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The Unconscionability Exception

cases the courts will intervene where the exercise of that right is abusive although the conduct of the beneficiary in demanding payment does not amount to fraud.

7.61 Following the decision o f the Gourde Cassation recognizingabusive demand as an additional exception separate from the fraud exception, courts have been able to intervene on the ground of abusive demand in a number of cases. Thus, in one case,134 where a demand guar­ antee had been issued as a tender guarantee and the eventual contract was not concluded due to the fault of the beneficiary (employer), it was held that in such a case a demand for payment by the beneficiary was manifestly abusive and that the bank ought to have refused to pay once it had been made aware of the situation. In another case,13516a call by the issuing bank under its counter-guarantee issued by the account party’s bank had been held to be manifestly abusive on the basis that the issuing bank did not intend to pay the beneficiary under its demand guarantee and intended to raise against the beneficiary the defence that the guarantee had expired. However, care should be taken in finding that a demand is abusive. For example, the mere fact that the issuing bank intended to raise a defence against the ben­ eficiary of the performance bond does not mean that the defence will succeed. So, it may make commercial sense for an issuing bank that has received a demand under its perfor­ mance bond to call on the counter-guarantee of the instructing party even though the issuing bank intends to raise a defence against the beneficiary. This may be the case, for example, where the counter-guarantee is due to expire so that the issuing bank cannot wait for the conclusion of any litigation with the beneficiary before demanding payment under the counter-guarantee when it will be too late.

7.62 Since the courts recognize an exception based on abusive demand, if a bank pays with full knowledge of facts establishing that a demand is abusive, the bank will not be entitled to reimbursement under its counter-indemnity. In Banque Indosuez v. Ste Entrepose,m the account party, who was bidding for a contract for the construction of a gas pipeline in Bangladesh, instructed a bank to issue a tender guarantee to the employer. Under the guar­ antee the bank undertook to pay the beneficiary if the account party withdrew its offer during a stipulated period or if the account party, having received a notice of acceptance of its offer during the stipulated period, failed or refused to sign the contract when asked to do so. The account party was awarded the contract but the employer attempted to impose a new term, different from those stated in the documents calling for tenders, giving the employer the right to terminate the contract unilaterally. The account party, who found this unaccept­ able, broke off the negotiations and the beneficiary called on the guarantee. The account party provided the bank with all the information relating to the conduct of the beneficiary. However, the bank paid and sought reimbursement from the account party. The Cour de Cassation upheld the decision of the Court ofAppeal that the bank, which had been informed of the situation, should have refused to pay on the ground that the employer’s demand was manifestly abusive as it was based on the account party’s refusal to agree to a term not contained in the tender document.

134SA Rhone-Merieux c Banque Francaise du Commerce Extirieur, Tib. Com. Lyon, 3 July 1991, D. 1993 Somm. 100.

135Bankaljazira c. SA Banque I’rivee, Paris 22 January 1991, D. 1991. Somm. 200.

136Com. 2 decembre 1997, D. off. 1998, 107, obs. A.-R.; JCP 1998, 6d. E, 1781, obs. S. Hanna.

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///. Some Overseas Authorities

6. UN Convention

The United Nations Convention on Independent Guarantees and Stand-by Letters ofCredit 7,63 includes bad faith among the exceptions to the issuer’s obligation to pay. Article 15(3) of the Convention stipulates that when demanding payment the beneficiary ‘is deemed to certify

that the demand is not in bad faith and that none of the elements referred to in subpara­ graphs (a), (b) and (c) of paragraph (1) of article 19 are present.’ Article 19(1) allows the issuer to refuse payment against the beneficiary in the cases listed in subparagraph (a) to (c). Subparagraph (a) is concerned with documents that are not genuine or have been falsified. Tliis is wide enough to cover the fraud exception and the nullity exception. Subparagraph (b) deals with the case where no payment is due on the basis asserted in the demand and the supporting documents’. This seems to fall within the fraud exception. Subparagraph (c) deals with the case where, ‘judging by the type and purpose of the undertaking, the demand has no conceivable basis’. Article 19(2) then goes on to explain that:

[f]or purposes of subparagraph (c) of paragraph (1) of this article, the following are types of situations in which a demand has no conceivable basis:

