The sanctions regime imposed by the west on Russia after its invasion of Ukraine has dramatically increased the compliance burden and risk of enforcement for banks, piling more restrictions on top of what was already a sweeping range of measures on countries such as Iran, Syria and North Korea.
One step often taken by parties involved in trade finance is the insertion of a so-called “sanctions clause” into a letter of credit (LC) or associated documents, which theoretically allows the bank to refuse to make payment if it would put it in the crosshairs of sanctions enforcement agencies.
But the use of such wording has been controversial, and jars with the well-established irrevocability an LC is supposed to provide.
A judgement in Singapore’s High Court last year was an important test case for sanctions clauses. The judge backed JP Morgan’s reliance on the provision for refusing payment to coal trader Kuvera Resources under an LC because a vessel used to transport the goods had apparent Syrian ownership. Kuvera is appealing the judgement.
GTR speaks to three experts from Singapore law firm Wee Swee Teow LLP (WST): partner Arvin Lee, senior associate Mark Cheng and associate Monique Wan, as well as Derrick Koh, a sanctions specialist with a Singapore bank, about what banks need to consider when including sanctions clauses and how courts may treat them when a dispute arises.
GTR: Do a bank’s obligations under an irrevocable LC and its commitments under sanctions laws necessarily conflict?
Koh: The International Chamber of Commerce (ICC) [which publishes commonly accepted practice for documentary trade finance] takes the view that sanctions clauses in LCs bring into question the irrevocable nature of LCs. The ICC expresses concerns with sanctions clauses that allow the issuing bank a level of discretion as to whether to honour beyond the statutory or regulatory requirements applicable to that issuer.
On the other hand, at the onset of contract formation, contracting parties are free to negotiate terms to include in the LC that will be binding on the parties. If there is a meeting of minds between the parties to allow discretion in the discharge of obligations, there would arguably be no conflict in giving effect to the sanctions clause and not paying.
Cheng: Generally, parties’ obligations under the LC are contractual in nature, whereas sanctions laws create legal prohibitions. Only actual prohibitions which cannot be contracted out of would supersede the contractual obligations.
Banks are generally allowed to mitigate sudden sanctions exposure through the inclusion of sanctions clauses, but a clause which gives the bank excessive discretion to refuse payment – beyond mandatory sanctions regimes applicable to the bank – may be unenforceable.
Lee: Adding to that, what if sanctions are contemplated as part of a tightly worded force majeure clause? In other words, the sanction itself is a specified force majeure event. Note that a force majeure clause can co-exist with an LC – for example, when parties agree to apply the Uniform Customs and Practice for Documentary Credits (UCP) 600 rules, the force majeure provisions would already be incorporated. There does not seem to be any controversy on UCP 600 detracting from the non-irrevocability of an LC.
GTR: What does the Kuvera Resources vs JP Morgan case in Singapore – in which the court found in favour of the bank’s refusal to pay out pursuant to a sanctions clause in its LC confirmations – tell us about the practical effects of sanctions clauses?
Wan: Kuvera is the first time the Singapore courts were asked to consider the issue of validity and enforceability of a sanctions clause in the context of a bank’s payment obligations under an LC.
The bank’s defence was premised on a sanctions clause in its confirmations, that it is not liable for any failure to pay if the documents involve a vessel subject to US sanctions laws. Whilst there was compliant presentation of documents, they revealed a Syrian nexus, and the bank refused to pay to prevent its breach of US sanctions laws. The court held that the sanctions clause was incorporated as a contractual term of JP Morgan’s confirmations even though the clause did not appear in the LCs from the issuing bank.
Banks operating in multiple jurisdictions have to be more aware of sanctions laws and regulations which could affect their ability to perform their contractual obligations.
Koh: The case shows that express contract provisions, such as the sanctions clauses used by JP Morgan in its confirmation documents, can excuse a party from its obligations if the failure to perform certain obligations under the contract was intended to comply with sanctions imposed by foreign sanctions regulators.
Wan: That being said, it is crucial to ensure that sanctions clauses are not ‘fundamentally inconsistent with the commercial purpose [of LCs]’ as a payment mechanism, such as ‘if it renders a confirmed letter of credit no different in substance from an unconfirmed letter of credit’, as analysed by the High Court.
