Article

Prior History:Subaru Distributors Corp. v. Subaru of America, Inc. No. 98 Civ.5566 (CM), 1999 WL 216617 (S.D.N.Y. 1999) abstracted at 2000 Annual Survey 380.

Note:In 1975, Subaru Distributors Corp., Applicant, and Subaru of America, Inc., Beneficiary, entered into an automobile distributor agreement for the Applicant to obtain an exclusive sales territory in New York and northern New Jersey. The actual underlying distributor agreement anticipated multiple transactions on a monthly basis between Applicant and Beneficiary that renewed yearly in perpetuity. Article 7(3) of the distributor agreement provided that Applicant's order "'be accompanied by a domestic irrevocable Letter of Credit acceptable to Importer, in favor of Importer.'" Article 7(3) further detailed under the monthly quota ordering system that "the next quota order is due 'within seven days after each Letter of Credit becomes an acceptance ..." although over the 26 year relationship all of the LCs called for payment at sight and not on banker's acceptance financing terms. By this time, they were frustrated by their relationship and feeling threatened. Distributor sued North American Supplier for declaratory judgment and other relief regarding Distribution Contract and required LC.

1999 Preliminary Injunction: The instant action evolved from a denial of a preliminary injunction in April 1999 concerning whether the letter of credit provisions demanded were acceptable regarding draw down. In that decision, the court determined that there was nothing in the Distribution Agreement that prevented the Beneficiary from demanding payment prior to the tendering the vehicles for delivery. In its ruling, the court concluded that Beneficiary had not violated any provisions of either UCC Sections 2- 606(1), 2-507(1) or the state Automobile Dealers Acts by demanding payment prior to delivery subject to the demand being commercially reasonable for draw down. The court had noted that Beneficiary could make such a demand because of the provision in the distributor agreement that reserves for Beneficiary an "'acceptable'" LC. Furthermore, the UCC permits the parties to vary these terms. The court rejected Applicant's argument that it was improper to demand payment prior to delivery because it would impair the right to inspect the automobiles prior to payment on the basis that neither the UCC nor the distributor agreement provided for such rights to inspect.

After a trial, however, the U.S. District Court for the Southern District of New York, McMahon, J., found the LC demanded by the Beneficiary to be commercially unreasonable. In 1999, upon reviewing new developments and facts since the first preliminary injunction, the court re-examined the issues of import arrangements between the parties that affected how the LCs would be presented. The primary issue was whether the LC agreement was commercially reasonable.

Present Trial, New Facts and Developments: The judge remarked "my earlier decision [on the preliminary injunction] remains sound in the context of what ... [is] called a 'traditional' import letter of credit transaction. In a traditional l transaction, a foreign supplier loads goods onto a boat, waves goodbye as it sails off, presents his documents to the issuer of the letter of credit, gets paid, and is never seen again (which is to say, the supplier has nothing more to do with the transaction) . If [Beneficiary] ... had nothing more to do with these cars, I would have no reason to revisit my interpretation of the letter of credit provision of the [Distribution Agreement] ... But I do have to revisit the issue, because the [Applicant/Beneficiary] import arrangements do not conform to the traditional model." Based on this "wholly different backdrop" the judge stated "I must now determine whether I was right in the first place. I conclude that I was wrong."

After the initial decision on the preliminary injunction, Beneficiary had made fresh demands and different arrangements in the way vehicles were to be imported for Applicant and when the LCs would be paid. These new facts had to be considered by the judge.

Beneficiary demanded that Applicant accompany all future quota orders with an LC giving Beneficiary the right to present the LC for payment prior to the delivery of the vehicles. Specifically, Beneficiary wanted to draw down LCs immediately after it received Applicant's order and prior to delivery. Applicant was forced to approach its bank to request the new LCs lest it be left without inventory to sell. The Issuer informed Applicant that it could not provide the LCs because Beneficiary's intention to draw down on the LCs prior to delivery and in transit across the ocean did not allow for Issuer to protect itself or its collateral. Issuer mandated that the LCs must require that Beneficiary's draw down reference a particular purchase order, appropriate bills of lading, and proof of insurance. Beneficiary refused this request.

As a result, an emergency hearing was held in May 1999. The court ruled "if [Beneficiary] wanted to draw down on [Applicant's] DLCs while the vessels carrying the vehicles were somewhere in the Pacific Ocean, [Issuer] would be entitled to receive bills of lading and proof of insurance coverage at the time of drawdown.."

After this emergency hearing, it was discovered that Beneficiary had resisted the Issuer's demands for bills of lading because Beneficiary, acting as Importer, could not clear the cars through U.S. Customs without retaining the negotiable bills of lading as required under the distribution agreement. Acting as Importer, Beneficiary was responsible for all costs including duties and transport charges associated with the cars. Additionally, Beneficiary bore the risk of loss. As a result, Applicant and Beneficiary continued to have problems during the period.

