Banking law

Letter of credit

Sirius International Insurance Company v FAI General Insurance Ltd & Others [2003] EWCA Civ 470

In this case, Sirius entered into a retrocession reinsurance contract with FAI to cover the reinsurance of a third party.

Under the retrocession contract, Sirius wrote the policy on the basis that FAI would pay it, should Sirius be called on to pay the third party.

As a requirement for fronting the reinsurance, Sirius required and obtained a letter of credit from Westpac Bank, established by FAI for the benefit of Sirius.

The letter of credit was provided on agreed terms contained in a letter dated 3 September 1999.

The most important term was that Sirius undertook not to draw down on the letter of credit unless FAI agreed that Sirius should pay a claim but had not put it in funds to do so ('the draw- down term').

The third party made a claim against Sirius and agreed that it would not enforce payment against Sirius until proceedings against FAI were concluded.

Sirius brought arbitration proceedings against FAI.

In March 2001, provisional liquidators were appointed over FAI, effecting a statutory stay of the arbitration proceedings.

Sirius applied to lift the stay.

The application to lift the stay was compromised by a Tomlin order.

Paragraph 1 of the schedule to the Tomlin order provided that FAI was indebted to Sirius in the sum of $22.5 million and Sirius shall be entitled to prove in the liquidation...

in the said sum.

Subsequent paragraphs provided that Sirius shall draw down on the letter of credit, the proceeds of which were to be paid into an escrow account pending the resolution of the parties claims, if any, in respect of the letter of credit.

The money was drawn down and the question for the judge at first instance was who was entitled to the money.

The judge held that paragraph 1 of the schedule to the Tomlin order satisfied the draw-down term and Sirius was entitled to the sum of $5 million held in the escrow account.

The judge also dealt with the position if contrary to his interpretation of the Tomlin order, the draw-down term was not satisfied.

In these circumstances, the judge held that FAI could have relied on the draw-down term to prevent Sirius drawing down on the letter of credit even though the letter of credit itself contained no such restrictions.

FAI appealed the judge's construction of the Tomlin order and his conclusion that the relevant terms of the schedule to the order satisfied the draw-down term.

Sirius cross-appealed on the grounds that even if the draw-down term had not been satisfied, it was still entitled to draw down on the letter of credit.

The Court of Appeal agreed with FAI that the terms of the schedule to the Tomlin order did not satisfy the draw-down condition and that the judge had misconstrued the terms of the order.

However, the court upheld the decision of the judge at first instance on the cross-appeal.

Sirius was not entitled to draw down on the letter of credit in breach of the draw-down terms contained not in the letter of credit itself, but the agreement between it and FAI, recorded in the letter of 3 September 1999.

The court held that the autonomous nature of letters of credit does not extend to permitting beneficiaries to draw them down in accordance with their terms but in plain breach of a promise to the person who opened the letter of credit not to do so.

If draw-down is attempted in these circumstances, a court would be likely to restrain by injunction the breach of the underlying condition not to draw down other than in stated circumstances.

This important decision sheds light on the ambit of the principle of autonomy of letters of credit.

In general terms, the principle operates to enable merchants to treat a letter of credit as the equivalent of cash.

If the terms of the credit are complied with, the beneficiary is generally entitled to payment from the bank, irrespective of whether there is an underlying dispute under the agreement for sale or services.

The court held that there was no authority extending this autonomy for the benefit of a beneficiary of a letter of credit, so as to entitle him to draw on the letter of credit when he is expressly not entitled to do so, even though the restriction is contained not in the terms of the credit itself but another agreement.

In the absence of authority, the court refused to extend the principle.

On the facts of the case, the agreement restricting the ability to draw on the credit was contained not in the underlying agreement for the provision of a service, namely the retrocession contract, which the credit was intended to support, but a related and separate agreement dealing with the terms on which the credit would be established.

Even if the two agreements were combined, there is a prospect on the authority of this case that the parties to an agreement underlying a letter of credit will be entitled to fetter contractually the right of a beneficiary to treat the letter of credit as in general the equivalent of cash.

Such a fetter would not, it seems, operate as against the bank, which would still be obliged to honour a request for payment if the conditions of the credit were met.

However, there is a prospect that a well-advised buyer will use this authority as the basis for seeking significantly to restrict a seller/beneficiary's ability to draw down on a credit.

In this respect, the effect of the decision may herald the start of the gradual erosion of the principle of autonomy.

By Simon Sugar, barrister, 36 Bedford Row, London