Article

Note: In order to obtain a US$30 million insurance policy, John Bui (Insured) obtained a loan from UBS (First Lender) to pay the $4 million insurance premium. First Lender required a standby LC in the amount of $4.5 million in its favor and also required assignment of the $3.2 million cash surrender value of the policy. Insured convinced Trans Pacific National Bank (Second Lender), which mistakenly believed that Insured was a person of high net worth, to extend credit and cause a standby that was expressly subject to New York law to be issued by Union Bank (Issuer) in favor of First Lender. Although Second Lender was unaware, Insured had additional obligations outstanding to First Lender. When Insured defaulted on these obligations, First Lender drew the full value of the standby, which was paid by Issuer.

After reimbursing Issuer, Second Lender sued Insurer and First Lender in the California state courts, claiming the cash surrender value of the policy. Under US law, the action was removed from state court to federal court due to the diversity of citizenship between the parties. On First Lender's motion to dismiss the action, the US District Court for the Northern District of California, Armstrong, J., granted it.

Second Lender argued that since it applied for the standby and was obligated to reimburse, the case was governed by New York law as stated in the standby. The Judge, however, rejected this argument, noting that Second Lender "is not a signatory to the letter of credit and thus cannot enforce its terms." She then applied California law.

Noting that the standby was "a fully integrated document", the Judge ruled that Second Lender would not be entitled under a theory of subrogation to any greater right against beneficiary (First Lender) than would Issuer. Since the standby did not by its terms confine the drawing to Insured's debt on the policy premium, the Judge concluded that Second Lender could not claim any greater right.

Comment:

1. It is odd to hear an LC described as being "fully integrated", a term usually connected with the question of whether one can turn to extrinsic evidence to interpret a writing. Because an LC is independent, it turns on its own terms. However, when the question is whether the entity that was obligated to reimburse the issuer (probably the "applicant") under Rev. UCC § 5-102(a)(2) ("Definitions"), makes a post honor claim for wrongful drawing against the beneficiary, the matter could constitute a breach of warranty under Rev. UCC § 5-110(a)(2) ("Warranties"), namely the beneficiary's warranty "to the applicant that the drawing does not violate any agreement between the applicant and beneficiary or any other agreement intended by them to be augmented by the letter of credit." This latter clause was intended to be available to sureties, as is indicated in Official Comment 2, where there is no express contract between the beneficiary and the surety.

Since a post honor action follows honor of the LC, the independence principle does not operate to prevent consideration of the underlying transaction, although the principle of finality does. That principle, however, would not prevent recovery under a Rev. UCC § 5-110(a)(2) ("Warranties"). While a common law rule treating the LC as an integrated writing might operate (were it needed) prior to honor, it cannot limit the inquiry of a breach of a §5-110 warranty to the terms of the LC.

As a result, this case was wrongly argued, and the court should have inquired whether there was a violation of an agreement between the applicant and beneficiary or an agreement intended by them to be implemented.

[JEB/jsc]

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