Standby credits are the ticking time bomb of many commercial relationships. This note discusses the origins of standby credits, the autonomy rule and its exceptions in Australian law.
The standby credit has two ancestors, the documentary letter of credit and the first demand guarantee.
Documentary credits, the “crankshaft of modern commerce” (see (Chorley 1974) at p 225), are used by the parties to an international sale of goods. The buyer and the seller in an international sale may not know much of each other, in particular, the financial stability of their trading partner.
A documentary credit is a promise by the issuing bank to pay the beneficiary, usually the seller, against the presentment of certain documents. The credit is issued by the bank on the instructions of the account party, usually the buyer.
The operation of a documentary credit ensures that, with the assistance of the issuing, confirming and advising banks, both parties have substantial protection against the insolvency of the other. The essential features are:
payment is guaranteed by the bank provided the proper documents are tendered by the seller;
the “proper documents” include a bill of lading which is a document of title to the goods, a policy of marine insurance and a commercial invoice;
the bill of lading is issued by the shipper, the policy of insurance by the insurer. In the absence of fraud, the buyer may be assured that the goods exist and are in transit.
The result is that neither party to the transaction controls both the goods and the money at the same time. Insolvency of one of the parties will disrupt the expectations of the other party, but it will not result in the catastrophic loss of both goods and payment.
First demand guarantees, also called performance guarantees or unconditional guarantees, are like normal guarantees except that presentment of specified documents is conclusive evidence that the guarantee is payable. The issuing bank is the guarantor, the account party the “debtor”. In most cases, the documents required are under the control of the beneficiary. First demand guarantees are not subject to the usual rules which release the guarantor upon certain changes in the underlying contract: see (O’Donovan and Phillips 2006).
Standby credits are derived from documentary credits but perform the function of first demand guarantees. It is said that they are an invention of American banks which were allowed to issue letters of credit but not permitted to give first demand bank guarantees. In a triumph of form over substance, American courts held that a properly worded standby credit is not a bank guarantee: see Fair Pavilions Inc v First National City Bank 281 NYS 2d 23 (1967); Wichita Eagle & Beacon Pub Co v Pacific National Bank 343 F Supp 323 (N D Cal 1971) and Barclays Bank (DCO) v Mercantile National Bank 481 F 2d 1224.
The essential difference between a documentary credit and a standby credit is the identity of the document issuer. Two of the three essential documents tendered under a documentary credit originate with third parties who have independent reasons for ensuring that the documents reflect reality.
By contrast, the documents required by a standby credit are often under the control of the beneficiary. In many cases, the documents required are little more than a statement by the beneficiary that a certain state of affairs exists. In short, the documents are issued by a party whose principal interest is obtaining payment under the credit.
It is this difference that makes the documentary credit a safety feature while the standby credit is a ticking time bomb.
The “autonomy principle” holds that the documentary credit is a contract which is separate from, and unaffected by, the underlying contract which gave rise to the credit.
The inflexibility of this principle is illustrated most graphically by Discount Records Ltd v Barclays Bank Ltd [1975] 1 WLR 315 IL 110. An English company purchased goods from a French company. When the first shipments arrived, many of the boxes were filled with rubbish. There was evidence that the shipping marks had been tampered with. The buyers sought an injunction to prevent the sellers from drawing on the credit. The injunction was denied on the basis of the autonomy principle.
The same autonomy principle applies to first demand guarantees and standby credits: Edward Owen Engineering Ltd v Barclays Bank International Ltd and Umma Bank [1978] QB 159.
There are three “exceptions” to the autonomy rule:
the fraud exception
the negative pledge exception and
the unconscionable conduct exception
The fraud exception is usually traced to the American case of Sztejn v J Henry Schroder Banking Corp 31 NYS (2d) 631 (1941). It is often overlooked that Sztejn was decided in a procedural hearing which required the court to assume that fraud had been proved.
