Standby Letters of Credit

In July, the Court of Appeal in Shinetec (Australia) Pty Ltd v The Gosford Pty Ltd [2024] NSWCA 174 (Gosford) considered certain significant aspects of law concerning standby letters of credit, a type of financial instrument critical to many commercial transactions but rarely the subject of judicial consideration.

A standby letter of credit (SBLC) is used as a form of security, commonly used in connection with financing arrangements and construction contracts, as well as leasing transactions and international trade transactions among other things.

Below is a brief overview of key common law principles concerning SBLCs, including as examined recently by the New South Wales Court of Appeal. It is pertinent to note that, while there is relatively little case law concerning the operation of SBLCs, should parties choose to be bound by international principles concerning the interpretation of SBLCs, embodied by the Uniform Customs and Practice for Documentary Credits (UCP 600), they can expressly agree as much within the relevant credit documentation.

Typical structure

Typically, the following structure will be implemented in relation to a SBLC:

1. An agreement will be entered into between an applicant or “account party” (for example, a borrower or construction contractor) and the issuer of the letter of credit.
2. Subject to any conditions precedent in that agreement, the applicant can request, and the issuer will then be obliged, to issue an agreed form of SBLC to the relevant beneficiary (for example, the creditor or project owner).
3. If specified criteria for calling upon the SBLC are fulfilled (usually, the occurrence of some specific default or breach by the applicant) then the beneficiary is permitted to call on the SBLC.
4. If a call is made upon the SBLC, the issuer is then obliged to pay the creditor up to the maximum liability of the SBLC.  This critical point is discussed further, below.

Obligation to pay and primacy of documentation

The issuer is not obliged to make any enquiries concerning whether the demand was validly made and must pay upon receipt of a demand.  There are limited exceptions to that position, some of which arose for consideration in Gosford.

In that case the applicant had, at first instance and in relation to a SBLC, sought a declaration that a demand made by the beneficiary was “invalid and of no effect” and an order that the standby letter of credit be returned. The NSW Court of Appeal confirmed the primary tenet of payment upon demand under a SBLC, inter alia, absent fraud or unconscionability, the issuer must pay if demand documentation is presented and is compliant with the terms of the credit, see Gosford at [11].

The demand in Gosford had been signed by receivers appointed to the beneficiary of the SBLC. The Court of Appeal confirmed the decision of the primary judge, to the effect that the appointment of receivers to a beneficiary does not, and nor does the signing of the demand by receivers acting for the beneficiary, constitute a proper basis for the issuing bank to refuse compliance with the demand, see Gosford at [14], [163]-[172].

A letter of credit typically provides, in clear and express terms, that payment will be made upon receipt of documents which may include a certificate or other confirmation from the beneficiary, or other stipulated conditions. As between the issuer and other parties, the payment obligation arises as soon as the issuer receives documentation which appears on its face to comply with the terms of the letter of credit.

The principle of independence or autonomy

The Gosford decision also reinforced another key principle relating to payment pursuant to a SBLC, being the principle of independence or autonomy.

The principle of autonomy provides that the financier’s unconditional payment obligation in commercial instruments such as SBLCs is independent of the underlying contract between the applicant and the beneficiary.  In Gosford, the Court of Appeal affirmed that principle, by reference to the independence of the SBLC from underlying contracts.  That is, subject to the absence of fraud of unconscionability, any breach of the underlying construction contract by the applicant does not result in a call on the letter of credit being invalid, void or of no effect. Although related issues may sound in damages. Generally, see Gosford at [11], [134]-[140].

The importance of independence in relation to the obligations under a SBLC was previously propounded by the High Court in Trident General Insurance Co Ltd v McNiece Bros Pty Ltd (1988) 165 CLR 107; (1988) 80 ALR 574; (1988) 62 ALJR 508, where it was held that the issuer of a letter of credit must honour the payment irrespective of any disputes that may arise between the contracting parties. This decision solidified the principle that banks are bound to pay upon presentation of the required documents, thus enhancing the reliability of SBLCs.

This principle underpins the general position that, with limited exceptions, courts do not interfere with performance of the payment obligation. The principle also applies to documentary (as opposed to standby) letters of credit, and certain types of demand guarantees, such as performance bonds. See Boral Formwork & Scaffolding Pty Ltd v Action Makers Ltd (in administrative receivership) [2003] NSWSC 713 at [32]-[45].