Note: In connection with the sale of real estate in Muskegon, Michigan, Lakefront Development (Applicant) obtained a standby letter of credit in an amount not to exceed US$1.7 million issued on 10 October 2002 by the predecessor of Michigan Commerce Bank (Issuer) for the benefit of TDY Industries (Seller/Beneficiary), the seller of the property.

The standby was connected to an environmental remediation agreement under which Seller/Beneficiary was to bring the property into environmental compliance. It was subject to UCP500 (1993 Version) and the laws of the State of Michigan.

As noted in the opinion, the standby establishes three conditions precedent to the payment of any draft: (a) a final approval of the remedial action plan by the [Michigan Department of Environmental Quality], as set forth in the attached Environmental Remediation Agreement; (b) a statement signed by [Seller/Beneficiary] affirming that it is provided notice of both the draw request and the amount of the draw to the purchaser and that the purchaser has not objected within the preceding ten-day period, or, alternatively, a statement signed by both buyer and seller confirming the balance owed under the purchase agreement; and (c) presentation of the draft on or before the expiration date of the LOC, accompanied by a specific reference to the LOC.

The standby also provided:

3. Term

a. Initial Term. All drafts on this Letter of Credit shall be honored on presentment and delivery of the above-specified documents on or before the expiration of this Letter of Credit. The initial term of this letter of credit shall extend to and including March 10, 2003, after which this Letter of Credit shall automatically renew on a month to month basis.

b. Termination. Bank shall not be permitted to terminate or in any manner reduce or limit this Letter of Credit during the initial term or any renewal term.

The standby also provided that the amount available under the standby could be reduced if Buyer/Applicant sold any of the property prior to final approval of the remediation plan. "The standby provide[d] that any amounts paid to [Seller/Beneficiary] pursuant to this scheme 'shall reduce the amount that will be paid from this Letter of Credit upon approval....'"

Alternatively, the standby provided that on the failure of either Buyer/Applicant or Seller/Beneficiary to pay the monthly LC fee of US$2,125 after the initial term, "the Bank may pay the fee from the [standby] and reduce the amount available to [Seller/Beneficiary] by the amount of the advance."

The opinion noted that no final approval had been given to the environmental remediation plan although Seller/Beneficiary continued to work on the plan and has not drawn on the standby.

In 2011, after discovering the LC in a desk drawer of the predecessor bank's president, Issuer sued Seller/Beneficiary for a declaratory judgment that the LC was now unenforceable as a matter of law. On cross motions for summary judgment, the U.S. District Court for the Western District of Michigan, Southern Division, Scoville, J., Magistrate Judge, entered judgment for Seller/Beneficiary and dismissed the action.

Issuer sought relief based on two theories: 1.) as a perpetual LC, Issuer contended that the standby would expire after five years under the Michigan's Revised U.C.C., § 5-106(d), MICH. COMP. LAWS § 440.5106(4), [U.S. Revised UCC § 5-106(d)]; 2.) it was now impossible for the LC to be drawn on based on its stipulated documentary requirements, involving approval of an environmental remediation plan for the purchased property by the Michigan Department of Environmental Quality.

Standby NOT Perpetual

Issuer argued that because the standby LC's term was indefinite, renewing every month until fully drawn on, if ever, that it should be considered perpetual for the purposes of Michigan's Revised U.C.C. § 5- 106(d) that states, "(d) A letter of credit that states that it is perpetual expires 5 years after its stated date of issuance, or if none is stated, after the date on which it is issued."

The Magistrate Judge rejected this argument and ruled that the standby did not state that it was perpetual because it contained an evergreen clause.

In interpreting U.S. Revised U.C.C. Article 5, the Judge noted the emphasis in the Official Comment to Revised U.C.C. § 5-101 on flexibility and freedom of contract. He noted that Revised U.C.C. § 5-106 "obviously allows the parties to establish an agreed upon expiry (the 'stated expiration date'), or, alternatively, a mechanism that does not expressly identify the expiration date but nevertheless determines it (an 'other provision that determines its duration'). Only in default of these agreed-upon provisions does the statute take effect, by providing a one-year expiration date." The Judge observed that evergreen clauses "fall within the second type of agreed-upon duration contemplated by section 5- 106(c)-a provision determining the duration of the letter."

By using an evergreen clause, the Judge concluded that "the parties thereby exercised their freedom of contract under section 5-106(c) to adopt an 'other provision that determines [the LC's] duration.' "

He also observed that "the LOC at issue here does not 'state that it is perpetual.' " He rejected Issuer's argument that "the LOC as drafted might have an indefinite duration," stating this interpretation would amount to rewriting U.C.C. 5-106 since it would apply "not only to a letter that 'states' that it is perpetual, but also to letters that might in effect turn out to be of indefinite duration." He observed that had the drafters intended this result, "it would have been an easy thing to draft the statute to say so clearly." The Judge concluded with the observation that "if the [Issuer]'s construction were adopted, every evergreen letter of credit would be subject to a five year durational requirement." He cited the decision in Golden West Refining Co. v. SunTrust Bank, 538 F.3d 1233 (9th Cir. 2008) abstracted in 2009 ANNUAL REVIEW OF INTERNATIONAL BANKING LAW AND PRACTICE, 428, with approval.

