Letters of Credit play an important role in enabling the completion of commercial transaction, particularly those involving the transportation of goods to or from other countries.  It is important to keep in mind when dealing with a Letter of Credit that there may be obligations placed on the parties beyond simply following its strict terms.

How Letters of Credit Work

Typically, a Letter of Credit will stipulate that once specified documents proving that goods have been shipped are delivered to the bank issuing the Letter of Credit, the bank will arrange for the seller to be paid and then deliver the documents, which usually represent title to the goods, to the buyer.  The purpose of this is to provide a measure of protection to a seller that it will be paid in a timely fashion once the goods have been delivered as promised to the buyer.

The Element of Good Faith

Recently, the Ontario Court of Appeal addressed whether or not it is sufficient to merely follow the strict requirements of a Letter of Credit or if more is required of the parties.  In Nareerux Import Co. Ltd. v. C.I.B.C. the court recognized that the principles of fairness and equity operate in the context of a Letter of Credit and may impose a duty of good faith not to act in a manner which defeats the purpose and objective of the Letter of Credit.

In Nareerux, Thai Fisheries accepted a Letter of Credit to secure payment for approximately $40 million worth of shrimp delivered to Douglas R. Robertson International Inc..  Under the terms of the Letter of Credit, Thai Fisheries was entitled to payment once the bank received a signed purchase order and delivery receipt from Sam's Club, who was to purchase the shrimp from Douglas.  (It should be noted that it is not typical for a seller to give up control over the receipt of payment in this fashion)

A dispute arose between Thai Fisheries and Douglas, and the necessary documents were not delivered to the bank.  As a result, an unpaid balance of just over $10 million remained.  Without the knowledge of Thai Fisheries, Sam's Club continued to purchase the shrimp but Douglas did not provide documentation to the bank.  Instead, the proceeds of the sales were used to pay down Douglas' line of credit with CIBC.  CIBC knew that Sam's Club had purchased shrimp for which Thai Fisheries had not been paid and also permitted Douglas to sell shrimp to others.  These actions ensured that Thai Fisheries would be unable to meet the requirements of the Letter of Credit and would not be paid.

The court held that CIBC knowingly contributed to circumstances that frustrated the conditions of the Letter of Credit and then used that non-compliance to justify its refusal to pay.  This conduct constituted a breach of contract.  The court also found that the Letter of Credit was infused in these circumstances with a duty of good faith which was breached by CIBC's actions.

Why Does this Matter?

This case signifies that strict compliance with a Letter of Credit may not always be enough - fairness and equity may also be important considerations.  While this case does not import a universal duty of good faith into the law of Letters of Credit, the fact remains that good faith should be considered.  Most significantly, where the terms of a Letter of Credit provide a party with discretionary control over some aspect of compliance, that control must be exercised with fairness in mind.

If you have any questions about Letters of Credit or other legal issues you can reach the writer at sean.morrison@gowlings.com or our Manufacturing and Distribution website at www.gowlings.com/industry/md.asp.