Article

Factual Summary: As an earnest money deposit for the pre-construction purchase of two condominium units, Purchasers obtained LCs in favor of Developer. The purchase agreements stated that on default by the Purchasers, Developer "shall draw on the existing Letter of Credit in whole and create with the proceeds thereof a cash Deposit to be placed with Escrow Agent, with said funds to be delivered to [Holiday Isle] as liquidated damages." [2] It also provided that the units were to be completed within two years of 1 April 2005, and that disputes were subject to arbitration pursuant to the American Arbitration Association rules (AAA) but not by the AAA. Although Certificates of occupancy were issued on 28 March 2007, but Purchasers refused to close the transaction on the ground that the units had not been completed within the time frame although a pre-closing inspection of the units had taken place on 2 April 2007.

When Developer refused to return the LCs, Purchasers sued Developer seeking a temporary restraining order to prevent drawing on the LCs, a declaratory judgment, rescission of the purchase contract, and a permanent injunction. Developer's motion to compel arbitration pursuant to the agreement was granted. Developer opposed entry of an injunction on the ground that there was want of jurisdiction. The state trial court appointed an arbitrator and issued a preliminary injunction. On appeal, reversed.

Legal Analysis:

1. Jurisdiction. Developer/Beneficiary argued that the trial court lacked jurisdiction to issue an injunction in light of the arbitration agreement which did not reserve jurisdiction to grant equitable relief. Purchasers/Applicants responded that at the time that the order was entered there was no other tribunal that could grant extraordinary relief. They also noted that the American Arbitration Association Rule R- 34(e) provides for interim measures from a judicial authority. Applying these rules, the appellate court decided that the trial court had jurisdiction to preserve the status quo by an equitable order.

2. Revised UCC Article 5, applicability. Purchasers/Applicants argued that Revised UCC Article 5 and related LC jurisprudence was displaced by the Alabama Uniform Condominium Act (AUCA) § 35-8A-110 et seq., Ala.Code 1975. The Act provides that an escrow must deposit money he held until the closing, a default, or a refund. Purchasers/ Applicants argued that "their letters of credit do not exist independently of the underlying transaction to purchase the condominiums" and that the Alabama Condominium Act provides that "the depository party has a duty of some care in being persuaded by a developer that the buyer has defaulted" [5]. The appellate court rejected this argument. It concluded that the statute did not "operate to preclude the parties from entering into an agreement in which, in lieu of an earnest-money deposit, a standby letter of credit is issued by a neutral bank and is payable to the beneficiary upon the purchaser's default." [Emphasis in original] [5] The court noted that the Purchasers/Applicants do have a remedy of an action of law if the default is not sufficiently established.

3. Injunction. Beneficiary/Developer argued that under Alabama law "it is well settled that the unique nature of letters of credit makes enjoining a letter of credit inappropriate." Beneficiary/Developer noted that the Supreme Court of Alabama had reversed every injunction issued by a trial court preventing a beneficiary from drawing on a letter of credit. The appellate court agreed, referencing the independent character of an LC. It stated that "t]he purchasers bargained for the advantages and disadvantages of electing to use a letter of credit in lieu of cash to satisfy their earnest-money deposit on the purchase of the their condominium units, and the fact that the AUCA provides that a deposit for a condominium unit is kept until default occurs does not protect a purchaser from the universal rule that an injunction preventing a beneficiary from drawing on a letter of credit is inappropriate." The opinion further stated "This Court is committed to a narrow interpretation of the fraud exception to the general rule against the issuance of injunctions in letter-ofcredit transactions."

Dissent: In an opinion in which he was joined by another Justice, the Chief Justice dissented, reciting various factors that suggested that the agreed condominium units were not completed because construction was ongoing beyond the two year completion date. For example, it was necessary to wear hard hats for the pre-closing inspection, the reception area was not glassed in, an elevator did not appear to work, the parking deck was not complete, and there were workers still laboring in their units. He also noted that the escrow agent designated in the purchase agreements had resigned and been replaced by another agent who delivered the LCs to the Developer/Benficiary.

The Dissent stated that permitting a drawing on the LCs before arbitration was completed would frustrate the purpose of the AUCA. "If [Developer] is allowed, as the majority holds, to negotiate the letters of credit before arbitration is completed, the purpose of the Alabama Legislature in enacting § 35-8A-410 will be frustrated. The possibility exists that, before the parties can arbitrate their dispute, creditors of [Developer] may make a claim on the letters of credit as soon as they are converted to cash. As argued throughout the purchasers' brief, the injunction in this case provides a close analogy, both legally and equitably, to a constructive trust. The constructive-trust-fund nature of the letters of credit will be lost as soon as the preliminary injunction is dissolved." As to the availability of a remedy at law, the Dissent stated that the injunction is necessary to "preserve the status quo and prevent dissipation of funds in a constructive trust when there are specific identifiable funds that the defendant has refused to turn over." [10] He noted that the inadequacy of legal remedy is a basis for injunctive relief and recited the traditional equitable tests for injunctive relief.

Comments:

1. This decision involves an important issue, namely whether letter of credit law is subject to collateral statutes that permit or allow use of letters of credit and, in particular, whether their policies can affect whether or not an injunction is appropriate. The Alabama Court forcefully (and properly) concluded in this case that LC policies controlled.

2. While the Majority referred to Revised UCC Article 5 and in a footnote to Revised UCC Section 5-109 (Fraud and Forgery), the opinion relied chiefly on case law. There was, most importantly, no reference to a determination of a probability of a determination that honor would facilitate a fraud on the applicant or issuer. The Dissent did not even mention LC fraud and the litany of problems sounded more like a breach of contract or warranty than LC fraud.

3. An interesting aspect of the case is the role of the escrow agent. It is not clear whether it was the beneficiary or, if not, what role it played.

4. Another interesting question is how an agreement between the applicant and beneficiary to purchase a condominium that provides for arbitration can affect an action for injunctive relief against the issuer with respect to the LC. In concluding that the court had jurisdiction to enter relief notwithstanding the arbitration provision, the court avoided the need to consider this question.

[JEB/mgb]

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