Do sanctions excuse a confirming bank from making payment?

The interaction of trade finance instruments and international sanctions raises difficult issues.  Instruments like letters of credit are intended to pay out on demand, save in exceptional circumstances.  But sanctions can get in the way, and courts are increasingly being asked to determine the liability of banks caught between their obligations under letters of credit and restrictions imposed by sanctions.  

In a recent English case, two Russian companies (the "Lessees") entered into agreements in 2017 and 2020 to lease aircraft from an Irish aircraft leasing company (the "Lessor"). Those agreements were supported by letters of credit issued by Sberbank, a Russian bank, and confirmed by the London branch of a German bank (the "Confirming Bank"). 

Shortly after Russia's invasion of Ukraine in late February 2022, the Lessees defaulted on their obligations under the leases and the leases were subsequently terminated. In March 2022, the Lessor made demands for payment under the letters of credit. The Confirming Bank refused to make payment. It argued that it was prevented from doing do by Russian sanctions imposed by the UK, the EU and the US. The Lessor, who was the beneficiary under the letters of credit, disagreed.

In a judgment handed down last week, the High Court rejected the Confirming Bank's arguments. 

1. On 1 March 2022, the UK introduced sanctions which prevented the provision of "funds" (which includes letters of credit) "in pursuance of or in connection with an arrangement whose object or effect is" the provision of certain "restricted goods" (which includes aircraft) to or for use in Russia¹. The supply of the restricted goods (i.e. the aircraft), and the associated letters of credit, took place before the relevant UK sanctions came into force, i.e. these transactions were lawful when they took place. All that remained thereafter was the obligation of the Confirming Bank to make payment on demand to the Lessor under the letters of credit.

2. The High Court held that the Confirming Bank's payment obligation was wholly independent from the other elements of the transaction (applying the well known "autonomy principle" of letters of credit) so was not prohibited by the UK sanctions. In reaching this conclusion, the Judge adopted a purposive approach to the interpretation of UK sanctions legislation. In addition, the Judge appeared to be influenced by the fact that the obligation would be fulfilled by the London branch of a German bank for the benefit of the Irish Lessor and there was no involvement of, or benefit to, any of the Russian entities.

3. The involvement of Sberbank raised a separate issue – as the Russian bank is subject to a full UK asset freeze. Sberbank became designated for the purposes of the UK asset freeze on 6 April 2022. The High Court held that payment on demand by the Confirming Bank under the letters of credit to the Lessor would not breach the UK asset freeze provisions. This was primarily because Sberbank became designated only after the Confirming Bank's obligation to make payment crystallized. However, the UK's asset freeze provisions would not be breached in any event because:

• an issuing bank does not have any proprietary interest in the obligation of the confirming bank to make payment on demand, so making such payment would not constitute "dealing" with Sberbank's property²; and
• payment by the confirming bank to the beneficiary under a letter of credit would not discharge any of the issuing bank's obligations, so the Confirming Bank would not be making funds "available to any person for the benefit of" Sberbank³.

4. What about the impact of US sanctions on Russia? The Court rejected the Confirming Bank's reliance on the principle in Ralli Bros⁴ - that the Court will not compel performance of an obligation where this would require an unlawful act in the place of performance. The Confirming Bank had argued the place of performance was the US due to the requirement that payment be made in US dollars to a bank account in London. However the Court disagreed:

• Where a dollar payment is required under a contract, the customer is entitled to demand such payment in cash (however impractical that may be) to avoid any involvement of the US banking system. The Confirming Bank was not required to make payment only as specified in the letter of credit (i.e. in USD through a correspondent bank) – it could choose to do so in any other way. Where the fundamental obligation is to make payment, and where it is possible to make such payment, then the bank must do so.
• In any event, the Confirming Bank failed to demonstrate that US sanctions in place at the time the payment obligations crystallised prohibited performance of the Confirming Bank's payment obligations.

The decision provides some welcome clarity on the application of Russian sanctions to payment obligations under letters of credit. In particular, the Court's conclusions on the application of the Ralli Bros principle will be of interest in the current climate given the prevalence of US dollar denominated financial instruments. Taken together with the Court of Appeal's decision in MUR Shipping⁵ (where it was found that an obligation to use reasonable endeavours extended to accepting payment in Euros, rather than the contractually stipulated US dollars) , this decision indicates that the English Courts are taking a pragmatic approach to cases involving sanctions issues.

Our Russian sanctions tracker provides a summary of all the measures imposed by the UK, EU, Australia and Japan following Russia's invasion of Ukraine in February.

Authors: Tom Cummins and Sophie Law

References

1. Regulation 28(3) of The Russia (Sanctions) (EU Exit) Regulations 2019
2. Regulation 11 of The Russia (Sanctions) (EU Exit) Regulations 2019
3. Regulation 13 of The Russia (Sanctions) (EU Exit) Regulations 2019
4. Ralli Bros v Compania Naviera Sota y Aznar [1920] 2 KB 287
5. MUR Shipping BV v RTI Ltd [2022] EWCA Civ 1406