High Court considers impact of Russian sanctions regimes in UK, EU and US on payment obligations under standby letter of credit

In the recent decision of Celestial Aviation Services Ltd v UniCredit Bank AG (London Branch) [2023] EWHC 663 (Comm), the High Court has considered two Part 8 claims heard together which concerned the impact of UK, EU and US sanctions on payment obligations under several standby letters of credit (LoC).

In a first instance decision that will be of significant interest to parties to transactions which are impacted by sanctions issues, the court considered a factual scenario involving a refusal to make payment by UniCredit Bank AG (London Branch) (UniCredit), the confirming bank under several LoC issued by the Russian bank Sberbank Povolzhsky Head Office (Sberbank), in relation to leases of aircraft to Russian companies. The LoC were governed by English law, all payable in USD, and were issued in favour of the claimant beneficiaries, based in the EU.

On the facts of the present case, the court held that Russian sanctions imposed by the UK in response to the conflict in Ukraine (specifically Regulations 11, 13 and 28 of the Russia (Sanctions) (EU Exit) Regulations 2019 No. 855) did not suspend UniCredit's obligation to pay under the LoC. In particular:

• Regulation 28. The purpose of Regulation 28 is to ensure that financial assistance is not provided to Russian parties (including the supply of aircraft). The court held that the provision of "financial assistance" in this context occurs when an LoC is issued. As the LoC in this case were issued before Regulation 28 came into force (which does not have retrospective effect), UniCredit was not relieved of the obligation to make payment to the beneficiaries. In reaching this conclusion, the court dismissed UniCredit's arguments that paying under the LoC would extinguish the obligations of the Russian company lessees and Sberbank towards the beneficiary, thereby providing financial assistance to them. The court considered that this was a wholly collateral matter and noted that the payment under the LoC still meant that Sberbank remained liable for reimbursement to UniCredit. The court considered each limb of the trade finance transaction to impose separate and distinct contractual obligations. In this regard, the court placed particular emphasis on the principle that LoC are to be regarded as autonomous instruments. The court also considered it important to take a step back and ask whether the fulfilment of an independent obligation - owed by the UK branch of a German bank to Irish companies - could be said to be intended to benefit the Russian entities who happened to be involved in other elements of the overall transaction. The court considered the answer to this question was clear – it could not.
• Regulation 11. The purpose of Regulation 11 is to prevent a party dealing with funds or economic resources owned, held or controlled by a designated person. The court held that Regulation 11 did not come into force until after the date on which the obligation to make payment under the LoC matured, and so did not prohibit payment by UniCredit to the claimants. However, in obiter commentary, the court suggested that such payment would not amount to "dealing" with Sberbank's property in any event, because UniCredit was satisfying its own independent contractual obligations and "Sberbank's property was not in any way interfered with".
• Regulation 13. The court also held that Regulation 13, which prohibits making funds (including financial benefits) available to a sanctioned entity, did not come into force until after the date on which the obligation to make payment under the LoC matured. Again on an obiter basis, the court suggested that payment by UniCredit would not amount to a financial benefit for Sberbank, because it would not discharge its obligations under the LoC and would remain liable to repay UniCredit.

In the present case, the court also considered the foreign illegality rule in Ralli Bros v Compania Naviera Sota y Aznar [1920] 2 KB 287, pursuant to which the English court will not enforce an obligation which requires a party to do something which is unlawful by the law of the country in which the act has to be done. The question in this case was whether payment under the LoC in USD would engage the US sanctions regime which, given the LoC were payable in USD, would involve a US correspondent bank and therefore potentially US illegality in the place of performance of the contract. The court decided that the US sanctions regime did not apply at the time the payment obligation arose, and did not apply to this payment in any event. However, the court went on to suggest that any impediment to payment presented by the US sanctions regime was capable of being avoided, because it would have been possible for UniCredit to pay in USD by alternative means (such as in cash, rather than through a correspondent bank in the US) which, the court believed, would bring the place of performance within the jurisdiction of the UK.

A consequentials hearing took place on 21 April 2023 and the court held that the claimants were entitled to interest and costs (subject to certain limited disputes): Celestial Aviation Services LTD v UniCredit Bank AG, London Branch [2023] EWHC 1071 (Comm). The court found that UniCredit was not entitled to rely on s.44 of the Sanctions and Anti Money-Laundering Act 2018 (SAMLA), which provides protection from civil liability for acts/omissions done in the reasonable belief of compliance with UK sanctions law. In the view of the court, UniCredit's belief that payment was prohibited by sanctions was not a reasonable one. We are monitoring this case to see if an application for permission to appeal is made by the bank.

We consider the decision in more detail below.

Background

The dispute related to LoC issued by Sberbank, which were confirmed by UniCredit, the London branch of the German bank.

In 2017 and 2020 Sberbank issued seven LoC to Celestial Aviation Services Limited (Celestial) in relation to leases of aircraft to Russian companies, which were confirmed by UniCredit shortly after issue. Separately, UniCredit was also the confirming bank under standby LoC issued to Constitution Aircraft Leasing (Ireland) 3 Limited and Constitution Aircraft Leasing (Ireland) 5 Limited (Constitution) in 2018 and 2020, which were again confirmed by UniCredit shortly after issue.

