In this case, Slattery J considered whether a buyer of commodities could restrain a seller from making demand under an unconditional standby letter of credit (“Standby LC”) issued for the seller’s benefit. The case has important lessons for parties who agree to secure their performance by arranging Standby LCs or bank bonds, and for lawyers advising them.

Facts

The case concerned a contract for the sale by Caprock Commodities Trading Pty Ltd (“Caprock”) and the purchase by ALYK (H.K) Limited (“ALYK”) of iron ore fines in a number of shipments over a period of three years. The contract required ALYK to arrange the issue of:

  • an irrevocable transferrable documentary letter of credit (“LC”) to cover 100% of contract value; and
  • “extra over the LC”, an unconditional US$20 million Standby LC for the benefit of Caprock.

The contract specified that the Standby LC was to be for $US 20 million (being expressly the price of one month’s shipment of 160,000 tonnes), “unconditional”, issued by a major bank and in a form reasonably acceptable to Caprock. The contract did not expressly control the circumstances in which Caprock could call on the Standby LC.

At the request of ALYK, the second defendant, the China Construction Bank Corporation (“Bank”), issued a US$20 million Standby LC for the benefit of Caprock. The Standby LC required that a compliant demand for payment was to include a statement of five matters: (1) the number and date of the Standby LC, (2) the amount claimed, (3) that ALYK was in breach of its obligations under the contract; (4) the nature of the breach; and (5) that Caprock was not in breach so that ALYK could not ascribe its breach to Caprock or exempt itself from performance.

Following a sharp fall in iron ore prices the parties agreed substantial amendments to the contract, including a requirement that ALYK give instructions to the Bank to issue an amended Standby LC within a certain period. When the Bank failed to issue an amended Standby LC within that period Caprock made demand on the Standby LC, identifying failure by ALYK to issue the requisite instruction to the Bank and the non-issuance of the amended Standby LC by the Bank as the breaches of contract relied upon.

ALYK sought to enjoin the Bank from paying funds to Caprock under the Standby LC. ALYK disputed that it had failed to issue the requisite instruction to the Bank, disputed that the contract required it to ensure that the Bank actually issued an amended Standby LC and, more fundamentally, disputed that Caprock was entitled to call on the Standby LC in the event of any breach other than failure to pay for a shipment. ALYK contended that the contract included an implied term limiting Caprock’s right to call on the Standby LC to non-payment for a shipment.

The decision

Slattery J explained the relevant law in relation to payment under documentary credits. His Honour stated that documentary credits are independent of the underlying contracts that give rise to them. His Honour considered that where there are express statements in letters of credit stipulating that the terms are ‘unconditional’, the terms should not be qualified by implied conditions in the agreement. Does this mean that a principal is entitled to call a Standby LC whenever they wish to do so?

Limitations

There are limited exceptions to this approach to the construction of letters of credit:

  1. The court will recognise an exception for fraud: Wood Hall Ltd v The Pipeline Authority (1979) 141 CLR 443.
  2. The court will recognise an exception for unconscionable conduct in contravention of section 20 of the Competition and Consumer Act 2010 (Cth): Olex Focas Pty Ltd v Skodaexport Co Ltd [19098] 3 VR 380.
  3. If the party in whose favour the guarantee has been given has made a contract promising not to call upon the standby letter of credit, breach of that contractual promise may be enjoined by the Court relating to the enforcement by injunction of negative stipulations in contracts: Reed Construction Services Pty Ltd v Kheng Seng (Aust) Pty Ltd (1999) 15 BCL 158.

Issues in dispute

His Honour considered whether an express negative stipulation existed to prevent the making of a claim under the Standby LC. Determining whether this stipulation exists was a matter of construction of the relevant contractual provisions. They must be construed in the context of the whole contract, giving proper weight to the commercial purpose of the parties. Clear words are needed to support a construction inhibiting a beneficiary from calling on an unconditional performance guarantee.

The relevant clause in the contract did not regulate the circumstances in which the Standby LC could be called on. ALYK argued that the contract did not confer an unconditional or unqualified right to make demand under the Standby LC, but that demand would only be made where ALYK has failed to pay for a shipment of iron ore.

Slattery J held that, on the proper construction of the whole of their dealings, they intended the Standby LC to operate without qualification or restriction.

  • In clause 6 the parties agreed to the provision of a Standby LC in a format acceptable to the seller. As the contract lacked a clause regulating the right to call on the proposed Standby LC, the parties can be assumed to have been aware of that gap and to have been filling it with the terms of the Standby LC itself, to which they assented.
  • The parties reaffirmed the unqualified terms of the Standby LC in their first amendment to the contract stating that the terms of the Standby LC “have been accepted by both parties should remain unchanged.”
  • A second amendment to the contract made some alterations to the Standby LC but did not change the essential terms which entitled the beneficiary to make a demand under it.

Slattery J considered whether an implied contractual negative stipulation existed to limit Caprock demanding payment under the Standby LC unless ALYK had failed to pay for a shipment of iron ore fines. He held that an implied negative stipulation could qualify the making of a demand under the Standby LC, if it satisfied the test in BP Refinery (Westernport) Pty Ltd v Hastings Shire Council (1977) 180 CLR 266 regarding implied terms. The term must:

  • be reasonable and equitable;
  • be necessary to give business efficacy to the contract so that no term will be implied if the contract is effective without it;
  • be so obvious that it ‘goes without saying’;
  • be capable of clear expression; and
  • not contradict any express term of the contract.

Slattery J concluded that such a term was not necessary. His Honour:

  • found that the contract worked without it, with the Standby LC operating according to its terms to allow Caprock to obtain prompt payment;
  • rejected ALYK’s argument that the sole commercial purpose of the Standby LC was to provide security for the payment of cargo. The contract’s description of the Standby LC as “extra over” the LC indicated that it was intended to cover subject matter beyond payment for cargo, which was the focus of the LC;
  • found that implying a negative stipulation would contradict an express term of the contract - the parties had incorporated by agreement into the Contract all the terms of the Standby LC, which were inconsistent with the claimed implied term; and
  • held that the claimed implied term was not capable of clear expression – ie, it was unclear as to which cargo payment issues would be caught by the term and which would not be caught.

Lessons learned

The case demonstrates the need for sellers to insist on express terms regulating when the buyer can call on a Standby LC. Otherwise the seller is apt to learn that their “unconditional” Standby LC is precisely that.

Sometimes the bank, or other issuing financial institution, will resist the inclusion of agreed conditions in the Standby LC itself. This reflects a fear of being drawn into complex judgments (and disputes) about whether conditions have been met and a desire to use their own standard form documentation which generally allows for payment “on-demand”. In those circumstances the seller should insist that any agreed conditions be included in their contract with the buyer.

To see the full judgment in this case, please click here.