Analysis: Key considerations when assessing whether a beneficiary of an irrevocable standby letter of credit is entitled to exercise its rights

In Canadian insolvency proceedings, standby letters of credit are occasionally a form of security that certain parties may hold, which can potentially give enhanced rights. Whether a beneficiary of an irrevocable standby letter of credit is able to exercise its rights set forth under such a letter of credit during an insolvency proceeding of the applicant (who is typically the debtor company subject to an insolvency proceeding), is often an issue that the issuing bank, the applicant or the court-appointed officer of such applicant, as applicable, will consider, as it has a direct impact on the estate of the debtor.

This bulletin will outline a brief analysis of an irrevocable standby letter of credit (the Letter of Credit) granted by a Canadian financial institution (the Bank) and certain key considerations that the financial institution issuing the Letter of Credit, debtor company or court-appointed officer involved in an insolvency proceeding typically take into account when assessing whether the beneficiary of same (the Beneficiary) is entitled to exercise its rights set forth under the Letter of Credit.

In brief, the terms of the Letter of Credit will dictate the rights and obligations of the Bank and the Beneficiary. Let’s take for instance that the Letter of Credit states, inter alia:

PURSUANT TO THE REQUEST OF OUR CUSTOMER, THE SAID APPLICANT, WE, THE BANK, HEREBY ESTABLISH AND GIVE TO YOU AN IRREVOCABLE STANDBY LETTER OF CREDIT IN YOUR FAVOUR IN THE ABOVE AMOUNT WHICH MAY BE DRAWN ON BY YOU AT ANY TIME AND FROM TIME TO TIME, UPON WRITTEN DEMAND FOR PAYMENT MADE UPON US BY YOU, WHICH DEMAND WE SHALL HONOUR WITHOUT ENQUIRING WHETHER YOU HAVE A RIGHT AS BETWEEN YOURSELF AND THE SAID CUSTOMER TO MAKE SUCH DEMAND, AND WITHOUT RECOGNIZING ANY CLAIM OF OUR SAID CUSTOMER OR OBJECTION BY IT TO PAYMENT BY US.

THIS LETTER OF CREDIT IS SUBJECT TO THE RULES SET OUT IN INTERNATIONAL STANDBY PRACTICES (ISP98) INTERNATIONAL CHAMBER OF COMMERCE PUBLICATION NO. 590 AND ENGAGES US. IN ACCORDANCE WITH THE TERMS THEREOF.

The Bank’s obligations will be bound by ISP98 and the terms of the Letter of Credit. Article 4.01 of the ISP98 sets out the rule by which documents presented to obtain payment under a standby Letter of Credit must appear to comply. In principle, Article 4.01 requires the Bank to pay the Beneficiary the amount of the Letter of Credit upon presentation of documents that appear to comply with the terms and conditions of the Letter of Credit, subject to the fraud exception¹. This analysis will assume that the fraud exception does not apply and that the Letter of Credit has not expired.

As the Letter of Credit states that the funds are available “UPON WRITTEN DEMAND” and, “WHICH DEMAND WE SHALL HONOUR WITHOUT ENQUIRING WHETHER YOU HAVE A RIGHT AS BETWEEN YOURSELF AND THE SAID CUSTOMER TO MAKE SUCH DEMAND”, disputes between the parties regarding the underlying commercial transaction, including whether amounts are properly due and payable or whether the Applicant has fulfilled its end of the bargain, do not and cannot provide a basis on which the Bank may refuse to make payment under the Letter of Credit². The Ontario Court of Justice in the 1993 case of Cineplex Odeon Corp. v 100 Bloor West General Partner Inc., [1993] OJ No 112 stated that letters of credit are “designed by their very nature to be free and clear of the equities between the parties to the underlying transaction which they are issued to secure. They constitute an independent contract between the issuer (usually a bank, as in this case) and the beneficiary (one of the parties to the underlying transaction which they are issued to secure)”.

Justice Le Dain summarized the principle of autonomy referred to in the above case in the Bank of Nova Scotia v Angelica Whitewear Ltd., [1987] 1 SCR 59 case, stating at p 70 (para 10):

The fundamental principle governing documentary letters of credit and the characteristic which gives them their international commercial utility and efficacy is that the obligation of the issuing bank to honour a draft on a credit when it is accompanied by documents which appear on their face to be in accordance with the terms and conditions of the credit is independent of the performance of the underlying contract for which the credit was issued. Disputes between the parties to the underlying contract concerning its performance cannot as a general rule justify a refusal by an issuing bank to honour a draft which is accompanied by apparently conforming documents. This principle is referred to as the autonomy of documentary credits.

Subject to the obligations of the Bank which are dependent on the terms and conditions of the Letter of Credit, including ISP98 and documents presented by the Beneficiary³, if a demand by the Beneficiary is made in compliance with the terms of the Letter of Credit, the Bank will be obligated to pay the Beneficiary upon demand.