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Note: First Trust & Savings Bank, a Tennessee Bank, (Lender) loaned US$600,000 to Edward and Jerri Smith (Borrowers) whose collateral for the loan included several LCs purportedly issued by Citizens Bank (Issuer), a Kentucky Bank of which Mr. Smith was President at the time.

When the loans became due, Lender sent Issuer a letter demanding payment on the LCs. Issuer responded by seeking declaratory judgment in the state courts of Kentucky. Issuer "alleged that the [Borrowers] obtained the [LCs] by fraud and sought a determination that [Lender] was complicit in the fraud, thereby rendering [Issuer] not liable for payment on the [LCs]."

Claiming diversity of citizenship for purposes of obtaining jurisdiction in the U.S. federal court system rather than the state courts, Lender removed the case to the U.S. District Court for the Eastern District of Kentucky, London Division and moved to dismiss the case. Meanwhile, Issuer moved to remand the case back to the Kentucky state court. The U.S. District Court for the Eastern District of Kentucky, London Division, Reeves, DJ., granted Issuer's motion to remand and dismissed the other motions as moot.

Issuer argued that removal was improper under applicable procedure since there was no unanimity among the defendants because the Smiths had not consented to the removal.

Lender argued that Borrowers were fraudulently joined by Issuer as defendants in the case merely for the purpose of defeating diversity jurisdiction in anticipation of litigation by Lender. Rejecting this argument, the court noted that Lender had not met the burden of proving that Issuer had no valid claims against Borrowers.

The court noted "[Issuer's] action in state court was for declaratory judgment, coupled with a complaint against the [Borrowers] personally for fraud. A significant part of its claim against [Lender] is that [Lender] was complicit with the [Borrowers] in a scheme to defraud [Issuer] by accepting letters of credit it knew to be improper. If this factual allegation is proven, or if [Issuer] establishes that [Lender]...had reason to know the letters of credit were invalid, [Issuer] would be without liability. Consequently, the [Borrowers] would be solely liable to [Lender]. Conversely, a court could determine that the letters of credit were proper (or that [Lender] had no reason to know they were improper), rendering [Issuer] liable on the letters of credit. Under any of these scenarios, a resolution of the declaratory judgment action would necessarily involve all three parties." Therefore, the court concluded that Issuer" has a colorable claim that the [Borrowers] would be a necessary party to a declaratory judgment action over the letters of credit issued." Since Issuer could claim that Borrowers were a necessary party to the case, the court ruled that there was no diversity jurisdiction in this case and Lender could not remove the case to a federal court without Issuer's consent, which was not given.

Comment by James E. BYRNE:

1. An issuer should not be able to escape its LC obligation except under extraordinary circumstances. Here, the court points towards one, namely where the issuer and beneficiary act in collusion to defraud the issuer. Such a circumstance could occur where beneficiary falsified the existence of a loan or where it returned the proceeds of a nominal "loan" to applicant and the economic purpose of the exercise was solely to obtain the LC proceeds. Conversely, the actual disbursement of the loan to borrower would be sufficient to defeat such a claim.

[JEB/az]

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