Article

Factual Summary: As a condition to further financing for a construction loan, Developer was required to provide an additional US $1 million in the form of an LC in favor of Lender. In order to obtain the LC, Applicant agreed with Developer that Applicant would procure the LC. The letter of credit required presentation of a draft and of the following signed and dated statement:

The undersigned, an authorized officer of [Lender,] hereby certifies, under penalty of perjury, that all funds have been advanced (less any interest reserve) to [Developer] under or in connection with that certain construction loan promissory note (the "Note") dated as of June 27, 2003 in the aggregate amount of $4,500,000 established by [Lender] in favor of [Developer], an "Event of Default" (as defined in the Note) has not occurred, no event exists that may, with the passage of time, constitute an "Event of Default", [Developer] is currently not in default, [Lender] has notified [Surety] of the intended drawing under the [Issuer] Letter of Credit No. NZS488105, [Lender] will disburse the proceeds of this Letter of Credit to [Developer] solely for the development and construction of the Project and such funds shall not be used by [Lender] for any other purpose, including, without limitation, retiring any portion of the Note, and [Lender] is now drawing the sum of {insert amount}.

Before the letter of credit was issued, Applicant proposed a side letter of agreement that stated that a drawing would not occur in the event of default and that the LC would only be utilized after the proceeds of the loan were disbursed. Beneficiary's response did not include these provisions, and the existence of such a contract was an outstanding issue of fact.

Over the course of the year, Beneficiary/Lender provided an additional US $1 million in loans, and drew the full $1,000,000 on the LC although aware that Developer had increased the scope of the project, adding another $1,000,000 in construction costs, thereby creating concerns about Developer's ability to repay the loans. Additionally, Developer had not paid its real estate taxes for the first half of the year. Beneficiary did not inform Applicant of its concerns about the project.

At the end of the year, Beneficiary declared Developer to be in default on its loan, and Developer defaulted on its letter of credit agreement with Applicant/Surety. Beneficiary's position as the first mortgagee rendered it likely that Applicant's mortgage would yield no proceeds to Applicant. Applicant then sued Beneficiary for breach of contract, tort, and equitable claims. The trial court granted Beneficiary's motion for summary judgment. On appeal, reversed and remanded.

Legal Analysis:

1. Independence Principle; Statutes of Limitations; Scope; Rev. UCC § 5-103

Beneficiary argued that the only connection between Applicant and Beneficiary was the letter of credit, making Applicant's actions time-barred by the one year statute of limitations of Revised UCC § 5-115 (Statute of Limitations). The trial court concluded that "the sole relationship between [Applicant] and [Beneficiary] was the letter of credit, that [Applicant's] sole line of recovery is under Article 5's warranty provision, and that Article 5's statute of limitations barred [Applicant's] claims." Relying on Krause v. Stroh Brewery Co., 240 F.Supp.2d 632 (E.D.Mich. 2002), a decision that treated the plaintiffs' claims for conversion, breach of contract, and negligence, as having arisen under the letter of credit agreement and as being time-barred by Revised UCC Article 5's one-year statute of limitations, the trial court decided that the "sole line of recovery" was based on the letter of credit.

Admitting that the claim was filed more than one year later, Applicant argued that Revised UCC Article 5 "does not displace all legal and equitable principles associated with letters of credit transactions and that he may therefore maintain his cause of action in contract, tort, and equity."

The appellate court considered the scope of Revised UCC Article 5 as stated in Revised UCC Section 5-103(1) (Scope), noting that it applies to "letters of credit and to certain rights and obligations arising out of transactions involving letters of credit." The appellate court also cited Official Comment 2 to Revised UCC Section 5-103 which notes that it will be necessary to turn to other principles of law to determine principles applicable to transactions related to letters of credit and that it may not expressly address issues related to letters of credit themselves. The appellate court then determined that Applicant's claims did not all arise under Revised UCC Article 5.

The claims were for "(1) breach of contract for drawing on the letter of credit when [Developer] was in default of the construction loan, (2) breach of contract for failing to pay [Applicant] 10 percent of the proceeds from the [Beneficiary's] sale of condominium units after it foreclosed on the construction loan, (3) promissory estoppel based on the [Beneficiary's] promise not to draw on the letter of credit if [Developer] was in default, (4) negligence in certifying that [Developer] was not in default, (5) negligent misrepresentation based on the [Beneficiary's] statement that it would honor [Developer's] assignment of 10 percent of the proceeds from the construction project, (6) conversion, (7) money had and received, and (8) negligence in failing to advise [Applicant] of changes in the scope of the construction project."

The appellate court declined to follow Krause, stating that it overlooked the independence principle in failing to recognize the separate contractual relationship between the beneficiary and the applicant. The appellate court pointed to applicant's claim that there was a contractual relationship between it and beneficiary as a result of the exchange of letters. The appellate court concluded that separate contract and tort claims existed "[although] these claims may rely on the same alleged conduct that would be subject to an Article 5 warranty claim."

2. Revised UCC § 5-110; Warranty:

Beneficiary argued that all of Applicant's claims arose under the warranty contained in Revised UCC § 5- 110(a)(2) (Warranties) which provides that "if the presentation is honored, beneficiary warrants ... to the applicant that the drawing does not violate any agreement between the applicant and beneficiary...." The appellate court rejected Beneficiary's highly technical reading of "any agreement" as referring only to letter of credit agreements as unsupportable.

