Article

Note: Previous decisions are noted in the 2005 Annual Survey of Letter of Credit Law & Practice at page 288, and the 2009 Annual Survey of Letter of Credit Law & Practice at page 424.

To assure payment of three long-term promissory notes issued by Foster Poultry Farms, Inc. (Buyer) for US$105,723,202.38 payable to the order of Zacky Farms, Inc. (Seller), SunTrust Bank (Issuer) issued standby LCs in that amount in favor of Seller/ Beneficiary in a syndication in which other banks participated.

Subsequently, Seller requested Issuer's assistance in monetizing the notes, a process addressed in the various underlying agreements. Issuer proceeded to monetize the notes and, in the process, transferred the LC to itself without signing it as provided by the agreements and despite the refusal of Buyer to consent to the monetization.

After the LCs had expired, Harris Bank issued replacements and the notes were satisfied by Buyers.

Alleging that in connection with the monetization Issuer used confidential information about its financial conditions to which it was privy when it issued the LCs, Buyer/Applicant sued Issuer alleging breach of contract, of a covenant of good faith and fair dealing, and sought disgorgement of US$3,528,519.70 in fees in connection with those fees paid to syndicate banks plus US$6,001,886.97 earned in connection with the monetization.

The US District Court for the Eastern District of California, Wanger, J., applying NY law as to the LC and California law as to the Confidentiality Agreement, granted judgment in favor of Buyer/Applicant with respect to breach of the Confidentiality Agreement, allowed disgorgement for its breach, applied the doctrine of laches to limit the disgorgement award, and ruled that the breach of the transfer provision of the LC was non-material. On appeal, the US Court of Appeals for the Ninth Circuit, Wallace, Graber, and McKeown, J.J., in a Memorandum Opinion, affirmed the decision that there was a breach of the confidentiality agreement, affirmed the disgorgement award, reversed the limitation of the disgorgement based on laches, and ruled that any error in the application of the wrong law to determine the nonmateriality of the LC transfer provision was harmless.

A. Breach of Confidentiality. The appellate upheld the trial court's ruling, under California Law, that Issuer "used [Buyer/Applicant's ] information to evaluate and make decisions about the proposed monetization and thereby violated the confidentiality agreement." The confidentiality provisions provided in the notes included:

"For the purpose of monetizing the Note, Maker [Buyer] agrees, at Holder's [Seller] requests, to provide the most recent annual audited (to the extent available) financial statements of the entities with reimbursement obligations and the guarantor of such obligations under the Letter of Credit to no more than three financial institutions proposed to be engaged by Holder [Seller] for the purpose of monetizing this Note, and to such other financial institutions who may be involved in any syndications of the monetization of this Note as Maker shall consent in writing, such consent not to be unreasonably withheld or delayed, provided, that such financial institutions agree in writing with Maker [Buyer] to keep such information confidential pursuant to the terms of Section 5.15 of the Purchase Agreement and not to share such financial information with any other person (including Holder[Seller])."

The appellate court reasoned that the confidential financial data used to approve the loans in connection with the LCs included information that was "material to and used to facilitate the approval of the monetization" and that such inferences are "more reasonable or probably than those against [Buyer/ Applicant]." Furthermore, the appellate court approved of the trial court's inference of a breach by examining the circumstances which included: 1) The same bank officials worked on both the monetization and Zacky acquisition; 2) the officer who prepared the credit package "admitted that [Buyer/Applicant's] confidential information should not have been included in the Credit Package;" 3) the credit likely considered the underlying support of the LCs issued by Issuer; and 4) the notes anticipated that monetization would require a review of recent financial statements.

B. Disgorgement. The appellate court found that the trial court properly awarded disgorgement of Issuer's profits resulting from the breach of confidentiality stating that, "If a bank chooses to use sensitive client data for the bank's own gain, it can seek to preserve that option in its client contracts; but it may not promise to use information only for certain purposes, breach that promise, and retain the profits therefrom."

Issuer argued that the trial court's award of disgorgement in favor of Buyer/Applicant was erroneous because Buyer/Applicant could not adduce evidence of any actual injury and that only nominal damages, if any, should be awarded. The appellate court ruled that, under California law, unjust enrichment can "satisfy the 'damages' element of a breach of contract claim, such that disgorgement is a proper remedy." Although no damages were reported in the opinion, it is important to note that the trial court awarded nominal damages of US$100, whereas Buyer/Applicant sought all fees paid in connection with the LCs in the amount of US$3,528,519.70, including those paid to the Syndicate Banks, in addition to the US$6,004,886.97 earned in connection with the monetization transaction.