Noting that the standby contained an expiration date and a mechanism for its reduction, the Judge stated,

In no sense can this letter of credit be construed to 'state' that it is perpetual. 'Indefinite' is not synonymous with 'perpetual' . . . Although article 5 prevents banks from inadvertently issuing indefinite letters, by providing that a letter without an expiration date expires in one year, U.C.C. § 5-106(c), banks are free to contract expressly for long-term letters, and beneficiaries are entitled to rely on the banks' undertaking. With the exception of letters that expressly state a "perpetual" duration, freedom of contract remains the rule. [Emphasis in original]

Drawing not Possible

On the second theory Issuer argued that no drawing was now possible because the original remedial action plan referred to by the LC had been replaced by a different one.

The Judge declined to rule on the Issuer's second theory, noting that issuance of a declaratory judgment was discretionary. The Judge stated that a ruling would be premature, as no attempt to draw on the LC had yet been made by the Seller/Beneficiary.


1. Another "Drawered" Standby. For more than a decade, stories have circulated about standbys issued by small banks that were filed in the drawer of a bank officer instead of being "booked" and only discovered on event of a retirement, death, or, more commonly, a merger. Invariably, these standbys also contain terms that are unsound or not workable as did the one in this case. The solution to this problem is training for small banks which issue considerable numbers of standbys.

2. The Duration of the Standby. The standby contained a fixed expiration date and provided for its "automatic renewal" on a month to month basis. It did not contain a final expiration date. Nor did it provide a mechanism by which the Issuer could give notice of non-extension. It did, however, contain a provision by which the standby could be paid down by reduction of the outstanding amount by the monthly fee of US$2,125 in lieu of payment of the monthly premiums. As a result, the Issuer would either be paid premiums or the amount would be reduced and eventually would be extinguished. At the rate of US$2, 125 per month, it would take approximately 67 years to reduce the amount outstanding to zero, assuming that no fees were paid.

Whether this approach is sound depends on factors not addressed in the opinion including whether or not the standby was cash collateralized. If so, then the bank would hold the cash and not be exposed since it could deduct its fees from the collateralized amount. However, given the amount and the size of the institutions, it may be wondered whether the bank held US$1.7 million for the applicant.

3. U.C.C. Section 5-106 and Evergreen Clauses. Revised U.C.C. Section 5-106(c) and (d) were drafted to provide finality to letter of credit obligations under the principle that all LCs should have an expiry date or the equivalent as a matter of public policy. The intention was to address situations where there was no expiration date or where the LC was by its terms in existence perpetually. The policy underlying these provisions is one of finality, namely that there should be a termination of the letter of credit obligation and that they should not be in existence without termination. It is not one of freedom of contract, as evidenced by the provision in Revised U.C.C. § 5- 103(c), which prohibits its variation.

Unfortunately, the statute used the phrase "states that it is perpetual". No letters of credit state that they are "perpetual." From the context of the statute and Official Comments, it should be obvious that the word "perpetual" need not be used. Subsection (d) was intended to apply to any letter of credit that by its terms operated in perpetuity.

Unmentioned in the text was the phenomenon of so-called "evergreen" clauses or automatic extension clauses. These provisions were addressed in the Official Comments. Although letter of credit doctrine was evolving at the time regarding such provisions, it was clear that a typical automatic extension clause, as such, was not "perpetual" assuming that it provided some mechanism by which the issuer could end the automatic extensions either by a notice of nonextension or by payment.

4. Revised U.C.C. Section 5-106(c) and (d) and Case Law. Unfortunately, these texts have not fared well in the two court decisions that have interpreted them. Most notorious was the decision in Golden West, cited with approval in the Michigan Commerce case. In Golden West, the LC could only be terminated by a notice from the beneficiary (and not the issuer), making the undertaking in effect perpetual since it is always open to the beneficiary to cancel the undertaking. The highly technical and wooden interpretation by the U.S. Court of Appeals for the 9th Circuit, however, was unsympathetic to these policy considerations. Indeed, it must be recognized that having issued such an undertaking merited little sympathy for the issuer.

5. The Result in Michigan Commerce. Although it seeks to follow Golden West, the Michigan Commerce LC is distinguishable from the LC in Golden West. Whereas the Golden West LC was perpetual, that in Michigan Commerce could be terminated by reduction of the amount through the application of the monthly fees. In effect, this provision is similar to the bank being able to extinguish the obligation by paying it.



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.