Establishing the case for fraud has proved to be the big stumbling block for account parties seeking an injunction. The applicant must establish a prima facie case: Inflatable Toy Co Pty Ltd v State Bank of New South Wales (1994) 34 NSWLR 243. An alternative formulation is that the applicant must establish
that it is seriously arguable that on the material available the only realistic inference is that [the beneficiary] could not honestly have believed in the validity of its demands on the [letter of credit].
This is the test of Group Joshi Re v Walbrook Insureres & Co Ltd (1996) 1 WLR 1152 at 251, quoted and followed in Olex Focas Pty Ltd v Skodaexport [1998] 3 VR 380.
This is a very difficult standard. The applicant in Discount Records failed even though a layperson might have thought that fraud was obvious. It is most unusual for the applicant to succeed: see Stylex Fashions Pt Ltd v National Australia Bank Limited [2004] VSC 64 for a recent Australian example where the fraud exception was established.
The underlying contract may contain a term which limits the circumstances under which a beneficiary may call upon the credit. Where this is the case, a court will hold the beneficiary to the agreement: Wood Hall Ltd v The Pipeline Authority (1979) 141 CLR 443; Boral Formwork & Scaffolding Pty Ltd v Action Makers Ltd (in administrative receivership) [2003] NSWSC 713.
The contract term must be clear. In Boral Formwork, the beneficiary agreed not to claim against the credit in the event of a dispute. There was a dispute, but the court found that certain actions by the receiver had effectively ended the dispute. The term therefore could not prevent the beneficiary from drawing on the credit.
It is very unlikely that any court will find an implied term which restricts the beneficiary. An argument to that effect was rejected by the court in Ideas Plus Investments Ltd v National Australia Bank Ltd [2006] WASCA 215. There it was argued that the beneficiary should exhaust other remedies before calling on the credit. This argument would, in effect, make the standby credit a remedy of last resort.
There may also be a restrictive term in the credit itself. Relying on such a term is not an exception of the autonomy principle, but rather an application of the principle. Banks resist, rightly, the attempt to insert terms that require “real world” rather than documentary evidence.
Unconscionable conduct as defined by the courts ,or under ss 51AA and 51AC of the Trade Practices Act 1974, may provide the grounds for an injunction preventing the beneficiary from drawing on the credit.
The unconscionable conduct exception to the autonomy principle was first raised in Australia in Olex Focas Pty Ltd v Skodaexport [1998] 3 VR 380. It caused a flurry of comment, much of it unfavourable, but was again visited by Austin J in Boral Formwork & Scaffolding Pty Ltd v Action Makers Ltd (in administrative receivership) [2003] NSWSC 713.
The exact requirements of the exception are still being developed: see the excellent article in this Journal: (Bisley and Mok 2005). That article also shows that, contrary to much of the comment at the time, the unconscionability exception has counterparts in the legal systems of other trading partners.
One common problem involves the beneficiary drawing on the credit when there is a dispute between the parties. The account party will nearly always think that this is unconscionable, but that is not the case. Often the whole point of the standby credit is to shift the financial burden and risk in the event of a dispute: see, for example, the Boral Formwork case. When that is the case, it cannot be unconscionable for the beneficiary to make use of the credit.
An account party can take a few precautions. The best is to ensure that the credit itself helps to guard against a wrongful claim. This means that the autonomy principle will work in favour of the account party, not against.
There are severe limits to the terms that a bank will find acceptable. An issuing bank, rightly, will wish to deal only in documents. This means that the best the account party can hope for is that the credit requires a certificate from a trusted third party expert which attests to the state of affairs which must exist before the beneficiary may draw. The required wording of the certificate should be as precise as possible.
The next best position is to have a negative pledge written into the underlying contract. As seen above, the contract term must be clear and explicit about the conditions under which the beneficiary will not draw on the credit.
In real life, the account party may not be able to insist on any particular requirement. There would probably be no standby credit if the bargaining position of the account party were that strong. On the other hand, if the potential beneficiary will not agree to a negative pledge in the contract, perhaps it would be better to look elsewhere for a contracting party. If that is an option, which it often is not. The cases are replete with account parties who were forced to give a standby credit or face immediate ruin.