The appellate court concluded that the purpose of Revised UCC § 5-110 was not to replace any breach of contract claims that an applicant may have with a breach of warranty claim, citing its Official Comment 2 which provides that "[in] most cases the applicant will have a direct cause of action for breach of the underlying contract." The appellate court found that this language supported Applicant's position that while a breach of contract claim may complement a breach of warranty claim, the breach of warranty claim does not subsume the breach of contract claim.

3. UCC § 5-110 Warranty;

Beneficiary argued that the warranty provision of Revised UCC Section 5-110 "has primary application in ... circumstances where the applicant is not a party to an underlying contract with a beneficiary", as noted in Official Comment 2 to Revised UCC Section 5- 110. Beneficiary pointed out that the transaction underlying the letter of credit was the loan agreement between Beneficiary and Developer.

The appellate court rejected this characterization of the relationships, pointing out that while the warranty provision in Article 5 may have "primary application" to situations where there is no contract between the applicant and beneficiary, it does not encompass all situations where no contract between the applicant and beneficiary exists. The appellate court also noted that Applicant alleged that there was a contract between Applicant and Beneficiary, concluding Applicant was not prevented by the Revised UCC Statute of Limitations from pursuing these claims.

Comments:

1. Certain Rights and Obligations Arising Out of Transactions Involving Letters of Credit.

Unfortunately, the appellate court has missed what is the essential question in the application of the Revised UCC Article 5 statute of limitation. Its purpose was to impose a rather short time bar on claims based on rights and obligations arising from a letter of credit and to certain letter of credit transactions. There is no doubt that Applicant's claims were not predicated on a letter of credit. Therefore, the question is whether or not the rights and obligations that it was asserting were of the sort that fell within the scope of Revised UCC Article 5.

The appellate court notes that UCC Section 1- 103 provides for judicial access to principles of law and equity in order to determine matters not specifically addressed by the UCC. As an aside, it fails to note the reference in that section to the law merchant which would seem to be more appropriate to a matter related to a letter of credit. This reference is, however, not the end of the process of analysis, as the appellate court seems to think, but only the beginning. The question is whether drawing on general principles of law supplementary to Revised UCC Article 5 including the law merchant, the claims being asserted were of the type that the drafters intended to be short-lived or whether they should have the type of longer life that would be available outside of the rarified atmosphere of Revised UCC Section 5- 115.

Under the general principles of law, for example, courts regularly refuse to allow parties to raise claims in tort that overlap those that sound in contract where the gravamen of the claim is contractual and the tort claim is duplicative. Therefore, the appellate court should have scrutinized the claims raised by the Applicant with a view towards principles of judicial economy, asking whether they were essentially claims that arose from the letter of credit relationship. It was this type of analysis that led the Krause court to conclude that the claims asserted were essentially letter of credit-related claims. Whether its conclusion that they were was correct or not should not bind other courts regarding other claims but it should influence the analysis to be undertaken. If Krause is too broad (and in that case it is unclear that there was any other relationship), the language of the Alhadeff decision is too narrow.

Without access to the details of the communications between the applicant and beneficiary, it is difficult to reach any conclusions about whether the claims essentially arose out of a transaction relating to a letter of credit. On its face, the transaction appears to be one of those in which the applicant and beneficiary were linked only by the letter of credit. The role of the applicant was that of a surety for the Developer. The applicant had a contractual relationship with its bank, the Issuer, and with the principal debtor, the Developer. If the communications were merely incidental to the letter of credit that was the form of assurance, then they should not be raised to the level of a separate relationship and should fall within the Revised UCC Article 5 time frame. On the other hand, if there was a contractual relationship involving a bargained for exchange between the two parties, then they also have a contractual relationship that would give rise to dual causes of action.

2. Whatever the outcome of this analysis, it is doubtful if the multiplicity of causes of action asserted (seven in all) should be allowed.

This laundry list of actions appears to be a shotgun like approach to a situation where the pleader had to generate a claim on an alternative basis in order to avoid the statute of limitations. Such attempts to create multiple claims should be rejected based on the very principles of law and equity (and the law merchant) that supplements the UCC and certainly should not be allowed to displace UCC rules where they are the only basis on which a party can predicate its claim.

3. Four Party Letter of Credit Transaction:

The appellate court engages in an interesting discussion of what it describes as a "four party letter of credit transaction", a notion built on the so-called "three party" paradigm which is superficially used to explain the various relationships surrounding a letter of credit in many judicial opinions and in some of the literature. This new twist apparently involves a situation where there is a surety that enters into a relationship with the beneficiary of the suretyship promise that differs (presumably) from the undertaking of the surety to it (at least where that undertaking is in the form of a letter of credit issued by a third party). Hopefully, this new diagnostic tool will not encourage courts to sketch out the relationships between all the parties to the various underlying transactions and the parties to the LCs, such as carriers, inspectors, freight forwarders, etc. If so, we will soon be visited with a 10 party LC. Oh well, the more the merrier.

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