Irrevocable payment undertakings in oil financings

Feature | 28 November 2006

Richard Gwynne, a partner at law firm Stephenson Harwood, examines irrevocable payment undertakings and their place in oil finance transactions following two recent court rulings that upheld their independence.

Irrevocable payment undertakings (IPUs) are frequently used in the oil trade and in oil financings. Typically the sale contract will provide for payment under the contract to be made by the buyer via an IPU issued in favour of either the seller or its bank.

The IPU will contain an undertaking by the buyer in favour of either the seller or its bank that upon presentation of the commercial invoice and shipping documents (or letter of indemnity in lieu of shipping documents) the buyer will pay ‘without discount, deduction, set-off or counterclaim’ the amount of the invoice on a specified date after the issue of the bill of lading.

The English courts recently considered two cases regarding the legal effect of an IPU where disputes have arisen between buyers and sellers under the sale contract.

In both cases, the courts upheld the independence of IPUs from disputes arising between the buyer and seller. This is good news for those seeking to rely on an IPU for financing purposes.

Totsa Oil v Bharat

In Totsa Total Oil Trading SA v Bharat Petroleum Co Limited[1] the issue was the effect of provisions in both the sale contract and the IPU that payment was to be made ‘without set-off, deduction or counterclaim’ of the amount of the seller’s invoice not later than 30 days after the bill of lading date. Under the bills of lading, about 949,000 barrels of oil were shipped with an invoice value of more than $36.9m. The buyer paid just under $35.2m, leaving a shortfall of about $1.745m. According to the buyer, it made the deduction because while just over 900,000 barrels of crude oil were shipped, between 42,000 and 45,000 barrels contained water.

The seller sought summary judgment against the buyer for the shortfall. It accepted there was a triable issue on the buyer’s counterclaim in respect of the alleged shortfall. But it argued the buyer had to pay the full amount, since a deduction had been made which was not allowed under the terms of the contract and the IPU.

According to the judge, the meaning and effect of the contract and the IPU, taken as a whole, was clear. On receipt of the bill of lading and an invoice the buyer was to pay whatever amount was stated in the invoice, and not a dollar less. If it had a claim that it should have to pay less than what the invoice called for, the terms of the no set-off clause precluded it from doing so.

The judge considered several authorities regarding the effect of a no set-off clause and said the effect of each depended upon the construction of the particular clause in question. But in this case the judge was in no doubt the buyer’s obligation was to pay the full amount and if it had any cross claim for under-delivery, that would have to be the subject of separate proceedings.

RZB v China Marine

The second case involved Raiffeisen Zentralbank Österreich (RZB) v China Marine Bunker (Petrochina) Co Limited[2]. Here, RZB claimed a sum of around $6.5m pursuant to an IPU issued by the defendant (China Marine) in favour of RZB’s Singapore Branch. China Marine was the buyer under the contract for the supply of oil. The seller was RZB’s customer Sinostar Energy Pte Limited (Sinostar), based in Singapore.

Under a contract dated 9 May 2005, China Marine agreed to buy a consignment of oil from Sinostar. Payment was to be secured by an IPU issued by China Marine to Sinostar’s nominated bank. China Marine printed out the IPU, signed it and sent it to RZB. It was addressed to RZB and copied to Sinostar and provided that: “We [China Marine] hereby irrevocably undertake that upon presentation of [the] seller’s commercial invoice and shipping documents or letter of indemnity in lieu of shipping documents [from Sinostar] we will pay without discount, deduction, set-off or counterclaim [in US dollars] in immediately available funds for account of [RZB Singapore branch] for credit to [Sinostar’s account] in full settlement of their invoice for the above purchase.”

Payment was to be made 60 days from the date of the bill of lading.