In March 2022, both Celestial and Constitution made valid demands (all payable in USD) and it was common ground that, subject to sanctions, UniCredit was liable to pay under the LoC. However, UniCredit refused to make payment on the grounds that it was prohibited from doing so by reason of the operation of sanctions affecting Russia which were imposed by the UK and the EU in response to the conflict in Ukraine, specifically: Regulations 11, 13 and 28 of the Russia (Sanctions) (EU Exit) Regulations 2019 No. 855 (UK Regulations) and of Article 3c of Council Regulation (EU) 2022/328 (EU Regulation). UniCredit subsequently asserted that US sanctions were another reason why it was prohibited from paying USD sums. Subsequently both Celestial and Constitution brought proceedings against UniCredit claiming various forms of relief designed to assist in obtaining payment under the LoC.

In the period between those claims being issued and the hearing, UniCredit applied for licences in the UK, EU and US to permit payment to Celestial and Constitution, on the assumption that payment would otherwise be prohibited under the relevant sanctions. On 13 October 2022, after the date of the hearing but before judgment was handed down, the Office of Financial Sanctions Implementation (OFSI), which administers financial sanctions in the UK, granted a licence under Regulations 11 and 13 and on 12 May 2022, the German Bundesbank granted a licence. A response from the US authority, the Office of Foreign Assets Control (OFAC), was not received before judgment was handed down in this case.

Following the receipt of the licences, the parties reached agreement in relation to the principal amounts owing under the LoC and UniCredit made the payments to Celestial and Constitution. However, the parties remained in dispute on the issues of costs and interest. The parties asked the court to decide a number of underlying matters which would assist the parties resolve the remaining issues. These matters were as follows:

1. Did the UK Regulations prohibit payment under the LoC? If the answer is “no”, did UniCredit nevertheless have a reasonable belief that it did?
2. Does US law have the effect of suspending or otherwise excusing non-performance of UniCredit’s obligation to pay in USD under the LoC?
3. Did the EU Regulations prohibit payment under the LoC? The parties agreed that the analysis in relation to the relevant EU sanctions is materially the same as in relation to the UK Regulations.

Decision

The court concluded that UniCredit was not relieved of the obligation to make payment to the claimants under the various LoC by reason of Regulation 28, 11 or 13 of the UK Regulations. Further, the court was not satisfied that, as a matter of US law, the payment under the LoC would breach the terms of the relevant US sanctions (it was not asked to reach any conclusions as to EU law at this stage). The court's analysis of the UK Regulations and US sanctions position is discussed further below.

UK Regulations

Before turning to the specific Regulations relied upon by UniCredit, the court confirmed some principles of statutory interpretation. In the court's judgment, it is important to take a purposive interpretation of the statute, preferring this approach to UniCredit's emphasis on a literal approach. The court then proceeded to consider each of Regulation 28, 11 and 13 of the UK Regulations.

Regulation 28 (provision of financing for the supply of restricted goods/technology)

The court confirmed that the purpose of this Regulation was clear, namely "to ensure that financial assistance was not provided to Russian parties in relation to, inter alia, the supply of aircraft".

On the facts of the present case, the court said that the provision of financial assistance to the Russian lessees of the aircraft occurred when the LoC was issued, which served as a mechanism for the satisfaction of the payment obligations of the lessees. The court confirmed that Regulation 28 operates prospectively and not retrospectively, and therefore the provision of the relevant services (i.e. the issue of the LoC) was perfectly lawful at the time provided.

In the court's view, at the time that the prohibition in Regulation 28 came into effect, all that remained was for the obligation under the LoC to be fulfilled. The court held that the only parties which stood to benefit from this were the claimants. While the fulfilment of payment by UniCredit to the claimants would have the collateral result of discharging the independent obligations of the Russian lessees and Sberbank towards the claimants; Sberbank would remain liable to UniCredit, and the Russian lessees would remain liable to Sberbank. Accordingly, neither the Russian lessees nor Sberbank would benefit from UniCredit's payments under the various LoC.

The court also confirmed that it is fundamental to the nature of a LoC that it gives rise to autonomous payment obligations which operate independently of the underlying transaction. In consequence, the payment obligations under a LoC are commonly described as equivalent to cash (see Salam Air v Latam Airlines [2020] EWHC 2414). The court regarded the autonomy principle as of importance; and stated that UniCredit's obligation to the claimants under the LoC was wholly independent from any other elements of the transaction. This meant that the transaction between the beneficiaries under the LoC and UniCredit was not prevented from being performed by sanctions, even if some of the other transactions may be (e.g. UniCredit's ability to obtain reimbursement from Sberbank).

In addition, the court considered it important to take a step back and ask whether the fulfilment of an independent obligation owed by a German bank to Irish companies can be said to be intended to benefit the Russian entities who happened to be involved in other elements of the overall transaction. The court considered the answer to this question was clear – it could not. This focus on intention, rather than object or effect (which is the language used in the Regulation) may prove to be a controversial aspect of this judgment.

