If an internally maintained sanctions list returns red flags, but the entity is not on an official sanctions list, is that sufficient to justify activating a sanctions clause to deny payment to that party? What considerations should financial institutions take into account when managing risk in dealing with sanctioned, or potentially sanctioned, entities?
These are difficult and fact specific questions, which the Singapore Court of Appeal recently considered. The Court of Appeal allowed an appeal against a decision of the High Court which found that a sanctions clause entitled a branch of a US-incorporated and US-regulated bank to refuse to pay Kuvera Resources Pte Ltd (“Kuvera“) under irrevocable letters of credit in which Kuvera was listed as the beneficiary ( Resources Pte Ltd v JPMorgan Chase Bank, N.A.  SGCA 28).
In doing so, the Court of Appeal provided guidance on how sanctions clauses should be interpreted, and also set out provisional views on the compatibility of sanctions clauses with the commercial purpose of confirmed letters of credit.
The circumstances leading to the appeal
The appellant, Kuvera, advanced funds to an Indonesian seller to enable it to purchase coal for on-selling to a third party buyer (“Buyer“). The Buyer was to pay for each of the two parcels by irrevocable letters of credit (“LCs“) in which Kuvera would be named as the beneficiary. The LCs were issued by a bank in Dubai, and are expressly subject to the Uniform Customs and Practice for Documentary Credits 600 (“UCP600“).
The respondent bank was appointed as the advising and nominatied bank for the LCs (the “Nominated Bank“), and duly advised both LCs to Kuvera and confirmed the LCs and their amendments (“Confirmations“). This is a common structure for transactions of this nature.
All of the Nominated Bank’s advices and Confirmations contained a sanctions clause. This sanctions clause provided that:
” [The Nominated Bank] must comply with all sanctions, embargo and other laws and regulations of the U.S. and of other applicable jurisdictions to the extent they do not conflict with such U.S. laws and regulations (“applicable restrictions”). Should documents be presented involving any country, entity, vessel or individual listed in or otherwise subject to any applicable restriction, we shall not be liable for any delay or failure to pay, process or return such documents or for any related disclosure of information.” (“Sanctions Clause“)
On or around late November 2019, Kuvera presented the documents through its presenting bank to the Nominated Bank under the LCs. However, the Nominated Bank sanctions screening procedure raised red flags on the potential Syrian ownership of the vessel (the “Omnia“) on which the coal had been shipped.
The Omnia was named in an internal list setting out the names of various entities and vessels that had been determined by the bank to have a sanctions nexus or concern. This was because the Omnia used to be named the Lady Mona. This vessel historically had been placed on the internal list as there was evidence that her beneficial owner, its parent company, and the ship operator/management company all had a place of business in Syria. However, the vessel was subsequently put under a new registered ownership in 2019.
The Omnia was only listed on this internal list – it was not listed on the Office of Foreign Assets Control (“OFAC“) Sanctions List, which is a publicly available list maintained by the OFAC of individuals and companies owned or controlled by, or acting for or on behalf of, targeted countries.
The Nominated Bank refused to pay Kuvera and the two LCs subsequently expired in mid-December 2019. Kuvera commenced proceedings against the Nominated Bank soon thereafter.
Following the proceedings below, the High Court Judge found that the Sanctions Clause entitled the bank to refuse to pay Kuvera and dismissed Kuvera’s claim in its entirety with costs.
Evidence was given at the trial below that the bank had subsequently communicated with OFAC and OFAC’s position was that if the Nominated Bank had paid Kuvera, this would have resulted in an apparent violation of OFAC regulations.
The Judge also found that the Nominated Bank’s decision not to pay Kuvera was founded in risk-management – the Nominated Bank would rather be sued by Kuvera as a result of failing to pay against a complying presentation than be found by OFAC to have breached US sanctions.
Because there was an unresolved possibility that the Omnia may be caught under any applicable restriction, the Judge found that the Sanctions Clause entitled the Nominated Bank to err on the side of caution to decline payment. The Judge described this approach as being “rational and contractually justified”.
Kuvera subsequently appealed.
The basis for the successful appeal
The Court of Appeal disagreed that the Nominated Bank’s approach was “contractually justified”.
