Article

Factual Summary: In connection with an agreement to form a new jointly owned company, Slovenian Buyer agreed to purchase two types of composite fiber manufacturing equipment from US Seller. One type was to be delivered within 14 weeks of receipt of the down-payment and the other 14 months later. To protect Buyer's deposit of US$550,000 for the second equipment type, Seller obtained a standby in that amount issued by a U.S. bank located in Texas. The standby required presentation of a sight draft accompanied by a signed statement.

As explained in the opinion, the statement recited that:

"[t]he delivery deadline under the Equipment Agreement had passed, [Beneficiary/Buyer] had examined the equipment supplied by [Applicant/ Seller], and [Beneficiary/Buyer] had refused acceptance of the equipment because:

A. It does not meet the fabrication drawings or specifications presented by [Applicant/Seller] prior to manufacture, and/or

B. It does not meet European Union/ANSI standards for safety and environmental protection, and/or

C. It is not in accordance with the best available technologies, and/or

D. It is not properly operational after a weeklong performance test, and any defects in construction or installation of the equipment were not remedied within an agreed upon time frame, and/or

E. The delivery of equipment does not otherwise conform materially to the contract between [Beneficiary/Buyer] and [Applicant/Seller] giving the buyer just cause to dispute payment."

Although there were problems and difficulties, Buyer and Seller continued to collaborate until Beneficiary/Buyer notified Applicant/Seller that it was revoking the order for the second type of equipment, canceling the contract, and drawing on the standby.

When Beneficiary/Buyer presented documents to claim the full amount of the standby letter of credit, Applicant/Seller filed this action and obtained a temporary restraining order against payment by Issuer. Claims and counterclaims were filed relating to the underlying contract. Issuer was given leave not to participate in the trial which resulted in a judgment declaring the standby letter of credit void and awarding damage to Appellant/Buyer on the contract. On appeal, the intermediate appellate court reversed the finding that there was material fraud justifying voiding the letter of credit, but affirmed the trial court's decision as it found that the error was not reversible because it concluded that Beneficiary was not entitled to recovery for wrongful dishonor and the dispute between Applicant and Beneficiary was settled.

Legal Analysis:

1. Independence; Limitations as between Applicant and Beneficiary; Injunction, Ultimate Right to Funds; Allocation of Risk: While noting the independence of the LC obligation, the appellate court noted that "payment of a letter of credit does not determine the ultimate right to retain the funds as between the beneficiary and the applicant." It noted that "[t]he beneficiary's immediate right of possession of the funds on payment of the letter of credit does not decide the dispute over who will ultimately retain those funds", concluding that "the letter of credit determines the beneficiary's right to immediate possession of the funds on presentation of conforming documents to the issuer, but not the right to ultimately retain those funds."

2. Material Fraud; Rev. UCC Section 5-109; Void: Noting that Rev. UCC Section 5-109 provided that honor of a LC could not be prevented absent material fraud, the appellate court explained that standard as "the wrong doing of the beneficiary has so vitiated the entire transaction that the legitimate purposes of the independence of the issuer's obligation would no longer be served," quoting from GATX Leasing Corp. v. DBM Drilling Corp., 657 S.W.2d 178, 182 (Tex. App.-San Antonio 1983, no writ).

3. Fraud, Elements of a Cause of Action: The appellate court noted that: "The elements of a cause of action for fraud are: '(1) that a material representation was made; (2) the representation was false; (3) when the representation was made, the speaker knew it was false or made it recklessly without any knowledge of the truth and as a positive assertion; (4) the speaker made the representation with the intent that the other party should act upon it; (5) the party acted in reliance on the representation; and (6) the party thereby suffered injury." It also indicated that the fraud must be "extreme, intentional, and unscrupulous".

4. Stipulation; Injunction: The court noted that the stipulation between Issuer, Beneficiary, and Applicant required Issuer to pay the proceeds of the LC as directed by the court after a trial on the underlying issues and the parties waived any claims that they had against the bank. Accordingly, the appellate court ruled that "regardless of whether the trial court properly enjoined the Bank from honoring the letter of credit, [Beneficiary/Buyer] is not entitled to the requested judgment against the Bank." However, because the parties claimed attorney's fees, the court considered the propriety of the injunction.

5. Void; Injunction; Rev. UCC Section 5-109 OC 5: The appellate court noted that a declaration that the standby was void "has the same effect as a permanent injunction against payment", citing Rev. UCC Section 5-109 Official Comment 5 to the effect that "same principles apply when applicant tries to achieve same legal outcome as injunction against honor by other methods including declaratory judgment."

6. Material Fraud, Breach of Underlying Agreement: Applicant argued and the trial court agreed that Beneficiary had breached the underlying agreement. The appellate court ruled that "breach does not constitute material fraud permitting a court to enjoin payment of the letter of credit." The court also noted that drawing on the standby before permitting the applicant to perform also was a contractual dispute that did not constitute material fraud.

7. Material Fraud, Incorrect Term in LC: The LC contained a required statement that did not correctly reflect the terms of the underlying agreement, namely that both types of equipment had to be delivered by the earlier of the two dates agreed, thereby making it easier than intended for the Beneficiary/Buyer to draw. Applicant argued and the trial court agreed that Beneficiary's knowledge of this error and failure to call it to the attention of Applicant constituted material fraud. The appellate court noted that the silence of the Beneficiary did not constitute fraud absent a duty to speak and that there was no duty where the evidence did not establish that the Beneficiary did not know that Applicant had not had an opportunity to inspect the LC.

8. Material Fraud, False Statements; Material Fraud, White Lies: Applicant argued and the trial court found that there were several statements made by Beneficiary in the documents that constituted material fraud. The statements related to issues of quality and performance. Beneficiary argued that its interpretation of the contract terms justified these statements.

The appellate court stated that "The evidence supports the trial court's findings that [Beneficiary/ Buyer] made false statements to the Bank in presenting the letter of credit. However, false statements in the presentment documents are insufficient to warrant enjoining payment of the letter of credit. ... Establishing material fraud or fraud in the transaction requires more than a showing of untruthful statements in the presentment documents." It also stated that "Such false statements in making presentment would not amount to egregious fraud vitiating the transaction and warranting a declaration that the letter of credit is void."

Comment:

In this sensible decision, there is only one line of analysis that is troubling, namely the appellate court's analysis of the claim of material fraud resulting from the failure of the beneficiary to inform the applicant of terms of the LC that did not conform to the underlying contract. The court concluded that such a failure could not be fraud under traditional common law analysis relating to whether silence could constitute fraud or misrepresentation, concluding that there was no evidence to show that applicant was not aware of the LC terms. There is an implication, however, that there would be material fraud were the beneficiary aware that the applicant did not know of the LC terms. While this analysis is proper for non-LC fraud, there is some question as to whether or not it is appropriate for LC fraud. Where a beneficiary recites terms that are contained in the LC and that are true but that do not reflect what was agreed in the contract, it is difficult to conclude that material LC fraud has been perpetrated. Where the statements required by the LC are not true, then the issue should be analyzed on the same basis as the court analyzed such statements in this case, namely that they relate to the underlying contract.

[JEB/kvc]

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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.