Article

Factual Summary: To assure construction of electrical substations in Pakistan, Contractor was required to provide two performance guarantees for Local Beneficiary. Accordingly, it obtained Counter Guarantees from Counter Guarantor in favor of Local Bank, which then issued its Local Guarantees in favor of Local Beneficiary.

The Local Guarantee provided "a form of commercial credit used to secure the performance of international construction contracts" and Local Bank "irrevocably and independently guarantee[d] to pay to [Local Beneficiary] without delay upon [Local Beneficiary]'s first written demand any amount claim by [Local Beneficiary]."

The Counter Guarantee provided "the surety [Local Bank] waiving all objections and defences under the aforesaid contract, hereby irrevocably and independently guarantee[d] to pay to [Local Beneficiary] without delay upon [Local Beneficiary]'s first written demand any amount claimed by [Local Beneficiary] upto [sic] the sum named herein, against [Local Beneficiary]'s written declaration that the principal [Contractor] ha[d] refused or failed to perform the aforementioned contract (Compl. Ex. 1 (capitalization normalized)) ... Our counterguarantee irrevocable unconditional in your favour is valid to receive your eventual claims made under your guarantee that we undertake to pay to you on your first demand notwithstanding any contestation from us or our applicants part [sic] or third party" and "[Counter Guarantor] undertook to pay [Local Gurantor/Beneficairy of Counter Guarantee] on its first simple demand which shall be final and conclusive."

When a dispute arose over Contractor's performance, Contractor filed for arbitration pursuant to the contract and obtained an injunction from a Spanish court enjoining a draw on the Local Bank. Utility/Local Beneficiary drew on the Local Guarantees. Claiming bad faith, Local Bank refused to honor them and was sued in Pakistan by Local Beneficiary for wrongful dishonor, but in turn, drew on the Counter Guarantees in its favor. Also claiming bad faith on the part of the Local Bank, Counter Guarantor refused to honor the Counter Guarantees, which prompted Local Bank to file this action in S.D.N.Y. for wrongful dishonor. The court, however, dismissed the action pending arbitration by the ICC pursuant to a clause in the contract between Contractor and Utility/Local Beneficiary. Upon rendition of an arbitral award of US$788,066 in favor of Contractor, Utility/Local Beneficiary refused to pay or cancel the Local Guarantee and filed a proceeding in Pakistan to set aside the award. Meanwhile, Local Bank and Counter Guarantor renewed their motions in S.D.N.Y. Local Bank claimed (1) a right to payment of the Counter Guarantees, regardless of whether it paid Local Beneficiary or refused to pay Local Beneficiary; and (2) in the alternative, that Local Bank was entitled to declaration of future rights against Counter Guarantor. Counter Guarantor moved to dismiss. The trial court dismissed without prejudice.

Legal Analysis:

1. Choice of Law; US Revised UCC Section 5- 116: Local Bank argued that New York law should apply to the dispute because the parties' agreement was executed there. Counter Guarantor claimed that Spanish law should apply or, if New York law applied, that it should be immune to liabilities not also applicable under Spanish law. The court assumed that New York law applied because the Local Bank so assumed and if it failed to state a claim under NY Law, then resolving choice of law would be moot.

2. Classification: Both parties disputed whether the Local Guarantees and Counter Guarantees were subject to LC law. Local Bank argued the instruments were simple contracts not subject to NY Rev. UCC Article 5. Counter Guarantor claimed the instruments were "functionally and legally equivalent to international letters of credit" and, therefore, should entitle Counter Guarantor to the "material fraud" exception recognized in Article 5. In finding LC law to apply, the Judge ruled that the instruments irrevocably reflected the parties' expectation that Local Bank would pay Local Beneficiary if Local Beneficiary certified that Contractor failed to perform its obligations.

3. Demand; US Rev. UCC Section 5-102(a)(10): Local Bank argued that the Counter Guarantees did not require a documentary presentation as required by US Rev. UCC Section 5-102(a)(10). The Judge pointed out the promised payment was on Local Bank's "first written demand".