The court noted the "impasse" resulted from the Issuer rightfully wanting possession of the bills of lading before allowing Beneficiary to draw down. However, Beneficiary needed the bills of lading to complete its duties as Importer under the distribution agreement. Under a 1981 Amendment to the distributor agreement, title to the vehicles passed automatically from Beneficiary to Applicant upon payment. Therefore, if payment occurred prior to delivery and clearing U.S. Customs there was a serious question as to whether Beneficiary could act as Importer.

Matters were made worse when it was discovered that Beneficiary could not pass title under the Amendment during transit because Beneficiary in fact did not hold title to the vehicles. Instead, the cars were owned by Marubeni America Corp., a subsidiary of a Japanese Bank that financed the sale of Subaru vehicles shipped to the U.S. The transaction scheme operated in the following way. Marubeni provided Beneficiary with trade financing. In return for the financing, Marubeni received title to the automobiles while they were in transit. Beneficiary only regained title to the cars once they were offloaded at the port of destination and passed U.S. Customs. Beneficiary's credit facility required the terms under the Marubeni Agreements be maintained lest Beneficiary be left in default to them.

The judge upon discovery of this complication stated "[i]f I had been aware of the Marubeni Agreement and the bank covenants in 1999, I would not have reached the conclusion I did about the commercial reasonableness of [Beneficiary's] demand for letters of credit that required payment prior to delivery for imported vehicles." The judge further held "[t]here is nothing commercially reasonable about demanding a term in a letter of credit of which you cannot take advantage [Beneficiary] could not have taken advantage of payment prior to delivery, because (1) it could not pass title while the vehicles were in transit consistent with the Marubeni Agreements and its Credit Agreement, and (2) it could not take possession of the cars and clear them through customs without having possession of [the negotiable bills of lading]."

While Beneficiary argued that the bank covenants and Marubeni Agreements could be canceled or waived, the court determined that Beneficiary's "lack of candor" resulted in the court making an "uninformed judicial decision".

NBOL Issue: The judge proceeded to analyze the unorthodox LC agreement to reconcile how the new developments affected the initial preliminary injunction decision. The court stated "[t]he entire situation was patently unreasonable." The court continued "the parties and their clever lawyers negotiated a truly byzantine document." The hallmarks of this unorthodox agreement were that 1) Issuer would take the bills of lading from Beneficiary when it drew down on the LCs; 2) Issuer would then tender back the bills of lading to Beneficiary with Beneficiary acting as the Issuer's bailee. As bailee, Beneficiary could then clear the cars through U.S. Customs and fulfill its contractual duties as Importer for Applicant. The court observed that the entire agreement was "counter to the premises underlying traditional letter of credit transactions" for the following reasons. First, Beneficiary remained in the deal after being paid. Next, the agreement brings the Issuer into the underlying transaction. Then, a commercial relationship arose between the Issuer and Beneficiary. Finally, the agreement "contains the seeds of its own destruction" in that it allowed Applicant to challenge the agreement as commercially unreasonable.

The court relied on an LC expert's opinion. The expert testified that "she had never seen anything like it before, and the Uniform Customs and Practice for Documentary Credits ("UCP") nor the Revised UCC Articles 5 and 9 ... has any provision covering, or even contemplating such an arrangement." The Issuer's own witness testified to the "unorthodox nature of the arrangement." Persuaded by this testimony, the court continued with its analysis.

Noting that Beneficiary had admitted that Issuer's return the bills of lading after paying a letter of credit was an "anomaly", the court concluded that Issuer's release of the bills of lading represented its only rights against Beneficiary. The court observed the exercise resulted in Issuer giving up its perfected security interest in the cars to Beneficiary, who had been paid. The risk created was unacceptable and not in line with the goals of LC practice because if a conflict arose, the only way to settle the matter under the payment scheme was to file a lawsuit. This, the court concluded was anathema to transacting business with LCs in the first place. The court reasoned that to find cure in the courts under the agreement effectively removed the advantages of conducting business transactions with LCs

Next, the court noted in the event that the automobiles were lost and Beneficiary failed to deliver the vehicles to Applicant, neither Applicant nor Issuer could recover the cars or the proceeds. Beneficiary was in a position such that it could refuse to refund Applicant and if Beneficiary became 127 insolvent, Issuer and Applicant would effectively bear the risk of loss. Again, this created a risk that LC practice aimed at reducing not increasing.

For these reasons, the court held "in the face of these extraordinary, potentially catastrophic consequences, that [Beneficiary's] demand for a letter of credit that provides for payment prior to delivery of the cars - viewed in light of [Beneficiary's] contractual obligations as Importer of the cars - is commercially unreasonable" ... "This arrangement is 'commercially reasonable' only if that term can be equated with 'commercially possible'".

The court next considered whether there was bad faith on the part of Beneficiary. The court found the unorthodox LC terms were demanded in bad faith in an effort to deal with Applicant unfairly in the context of how and when title passed and when payments were made. The court found at no point had Beneficiary made efforts to obtain releases from the Marubeni Agreements affecting title. Indeed, the court found the arrangement for trade financing ongoing until January 2000. Therefore, the court allowed Applicant to terminate the bill of lading agreement on the grounds that it was commercially unreasonable.

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