Article

Note: For tax reasons, Zacky Farms, Inc. (Seller), insisted that in connection with the purchase of a chicken processing facility, Foster Poultry Farms, Inc. (Buyer) issue promissory notes backed by a letter of credit instead of paying cash. Accordingly, Buyer paid US$145,000,000 in cash and issued short-term notes and four 20 year negotiable purchase money notes totaling US$105,676,438.38 to be backed by LCs. Pursuant to the Credit Agreement, Suntrust Bank (Issuer) issued an LC subject to UCP500 in the amount of US$105,723,202.38 to secure three of the four notes. The LC was syndicated to 10 separate financial institutions for 79% of the financing. By agreement with the syndicate of banks, Issuer acted as the administrative agent and its decision regarding the compliance of documents was to be final.

In a corresponding Credit Agreement, Buyer/ Applicant agreed to pay all related fees to Issuer for its own charges and those charges of the members of the syndicate. The Credit Agreement provided for an increase by 2% per annum of fees payable in the event of breach by Buyer. No similar remedy was provided in the event of breach by Issuer. Issuer was also obligated to provide a U.S. $20,000,000.00 revolving letter of credit. The Credit Agreement provided that any changes must be in writing and signed.

It was expected that the letter of credit would follow any transfer of the notes. Accordingly, it contained the following provision regarding transfer:

This Letter of Credit is transferable in its entirety (but not in part) to any successor or assignee of yours which becomes a holder of the Notes in their entirety (but not in part) (your "transferee"), and may be successively so transferred. Transfer of this Letter of Credit to such transferee shall be effected by the presentation to us of this Letter of Credit accompanied by [an] "instruction to transfer" in substantially the form of Appendix D attached hereto, after which we will reissue this Letter of Credit to such transferee in the same form and substance (but not for the nominal beneficiary) as then effective. The Company shall pay to us our customary transfer fee of 0.25% of the stated amount of this Letter of Credit, not to exceed $ 10,000 upon each such transfer occurring.

When the notes were transferred by Seller to two separate trusts (Trusts), Issuer obtained Buyer/ Applicant's permission and effected transfer of the replacement LC by reissuing it as two separate credits in the manner instructed. Similar instructions were given to Buyer regarding payment of the notes. The two transferred LCs were similar to the original credit except that the expiration date was changed from 6 October 2006 to 9 October 2006. However, the notes were not endorsed by the Buyer/Applicant who was the payee and holder of the notes.

The notes anticipated and provided for their "monetization," a process that was set forth in a detailed procedure and that enabled the then-current holder to convert them to cash. The notes provided

"For the purpose of monetizing the Note, Maker [Buyer] agrees, at Holder's [Seller] requests, to provide the most recent annual audited (to the extent available) financial statements of the entities with reimbursement obligations and the guarantor of such obligations under the Letter of Credit to no more than three financial institutions proposed to be engaged by Holder [Seller] for the purpose of monetizing this Note, and to such other financial institutions who may be involved in any syndications of the monetization of this Note as Maker shall consent in writing, such consent not to be unreasonably withheld or delayed, provided, that such financial institutions agree in writing with Maker [Buyer] to keep such information confidential pursuant to the terms of Section 5.15 of the Purchase Agreement and not to share such financial information with any other person (including Holder [Seller]).

This provision was the only one among all the documents that required written consent from Buyer for a monetization of the notes. After approximately one year, the Trusts approached Issuer about monetizing the notes which would constitute extension of a long term loan backed by the notes and the LC. Seller sought the funds for its business operations which were still in competition with Buyer, as was known to Issuer. Issuer expressed interest in monetizing the notes in this manner and disclosed its on-going relationship with Buyer. In summarizing the transaction in an internal document, Issuer recognized that its position could change and urged that it "move quickly". The Judge noted that Issuer decided to move forward with the monetization although it was aware "at that time that a seller and a buyer can have very different interests in the same transaction [and that Buyer] still owed the Trusts millions of dollars." Commitment letters were then signed.

