Note: To enable SAAN (Borrower), a Canadian retailer, to obtain operating funds through a loan, a long term supplier, 167986 Canada, Inc. (Applicant/ Surety) obtained an LC for CAN$ 3,500,000 in favor of GMAC (Lender/Beneficiary). In connection with obtaining the LC, Applicant/Surety entered into an LC Agreement with Lender/Beneficiary and Borrower. The LC Agreement addressed various rights of the parties including the right of the Lender/ Beneficiary to the proceeds of the LC. In exchange for the LC Agreement, Lender increased its facility to Borrower to CAN$ 25 million and Borrower entered into a reimbursement agreement with Applicant Surety and a separate agreement with its principal.

After a series of defaults by Borrower, Applicant/ Surety instructed Lender/Beneficiary to draw on the LC instead of renewing it. The LC proceeds were to be converted into cash collateral under the LC Agreement. After receiving the LC proceeds, Lender/ Beneficiary assigned the cash collateral to Black Saxon in accordance with certain Loan Put Agreements between them.

Opposing this assignment, Applicant/Surety moved for an order requiring Lender/Beneficiary to pay the proceeds into the court registry and restraining the assignment. Applicant/Surety claimed that there were serious questions as to whether or not its guarantee obligations had been terminated by the conduct of the Lender/Beneficiary in granting extensions to the Borrower under suretyship law. The Ontario Superior Court of Justice, Morawetz, J., dismissed the motion.

The Judge concluded that Applicant/Surety had confused the rights of Lender/Beneficiary with principles of suretyship law. He rejected the argument that the cash collateral remained the property of Applicant/Surety until it was realized under the LC Agreement.

The Judge recited the proposition that "the funds paid on a letter of credit are the property of the issuing party, not the party who obtained the letter of credit from the issuing party." Moreover, the Judge noted that the LC Agreement "makes it clear that the [Applicant/Surety] irrevocably assigns and sets over to the [Lender/ Beneficiary], and grants to the lender a security interest in, [hypothecaction], and right to set off (compensate) against the Cash Collateral (emphasis added [by the Judge])."

The Judge stated "simply put, [Applicant/Surety] entered into a contract to supply a standby letter of credit. [Applicant/Surety's] only subsequent rights were to have the letter of credit drawn upon in accordance with the terms provided. A letter of credit is quite different from a simple guarantee. It is a form of security which may be called upon by the secured creditor when the event for which the security has been given occurs, without regard to the circumstances existing between the parties to the underlying transaction. In these circumstances, the law of guarantee has no application."

The Judge also took note of the submissions of Lender/Beneficiary's counsel as to why a standby was used, namely "... the documentary credit has been used increasingly as a security device in both international and domestic transactions ... it is the parties' wish to use the documentary guarantee, rather than the surety bond, which invokes the autonomy of the banker's undertaking. ... It is clear therefore that it is the use of a particular instrument which imports the entire body of letter of credit doctrines and policies into the standby credit area. In the final analysis, the basis for autonomy depends on the parties' deliberate choice of the letter of credit facility."

In addition, the Judge concluded that Applicant/ Surety had ratified any forbearance in any event.


One wonders at the effect of the LC Agreement. If the only obligation between the Beneficiary and the Applicant was the LC itself, what was the purpose of such an agreement? It would appear that it raises questions as to whether the issuer has other obligations with respect to the surety other than those embodied in the LC. Some of its terms reproduced from the opinion follow:

2.01 Limited Recourse Guarantee. Subject to the terms and conditions of this agreement, the Investor unconditionally guarantees and promises to pay to the Lender, on demand, any and all indebtedness of the Borrower, including, without limitation, under the Loan Agreement. Notwithstanding the preceding sentence or anything to the contrary contained herein, the liability of and recourse to the Investor hereunder will be limited to the Letter of Credit, the Lender will not have any right to sue or commence any action against the Investor to recover any amounts owing by the Investor pursuant to the provisions hereof except to the extent necessary to permit the Lender to realize upon the security constituted by the Letter of Credit and the Lender will not have any right to payment from the Investor or against any other property or assets of the Investor other than the Letter of Credit.