(a)The contingency or risk against which the undertaking was designed to secure the benefi­ ciary has undoubtedly not materialised;

(b)The underlying obligation of the principal/applicant has been declared invalid by a court or arbitral tribunal, unless the undertaking indicates that such contingency falls within the risk to be covered by the undertaking;

(c)The underlying obligation has undoubtedly been fulfilled to the satisfaction of the beneficiary;

(d)Fulfilment of the underlying obligation has clearly been prevented by wilful misconduct of the beneficiary;

(e)In the case of a demand under a counter-guarantee, the beneficiary of the counter­ guarantee has made payment in bad faith as the guarantor/issuer of the undertaking to which the counter-guarantee relates.

These types of situation, where a demand has no conceivable basis, are similar to instances 7.64 where it has been held in certain jurisdictions that the beneficiary’s conduct in making

the demand is unconscionable or an abuse of right.137 However, the manner in which the exception in Article 19(l)(c), has been expressed, including the types of situation listed in Article 19(2), lacks the flexibility of a broad exception such as unconscionable conduct. For example, a court applying Article 19(l)(c) and (2) may not be able to intervene where a demand is in bad faith because the amount demanded is excessive, since such a demand is not one that has no conceivable basis, whereas courts applying the unconscionable conduct exception have been able to intervene in such a case.

137 Although the type of case listed in (b), where the underlying obligation has been declared invalid, has some affinity with the illegality exception discussed in Chapter 8.

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8

THE ILLEGALITY EXCEPTION

I. INTRODUCTION

This chapter considers the extent to which, as an exception to the independence principle, 8.01 the rights and obligations created by a letter of credit or demand guarantee may be affected

by illegality in the underlying contract.1It is concerned with cases where there is illegality in the underlying transaction and the question is whether that illegality should be allowed, contrary to the general principle of independence, to taint the letter of credit or demand guarantee contract between the beneficiary and the bank.2 If the illegality exception applies, the possible consequences are that the bank will be entitled to refuse to pay the beneficiary (therefore, the illegality will be a defence to the beneficiary’s application for summary judg­ ment) and the account party may be entitled to apply for an injunction either to stop the beneficiary from demanding or receiving payment under the credit or guarantee or to stop the bank from making payment to the beneficiary. In such a case, the court will grant the injunction, ‘not because the letter of credit contracts were themselves illegal, but because they were being used to carry out an illegal transaction’.3 If the exception applies, it will operate as part of the illegality defence available under the general law.

1Illegality, as explained in the next paragraph, is different from other grounds on which the underlying contract may be void or voidable, such as lack ofcapacity, failure to comply with a required formality, or where one party’s consent was induced by misrepresentation, duress, or mistake.

2The discussion in this chapter isbuilt on myearlier comments published asN. Enonchong, ‘The Autonomy Principle of Letters of Credit: an Illegality Exception?’ [2006] LMCLQ404.

3GroupJosiRev. Walbrook Insurance Co Ltd [1996] 1 Lloyd’s Rep. 345, 362-363, per Staughton L.J.

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1. Introduction

instruments prohibiting the making of payments to any person in Iraq or Kuwait.*10 The

it was held that payment under a counter-guarantee issued in respect of such a contract had become unlawful and therefore unenforceable.

10e.g. the Control of Gold, Securities, Payments and Credits (Kuwait) Directions 1990 (SI 1990/1591); the Control ofGold, Securities, Payments and Credits (Republic ofIraq) Directions 1990 (SI 1990/1616); the Iraq and Kuwait (United Nations Sanctions) (Amendment) Order 1990 (SI 1990/1651); and the Iraq and Kuwait (United Nations Sanctions) (Amendment) Order 1990 (SI 1990/1768).

11[2001] UKHL 3 1; [2001 ] 1WLR 1462.

12See paras 13.103 to 13.119.

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The Illegality Exception

exclude the effect of the illegality exception by a provision in the instrument itself. And

Part V looks at some authorities in other jurisdictions.

