Article

Factual Summary: To assure Surety of repayment by General Contractor for whom it issued a performance bond in relation to the construction of a parking garage, Bank issued a standby LC in the amount of US $1,200,000. The standby required presentation of a sight draft accompanied by a written certification that liability on the bond had not been released or that claims were made on the bond. The standby provided that "[t]he proceeds of our draft will be retained and used by [Beneficiary]. In the event our liability under our bond(s) is satisfied, [Beneficiary] will refund to you the amount paid, less any amounts which may have been paid ...." The credit also stated, "[w]e ... undertake that all drafts drawn and presented will be duly honored by us within fifteen days of receipt."

When the construction project collapsed due to disputes about funding and without the garage being built, Beneficiary informed Issuer of its intention to pay on the performance bond in order to obtain a release of its liability under the bond.

On 17 November 2000, Beneficiary presented a sight draft and certification "as specified in the letter of credit." Issuer sent the documents to its attorney who responded to Beneficiary on 5 December 2000, 11 banking days and more than 15 calendar days following presentation, dishonoring because "... one of the terms and conditions of the letter of credit is that '[Beneficiary] has not been released of liability by the [O]bligees.' Despite your certification to the contrary, it is apparent that [Beneficiary] has, in fact, been released by the [Obligees]. As a result, we are dishonoring your draft ...."

The notice of refusal also discussed documents related to the underlying contract, asserting that these documents supported Issuer's knowledge of Beneficiary's allegedly fraudulent statement in the certification. Issuer's notice of dishonor did not indicate that it would either return the documents or hold them at the Beneficiary's disposal. Beneficiary never requested the return of the documents, and Issuer never made inquiry regarding their disposition.

Upon receipt of the notice of dishonor, Beneficiary filed suit, seeking actual and punitive damages for wrongful dishonor and conversion. On Beneficiary's motion, the court dismissed Issuer's counterclaim for declaratory judgment, noting that the claim was redundant and that the issues raised would be addressed in the initial suit. Again on Beneficiary's motion, the Court entered summary judgment for Beneficiary, and awarding damages for the face value of the LC (US$ 1,200,000) plus prejudgment interest.

Legal Analysis:

1. UCP; Application of Revised UCC Article 5 to UCP Credit; UCC: Describing the UCP as "commonly adopted by international and domestic letters of credit as the 'law of the transaction' by agreement of the parties," the court stated that "[u]nder Missouri law, the provisions of the UCC do not apply to a letter of credit which states that it is governed by the UCP. It cited Fidelity & Deposit Company of Maryland v. Federal Deposit Insurance Corp., 54 F.3d 507, 510 n. 3 (8th Cir. 1995); Landmark Bank v. National Credit Union Administration, 748 F.Supp. 709, 714-15 (E.D. Mo. 1990); Anchor Centre Partners. Ltd. V. Mercantile Bank, N.A., 803 S.W.2d 23, 34 (Mo. 1991).

2. Declaratory Judgment; Independence; Suretyship: As an additional reason in support of its dismissal of the Counterclaim, the court stated: "[f]urthermore, contrary to the [Issuer's] opinion, an adjudication of the [Issuer's] counterclaim would require this Court to inquire into and review the legal contractual relationships among several entities who are not parties to this lawsuit. Putting aside the [Beneficiary's] contention that such a review would violate a basic rule of surety law known as the 'independence principle' [sic], it is apparent that having this Court declare that the [Obligee] (a non-party) materially breached a contract to which [Issuer] is not a party to, and that such material breach relieved [Beneficiary] completely of any liability under bonds issued to other nonparties circumvents the [Issuer's] failure to add these parties to this lawsuit ...."

3. Preclusion: The court stated that "[t]o balance the rule of strict compliance," UCP500 Article 14 "provides for a rule of strict preclusion." It concluded that "an issuer is precluded from justifying a dishonor upon any ground that was not identified by the issuer in a timely notice of dishonor."