The court did not accept UniCredit’s submission that the UK Regulation should be read broadly, with any vagaries being assuaged by the use of the licensing system. The court commented that guidance suggests that the licencing authorities may take the view that prohibited transactions may nonetheless be licenced if they are thought to be “consistent with the aims of the sanctions”; which in turn indicates that a licence may be granted in relation to transactions even though they are prohibited on a proper reading of the sanctions, not that the sanctions should be regarded as all embracing, subject only to the licencing regime.

Accordingly, the court concluded that UniCredit was not relieved of the obligation to make payment under Regulation 28.

Regulation 11 (dealing with funds or economic resources owned, held or controlled by a designated person)

The court held that Regulation 11 did not come into force until after the date on which the obligation to make payment under the LoC matured. However, the court (on an obiter basis, given its primary finding above) accepted the claimants' argument that Regulation 11 did not in any event prohibit payment under the LoC by UniCredit.

The court rejected UniCredit's argument that paying the claimants would amount to "dealing" with "funds" (including LoC) which were "owned held or controlled" by Sberbank (Sberbank retained a legal interest in the LoC), because the payment would change the character of the LoC by extinguishing Sberbank's obligation to pay/trigger Sberbank's obligation to reimburse UniCredit.

The court said that UniCredit was not "dealing" with Sberbank's property when making a payment to the claimants under the LoC, because UniCredit was satisfying its own independent contractual obligations and "Sberbank's property was not in any way interfered with".

Regulation 13 (making funds available to any person for the benefit of a designated person)

The court also held that Regulation 13 did not come into force until after the date on which the obligation to make payment under the LoC matured. Again (on an obiter basis), the court accepted the claimants' argument that Regulation 13 would not relieve UniCredit of its payment obligation under the LoC in any event.

Regulation 13 deals with making funds (including financial benefits) available to a sanctioned entity. However, in the court's view, payment by UniCredit would not discharge Sberbank's obligations under the LoC, because while this would satisfy its obligation to pay the claimants, Sberbank would remain under an equal obligation to reimburse UniCredit, with no overall reduction in liability.

US sanctions

The court was asked to confirm whether US law had the effect of suspending or otherwise excusing non-performance of UniCredit's obligation to pay in USD under the LoC. In the court's view, at the moment that the payment obligations accrued, there was no relevant prohibition under US law, as regards Celestial. At the moment the first obligation to make payment to Constitution matured, there was no relevant prohibition. There was, however, a potentially relevant prohibition under US sanctions which came into force on 26 March 2022, which might affect the later payment obligations. This required the court to consider whether US law was relevant to the enforceability of the English law-governed payment obligation under the LoC.

The court confirmed that the governing law of each of the LoC was English law and that there was a well-recognised principle of English law that the English court will not enforce an obligation which requires a party to do something which is unlawful by the law of the country in which the act has to be done, known as the rule in Ralli Bros. The rule is engaged if performance of the obligation would require the performing party to act unlawfully in the required place of performance.

UniCredit argued that, under the Ralli Bros rule, payment via a correspondent bank in New York would be illegal in the place of performance. In particular, it drew the court's attention to the following factors:

• The currency of each of the LoC was USD.
• UniCredit’s payment obligation arose only in the event of a demand precisely in the format set out in the relevant LoC.
• Each of the demands identified a USD beneficiary account. In addition, those demands which specified a Dublin beneficiary account also specifically identified a correspondent account in the US through which payment was required to be made.
• Payment could not be made in accordance with these demands except via a correspondent bank in the US.

The claimants submitted that this case was akin to Kleinwort Sons & Co v Ungarische Baumwolle Industrie AG [1939] 2 KB 678, in which the Court of Appeal held that since payment was to be made in England, the place of performance was England. The Ralli Bros principle was therefore not engaged. The same principle, the claimants argued, was illustrated in Libyan Arab Foreign Bank v Bankers Trust Co [1989] 1 QB 728 (LAFB).

In another obiter section of the judgment, the court concluded that the LAFB case was authority for the proposition that, where a USD payment is required under the contract, the customer is entitled to demand such payment in cash. While the demand made upon UniCredit assumed that payment would be made through a correspondent bank, that did not entitle UniCredit to insist on making the payment in this way, despite the fact that such a payment could not in fact be made (or lawfully made).

The court further found that nothing turned on the fact that the demand in this case did not stipulate payment in cash. In the court's view, this would confuse the trigger for the obligation (the demand) with the manner in which that obligation (to make payment) may have to be fulfilled. It may be that the demand assumed payment would be made through a correspondent bank, but that did not mean UniCredit could not choose to perform in any other way, including via the tender of cash. Where the fundamental obligation is to make payment, and where it is possible to make such payment, then the bank must do so.

The court proceeded to consider the potential implications of various US sanctions if they were applicable to the claim, but this aspect of the judgment is not considered further in this blog post.

Note: In June 2023, the defendant applied to the Court of Appeal for permission to appeal.

In August 2023, the Court of Appeal allowed the defendant's application for permission to appeal. The hearing has been fixed for 14/15 May 2024.