Article

Note: To finance equipment for poultry processing, B.C. Rogers Poultry, Inc. and B.C. Rogers Processors, Inc. (Lessees) agreed with the CIT Group/Equipment Financing Inc. (Lessor/ Beneficiary) to a sale/leaseback arrangement. The prior owners of Lessees, John M. Rogers and J. Kelley Williams (Sureties/Applicants), concerned about payment of promissory notes covering the sale of the companies, agreed to apply for issuance of two LCs in favor of Lessor/Beneficiary in the amount of US$1,500,000 each to assure payment under the Lease. Lessees undertook in a separate agreement to reimburse Sureties/Applicants. Subsequently, Lessees became insolvent and filed for reorganization under the U.S. Bankruptcy Code. The Bankruptcy Court ordered payment of amounts due under the Lease by a certain date or ordered that the Lease be rejected. Lessees did not make the payments, whereupon Lessor/Beneficiary drew on the two LCs, was paid on one and enjoined on the other. Soon thereafter, the restraining order was dissolved and payment made. Sureties/Applicants then commenced state court proceedings against Lessor/Beneficiary and Lessees' successors, Koch Foods of Mississippi, LLC, Koch Properties of Mississippi, LLC, and Koch Farms of Mississippi, LLC to recover the funds drawn from their LCs, which were removed to federal bankruptcy court and consolidated.

On Lessor/Beneficiary's motion for partial summary judgment and motion for partial summary judgment for failure to meet its burden of proof, the United States Bankruptcy Court for the Southern District of Mississippi, Ellington, J., applying Mississippi's Revised UCC Article 5 to the LC, ruled that there were still material disputes of fact and dismissed the motions.

Sureties/Applicants' complaints included the assertion that (1) Lessor/Beneficiary breached its duty to mitigate damages following Lessees default; (2) Lessor/Beneficiary breached its duty of good faith and fair dealings; (3) Lessor/Beneficiary violated the terms of its Lease with the Lessees by failing to draw the same amounts at the same time from the two LCs; (4) the Lease is void based on unconscionability and law inconsistencies; (5) Lessor/Beneficiary's draws under the LC were both in bad faith and unauthorized; (6) Lessor/Beneficiary and Lessees' successors conspired to allow Lessees' successors to utilize the equipment without just compensation; (7) the terms of the Lease are materially different from the terms set forth to Sureties/Applicants to procure the LCs such that there was a failure of consideration in the LCs issuance; and (8) Lessor/ Beneficiary made material misrepresentations to Sureties/Applicants with regards to the equipment in the Lease.

Lessor/Beneficiary argued that Sureties/ Applicants do not have standing to bring this action against it because they are not parties to the Sale/ Leaseback nor any contractual relationship with Lessor/Beneficiary and cannot be subrogated to the Lessees' rights against Lessor/Beneficiary. It contended that Sureties/Applicants "are mere 'applicants' for letters of credit and the 'independence principle' prevents them from asserting the same equitable subrogation rights that a guarantor would enjoy."

Sureties/Applicants contended that the Sale/ Leaseback arrangement was either a disguised true lease or a security agreement. The Judge, however, recognized that the form used was that of a letter of credit and that it must be taken into account in determining whether there are rights that can be asserted by the applicant. The question that the Judge addressed, then, was whether applicants have rights under a letter of credit that can be asserted against the beneficiary.

Beginning with what he characterized as a "brief overview of letter of credit law," the Judge described it as a three party arrangement, citing Revised UCC Section 5-102(a)(10) (Definitions) ("Letter of Credit"). He noted that, "At common law, the issuer of a letter of credit had a direct obligation to pay independent of the underlying contract between the customer and the beneficiary as long as the documents presented satisfied the terms of the letter of credit," noting that it has been codified in Revised UCC Section 5-103(d) (Scope).

In this context, the Judge reviewed the split in pre-Revised UCC Article 5 case law regarding whether or not the independence principle barred the exercise of subrogation by the parties to a letter of credit against other parties with respect to claims that were related to the LC. The Judge, however, recognized that Revised UCC Section 5-117 (Subrogation of Issuer, Applicant, and Nominated Person) resolved this issue. The Judge stated that this revision "explicitly places an applicant who has paid an issuer of a letter of credit in the same position as if that person were a guarantor" and ruled that the pre-Revision cases cited by Lessor/Beneficiary were "inapposite."

Lessor/Beneficiary argued that Revised UCC Section 5-117 was only a limited exception to the independence principle and did not expressly grant an applicant subrogation rights against the beneficiary. The Judge rejected this interpretation. He stated Lessor/Beneficiary "misconstrues the nature of [Section 5-117]. This provision does not create narrow exceptions but instead removes the independence principle as a basis for denying equitable subrogation. Notably, subsection (d) of [Section 5-117] maintains the integrity of the independence principle, and thus the usefulness of letters of credit in the world of commercial financing, by conferring subrogation rights only after a beneficiary has been paid." The Judge also concluded that the argument that there was no reference to an award of subrogation rights against the beneficiary was not persuasive. The Judge stated, "It is therefore not surprising that the statute does not address the subrogation rights of an applicant against the beneficiary since they are usually already parties to the underlying transaction. In any event, [Section 5- 103] specifically recognizes that Article 5 does not govern all the rules and concepts of letters of credit and a statement of a rule 'does not by itself require, imply, or negate application of the same or a different rule to a situation not provided for, or to a person not specified....'"

Accordingly, the Judge ruled that Sureties/ Applicants were not precluded from asserting a right of subrogation against the beneficiary by virtue of the independence principle. He noted, however, that this ruling did not entitle them to exercise that right, a question which required factual determinations under state law, including the question of how the Sale/ Leaseback was to be characterized, and that was inappropriate for summary determination. In addition, the Judge noted that Lessor/Beneficiary may be entitled to raise various defenses, including estoppel, rights under the Lease with respect to excess proceeds, and compliance by Lessor/Beneficiary with the terms of the Lease.

Comment

This decision correctly applied Revised UCC Section 5-117 under which the independence principle is not a bar to the exercise of subrogation in a post honor situation where it would otherwise be available under equity.

The question that arises, however, is why this matter was subject to debate. The Judge recites an argument by the Lessor/Beneficiary that Revised UCC Section 5-117 does not grant subrogation rights to the applicant against the beneficiary. In fact, Revised UCC Section 5-117(b) permits an applicant that reimburses the issuer to exercise subrogation rights against the beneficiary. The situation in the case before the court, however, differed considerably (as the Judge recognized). But the question is to what rights is Sureties/Applicants seeking to be subrogation. It is the rights of the Lessees with respect to the Lease. These rights do not relate to or derive from the LC and, so, the independence principle and Revised UCC Section 5-117 are irrelevant to their exercise.

[JEB/anf]

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