In addressing whether a notice of refusal must raise fraud as a basis for refusal, the court stated that:

Article 14 of the UCP deals with patent defects. It is true that by its wording, Article 14 proscribes a specific deadline by which defects evidenced on the face of the documents should be readily discovered and notice of same given. Article 14 does not appear to deal with latent defects; i.e. cases in which the issuer discovers fraud, not readily apparent on the face of the documents, sometime after the time for notice of defects has passed. Caselaw addressing Article 14's notice of defect deadlines is scarce; however, one case (cited by both parties) has held that an issuing bank can disclaim based on latent fraud after the Article 14(d)(i) period has expired. It cited Hamilton Bank v. Kookmin Bank, 245 F.3d 82, 91 (2nd Cir. 2001)].

It continued by stating that:

[i]t is clear that the [Issuer's] claim of fraud is not based on latent fraud. The [Issuer's] notice of dishonor clearly stated that it was rejecting the sight draft because the statement in the certification regarding [Beneficiary's] non-release from liability by the obligee was "fraudulent". Furthermore, this wasn't a case where acts of fraud were discovered sometime after the notice of dishonor deadline had passed. [Issuer] concedes that its dishonor was based upon information it had in its possession prior to receipt of the sight draft and certification. [Issuer's] excuse of fraud as justification for its late notice of dishonor does not suffice as a matter of law.

The court concluded that:

as no material issue of fact exists that the notice of dishonor was given after the Article 14(d)(i) of the UCP 500 time period for notification of dishonor had passed, [Issuer] could not refuse to honor the LOC and the sight draft presented drawing upon it based upon fraud in the transaction, fraud in the documents presented, or the financial condition of [Beneficiary] at the time of the presentation.

4. Material Fraud: As to whether fraud existed, the court stated that "fraud must be found either in the documents or must have been committed by the beneficiary on the issuer or applicant. Furthermore, '[m]aterial fraud by the beneficiary occurs only when the beneficiary has no colorable right to expect honor and where there is no basis in fact to support such a right to honor.' [Revised UCC Section 5-109, Comment 1]." The court concluded that "it is clear that there was a basis in fact to support [Beneficiary's] colorable right to expect honor."

5. Effect of Beneficiary Insolvency: Issuer claimed that one of its reasons for dishonoring Beneficiary's draft was that due to "[Beneficiary's] financial situation, it would not be able to return any excess funds to [Issuer]." This reason was not included in Issuer's notice of dishonor. The court rejected Issuer's claim and stated that "an issuer must not only give its notice of dishonor within the proscribed time, but must also clearly and specifically identify the defect in the draft and/or accompanying required documents or the notice has no effect."

6. Conversion: Beneficiary claimed that the issuer had converted the documents by not returning them. Issuer charged that an action for conversion did not lie under Missouri law because the documents were "worthless" and because beneficiary never requested the return of the documents. The court rejected both contentions, stating that:

[i]t is clear under Missouri law that the physical manifestation of the security ownership (such as stock certificates) is not the subject of the conversion, but rather is only the "symbol" of the underlying ownership interest in the security. (Citations omitted) .... Here, the sight draft represents [Beneficiary's] exclusive right to collect monies based upon the terms and conditions of the LOC. In this case, that exclusive right is hardly "worthless", rather it is worth at least $1,200,000.00 plus interest. Furthermore, [Issuer's] contention that [Beneficiary's] claim of conversion fails because [Beneficiary] has not asked for the documents is equally without merit. As previously noted, the UCC and the UCP 500 both place an affirmative duty upon [Issuer], as the issuing bank dishonoring the sight draft, to notify the beneficiary ... of either its intention to return the documents or to hold them for disposal at the beneficiary's directions. [Issuer] did not comply with the requirements of the UCC and the UCP 500, and has retained the subject documents despite the filing of this lawsuit. Finally, it is no defense to a claim of conversion that the act was in good faith or in honest belief that the possession was lawful.

