Article

Factual Summary: To ensure satisfactory completion of contracts to construct power plants for two Beneficiaries, Applicant obtained two LCs from Issuer, one in favor of each Beneficiary, in lieu of retention of 10% of the amount paid to Contractors. One LC provided that First Beneficiary could draw if Contractors, subsidiary companies of Applicant, "failed to fulfill any or all of the conditions of the construction contracts." The other provided that Second Beneficiary could draw if Contractors "failed to perform in accordance with" the contract. One of the LCs increased over time to correspond with the amounts due.

When Applicant filed for bankruptcy, the subsidiary Contractors were unable to access funds that had been "swept" by Applicant, and could no longer pay subcontractors and suppliers. First Contractor and Beneficiaries entered into an agreement stipulating that First Contractor had not performed its obligations under the construction contracts, and each Beneficiary drew on its LC with a certificate asserting entitlement, which were honored by Issuer.

Unable to obtain reimbursement due to the insolvency of both Applicant and First Contractor, Issuer commenced a proceeding against Beneficiaries in the U.S. District Court, which referred it to the Bankruptcy Court. The Bankruptcy Court granted Beneficiaries' motion to dismiss Issuer's original complaint, but granted Issuer leave to replead its "direct fraud claims." Issuer filed an amended complaint seeking damages for fraud and breach of warranty owed by an LC beneficiary to issuer under the Florida and New York UCC. Issuer also claimed it was entitled to be subrogated to the rights of Applicant to assert the breach of warranty rights against the Beneficiaries.

On Beneficiaries' motions, the Bankruptcy Court dismissed the Issuer's amended complaint and denied its request for leave to amend the complaint to include the subrogation claims.

Legal Analysis:

1. LC Fraud; Interpretation; Plain reading: Issuer alleged that the agreement between Contractors and Beneficiaries was based on the pretense that conditions for the drawing of the LCs were present when, in fact, that was not the case. Specifically with respect to First Beneficiary, Issuer alleged that the conditions of the LC required that there be an actual default on the underlying contract before First Beneficiary could draw. First Beneficiary argued that in order to draw on its LC, it was not required to certify that a default had occurred, only to certify that the Contractors had failed to fulfill any or all conditions of the contracts.

The bankruptcy court stated that "ordinarily a court interprets the plain meaning of a contract as evidenced by the terms used by the parties. While most regard letters of credit as 'unique commercial instruments,' nevertheless, it is acknowledged that traditional contract principles apply to the extent that they do 'not interfere with the unique nature of credits.'"

The court determined that "the plain reading of [First Beneficiary's] Letter of Credit does not include a requirement that there be a default prior to a draw. Rather, it merely requires that [First Beneficiary] certify that [Contractors have] failed to fulfill a condition of any of the [contracts]."

The court explained the role of the LC as a substitute for retainage under which Beneficiaries could secure the payment of performance-related damages. The court found that when Applicant filed for bankruptcy, leaving its subsidiary Contractors unable to pay the subcontractors and suppliers, First Subsidiary's drawing of the LC was consistent with the purpose of retainage, which is to insulate the owner from having to go out of pocket to pay the claims of subcontractors and suppliers.

The court concluded that "even accepting all of the facts alleged by [Issuer] as true, the draws by [Beneficiaries] on their respective Letters of Credit were warranted and there was not any fraud. The trigger for the draw by [First Beneficiary] was that [Contractors] were 'unable' at the time of Enron's bankruptcy filing, which was 'during the course of performance of the Work,' to provide 'sufficient material, equipment, services [and] labor to timely perform the Work.' Without funds, [Contractors] were 'unable' to provide these items. [Second Beneficiary's contract] required [Second Contractor] to pay its debts as they came due. Again without funds, [Second Beneficiary] could not pay its debts as they came due."

2. Subrogation: Issuer alleged that it was entitled to subrogation to Applicant's claim for the LCs and to assert the warranty rights owed to Applicant by Beneficiaries. Beneficiaries argued that Issuer's subrogation claim was contrary to an order of the bankruptcy court that the Issuer could only replead its direct claims for fraud in its amended complaint.

The court pointed out that Issuer's original complaint acknowledged that the insolvency of the Contractors left them unable to pay their subcontractors and suppliers, which defeated Issuer's claim of fraudulent assertions in its amended complaint. The court stated that "[Issuer] does not assert that the original allegations concerning the result of the Swept Cash were inaccurate. Rather, it merely seeks to manipulate the pleading by omitting the allegations that defeat its claim because the allegations establish that the [Beneficiaries] were justified in drawing on the Letter of Credit."

With this in mind, the court denied Issuer's "request for leave to amend the complaint to assert the subrogation claims as any such amendment would be futile because the Court would not permit [Issuer] to omit its previous admissions without an adequate explanation. Further, including those admissions as part of the Amended Complaint defeats the claims for relief based upon subrogation to [Applicant]'s rights."

[JEB/adk]

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