The Judge recited the evidence which revealed various drafts of the monetization agreement with respect to notification of Buyer and obtaining its consent. They included clauses that conditioned the monetization on obtaining consent. The Judge noted, however, that these provisions

did not create an obligation on [Issuer] to obtain written consent from [Buyer] to provide such financial information. Regardless of what these documents specified, they do not modify [Buyer's] prior authorization terms for a monetization set forth in the ... Notes."

When Buyer was approached and requested to consent to the monetization, it refused to do so. There was no evidence that Issuer indicated to it that it had concluded that consent was unnecessary and Issuer's representative testified that there was no indication from Buyer that it objected to the monetization but only to signing the form provided which would entail additional obligations and risks on its part. In evaluating the monetization, Issuer relied on information provided by Buyer and concluded that it was the LC that provided it with assurance. There was no procedure at Issuer by which information related to Buyer was restricted from bank officials making the evaluation of the monetization for the Seller. However, there was no evidence that there was any disclosure of Buyer's confidential information to any third person other than bank employees.

After determining that Buyer would not consent to the monetization, Issuer obtained a legal opinion that endorsement of the notes in blank and their delivery together with the transfer of the LC would satisfy the transfer provisions of the LC. Issuer, however, failed to reissue the LCs which was found by the court to be in violation of the LC requirement. The consequence is that it was unclear who had the power to draw on the LCs. Buyer discovered that the monetization had occurred when Wells Fargo which had issued the LC for the fourth note informed it that the beneficiary had been changed to Issuer.

Taking the position that Issuer had a duty of disclosure as a result of their confidential relationship, Buyer then brought this action against Issuer, alleging breach of contract, of the covenant of good faith and fair dealing, and seeking declaratory judgment and disgorgement of all fees paid in connection with the LCs in the amount of US$ 3,528,519.70 including those paid to Syndicate Banks in addition to the US$ 6,004,886.97 earned in connection with the monetization transaction. After the LCs had expired, Harris Bank issued replacement letters of credit with fees to be paid by Buyers. The court granted summary judgment to Issuer on the claim of good faith and fair dealing and summarily ruled that Issuer had failed to follow the requirements of the LC regarding transfer. The case then proceeded to trial on the remaining questions of liability and damages.

The U.S. District Court for the Eastern District of California, Wanger, J., applying New York law as to the LC and California law as to the Confidentiality Agreement, granted judgment in favor of Applicant/ Buyer because Issuer did not re-issue the LCs to itself. The Judge further ruled that the transfer of the LCs only acted to establish a security interest, and did not make the Issuer the note holder. The Judge concluded that these actions did not amount to gross negligence on the part of Issuer, and that there was not sufficient proof to show that there was a conflict of interest for Issuer to monetize the long term purchase money notes.

The Judge noted that the LCs continued to perform their function despite the transfer, and that Buyer had not been harmed by the transfers despite the breach of the contract. Because there was no actual harm, the breach of the transfer provision was immaterial and disgorgement would have been inappropriate because Buyer received the full benefit of its bargain. The Buyer was awarded nominal damages of U.S. $100.00.

With respect to the breach of contract claim, the Judge ruled that the Credit Agreement between Buyer (applicant) and Issuer expressly incorporated the letter of credit. As a result, the court concluded that failure of the Issuer to follow the provisions regarding transfer regarding re-issuance of the credit on its transfer constituted a breach of contract. The court ruled that transfer provisions under UCP500 "are to be strictly construed." As a result, it concluded that the failure to re-issue the credit on transfer as well as the requirement that the transferee be the holder of the notes were not observed. Issuer failed to re-issue the credit when it was transferred to it and, in any event, it was not a proper transferee since it was not a holder of the notes since they had not been properly endorsed by the original holder.

The Judge, however, concluded that requirements of the LC constituted a constructive condition of the LC and that their breach was not material. He stated that only a material breach would have excused the Buyer from performing a constructive condition under the contract. It noted that Buyer did not terminate the Credit Agreement, that Issuer continued the LCs in force even after the claim of breach became apparent, and that there was no gross negligence by Issuer.