4. Counter Guarantee; Fraud; US Rev. UCC Section 5-109: Local Bank argued that Counter Guarantor's refusal to honor its Counter Guarantee was wrongful since the Local Beneficiary of its Local Guarantee was seeking to overturn the arbitral award in Pakistan and had drawn on its Local Guarantee. The Judge disagreed. He concluded that the Local Beneficiary's "continued demands for payment are flatly inconsistent with its contractual obligations." He noted that the underlying contract provided for binding arbitration, that an arbitral decision had been rendered in favor of Contractor/Principal, that Pakistan had adhered to the UN Convention for the Enforcement of Arbitral Awards, and that such awards have a res judicata effect under New York law. The Judge stated that "until the award is modified or vacated, neither [Local Beneficiary] nor [Local Bank had] a "colorable right" to demand honor of the guaranties or counterguaranties", citing New York's version of US Rev. UCC Section 5-109 regarding LC fraud as a defense. He further stated "by demanding immediate payment under the counterguaranties, however, Local Bank [sought] to have things both ways" in light of its opposition to the drawing on its Local Guarantee in Pakistan on the ground of fraud.

5. Declaratory Relief; Reimbursement: As an alternative, Local Bank sought a declaratory judgment that it was entitled to reimbursement if ordered to pay the Local Beneficiary by a Pakistani court. While recognizing that there was "nothing illegitimate" about the attempts of Local Beneficiary of Local Bank's Local Guarantee seeking to overturn the arbitral award, the Judge concluded that he could not make such a determination due to US Constitutional limitations of the jurisdiction of federal courts to actual controversies. The Judge concluded that Local Bank's claim depended on "multiple contingencies", making it unripe for determination. Nevertheless, he expressed what was described as a preliminary view that "if [Local Bank paid Local Beneficiary] because it [had] been ordered to do so by a Pakistani court, Counter Guarantor [would] be under an obligation to reimburse it. In such circumstances, [Local Bank] could make a good faith demand for honor of the counterguaranties, as the presumption of validity that [attached] to the arbitral award would no longer be conclusive."

6. Reimbursement; US Rev. UCC Section 5- 108(i)(1): Moreover, the Judge observed that "even if the counterguaranties could not be enforced because of the Spanish injunction, [Counter Guarantor] likely would have an independent obligation to reimburse [Local Bank] by virtue of having procured the guaranties from [Local Bank]. N.Y. U.C.C. Section 5-108(i)(1) ("An issuer that has honored a presentation as permitted or required by this article ... is entitled to be reimbursed by the applicant in immediately available funds not later than the date of its payment of funds...")."

Comments

1. Counter Guarantee: The Judge properly concluded that Local Guarantees and Counter Guarantees were LC undertakings and subject to letter of credit law. He also recognized that they were independent of the underlying transaction. What is less clear (as will be apparent from the next comment) is whether he appreciated that they were independent of one another, a conclusion that follows since the "underlying transaction" with respect to the Local Guarantee is the Counter Guarantee which has given rise to it. It is the local transaction which is also independent that gives rise to the Counter Guarantee.

2. LC Fraud, Colorable Basis: The Judge recognized that "in a case of actual controversy within its jurisdiction ... any court of the United States ... may declare the rights and other legal relations of any interested party seeking such declaration" and that the question of declaratory relief was "close". Actually, it is the question of the lack of a colorable basis for the drawing on the Counter Guarantee that is close. Unlike the Local Guarantee, the Counter Guarantee was payable on first demand "notwithstanding any contestation from us or our applicants..." The Judge seemed to conflate the two undertakings. He also seemed to be of the opinion that only a reversal or modification of the arbitral award would constitute a good faith basis for a drawing by Local Bank. That assumption is not warranted by the terms of the Counter Guarantee that are quoted in the opinion nor by LC law. The Counter Guarantee is independent from the Local Guarantee. A claim and litigation in Pakistan on the obligation of the Local Bank is a colorable basis for drawing on a Counter Guarantee. The terms could have been more explicit, referencing a claim on the Local Guarantee, but need not have been. The lack of a colorable basis would only arise if there was a final determination by a court in Pakistan that was binding on Local Beneficiary that there was no right to draw on the Local Guarantee and cancelling it. Otherwise, the purpose of the Counter Guarantee is to protect the Local Bank in just such contingencies. Nothing is said about the duration of the Counter Guarantee, but that is also a serious concern given that the litigation in Pakistan could take considerable time during which the Local Bank was exposed.

[JEB/ecw, ny]

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