II. SHOULD TH E EXCEPTIO N BE RECOGNIZED?

8.08 In determining whether or not an illegality exception should be recognized two conflicting policy considerations have to be weighed. As Colman J. explained, there is ‘on the one hand the well-established principle that contracts lawful on their face which are entered into in furtherance of an illegal purpose will be unenforceable at the suit of the party having knowl­ edge of that purpose at the time of contracting and on the other hand the policy of the law reflected in all the letter of credit cases of preserving the impregnability of the letter of credit save where the bank has clear evidence of an ex turpi causa defence such as fraud’.13 It is submitted that this conflict should be resolved by recognizing an illegality exception on the basis of the policy considerations discussed below but that the scope of the exception should be limited by a number of factors.14 The discussion of the policy considerations will be fol­ lowed by a consideration of the current state of English authorities on the availability of the exception.

1.Policy Considerations

A.Consistency with established principles

8.09 Application of the illegality exception to letters of credit or demand guarantee involves little more than an extension of established principles. It is settled law that an English court will not lend its aid to enforce a collateral contract or a security given for an illegal contract.15 The reason is that in such a case the collateral contract or the security, although in theory autonomous from the underlying illegal contract, is so closely connected with it that it becomes tainted by the illegality affecting the underlying contract. Thus, if A agrees to pay В a sum of money for В to murder C (the main contract), a loan agreement between A and D by which D agrees to advance A the money to pay В (the collateral contract) will be illegal and unenforceable by both A and D .16 There is no reason why a different principle should apply to a letter of credit or performance bond. If, instead of the loan from D, A persuaded D to issue a letter of credit in favour of B, can it really be said that because of the principle of autonomy В should be able to enforce payment under the letter of credit after committing the murder in accordance with the underlying transaction? Although the letter of credit is independent of the underlying transaction in support of which it is issued, it is so closely connected with the illegality of the underlying transaction as to become tainted with it.

13 M ahonia Ltd v.JP Morgan Chase Bank [2003] 2 Lloyd’s Rep. 911 at [68].

14The limiting factors are discussed at paras 8.22 to 8.41.

15Fisher v. Bridges (1854) 3 E& В 642; Specter v. Ageda [1973] 1 Ch30. See generally, N. Enonchong, Illegal Transactions (Lloyds of London Press, London, 1998) 38-43.

16Assuming of course that D is aware of the purpose of the loan. Even if D is not aware of the purpose of the loan, A, who intends to use the loan to perform an illegal contract, cannot enforce the loan agreement.

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they have clear evidence of illegality that they are under an obligation to carry out investiga­ tions to discover whether there is illegality in the underlying transaction. The duty of banks is only to examine a presentation to determine, on the basis of documents alone, whether or not the documents appear on their face to constitute a complying presentation.26 If that examination does not disclose evidence of illegality the bank is entitled and bound to pay on

17 e.g. Stone & Rolls Ltd (in liquidation) v. Moore Stephens (afirm ) [2009] 1 AC 1391 at [201, [26]; Scott v. Brown DoeringMcNab & Co [1892] 2 QB 724, 728; Pitts v. Hunt\ 1991] 1 QB 24, 30,37-38,49, 53; Kirkham v. C hiefConstable of'Manchester [1990] 2 QB 283, 290, 297; Saunders v. Edwards [1987] 1 WLR 1116, 1134.

18 Virgo, G., The Principles o fthe Law o fRestitution (Clarendon Press, Oxford, 1999)740.

19e.g. Birks, P., An Introduction to the Law o fRestitution (Clarendon Press, Oxford, 1985) 300.

20United City Merchants (Investments) Ltd v. RoyalBank o fCanada [1983] 1 AC 168.

21Ibid., at 183, per Lord Diplock.

22And the applicant, in cases where the applicant is not involved in the fraud.

23[2003] 2 Lloyds Rep. 911 at [68].

24McLaughlin, (1989) 49 Ohio St LJ 1197, 1222, and 1226.

25The argument was made in respect of letters of credit but the same must apply to performance bonds.

26See Art. 14(a) ofUCP 600 and Art. 19(a) of URDG 758.

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Ihe Illegality Exception

a complying presentation. Hie exception only applies where the bank has clear evidence of illegality. Therefore, availability of the exception will not impose an additional burden on banks in the examination of documents.