Lee: What to me is of practical interest about Kuvera is the court’s provision of the normative basis enabling parties to take the position that a sanctions clause is not fundamentally inconsistent with the commercial purpose of a confirmed LC. The court also makes clear that when a confirming bank adds its confirmation to the LC, it makes a separate offer of a separate unilateral contract to the beneficiary. That separate offer may adopt the terms of the issuing bank’s offer, but that isn’t legally required. This in itself is very useful because the concept of unilateral contracts is often applied in trade finance disputes, for example in the 2022 SICC judgment involving Crédit Agricole and PPT Energy, a case that I co-argued for PPT.
GTR: Situations involving LCs and sanctions are likely to include banks and clients from several different countries. The governing law and the sanctions law might also be from altogether separate jurisdictions – how does this complexity impact an instance where a sanctions clause is said to overrule an LC?
Chan: Sanctions regulations promulgated by one jurisdiction, for example the US, may not necessarily be implemented as local laws – or even recognised – outside of that jurisdiction. So the potential breach of US sanctions may not legally prohibit the bank from performing a Singapore law-governed LC. Generally, an allegation that the LC is unenforceable because performance would result in illegality under the foreign law would require proof of that foreign illegality.
The governing law of the LC prescribes the principles to be applied when interpreting the ambit of the applicable sanctions clause, to the extent that the sanctions clause is part of the LC. The Singapore High Court in Kuvera applied Singapore law to determine the scope of the sanctions clause in that case, i.e. which jurisdictions’ sanctions regulations were engaged. As required under Singapore law, the court further examined the commercial purpose of the sanctions clause, and construed the clause to mean that either US or Singapore sanctions laws and regulations would apply.
The governing law of the LC would also determine if a sanctions clause ought to be unenforceable, for incompatibility with the irrevocable nature of an LC.
GTR: What else should banks consider when including sanctions clauses in LCs and related documents, and when they are deciding whether to invoke such a clause to suspend or nullify an LC?
Lee: Kuvera makes it clear that there is no legal impediment to a confirming bank adding a term to its confirmation of an LC which is not found in the LC itself, save that the term cannot be fundamentally inconsistent with the commercial purpose of a confirmation. The court made it clear that a term is fundamentally inconsistent with the commercial purpose of a confirmation only if the effect of the term is to render a confirmed LC no different in substance from an unconfirmed LC. The court goes on to provide one practical scenario: a confirming bank cannot include a term in its confirmation which entitles it not to pay the beneficiary against a complying presentation unless and until the issuing bank reimburses the confirming bank. Banks would also do well to bear in mind that any term incorporated in a bank’s confirmation must continue to give the beneficiary rights against the confirming bank which are in substance additional to the beneficiary’s rights against the issuing bank.
GTR: Is the ICC’s non-binding guidance on sanctions clauses helpful in these situations?
Wan: It highlights that transactional practitioners should not do anything to affect the irrevocable nature of the credit or guarantee, the certainty of payment, or the intent to honour obligations. This ensures that the commercial purpose of trade instruments is retained, a point also emphasised in Kuvera.
The ICC maintains that sanctions clauses should not be the norm, and I agree. Such clauses merely give notice that the bank is subject to the relevant laws and regulations, which takes precedence over any contractual terms. A sanctions clause thereby adds nothing more to a contract, yet, depending on how it is drafted, runs the risk of diluting a party’s obligations.
It is also often difficult for global banks to pinpoint which laws apply to each LC, and they may try to circumvent this by drafting wide and general sanctions clauses. The ICC’s recently updated guidelines are useful in this regard – they include comments on different examples of sanctions clauses, which help practitioners be more aware of potential pitfalls when drafting or reviewing such clauses.
Koh: It remains to be seen whether the courts will recognise and give effect to the ‘wide sanctions clauses’ which entitles the banks to refuse to pay against a complying presentation of LC because the payment may breach the bank’s own internal sanctions policy, regardless of whether it would breach any applicable sanctions laws and/or regulations.
