Article

Factual Summary: In connection with the development of underdeveloped land, Buyer agreed to purchase a tract of land from Developer. To assure payment, Buyer/Applicant's bank issued a standby LC for US$250,000 in favor of Developer/ Beneficiary.

When the development plan failed, Developer/ Benficiary sought protection under Chapter 11 (reorganization) of US Bankruptcy law and rejected the real estate purchase agreement. Claiming that there was a default on obligations owed to the local governmental water and sanitation district by the subdivision, the local governmental unit obtained relief from the automatic stay imposed by the bankruptcy filing, and foreclosed its lien on the property, including the lots that were to be purchased by Applicant. Despite having rejected the purchase agreement and having lost the land to be sold to foreclosure, Beneficiary still sought to draw on the standby, claiming (correctly) that the Applicant did not purchase the undeveloped lots.

To prevent the threatened drawing, Applicant brought an adversary proceeding against Beneficiary for an injunction in the bankruptcy court. After failing to resolve the issue through mediation, Applicant filed a motion for permanent injunction, which the court granted.

Legal Analysis:

1. Bankruptcy; Independence: The court noted that letter of credit issues "fit so 'uncomfortably' in a bankruptcy case" because the obligation of the issuer is independent from the agreement between Applicant and Beneficiary.

2. Interpretation: The court noted that: "A general proposition of contract law that courts have applied to letters of credit is 'to take the words as strongly against the issuer as a reasonable reading will justify.'"

3. Interpretation: The court noted that it is preferable that the terms of an LC be constructed to make the LC vaild and enforcable. The court stated that: "[t]his means that, generally, the issuer/bank cannot litigate the performance of the underlying contracts. The issuer of a letter of credit cannot look to the underlying transaction to supplement or interpret the terms of the letter of credit." The court also stated that "The issuer cannot look to a course of dealing or performance to justify dishonor of a facially conforming demand, since to do so would inject a complex litigable issue into every wrongful dishonor case."

4. Contract, LC Not a Contract: The court stated that "[a]lthough a letter of credit is often loosely referred to as a contract between the issuer and beneficiary, 'the relationship between issuer and the beneficiary is statutory, not contractual.'" Ward Petroleum Corp. v. Federal Deposit Ins. Corp., 903 F.2d 1297, 1300 (10th Cir. 2005) (quoting Arbest Const. Co. v. First Nat'l Bank & Trust Co., 777 F.2d 581, 583 (10th Cir. 1985).

5. Fraud; Abusive Drawing: Noting that "courts have shown a general reluctance to enjoin the payments provided in that letter", the court stated that "[t]he independence principle is not without limitation." "Therefore, although the U.C.C. and the case law narrowly circumscribe the exceptions under which a court can enjoin an issuing bank from making payment on a letter of credit, they also illustrate that 'the law of fraud' is not static and the courts have, over the years, adapted it to the changing nature of commercial transactions in our society.' Dynamics Corp, 356 F. Supp. 991, 998 (1973) (citing S. E. C. v. Capital Gains Research Bureau, 375 U.S. 180, 192-195, 11 L. Ed. 2d 237, 84 S. Ct. 275, 283 (1963)). The Capital Gains case involved a security broker's tactics of recommending certain stock to customers, without disclosing his own holdings of the stocks and then selling his interests once the purchases by others raised the stocks' values. In Capital Gains, the Supreme Court noted that in a suit for equitable relief, it is not necessary that plaintiff establish all the elements of actionable fraud required in a suit for monetary damages, and it quoted with approval the following definitions of 'fraud' in equity jurisprudence: 'Fraud has a broader meaning in equity [than at law] and intention to defraud or to misrepresent is not a necessary element,' 375 U.S. 180, 193-94, 11 L. Ed. 2d 237, 84 S. Ct. 275, 284 (quoting De Funiak, HANDBOOK OF MODERN EQUITY (2nd ed. 1956), 235); and 'Fraud, indeed, in the sense of a court of equity properly includes all acts, omissions and concealments which involve a breach of legal or equitable duty, trust, or confidence, justly reposed, and are injurious to another, or by which an undue and unconscientious advantage is taken of another.' 375 U.S. 180, 193-94, 11 L. Ed. 2d 237, 84 S. Ct. 275, 284 (quoting Moore v. Crawford, 130 U.S. 122, 128, 32 L. Ed. 878, 9 S. Ct. 447, 448 (1889)."

6. Fraud; Revised UCC Section 5-109; Prior UCC Section 5-114: In considering the type of fraud necessary to justify enjoining honor under Revised UCC Section 5-109, the court looked to case law developed under Prior UCC Section 5-114. The court noted that "although the wording of the fraud exception differs between the original version (fraud in the transaction) and the current version (material fraud), both formulations refer to the same behavior. Material fraud does not need to occur at the inception of the agreement, but the lack of any performance by the beneficiary may make the demand for payment fraudulent in and of itself."

7. Contract; Breach of Contract; Contract, Breach: Beneficiary argued that its agreement with Applicant either was not a contract or was an executory contract subject to being assumed or rejected, and was independent from the LC obligation. The court found that Beneficiary's principal did not believe that a contract existed between Applicant and Beneficiary, but the agreement was only a letter of intent. The court decided that it "cannot reasonably find that [Beneficiary] can enforce the Agreement so as to demand payment of the LOC provided for therein" when Beneficiary did not believe and had acted consistently with the position that no contract existed between the parties. The court further stated that "[e]ven assuming that the Agreement does represent a valid contract between the parties, the Court cannot conclude, under the circumstances of this case, that [Beneficiary] should be allowed to make demand under the LOC."

8. Injunction; Standard of Injunction; Injunction, Standard; Injunction, Relative Harm: In considering the equitable factors related to injunctive relief, the court found that Applicant would suffer irreparable harm. "For the Court to deny the injunction would facilitate [Beneficiary's] fraud. [Applicant] should not be put to the burden of relitigating identical issues in another action to remedy the fraud which should have been prevented in this proceeding." It also concluded that harm to Applicant outweighed that to Beneficiary which "suffers no legally cognizable harm." It also concluded that there was no harm to the public interest by enjoining Beneficiary's fraudulent behavior.

Comments:

1. The facts in this case offer a classic illustration of an abusive drawing, that is, one in which the beneficiary's improper actions create the default that triggers the drawing on the LC.

2. While application of the rules related to LC fraud are correct in this case, the extensive reference to the expansive definitions of fraud in US security laws (noted above in paragraph 5), is unsettling. These definitions were intended to protect the integrity of the equities market and, accordingly, must be flexible and expansive. Letter of credit fraud is quite different. There are no retail users to protect and the definition, if regarded expansively, would undermine the independence of the LC.

[JEB/lhd]

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