The Court of Appeal held that clauses such as the Sanctions Clause must be construed objectively. Several key features of the Court of Appeal’s decision stand out and are summarised below:
- The question of whether a vessel is “subject to any applicable restriction” should be determined on an objective basis without ex post facto third-party input from entities such as OFAC. If a bank chooses to rely on an internal list of sanctioned parties, instead of an official list like the OFAC Sanctions List, then there is a risk that such reliance may not be sufficient to discharge its burden of proof.
- The question of whether the Omnia was in fact beneficially owned by Syrian ownership was an issue capable of proof. The burden of proof that the beneficial ownership remains unchanged falls squarely on the Nominated Bank (and not Kevara).
- The Nominated Bank had provided evidence of “red flags” which the Judge below regarded as sufficient circumstantial evidence to discharge the bank’s burden of proof. Such red flags included the lack of information on the Omnia‘s beneficial owners, the “unknown” status of the beneficial owners of the Omnia’s technical and ISM managers, and “publicly available sources” suggesting that the Omnia continued to have links to Syria.
- The Court of Appeal disagreed that these were sufficient to discharge the Nominated Bank’s burden of proof that the Sanctions Clause would catch the Omnia. The appeal was allowed on this basis.
Compatibility of Sanctions Clause(s) and Confirmations under the LCs
The trend, especially from the recent English cases, is towards a judicial recognition of sanctions clauses in commercial transactions. Other courts have more generally examined the impact of sanctions clauses on other transactional structures – for example, whether a sanctions clause suspends or extinguishes an insurer’s liability (Mamancochet Mining Ltd v Aegis Managing Agency Ltd & ors  EWHC 2643), or whether the operation of a sanctions clause suspends a borrower’s repayment obligation (Banco San Juan Interncional Inc v Petroleos de Venezuela SA  EWHC 2937).
However, the Court of Appeal observed, obiter, the difficulties in reconciling similar sanctions clauses like the Sanctions Clause with the commercial purposes of transactional structures such as LCs. Such transactional structures are unique (and unlike those previously examined) as one autonomous contract within the transaction secures the payment promised under another autonomous contract. In other words, the beneficiaries and the sellers do not negotiate directly and cannot be taken to have agreed, between them, on the wording or imposition of the Sanctions Clause.
Instead, the commercial purpose of the system of confirmed irrevocable documentary credits is to give the seller the assurance that he will be paid before he parts with the control of the goods, that will preclude any dispute with the buyer as to the performance of the contract of sale being used as a ground for non-payment, or reduction or deferment of payment.
The Court of Appeal observed that clauses such as the Sanctions Clause may run counter to this commercial purpose. As a case in point, Kuvera would not have known at the time it accepted the Confirmations whether the Sanctions Clause would apply to deny it being payment. This undermines the security that the LC transactional structure is intended to provide – that the beneficiary will receive payment so long as it is able to present the requisite complying documents.
The view from Hong Kong and other jurisdictions
The issue of reconciling sanction clauses with the commercial purpose of ensuring certainty in trade financing using LCs is not limited to Singapore.
The LC structure is universally accepted and used across a wide range of jurisdictions. It affords the buyer the protection of payment against documents and provide the seller with protection against buyer default by substituting a bank as the party to which the seller looks for payment, regardless of any dispute which the buyer might raise in respect of the underlying sale contract. The UK High Court have also noted in a recent decision (Heytex Bramsche GmbH v Unity Trade Capital Ltd  EWHC 2488 (Ch)) that LCs are also useful because they benefit from a “remarkable degree of international standardisation” as a result of the worldwide adoption by banks of the rules embodied in the UCP 600. A full discussion of the UK decision can be accessed on our blogpost here. As such, case law from other jurisdictions will be of persuasive value to a Singaporean court. Nonetheless, the rising geopolitical tensions and the increasing frequency of sanctions clauses being invoked by contracting parties to seek to be excused from performance of their contractual obligations have perhaps added a dimension of uncertainty.
Case study from Hong Kong
Our team in Hong Kong recently advised a bank client on a dispute of similar nature in which a contracting party resisted honouring a recourse clause under an LC-related contract by relying on a sanctions clause. While our team successfully secured a resolution without proceeding to litigation, on this particular fact pattern (as will be explained below), we considered the court would likely have found in favour of the party involving the recourse clause (our client), on the basis that that the contract had allocated sanctions risks to be born by the other party.
We will explore the issues arising in the Hong Kong case so to draw out the factors that parties should consider when seeking to rely on sanction clauses and enforcing (or avoiding obligations under) LCs and related agreements.