D. Narrow scope

8.13 Much of the anxiety about the illegality exception is that it will have a scope which is too wide, with the consequence that many letters of credit and performance bonds will become vulnerable.2728However, the risk that an illegality exception will be easily available and there­ fore will have an unsettling effect on the lifeblood of commerce is not as high as is feared. The exception is likely to have a limited scope and so its effect on the independence principle is likely to be minimal in practice. Stringent requirements will have to be satisfied for the exception to apply. These requirements are discussed at paragraphs 8.22 to 8.41 below.

2. State of English Authorities

8 .1 4 There is no reported case in which an English court has applied the illegality exception. However, there are judicial statements to the effect that the exception is available under English law. Some of the authorities in which the exception has been discussed are con­ sidered below, followed by a discussion of the requirements for the application of the exception.

A. Early indication

8.15 An early case in which illegality was raised as an exception to the principle of independence ofletters ofcredit is GroupJosi Re v. Walbrook Insurance Co LtdmThe claimants were reinsurers under various insurance contracts in which the defendants were the reinsured. The claimants arranged for banks to issue letters ofcredit in favour of the defendants in return for the defen­ dants paying them certain sums which had been retained by the defendants as loss reserves. The claimants applied for injunctions to restrain the reinsured from demanding payment under the letters of credit. One ground for the injunction was that the underlying reinsur­ ance contracts were illegal under section 2 of the Insurance Companies Act 1982 since the claimants were not authorized to carry on insurance business in England. It was argued that as the underlying contract was illegal the letters ofcredit were affected by the illegality and therefore unenforceable. Clarke J. took the view that because of the principle of autonomy the letters of credit remained valid and enforceable even though the underlying reinsurance contracts in respect of which they were issued were void and unenforceable.29 In the Court of Appeal it was held that under section 132(6) of the Financial Services Act 1986 the effect of the prohibition in section 2 of the 1982 Act was only to make the reinsurance contracts unenforceable by the reinsurers and not by the reinsured companies. As the reinsured com­ panies could enforce the underlying contract they could also enforce payment under the letters of credit. In the light of that decision it was not necessary to decide the question

27Barnes, J .,‘“Illegality" as excusing dishonour of L/Cobligations’ DCfoirg/rfvol. П No l,Jan-March2005.

28[1996] 1 Lloyd’s Rep. 345.

29In related proceedings, Deutsche RuckversicherungA. G. v. Walbrook Insurance Co Ltd [1995] 1 WLR 1017, 1027, Phillips), appeared to take the contrary view that there is an illegalityexception separate from fraud when he said that ‘[i]t is the policy of the law, save in cases of fraud or illegality, not to interfere by injunction with the operations of banks under letters of credit’.

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German bank with offices in London, New York and elsewhere, issued a letter of credit for the benefit of Mahonia Ltd. The letter of credit was issued to support a swap transaction between a subsidiary of Enron, Enron North American Corporation (ENAC) and Mahonia Ltd. Shortly after it was issued (on 5 October 2001) Enron’s financial difficulties began to come to light and on 2 December 2001 Enron went into Chapter 11 Bankruptcy. Under the letter of credit Enron’s bankruptcy was an event of default which entitled Mahonia to make a demand. That demand was made on 5 December 2001 for the amount due under the credit (about US$165 million). But West refused to pay contending that it had a defence in that, although the document presented for payment was in conformity with the letter of credit, the letter ofcredit was unenforceable for illegality. The illegality alleged was that the purpose of the underlying swap transaction was to provide Enron with a disguised loan so as to enable Enron to improperly manipulate its account in breach of US GenerallyAccepted Accounting Principles (GAAP) and the Securities Exchange Act 1934.34

30Ibid., at 368.

31Ibid., at 362.

32[2004) EWHC 1938 (Comm); [2003] 2 Lloyd’s Rep. 911.

33Prior to its dramatic collapse in 2001, the giant Enron Corporation was highly regarded as one of the world’s most successful companies, employing innovative methods to raise ‘structured finance’.