C. Laches. The appellate court reversed the trial court's reduction of Buyer/Applicant's disgorgement award based on the doctrine of laches. The trial court applied the affirmative defense of laches, which is an equitable doctrine by which a court denies relief to a claimant who has unreasonably delayed asserting a claim so as to prejudice a defendant. Noting that the affirmative defense of laches was not asserted by Issuer at trial nor found in any amended motions, the appellate court reasoned that laches could not limit damages because Issuer failed to raise the affirmative defense as required by the applicable rules of procedure.

D. Transfer of LCs/Materiality of the Breach. The appellate court affirmed the trial court's ruling that Issuer's breach of the transfer provisions of the letter of credit, and by extension the Credit Agreement, was non-material. The LCs were issued subject to New York law, and the appellate court reviewed governing law to determined that the trial court had applied the wrong law, although analysis under the correct standard was not outcome determinative because under the proper test, there was no material breach.

The appellate court cited Frank Felix Assocs., Ltd. V. Austin Drugs, Inc., 111 F.3d 284, 289 (2d Cir. 1997), to rule that, under New York Law, "for a breach of a contract to be material, it must go to the root of the agreement between the parties. A party's obligation to perform under a contract is only excused where the other party's breach of the contract is so substantial that it defeats the object of the parties in making the contract." The appellate court reasoned that because the purpose of the contract was to "obtain the security required to complete the [original sale] acquisition, and that the letters of credit provided that security and continued to do so until their expiration" the breach was non-material. Furthermore, the appellate court cited Bear, Stearns Funding, Inc. v. Interface Group-Nev., Inc., 361 F.Supp.2d. 283,296 (S.D.N.Y. 2005) as authority to apply the section 241 of the Restatement (second) of Contracts. Section 241 includes the following factors relevant to analyzing whether a material breach of contract exists:

(a) the extent to which the injured party will be deprived of the benefit which he reasonably expected;

(b) the extent to which the injured party can be adequately compensated for the part of that benefit of which he will be deprived;

(c) the extent to which the party failing to perform or to offer to perform will suffer forfeiture;

(d) the likelihood that the party failing to perform or to offer to perform will cure his failure, taking account of all the circumstances including any reasonable assurances;

(e) the extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealings.

The appellate court ruled that subsections (a) and (b) were not satisfied because applicant "received the benefit it reasonably expected." As to subsection (c) the appellate court found that Issuer would suffer forfeiture if Buyer/Applicant were relieved of its fee obligations, because Issuer/Transferee would effectively have "administered and secured the notes for free." The appellate court ruled subsection (d) to be a moot issue because the LCs were replaced by LCs from a different bank. As to (e), the trial court "found insufficient evidence that the monetization represented a conflict of interest" and "there is no evidence that [Issuer's] breach of the transfer provisions was due to bad faith, rather than, as the record suggests, a result of faulty legal advice."

After establishing that the breach of the transfer provisions was non-material, the Credit Agreement issue was not considered by the appellate court because it was raised only as another grounds for Issuer to limit liability.

Comments:

1. This decision has two aspects that require attention, namely i) the result regarding the court's interpretation of the duty of confidentiality and the damages imposed and ii) the determination that there was a breach of the transfer provisions of the agreement.

2. As to the matter of confidentiality, breach, and damages, the result turns on inferences, namely that the issuer used the confidential information in making its decision. With respect, the decision should have turned on whether the information was material in the determination by the bank; that is whether the decision to act would likely have been made without it. Absent such a determination, the full measure of damages imposed by the appellate court seems to be excessive and disproportionate to the harm caused.

3. As to the transfer, the appellate court decided that the failure of the issuer to follow agreed procedures in transferring the standby to itself as beneficiary, although it was a breach, was not material. This conclusion is correct. The method of effecting a transfer cannot matter to anyone except the issuer provided that the entitlement to draw has been transferred. Given that the issuer was also the transferee beneficiary, there can be little doubt that the transfer was effective.

[JEB/tss]

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