When the payment under the IPU became due, China Marine refused to pay. It claimed it had effectively entered into the contract as an import agent for Sinostar to enable the oil to be sold to an associated company of Sinostar based in China, called Guangdong. It asserted that, although it had taken delivery, Guangdong had not paid it for the oil. It also produced a ‘supplementary agreement’ between Sinostar, China Marine and Guangdong, which included a provision that if Guangdong failed to pay China Marine, China Marine was entitled to extend the time under which it was obliged to pay Sinostar. Furthermore, if Guangdong failed to pay China Marine, China Marine was “not responsible to make any payment for the cargo in US dollars to [Sinostar]”.

The IPU contained an English governing law and jurisdiction clause. RZB applied for summary judgment against China Marine.

China Marine alleged that the obligation to pay, to which the IPU gave rise, was owed only to Sinostar and not to RZB. It said RZB was acting merely as agent for a disclosed principal (ie, Sinostar) and so could not itself enforce the obligation. It argued RZB had given no consideration for any promise that it should be paid. It also claimed that looking at the back-to-back purchase agreement between China Marine and Guangdong and the supplementary agreement, there was a serious issue to be tried regarding whether there could be any possible commercial intention on the part of China Marine to afford any rights to RZB that were unaffected by the obligations in the supplementary agreement.

But the judge rejected these arguments, stating it was clear from both the sale contract and the IPU that the IPU was an independent, freestanding obligation in favour of RZB. According to the judge, the whole function of the IPU was to secure payment to RZB, albeit for the credit of its customer Sinostar. It was accepted that all parties, including China Marine, would have been well aware of RZB’s role as financier of Sinostar. The fact that RZB, in acting as collecting bank, may be acting as an agent in presenting the documents for payment did not prevent RZB from having an independent status as principal under the terms of the IPU.

The judge also rejected the argument over lack of consideration. She said that in a commercial transaction the court would be reluctant to say an agreement, which gives every impression of being a contractual undertaking, fails for want of consideration. One way of finding consideration was that the offer was one by China Marine to RZB that, if presentation was made, payment would be made by China Marine and that, effectively, consideration was provided by RZB in presentation of the documents. Alternatively, consideration might be provided by the recognised financing role of the bank in the transaction by making funds available.

Accordingly the court gave summary judgment to RZB for the sum claimed under the IPU.

In these decisions the English courts have ensured IPUs do what they are intended to do, that is, to ensure payment, without deduction, of the invoice due because of some dispute under the underlying contract. Although the decisions do not make express reference to the performance bond and letter of credit cases, they are clearly informed by the same concern to ensure that in an international trade transaction, what is expressed as an unconditional promise of payment should be given effect.

Hence IPUs issued by buyers, if properly drafted, will be equated to instruments like letters of credit and performance bonds. Thus, if an IPU is addressed to a bank it is a document against which the bank can provide finance with confidence that the English courts will enforce it summarily. Of course, there will remain the issue of the creditworthiness of the issuer of the IPU and the enforceability of a judgment against the issuer’s assets and identifying where those assets might be.

Provided the IPU is in clear terms it does not need to be an elaborate document. It must make it clear that the buyer is to make payment of the invoice without discount, deduction, set-off or counterclaim. And the boilerplate here is very important. The IPU must be expressly governed by English law and subject to the jurisdiction of the English courts. If it is silent on governing law, the IPU is likely to be governed by the law of the issuer of the IPU. If it is silent on jurisdiction, obtaining English rule will at least be more complex, and at worst may not be possible. It is also advisable to ensure proceedings can be served easily on the issuer by including an address for service, or agent for service, based in England.

Richard Gwynne specialises in commercial litigation and arbitration at Stephenson Harwood in London. He has particular expertise in trade finance litigation in the UK and internationally. Stephenson Harwood acted for Raiffeisen Zentralbank Österreich in RZB v China Marine.

[1] Commercial Court, Mr Justice Christopher Clarke, 14 January 2005

[2] Commercial Court, Mrs Justice Gloster, 13 January 2006

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