit is expressed to be "irrevocable", but not "unconditional", the court is open to adopt a construction that there are conditions to payment (but they need to be specifically recorded).
  
  
• Where the instrument is a bank guarantee, under which a bank "unconditionally" undertakes to "pay on demand", the court will adopt a construction of the instrument that reflects the unconditional nature of the payment obligation, and will not make the bank's payment obligation dependant on the claimant establishing an entitlement to be paid.
  
  
• A standby letter of credit provides for payment by the financier on receipt of documents, rather than simply on demand. Whether a standby letter of credit should be construed in the same fashion as a bank guarantee or performance bond depends on the commercial purpose of the instrument.

The court contended that it is theoretically possible, though highly unlikely, that, in a case where the purpose of a letter of credit is nothing more than to provide security for payment of valid claims, the financier's obligation to pay might depend on its being satisfied that the beneficiary has a valid claim against the account party for the amount called. However, standby letters of credit are more typically in the nature of a bank guarantee, intended to shift the credit risk, rather than to provide security for payment.

1 Boral Formwork & Scaffolding Pty Limited v Action Makers Limited (In Administrative Receivership) & Anor [2003] NSWSC 713

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