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“Mens rea” in calls under on demand security instruments

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Summary: This blog post analyses two recent judgments, National Infrastructure Development Company v Banco Santander and MUR Joint Ventures BV v Compagnie Monegasque de Banque, which have tested the courts’ commitment to enforcing on demand security instruments where there is a question over the state of mind of either the beneficiary or the bank.

The beauty of an on demand bond or standby letter of credit is that the beneficiary can call the security instrument and pocket the money without having to prove that the contractor (or sub-contractor) is actually in default or owes the money. It is a separate, independent agreement between the beneficiary and the provider of the security, often a bank, which creates a primary obligation on the bank to pay out on first demand.

The objective of these instruments is to provide solid, reliable security, which can be enforced quickly and simply, with no questions asked. English judges have long sought to promote this objective, regularly intoning ritual incantations as to the “life blood of the construction industry” and the reputation of English law for certainty and predictability.

The result is a formalistic approach, in which the terms of the instrument and the demand are central, and the state of mind of the beneficiary making the demand and the bank receiving the demand are irrelevant. However, two recent cases have tested the courts’ commitment to enforcing demands where there is a question over the state of mind of either the beneficiary or the bank.

The state of mind of the beneficiary

The courts’ principle of enforcing on-demand instruments is of course subject to the fraud exception. Even if the beneficiary is simply required to state that sums are “due and owing” in its demand, the court may not order payment if the beneficiary had no honest belief that it was entitled to make that statement.

In National Infrastructure Development Company v Banco Santander, the defendant bank argued that a statement made by the beneficiary, NIDCO, in its demand under a standby letter of credit that “the amount of $X is due and owing to us by the Contractor” was a false statement, made intentionally or at least recklessly in the sense of indifference as to what was due and owing. It did so on the basis of three pieces of evidence:

  • Oral evidence by the president of NIDCO to a parliamentary committee that NIDCO and its contractor did not owe each other any money.
  • A notice of termination which made no mention of any sums being due to NIDCO.
  • A letter from NIDCO to the contractor which considered sums described as “due” separately from other sums described as “requiring quantification in due course”.

The judge at first instance brushed that evidence aside (rather summarily in my view; I think the first and third points appear, on their face, to be valid points).

Finally, the bank said even if NIDCO believed some money was due, it knowingly or recklessly over-claimed because its payment certificate declared it was entitled to $31 million, but it demanded a total of $35 million. The judge rejected this (again rather summarily), deciding that “[NIDCO’s] belief is not a function of the legal analysis”.

The bank’s final and most interesting argument was that none of the key individuals at NIDCO had given a witness statement saying what was in their mind at the time the demand was made, there had been no trial and so there was no opportunity to explore states of mind by cross-examination. The judge resisted that approach, finding that the “foundations” for such cross-examination were not present in the case (again, somewhat briefly, and without explaining what those foundations might be or when they could be present).

So the bank failed in its challenge to the bona fides of NIDCO, and was denied a full forensic investigation of its mens rea. The court upheld the demand and the bank had to pay out.

The bank appealed. The Court of Appeal, while noting that the judge had erred in the proper test to be applied to establish the fraud exception, nevertheless upheld the first instance decision.

The state of mind of the bank

If it is rare for the court to enquire as to what the beneficiary was thinking, it is even rarer for it to concern itself with what the bank was thinking. Of course the bank’s state of mind is not determinative. Yet it can be part of the factual matrix informing the court’s decision on interpretation of the documents and the enforcement of the demand.

MUR Joint Ventures BV v Compagnie Monegasque de Banque concerned a bank’s somewhat technical challenges to the form of two demands under a demand guarantee. It resisted enforcement on two grounds:

  • The demands did not contain the requisite authentication or authorisation that the person signing on behalf of the beneficiary, MUR, had authority to do so. This was because the notary who witnessed the signature and reviewed the documents which purported to give him authority to sign expressly disclaimed any judgment as to the authority or competence of the signatory. Cranston J held that the notarial certificate was sufficient, because the guarantee required only that the signatory’s powers be “authenticated”, which concerns only the verification of authenticity of documents and does not extend to making a judgment on the content or substance of documents. Interestingly, he commented that the fact that “[the bank’s] interpretation was never raised by [it] until litigation began is some evidence of how [the bank’s personnel], as reasonable bankers, interpreted it.”
  • The demand was defective on its face. Under the company’s statutes the signatory was authorised to do various things “jointly with other board members”, but signed alone. Again Cranston J was unimpressed. This was not just a matter of objective interpretation: part of his reasoning was that no-one at the bank reading the demand document at the time ever raised the point, and when the bank’s solicitors came on the scene they were in no doubt that a demand was being made.

The result was the same as in the NIDCO case: the bank’s challenges to the form of the demand failed, in part because, the judge found, it never really believed in those challenges in the first place. Its own state of mind was a limiting factor in its contractual entitlement.

Comment

Taken together, these cases are comforting for those who prize the robust enforcement of on demand instruments as the lifeblood of the construction industry. Each judge came to the conclusion that the demand was good and the bank had to pay out. The English courts yet again stoutly defended the hallowed status of on demand security instruments, which should be reassuring. But there is more to see here:

  • There is a tendency for the courts to enforce such instruments on principle even in the face of meaningful challenges, and for solemn incantations as to the importance of enforcement to prevail over or replace logical analysis or examination of the facts.
  • Despite this, the court in each case was plainly tempted to be drawn into issues of the mental state of the beneficiary or the bank. If the NIDCO case did not present the right foundations for full witness evidence as to what the employer’s senior management were really thinking, then another case surely will. Even more oddly, perhaps if the bank in the MUR case had raised its arguments earlier, the judge might have taken a different view. Who knows? But let’s remember, it is not only criminal judges who think about mens rea. Commercial Court judges are people too. Even in the dry, “formalistic” world of letters of credit and on demand bonds, the parties’ state of mind can play a role.

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