Credit Where Credit Is Due – Except in Cases of Fraud

Letters of credit are one of the most widely used financial tools in international commerce. They provide a secure, bank-backed method of payment for parties entering into commercial transactions across international borders. A letter of credit is initiated by a buyer and issued by their bank, serving as an assurance to a seller that payment will be honoured. Once the seller has fulfilled their obligations under the purchase agreement, they present the required documents to the issuing bank to receive payment directly under the letter of credit. The issuing bank then collects the funds from the buyer in accordance with the agreed-upon terms.

What gives a letter of credit its commercial utility is that it operates independently from the underlying commercial contract, a rule known in Canadian law as the principle of autonomy. As noted in Bank of Nova Scotia v. Angelica-Whitewear,^[1] a foundational case on letters of credit, the principle of autonomy imposes an obligation on issuing banks to pay the beneficiary of a letter of credit, irrespective of any dispute arising from the underlying transaction. The efficacy of letters of credit relies deeply on such autonomy, and independence is critical in terms of commercial certainty and security.

However, this autonomy is not absolute. Under Canadian law, an exception arises where there is clear and compelling evidence of fraud relating to the transaction (the “Fraud Exception”). In such cases, a bank will be justified in refusing payment. At present, evidence of fraud serves as the only exception to the independence of letters of credit.

The Fraud Exception: Eurobank v. Bombardier

In its 2024 decision in Eurobank Ergasias S.A. v. Bombardier inc.,^[2] the Supreme Court of Canada (“SCC”) explored the Fraud Exception in a modern commercial context, viewing the exception as a narrow but real limit to the principle of autonomy. The case arose from a dispute involving a procurement contract between Bombardier Inc. and the Hellenic Ministry of Defense (“HMOD”), which had been secured by a letter of guarantee from Eurobank and subsequently backed by a counter-letter of guarantee from National Bank of Canada. When HMOD demanded payment despite an arbitration-related freeze on the funds, Eurobank disbursed the funds and requested reimbursement from National Bank. Bombardier sought to block payment to HMOD under the letter of guarantee, alleging that HMOD’s initial demand was fraudulent. The SCC found that because Eurobank had clear knowledge of the freeze on payments, it had actively participated in the fraudulent demand. Therefore, the Fraud Exception applied and prevented National Bank from honouring the counter-letter of guarantee.

The decision in Eurobank did not dramatically alter the legal landscape of letters of credit in Canada. Instead, it affirmed the state of the law as set out in Angelica-Whitewear, while expanding on the Fraud Exception, particularly as it relates to the involvement of third parties.

Evolving Standards for Knowledge and Participation

As it stands, the threshold for establishing fraud remains high and “must import some aspect of impropriety, dishonesty or deceit.”^[3] In order for fraud to be attributable to a beneficiary, it requires compelling evidence that they had knowledge of the clear and established fraud. Where fraud originates from a third party, it must also be established that the beneficiary knowingly participated in or was complicit in the fraudulent conduct. The bar for the “participation” of fraud, according to Eurobank, is also high, yet remains somewhat ambiguous.

The Eurobank decision highlights the necessity for parties to understand the scope and boundaries of the Fraud Exception when they are engaged in international transactions supported by letters of credit. Financial institutions, in particular, should be aware that their role is not always purely mechanical. They must remain vigilant and, where appropriate, conduct reasonable inquiries when faced with suspicious circumstances. Failure to detect and act on red flags could result in liability, as was the case in Eurobank. Practices such as documentation of due diligence processes and ensuring staff are equipped to understand the broader context of a transaction are important. Implementing clear internal protocols can mitigate exposure to fraud-related liability while maintaining the commercial reliability of letters of credit.

Going forward, it will be important to monitor how Canadian courts refine the standard for knowledge and participation of fraud and the extent to which it can be attributed to parties in complex commercial arrangements. Understanding the contours of the Fraud Exception will be essential to managing both legal and reputational risk for all participating parties.

The Financial Services Group at Aird & Berlis LLP will continue to monitor developments related to the Fraud Exception and letters of credit. Please reach out to the authors or a member of the group for more information.