This article also appeared in the Summer 2024 issue of Build Manitoba magazine.
On April 5, 2024, the Supreme Court of Canada released reasons for decision in Eurobank Ergasias SA et al. v. Bombardier Inc. et al. The decision provides important clarity to the law surrounding letters of credit as security for contractual obligations and the limited exceptions available to prevent payment to a beneficiary.
Although perhaps not as prevalent as bonds, letters of credit are occasionally used by owners, stakeholders and in Court matters to serve as a guarantee for performance of contractual or statutory obligations. For example, letters of credit can be used to stand as security for liens (as an alternative to cash or lien bonds), or can be used as a method of early payout of contractual holdback. Therefore, it is important to have some understanding of the law relating to letters of credit in Canada.
The facts of Eurobank
The Eurobank case involved the Hellenic Ministry of National Defence's procurement from a Canadian company of firefighting amphibious aircrafts. The arrangement included an offsets contract pursuant to which the Canadian company would subcontract some of the work associated with the aircraft procurement to Greek companies.
The offsets contract provided that the Canadian company would owe the Ministry liquidated damages if it did not fulfill its subcontracting obligations. The payment of the liquidated damages was secured by a letter of credit issued by a Greek bank in favour of the Ministry. In turn, a second letter of credit was issued by National Bank of Canada in favour of the Greek bank to secure payment of any amounts by the Canadian company demanded under the Greek letter of credit. Any disputes under the offsets contract were to be resolved by international arbitration.
The Canadian company took the position that it was unable to meet its subcontracting obligations under the offset contract. The international arbitration process was initiated to resolve the dispute. Although the Ministry undertook not to make demand under the Greek letter of credit while the arbitration was ongoing, prior to the final award, it made demand on the Greek bank.
The Canadian company sought and obtained an order from the arbitral tribunal preventing the demand, and sought an injunction from the Canadian Courts to prevent payment under the letters of credit. Despite this, the Ministry made a final demand for payment and took the position that the Greek bank would be subject to civil and criminal legal measures if it refused to pay. The Greek bank paid and made demand on the Canadian bank.
The arbitral tribunal issued an award that the offsets contract violated European Union law such that it was null and void and no liquidated damages were payable by the Canadian company to the Ministry. The Greek bank unsuccessfully attempted to recover the monies it paid to the Ministry. It made demand on the Canadian bank. In proceedings in Canada, the Canadian company sought a permanent injunction enjoining the Canadian bank from paying the Greek bank, arguing that the 'fraud' exception to the near absolute duty to honour a demand for payment on a letter of credit was met. The trial judge agreed and issued an injunction that the Canadian bank not pay the Greek bank's demand. The matter was appealed to the Court of Appeal, which agreed with the trial judge, then to the Supreme Court of Canada.
The Supreme Court of Canada decision
In its reasons for decision, the majority of the Supreme Court of Canada described the law relating to letters of credit in Canada as follows:
- A letter of credit is an instrument, understood to be autonomous from the underlying contract to which it applies, issued by a financial institution at the request of its client;
- A letter of credit entitles the beneficiary of the letter to payment on demand from the issuing bank, so long as that demand conforms to the requirements in the letter of credit;
- Typically, the customer contracts with the financial institution to issue a letter of credit as a means of providing comfort to the beneficiary that an underlying agreement will be performed as promised;
- The financial institution has a nearly absolute obligation to pay when presented with a valid demand by a beneficiary; and
- The only recognized exception in Canadian law to payment on demand is fraud by the beneficiary which is brought to the attention of the financial institution prior to payment.
The Court commented that although "standby" letters of credit are often referenced when the letter is intended to guarantee performance of a duty or obligation, there is little difference between instruments referenced as "demand guarantees," "letters of credit" or "standby letters of credit." The strength of a letter of credit is that a beneficiary may have comfort in knowing that they will be paid by the financial institution if the co-contracting party fails to perform its obligation, subject only to the fraud exception.
The Court also commented that Courts must be very slow to interfere with a demand on a letter of credit because it impairs the reliance industry places upon such instruments. A letter of credit is autonomous from the contract between the contracting parties, being an obligation of the financial institution guaranteeing a party's performance. Therefore, any disputes between the parties concerning the underlying contract are usually irrelevant to the demand on the letter of credit. So long as the beneficiary strictly complies with the terms of demand, payment will be made. The terms often involve making demand in a certain manner, within certain timeframes and at a certain place of business of the financial institution.
In this extraordinary case, the Court did, however, apply the one exception to the financial institution's obligation to pay upon demand. The Court decided that the Ministry perpetrated a fraud as beneficiary under the primary letter of credit. The Greek bank had knowledge of the fraud yet called for payment from the Canadian bank. The Canadian bank, having knowledge of the true state of affairs before it paid on the demand, was rightly enjoined by the lower Court from paying any amount under the letter of credit.
Takeaways for the industry
The decision of the majority of the Court is a reminder for those in the construction industry that letters of credit guaranteeing performance, or guaranteeing other obligations for a project (such as damages or contractual holdback) are nearly absolute in the obligation to pay upon demand. In this way, letters of credit differ from bonds, which allow a surety to raise defences relating to the underlying dispute, such as whether a party is in default and whether the claim falls within the coverage provided by the bond. When letters of credit are provided, it is very rare indeed that the one and only exception to payment will apply. Usually, the underlying dispute is irrelevant and the financial institution will make payment on the letter of credit so long as the strict terms of the letter of credit are met.
If you have any questions about letters of credit, the construction projects lawyers at MLT Aikins are pleased to assist.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.