2.05 Renewal of Letter of Credit. The Borrower must have the Letter of Credit renewed or replaced annually for an additional one-year period and the Lender has the right to draw against the Letter of Credit within 30 days of maturity and hold the proceeds as cash collateral (the "Cash Collateral") if it has not been renewed within 3 months of the maturity. The Borrower and the Lender acknowledge that after March 31, 2008 the Letter of Credit will expire and the Investor shall have no legal obligation to renew it whatsoever. The Investor acknowledges that the immediately preceding sentence does not preclude the Lender from enforcing its rights to draw against the Letter of Credit, in accordance with the provisions of the first sentence of this section 2.05 and to hold the Cash Collateral in accordance with this agreement, including sections 2.06 and 2.07.

2.06 Enforcement of Letter of Credit. Notwithstanding any other provision hereof, if, but only if, at any time while the Lender is in possession of the Letter of Credit or the Cash Collateral, as the case may be, while the Facility is then in place or any Indebtedness under the Facility remains outstanding, the Lender issues to the Borrower a demand for payment or notice of intention to enforce security pursuant to section 244 of the BIA under the Facility, the Borrower has become a bankrupt pursuant to the provisions of the BIA or a "receiver" as defined in the BIA or an interim receiver under the BIA has been appointed, the Lender may retain the Letter of Credit or the Cash Collateral, as the case may be, as security against any ultimate shortfall in recovery of the Borrower's indebtedness, in principal, interest and costs, including all costs of liquidation of the Borrower's inventory (collectively, the "Indebtedness") under the Facility realized from the assets of the Borrower as set out in section 2.07.

2.07 Realization of Security. For greater certainty, the Lender will be obligated to sell or otherwise dispose of all of the Borrower's inventory before claiming any payment under the Letter of Credit or the Cash Collateral, as the case may be. In realizing upon the Borrower's inventory, the Lender must act in all respects in a commercially reasonable manner and comply with all applicable laws. After the Lender's disposal of the Borrower's inventory, if there is any ultimate shortfall in the Lender's recovery under the Facility, the Lender may draw under the Letter of Credit for the amount of the shortfall or apply against the Cash Collateral the amount of the shortfall, and the Letter of Credit will then be cancelled or the remaining balance of the Cash Collateral, if any, will be returned to the Investor, as the case may be. As soon as the Lender, acting reasonably, has determined that the Borrower's Indebtedness under the Facility has been paid in full, the Lender will so notify the Investor and will, if required by the Bank at that time, confirm to the Bank in writing the Lender's consent to the immediate cancellation of the Letter of Credit.

2.10 Assignment of Security. The Investor agrees that it will not have, and hereby waives, any rights of subrogation until such time as the Borrower's Indebtedness under the Facility has been indefeasibly paid in full to the Lender. All money received by the Investor on account of any sums due on the Letter of Credit prior to subrogation as a result of such subrogation will be received in trust for the Lender until all Indebtedness is paid in full; provided, however, that if: (i) drawing(s) have been made by the Lender on the Letter of Credit; and (ii) all Indebtedness has been paid in full, the Lender agrees, at the Investor's request and expense, to execute and deliver to the Investor appropriate documents (without recourse and without representation or warranty except as to authority to transfer and assign the Indebtedness and security related thereto (the "Security"), and no previous transfer, assignment or postponement) necessary to evidence the transfer by subrogation to the Investor of the Indebtedness and Security.

2.11 Cash Collateral. To the extend that the Lender is, in accordance with section 2.05 to hold the Cash Collateral, the Investor hereby irrevocably assigns, pledges, hypothecates, transfers and sets over to the Lender, and grants to the Lender a security interest in, hypothec on, and right to sell of (compensate) against the Cash Collateral. The hypothec created herein is for the amount of the Cash Collateral. The Cash Collateral shall be held by the Lender, without interest, in an account designed by the Lender for such purpose in its books and records and may be commingled with the Lender's own funds. For purposes of greater certainty, the foregoing sections 2.06 to 2.09 will apply, mutatis mutandis, if, at the applicable time, the Lender is holding the proceeds of the Letter of Credit as Cash Collateral, pursuant to section 2.05.

3.04 Successors and Assigns. This agreement will enure to the benefit and will be binding upon the Investor, the Borrower and the Lender and their successors and assigns.



The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.