Buyer argued that it was a conflict of interest for Issuer to loan funds to a competitor. The Judge, however, rejected this position. Buyer "did not identify any statute, rule, or banking regulation that prohibits a commercial bank from doing loan business with a customer's competitor." Noting that Buyer received the full benefit of the LCs, the Judge rejected Buyer's arguments that Issuer's profits should be disgorged and, instead, ruled that where there is innocent nonmaterial breach by a party that has fully performed without thwarting the purpose of the contract, nominal damages are appropriate especially where the actual damages cannot be proven with any certainty. The Judge ruled that any liability would be limited to Issuer and not extend to any of the Syndicated Banks since they were without knowledge of Issuer's conduct with respect to the monetized transaction.

Issuer argued that the provisions of the Credit Agreement providing for exculpation would have excused its liability in any event. The Credit Agreement provided that:

"Neither the Administrative Agent [SunTrust], the Issuing Bank [SunTrust], the Lenders nor any Related Party [the syndicate banks] of any of the foregoing shall have any liability or responsibility by reason of or in connection with the issuance or transfer of the Letter of Credit . . . or any error, omission, interruption, loss or delay in transmission or delivery of any draft, notice or other communication under or relating to the Letter of Credit (including any document required to make a drawing thereunder), any error in interpretation of technical terms or any consequence arising from causes beyond the control of the Issuing Bank; provided, that the foregoing shall not be construed to excuse the Issuing Bank from liability to the Borrower to the extent of any direct damages (as opposed to consequential damages, claims in respect of which are hereby waived by the Borrower to the extent permitted by applicable law) suffered by the Borrower or caused by the Issuing Bank's failure to exercise care when determining whether drafts or other documents presented under the Letter of Credit comply with the terms thereof. The parties hereto expressly agree, that in the absence of gross negligence or willful misconduct on the part of the Issuing Bank (as finally determined by a court of competent jurisdiction), the Issuing Bank shall be deemed to have exercised care in each such determination."

The Judge concluded that this provision was not against public policy as argued by Buyer/Applicant and that it operated to limit damages to nominal damages.

Buyer argued that the LCs became meaningless because of the improper transfer and that the purpose of the transaction was thereby frustrated. The court rejected this argument, noting that there is no reason that an issuer cannot become a partial beneficiary under an LC and that the LCs continued to operate to provide security for the Buyer's obligations.

As to the Buyer/Applicant's arguments about the breach of the Confidentiality Agreement, the Judge agreed that Issuer improperly used confidential information for its own purposes without following the procedures set forth in the confidentiality agreement. However, the court ruled that the damages for such a breach constituted those foreseeably caused by the breach measured by its natural and probable consequences. Noting that the parties could not be placed in their original positions, the Judge concluded that damages were warranted since Issuer "was able to utilize more of [Buyer's] financial information than was authorized to make two Term Loans to the Trusts from which [Issuer] earned interest and fees for its sole benefit." Although the losses were difficult to calculate, the Judge ruled that Issuer's "gains from the breach of the Confidentiality Agreement are specifically quantifiable and represented by the amount of interest and fees earned under the Term Loans to the Trusts." The Judge ruled that disgorgement of these profits was an appropriate remedy for Issuer's breach because Issuer "exploited its position and knowledge it acquired through its confidential relationship as trusted banker to the Plaintiffs. This financial information was confidential and had a business value similar to trade secrets. [Buyer] had the sole right to use and benefit from this information. [Issuer] was able to enter into the monetization of the LTPM Notes by its misuse of the [Buyer's] confidential information and earn interest under the Terms Loans to the Trusts." However, since Buyer/Applicant delayed considerably in pursuing its remedies, the Judge applied the equitable doctrine of laches to limit the remedies to the time from the filing of the suit to the expiration of the LCs, namely from 15 March 2004 to 9 October 2005.

[JEB/krp]

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