34The allegation was that this illegal purpose emerged when the swap transaction was seen together with two other related swap transactions: one between Mahonia and Chase and the other between ENAC and Chase. The

swaps provided for fixed and floating payments in opposite directions. Chase paid a sum of US$350 million (less an arrangement fee of US$ 1 million) to Mahonia under the Chase/Mahonia swap and Mahonia paid it to ENAC under the ENAC/Mahonia swap. And under the ENAC/Chase swap the fixed payment which ENAC agreed to pay Chase was US$356 million. The effect of the three swap transactions was that US$350 million was paid by Chase to Mahonia and by Mahonia to Enron and Enron was obliged about six months later to pay approximately US$356 million to Chase. As the floating payments were exactly the same in each of the three swap transactions, the ultimate effect of the transaction was to provide Enron with US$350 million (less the arrangement fee) for a period ofsix months, for which it was obliged to pay a figure which equated to repayment of a loan of US$350 million with an effective annual interest rate of 3.44%.

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The Illegality Exception

8.19 Upon Mahonia’s application for the illegality defence to be struck out and for summary judgment, Colman J. took the view that in certain cases the illegality of the underlying trans­ action can taint the letter of credit and thereby render it unenforceable. Accordingly, he dismissed Mahonia’s application, holding that ‘there is at least a strongly arguable case that the letter of credit cannot be permitted to be enforced against the defendant bank’.35 He also held that the decision whether enforcement is permissible at least arguably depends on the gravity of the illegality alleged and that ‘the uncertainty of this area of law is such that this is an issue which ought to be determined by reference to the evidence before the court at trial’.36

8.20 After a full trial Cooke J. found that there was no illegality in the underlying transaction since Enron’saccounting was not in breach of US Securities lawand the beneficiary, Mahonia, was not privy to any unlawful purpose, having no knowledge of any element of wrongful accounting.37 Consequently, as in GroupJosi Re, it was not necessary for the court to decide what would have been the efFect of illegality in the swap transaction on the enforceability of the letter of credit. Nevertheless Cooke J. went on to consider this issue and arrived at the same conclusion as Colman J., namely, that the autonomy of a letter ofcredit does not pre­ vent it from being tainted by the illegality of the underlying transaction. In other words, illegality in the underlying transaction could constitute a defence to the enforcement of the letter of credit.

C. Post Mahonia

8.21 Cooke J .’s opinion on the availability of the illegality exception is, strictly speaking, obiter. And it is true that since there is as yet no English decision in which the court refused to enforce a letter of credit or demand guarantee because of illegality in the underlying transac­ tion, the position of English law is less than settled, even after Mahonia. However, since Cooke J .’s view was expressed after full argument on the point and since it accords with the opinion of Colman J. in the same case and the view of Staughton L.J. in Group Josi Re, Mahonia can be seen at least as a strong indication of the direction in which English law is heading. Thus, in the subsequent case of Oliver v. Dubai Bank o fKenya3839Andrew Smith J. said that the exceptions to the independence principle of letters of credit are fraud on the part of the beneficiary ‘and possibly illegality’. In Lancore Services Ltd v. Barclays Bank Pic,33a case concerned with credit and debit cards, it was contended for the defendant bank that since illegality in the underlying contract is a defence to a claim under a letter of credit, ‘illegality in the underlying transaction must also found a defence to a claim in respect of card pay­ ments’.40 The claimant did not dispute that there was such an illegality defence. The claim­ ant’s contention was simply that the defence did not apply in that case because of the reliance principle.41 The judge did not decide the point as it was not necessary for him to do so since in that case there was an express provision in the contract allowing the bank to withhold

35[20031 2 Lloyd’s Rep. 911. In Tayeb v. HSBC Bank Pic [2004] EWHC 1529 (Comm) at [61]; [2005] 1 CLC 866, after mentioning the fraud exception, Colman J. said (obiter) that Jt]he same exception is likely to apply in respect of illegal transactions’, citing his decision in the Mahonia case.

36Ibid., at [69].

37[2004] EWHC 1938 (Comm) at [423].

38[2007] EWHC 2165 (Comm) at [12].

39 [2008] EWHC 1264 (Ch), ^ [ 2 0 0 9 ] EWCACiv752; [2009] 2 CLC 306.

40Ibid., at [115].

41Ibid., at [116].

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