Can a Beneficiary Be Prohibited from Drawing on a Letter of Credit?

Letters of credit are occasionally used in construction contracts to secure the performance of a contractor’s obligations to the owner.

They are instruments created at the request of a customer (i.e. the contractor), obligating an issuer (such as a bank) to pay money to a beneficiary (i.e. the owner) upon presentation of documents that are in strict compliance with the terms of the letter of credit.

The leading Canadian case with respect to letters of credit is a 1987 Supreme Court of Canada decision of Angelica-Whitewear Ltd. v Bank of Nova Scotia. In Angelica-Whitewear, the Court recognized the “principle of autonomy” for letters of credit, namely that the obligations of the issuer to pay the beneficiary of a letter of credit are independent of the underlying contract.

As such, where complying documents are presented to the issuer, a dispute between the customer and beneficiary as to the underlying contract would generally not justify a refusal by an issuer to honour a draw. The Court recognized the exception of fraud to the principle of autonomy and remarked that a strong prima facie case of fraud by the beneficiary would be a sufficient test on an application for an interlocutory injunction to restrain an issuer from paying out on a letter of credit.

This year – more than 30 years after Angelica-Whitewear – the issue of interlocutory injunctions restraining payout of letters of credit came before the Court of Appeal for Saskatchewan in Veolia Water Technologies, Inc. v K+S Potash Canada General Partnership.

Specifically before the Court was the question of when an interlocutory injunction may be granted to prohibit a beneficiary from drawing on a letter of credit.

K+S Potash Canada General Partnership (“KSPC) entered into a contract with Veolia Water Technologies, Inc. (“Veolia”) to design, supply and commission an evaporation, clarification and crystallization system for a potash mine owned by KSPC.

As required by the contract (and a later reservation of rights agreement), Veolia provided two irrevocable standby letters of credit naming KSPC as the beneficiary. Following the collapse of a crystallizer that Veolia designed and supplied, KSPC commenced a claim against Veolia for more than $180 million in damages, including for breach of contract. KSPC then made a demand to draw on one of the letters of credit and gave notice to Veolia of its intention to draw on the other letter of credit (collectively, the “Letters of Credit”).

In response, Veolia began legal proceedings against KSPC, alleging that KSPC did not satisfy the conditions necessary to make draws on the Letters of Credit. Veolia also brought an application seeking an interlocutory injunction prohibiting KSPC from drawing on the Letters of Credit until a court or arbitral tribunal had determined whether KSPC had a right to do so.

Veolia’s application was dismissed by the Saskatchewan Court of Queen’s Bench. The Chambers judge held that to enjoin KSPC from drawing on a letter of credit, Veolia would have to show a strong prima facie case that KSPC acted fraudulently. The Chambers judge held that Veolia did not allege or demonstrate a strong prima facie case that KSPC acted fraudulently in seeking to draw on the Letters of Credit.

Veolia appealed the Chambers judge’s decision to the Court of Appeal for Saskatchewan. In a decision written by Chief Justice Richards, the Court of Appeal dismissed the appeal. The Court stated that there may be legal and commercial justifications to grant interlocutory injunctions not only on the basis of fraud, but also where there is a strong prima facie case that the beneficiary is expressly disentitled from making a draw. However, the Court declined to formally decide whether the test should be expanded, as Veolia was unable to establish a strong prima facie case that KSPC was contractually prevented from making the draws in question in any event.

The Court of Appeal decision confirms that when an irrevocable standby letter of credit is provided on a construction project, absent exceptional circumstances, a beneficiary is entitled to make draws upon it pursuant to its terms, in many cases prior to litigation or arbitration being concluded.

Veolia has indicated it intends to seek leave to appeal the Court of Appeal’s decision to the Supreme Court of Canada, and has applied to the Court of Appeal for an interim injunction against KSPC pending a hearing before the Supreme Court. At the time of writing this article, a leave application has not yet been filed, and no decision has been released with respect to the requested interim injunction pending appeal.

This article first appeared in Build Manitoba, a publication of the Winnipeg Construction Association. 

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.

Shaunt Parthev, Q.C., is a partner who practises in the area of construction litigation with MLT Aikins LLP. Reach him at Janelle Souter is a litigator with MLT Aikins. Reach her at MLT Aikins acts as counsel for KSPC.