7. Punitive Damages: Beneficiary sought an award of punitive damages in addition to the value of the LC and prejudgment interest. The court rejected Beneficiary's claim, noting that while punitive damages are not addressed by the UCP 500 or the UCC Article 5, the UCC forbids the award of consequential damages in cases of wrongful dishonor. The court went on to state that:

[Beneficiary] fails to provide this Court with any statutory or caselaw authority in support of its demand [for punitive damages]. It is this Court's considered opinion that punitive damages are disfavored by commercial law, especially in the context of letter of credit law, and the instant case does not provide evidence of the type supporting an award of punitive damages for wrongful dishonor of a letter of credit.

Comments:

1. Application of UCC to UCP Credit: The LC in the case at bar was issued on 25 October 1999 and Missouri's revision of UCC Article 5 was effective in 1997. Missouri's former version of UCC Article 5 contained a nonconforming amendment to former Section 5-103. Styled UCC Section 5-103(4), it provided that where a credit indicated that it was subject to the UCP, it was not governed by the UCC. NY first enacted this amendment and followed by three other states including Missouri. It reflected the hostility of the LC banking community to national law in general and letter of credit law in particular. Because the Revised Sections 5-108 and 5-116 expressly embraced rules of international banking practice such as the UCP, there is no provision parallel to prior non conforming Section 5-103(4) in model Revised UCC Article 5 or in Missouri law. Although the court applies Missouri law, it does not appear whether the LC was issued in Missouri, and, consequently, whether Missouri law would apply under Revised UCC Section 5-116.

2. Modification of Reasonable Time. The court concludes that the notice of refusal is not timely without even considering whether the statement in the LC that drafts will be honored within 15 days of receipt by the bank constitutes a modification of the reasonable time standard of UCP500 Articles 13 and 14. In any event, the notice was given later than 15 calendar days. From the perspective of LC practice, the time period for notice can be modified in the credit, but the terms of this credit did not do so. To modify this time period, something more must be stated than "we will honor the draft 15 days after presentation." Such a statement constitutes a deferred payment undertaking and not a modification of the time within which refusal must be noticed.

3. Patent and Latent Defects and Fraud: The opinion relies on unhelpful terminology distinguishing between so-called "patent" and "latent" defects in assessing whether or not the bank must raise the defense of fraud in its notice of refusal. Whatever the distinction may mean, there is no doubt that under LC law and practice that the defense of fraud need not be raised in a notice of refusal and is not subject to the preclusion rule of UCP500 Article 14 or revised section 5-108. Material fraud within the meaning of section 5-109 will excuse the issuer from honoring (provided that there is no protected nominated bank or transferee beneficiary).

4. Strict Preclusion: The opinion also uses the discredited notion of "strict preclusion". This theory, based on a geometrical balancing between so-called strict compliance and so-called strict preclusion is a historical anomaly and unnecessarily obscures the basis for the development of the preclusion rule in codified practice and law. Preclusion applies without regard to the issuer's intent or the presenter's reliance and is, in that sense, strict. Whether or not it is to be applied, however, is another matter. Where a discrepancy is not noted, it may not be raised. To fail to raise a discrepancy, however, does not make the notice defective or insufficient as to discrepancies that are stated. Moreover, whether or not a discrepancy is stated depends on whether it would be understood to have been raised under letter of credit practice. There is no need to have lawyers draft notices of refusal.

5. Fraud: On the issue of fraud, the court properly turns to and applies the standard of material fraud in revised section 5-109. Its conclusion that material fraud was not established (i.e., that the beneficiary had a colorable basis for drawing) appears to be sensible and correct. Hopefully, the dicta to the effect that the issuer was precluded from raising a fraud defense (because the fraud defense was not stated in a timely notice of dishonor) will go unused.

6. Independence. The court's reference to the independence principle as a "basic rule of surety law" is an unfortunate typographical error. Independence is one major difference between surety law and LC law.

[JEB/fkd]

COPYRIGHT OF THE INSTITUTE OF INTERNATIONAL BANKING LAW & PRACTICE

The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.