Article

Factual Summary: Enron North America, a subsidiary of Enron Corp., J. P. Morgan Chase, and Mahonia Ltd., a special purpose vehicle created for this transaction by the other parties, entered into three back to back swap transactions. In effect, JPMC paid Mahonia $350 million under the Mahonia/JPMC swap and Mahonia paid this sum to Enron NA under the Enron NA/Mahonia swap. Enron NA was to pay JPMC the sum of $355,961,248.40 approximately six months later.

To assure fulfillment of Enron NA's obligations under one of the swap agreements, its parent, Enron Corp., applied for and obtained a standby issued by WestLB in favor of Mahonia for $165,000,000.

Mahonia demanded payment of the full amount of the LC by presenting the required "Event of Default Statement" three days after Enron NA and its parent Enron Corp. filed for bankruptcy protection under Chapter 11 (reorganization) of US Bankruptcy law. Issuer dishonored, asserting illegality.

Issuer claimed that Applicant's purpose in entering the three swaps transactions was to obtain a loan without showing it as such on its accounts contrary to applicable US accounting standards. Issuer alleged that such a deviation would have constituted a breach of US securities laws if those accounts had been filed with the S.E.C., and could lead to criminal and civil liability under US law.

The bulk of this very long decision addresses whether Enron, the applicant, and Enron NA knowingly improperly accounted for the three related swap obligations and, to a lesser extent, whether JPMC was a party to that improper activity and, if so, whether Mahonia, the beneficiary, was also a party thereto. The opinion answers these questions in the negative and explains the basis therefor. Of chief interest to LC specialists are the court's concluding statements that illegality in the underlying transaction is a defense that a dishonoring issuer may raise against a complicit beneficiary.

Legal Analysis:

1. Illegality Defense: The trial court held that "illegality", like "fraud", is an exception to the LC independence principle and that "illegality" excuses dishonor of an apparently complying demand:

432. ... For the reasons essentially set out by Colman J in July 2003 [Mahonia Ltd. V. JP Morgan Chase Bank, [2003] 2 Lloyd's Rep 911] ..., I would not have held that the "autonomy" principle of letters of credit required a different conclusion. If the L/C had played a part in an overall scheme of the magnitude alleged, to deliberately mislead by wrongful accounting, contrary to section 10(b) of the Exchange Act 1934, and [the beneficiary] had been complicit therein, public policy would, in my view have required the court not to lend its aid to the enforcement of the L/C ... .

The illegality defense in Mahonia was based on allegations that Enron intended to and did publish financial statements in violation of GAAP and filed public company reports in violation of US securities laws. The primary violator would have been the applicant. The nature of the violation would have been securities fraud on the market, and not fraud within the "fraud" exception to LC independence.

Comments:

1. The LC independence (or "autonomy") principle protects, among other things, the beneficiary's rights under an LC that is procured by applicant fraud on the issuing bank. It should take something like an active conspiracy between an insolvent applicant and a solvent beneficiary to defraud an issuing bank, before LC law allows an applicant's fraud to be converted into an excuse for dishonoring the beneficiary's draw. LC law should not allow an issuer (or the applicant) to convert an applicant's willingness to violate securities laws into an excuse for dishonoring an LC obligation.

2. Revised UCC 5-109 spells out the exceptions to the "independence" principle and limits them as follows: "a required document is forged or materially fraudulent or that honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant ...". The exceptions do not include "illegality". Banks issuing letters of credit will observe a court injunction or other government order that prohibits payment under an LC, but only if the prohibition on LC payment is clear. Declarations that the underlying obligation is illegal and unenforceable will not do. In such cases relief based on illegality must be sought after the bank pays.

3. Mahonia creates another split between US and English law on LC obligations, and one that favors the US when it comes to choosing the law governing standbys that are intended to cover obligations that might later be alleged to be illegal as unreasonable liquidated damages or as unreasonable executive compensation or as payment for securities issued without sufficient disclosures, etc.

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