Article

Factual Summary: To secure a loan for the construction of a luxury yacht, U.S. Buyer obtained LC (LC) from U.S. Bank (Issuer) in favor of Chinese Bank/Beneficiary, which was to lend construction funds to Yacht Builder. Chinese Bank/Beneficiary had not done business with Yacht Builder, and an officer visited two facilities to determine whether it was capable of building yachts and found several in the process of being built. It relied on the LC, however, for its reimbursement. The terms of the LC "provided that [Issuer] would pay [Beneficiary/Chinese Bank] from the letter of credit upon the presentation of a certified statement of [Beneficiary]'s loan of funds to [Yacht Builder]". To protect themselves, Applicants/Buyers demanded and received an LC (Yacht Builder's LC) in the amount of US$300,000 in their favor to be issued by Chinese Bank/ Beneficiary in the event that the yacht was not built. They also demanded and Yacht Builder tendered a performance bond from Allianz, which guaranteed payment to Applicants in the event the yacht was not built. After Buyer's LC had been issued, Buyers/ Applicants discovered that this performance bond was fraudulent.

Beneficiary subsequently loaned funds to Yacht Builder and, when it was informed by Applicants that the yacht had not even been started, Buyer/Applicants drew on the Yacht Builder's LC for the full amount of US$300,000. When it was informed by Yacht Builder that it had not commenced work on the yacht, Beneficiary/Bank honored the drawing on Yacht Builder's LC and demanded that Builder return the loan amount. Yacht Builder paid back a small part of the loan, but a significant amount remained outstanding.

After unsuccessfully demanding return of the LC and being informed that Issuer would honor a complying presentation, Applicant/Buyer sued Issuer to enjoin honor based on the fact that the yacht had not been built and alleging that Beneficiary and Yacht Builder had conspired together to defraud Buyers/ Applicants. Issuer did not object, and the Judge granted an emergency injunction which, after a hearing, was continued as a preliminary injunction. Beneficiary subsequently intervened, and Issuer asserted a counterclaim against Applicants and thirdparty claims against Beneficiary and Yacht Builder, seeking declaratory judgment. Applicants amended their complaint, naming Issuer, Beneficiary, and Yacht Builder as defendants and seeking recovery against Issuer on theories of breach of fiduciary duty, negligent misrepresentation, equitable estoppel, and civil conspiracy with Beneficiary. Applicants sued Beneficiary for civil conspiracy, unjust enrichment, and fraud. Applicants also sued Yacht Builder for fraud, but Yacht Builder was eventually dismissed as defendants for failure to obtain service of process.

After a full trial, the Judge ruled in favor of Issuer and Beneficiary and subsequently denied Applicants' Motion to stay dissolution of the injunction pending appeal.

Legal Analysis:

1. Fiduciary Duty. Applicants claimed that Issuer had breached its fiduciary duty to them in connection with the issuance of the LC without protection against fraud by the Yacht Builder. The Judge noted that there must be the existence of a fiduciary duty and a breach of it that caused damages. He recited Florida cases that required a degree of dependency and an agreement to provide advice, counsel, and protection by the other party, a situation that does not occur where there is an arms-length transaction. He also noted that such a duty does not arise in an ordinary lending transaction even where there is a long-standing business relationship. Accordingly, the Judge ruled that Applicants had failed to prove the existence of a fiduciary duty, that the most that had been proven was the existence of a long-standing relationship. "[S]uch a relationship alone does not create a fiduciary duty. Plaintiffs did not request [Issuer] to undertake a duty of trust and dependency, and no one at [Issuer] ever agreed to assume such a duty".

2. Negligent Misrepresentation; Equitable Estoppel. Applicants claimed that Issuer had engaged in negligent misrepresentation and was equitably estopped from asserting that it was not liable. The Judge reviewed the elements of these actions: Negligent misrepresentation required proof of a statement of a material fact that was believed to be true but was false and that would not have been made had reasonable care been exercised in that the person making the statement should have known that it was false and on which the person seeking recovery justifiably relied to its detriment. Equitable estoppel required proof of a statement that was contrary to a statement that was asserted later on which the person relying on it did so reasonably to its detriment by changing its position and was damaged and where there is proof of some affirmative deception.

In reviewing the testimony, the Judge noted that these claims turned on telephonic conversations between one of the Applicants, Mr. Jaffe, and a member of Issuer's private banking unit, Christopher Ross. On direct testimony, Jaffe stated of his conversations with Ross, "[a]nd I asked him point blank, does this letter language mean, no boat, no money? And he told me, absolutely". The opinion observed that

[o]n cross examination, Mr. Jaffe noted that he had done more than $1 billion in loans during his career ... , that he understood that banks sometimes require collateral for loans ..., and that he was aware that the letter of credit was being used as collateral for the loans the bank was making to the shipyard to build the boat ... He admitted that he wanted to buy the boat from a Chinese company for a low price and then planned to flip it and make approximately a $3 million profit ... He also said he didn't understand what it meant that [Chinese Bank/Lender] was the beneficiary of the letter of credit, and he never asked anyone what it meant...

Jaffe further admitted that he had no notes or evidence of his conversations with Ross ... Significantly, he also admitted that he approved the letter of credit language which did not include a stipulation that the money would only be paid upon completion of the yacht.