The Hong Kong case can be summarised as follows:
- The LC was issued by the Issuing Bank on the instructions of its client, the Purchaser, in favour of the Seller, so to finance the Purchaser’s purchase of goods from the Seller. Pursuant to the LC, Issuing Bank was to pay the Sellar’s bank, i.e. the Nominated Bank, on a complying presentation.
- Our client, the Forfaiting Bank, and the Nominated Bank entered into a Forfaiting Agreement, pursuant to which the Forfaiting Bank purchased the receivables under the LC from the Nominated Bank. The Forfaiting Bank thus stepped into the shoes of the Nominated Bank and became entitled to be paid by the Issuing Bank under the LC.
- Later, OFAC designated the Seller as a Specially Designated National (“SDN”) pursuant to an Executive Order.
- As a result of this designation, the Issuing Bank refused to pay the monies due under the LC, claiming that it was prohibited to do so and was entitled to not honour the LC by virtue of the sanctions clause contained in the LC.
- The Forfaiting Agreement was made on a “without recourse” basis, namely, the parties agreed that the Forfaiting Bank shall have no right of recourse to the Nominated Bank for monies paid under the Forfaiting Agreement, unless one of the stated contractual exceptions applied. One such exception was “if… [the Issuing Bank] refuses to pay any of the sums payable under [the Issuing Bank’s] reimbursement obligations on the ground that [the Issuing Bank] is prohibited to make the payment due to an order issued by any authority or a Court judgment, decision or order…” (the “Exception“). Notably, the drafting of this Exception does not expressly use the word “sanctions”.
- The Forfaiting Bank, having been refused payment by the Issuing Bank, involved the Exception and demanded recourse from the Nominated Bank.
Does the Forfaiting Bank have a right of recourse against the Nominated Bank under the forfaiting agreement?
Sanctions clauses are subject to the usual canons of contractual interpretation. In the circumstances, the Exception was clear and unambiguous in its meaning, such that the Forfaiting Bank could argue that OFAC is an “authority” on the plain meaning of the term. Similarly, OFAC’s decision to designate the Seller as an SDN and the consequent prohibitions dealing with the Seller likely amounted to an “order”. On this interpretation, the Forfaiting Bank should prevail.
On the other hand, the Nominated Bank could perhaps have argued that the Exception was not intended to cover sanctions given there is no express reference to the same (in particular because (i) the contracting parties are highly sophisticated and could be expected to have chosen the words used in the contract carefully, and (ii) there are other references to this term elsewhere in the agreement). This would be a highly fact-sensitive enquiry on the parties’ intention at the time of contracting.
Ultimately, the dispute was amicably resolved following relevant authorisations given by the OFAC, and the foregoing arguments were not tested before a court.
Key takeaways for financial institutions (“FIs”)
Kuvera and the Hong Kong case study are unique and fact-specific cases. Nonetheless, FIs may find the following points of law helpful:
- If an FI wishes to deny payment based on the operability of sanctions clauses, it would be safest if the offending party is in fact on the OFAC Sanctions List or other official lists. Reliance on any internally maintained lists may be insufficient in discharging the burden of proof to justify the decision to deny payment. The main difference between Kuvera and the Hong Kong case study is that in the latter, the seller in question was designated as a sanctioned entity under the OFAC list, rather than some internally maintained list, after the LC was entered.
- Citing the lack of available sources or information, essentially requiring the beneficiary to prove a negative, will not suffice to discharge this burden. The ability to prove a party’s ownership or ties to sanctioned individuals, entities and/or states is an objective one.
- Notwithstanding this, in cases where information is not readily available, the priority comes down to managing risk. It is notable that while the Singapore Court of Appeal found that the decision by the bank in this case to prioritise “risk-management” (i.e. it would rather be sued by Kuvera than potentially breach OFAC’s regulations) was not “contractually justified”, it did not disagree that this decision was rational from a risk-management perspective.
- In other words, in deciding how to proceed on any given case, the potential for compensatory losses should be factored into the risk-management matrix at the initial stage.
- FIs’ terms for LCs and related contracts are likely to be consistent across jurisdictions. FIs should ensure they adopt clear and unequivocal contractual language in their contracts, even when relying on template or standard term documents, and properly detail the allocation of risks and liabilities among the parties.
- FIs should also seek to consider further issues including currencies of payment, communication with the relevant sanctioned authority, the relevant jurisdiction and governing law clauses, and how to successfully secure enforcement on unpaid sums in cases of dispute.
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