The Judge stated that Applicants' "allegation that [Issuer] told Mr. Jaffe that he would be protected in the letter of credit transaction with a stipulation that the letter of credit would only be paid upon completion of the yacht construction (i.e., 'no boat, no money') fails for lack of any credible proof". Moreover, the Judge stated that had Ross made such a representation, "the claims would still fail as a matter of law because ... reliance upon alleged oral misrepresentations is unreasonable and unjustified where the subsequently executed written document does not contain the alleged representations or promises. Here, the letter of credit contained the language requested and which was entirely provided by Mr. Jaffe to Mr. Ross. Mr. Jaffe read, approved, and signed the document. Reliance on alleged oral representations is unjustified in such an instance".

3. Fraud. Applicants had alleged that Beneficiary committed "fraud by (1) making loans to [Yacht Builder] without securing those loans with collateral, (2) loaning money to [Yacht Builder] to build the yacht when it knew that [Yacht Builder] did not have the capability to do so, and (3) lying when it demanded payment on the letter of credit by stating that it was indebted to [Yacht Builder] for building the yacht. [Applicants] have not met their burden of proof in this record to establish any of the three allegations". The Judge noted that in fact the record contained undisputed evidence to the contrary.

The court expressed its sympathy for Applicants, noting that they were the victims of fraud perpetrated by Yacht Builder and the issuer of the fraudulent performance bond. Those two parties, however, were not defendants in the instant action, and the two defendants named committed no unlawful acts. Accordingly, the Judge ruled in favor of Issuer and Beneficiary on all counts and ordered the injunction enjoining Issuer from honoring LC vacated and dissolved.

4. Unjust Enrichment. Regarding Applicants' claim that Beneficiary was unjustly enriched, the court ruled that LCs are payable on demand, regardless of the underlying transaction, so Beneficiary was entitled to payment since the record showed that Beneficiary had in fact made the loan to Yacht Builder.

5. Civil Conspiracy. Regarding Applicants' claim against Issuer and Beneficiary for civil conspiracy, the Judge ruled that Applicants presented no evidence to support their theory that Issuer and Beneficiary conspired to defraud Applicants. In fact, the record showed that Applicants themselves provided the exact language to be used in the LC.

6. Injunction, Stay of Dissolution Pending Appeal. Applicants subsequently moved to stay/ restore the injunction. The Judge stated that in order to grant such a motion, it must consider "1) whether the applicant made a strong showing that it is likely to prevail on the appeal; 2) whether the applicant will be irreparably injured absent a stay; 3) whether the issuance of the stay will substantially injure the other parties interested in the proceeding; and 4) where the public interest lies". The court ruled that Applicants did not meet any of the factors entitling them to such relief.

Comments:

1. LC Fraud and the Injunction. The detail in the Judge's opinion partially explains why a preliminary injunction was granted. The treatment in prior volumes of the trial court's order and the appellate court's confirmation of the preliminary injunction was critical due to the lack of a convincing explanation of how the facts revealed LC fraud. It was clear from them that there were allegations that the boat had not been built. What is clearer from the August opinion is that there were allegations that the Chinese Bank which was beneficiary of the LC issued by Jaffe had colluded with the Yacht Builder in seeking to defraud the Jaffes.

The only justification for an injunction would have been a finding that there was such LC fraud on the part of the beneficiary. The August opinion makes it clear that there was no contrary evidence whatsoever presented by Chinese Lender/Beneficiary so that the only evidence on the record was that suggesting that there was fraud.

However, even in this opinion the Judge finds that there is no proof of fraud without recognizing the special character of LC fraud, namely that the applicant is more likely than not to succeed in proving that the beneficiary will succeed in proving its claim that honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or applicant as provided by Revised UCC Section 5- 109. Indeed, Rev. UCC Section 5-109 is not even cited.

2. Fiduciary Duty. The allegation of the existence of a fiduciary duty between a bank and its LC customer sometimes is raised in LC cases. Inevitably, the applicant expects the issuer to advise it in structuring the LC to protect it against beneficiary misconduct. While banks do advise their customers on the technical details of LCs, few assume the risk and responsibility of assuming a special duty. Certainly, the issuance fees for LCs do not cover such a responsibility. The detailed explanation of why no such duty arose in this case is helpful and cautionary. Jaffe also relied on an attorney, as is apparent from his testimony. One wonders what the result would have been had he not.

3. Private Banking. It is no surprise that the private banking unit of the bank was involved in this case. This unit is designed to provide extra services to special wealthy customers and to give the impression that all their banking needs are being serviced. It is no surprise that Jaffe had the impression that these services included "being taken care of" in providing a fool-proof LC. While disclaimers are not entirely welcome in such a cozy atmosphere, they are important to protect the bank from being liable for a service that private banking is not offering and probably not qualified to offer. The very structure of the LC invited fraud by the Yacht Builder and the absence of a required document from a neutral engineer or other mutually acceptable third party (a requirement that reasonably would have been unacceptable to the Chinese Lender) opened the door for the Yacht Builder to take the proceeds of the loan and use it to cover ordinary expenses which is apparently what happened.

4. Commercial Fraud. This case is a classic example of the use of the banking system and LCs to commit commercial fraud. It should be required reading for all LC applicants. The lesson is to not only know the entity with whom you are dealing but to understand the structure of the transaction and its risks.

[JEB/jdc]

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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.