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Factual Summary: Lender extended secured loans in the form of revolving credit and asset-based financing and provided cash management services to Borrower, which sold jewelry. When Borrower later declared bankruptcy, Lender agreed to provide exit financing as part of an approved reorganization plan and entered into another secured loan agreement (Loan Agreement). Three months later, Borrower foresaw that it might experience cash flow problems during the upcoming end of year holiday selling season and requested Lender's consent to fund its cash shortfall. However, because an overadvance of the loan agreement would result, triggering immediate repayment obligations, Lender and Borrower executed an amendment to the Loan Agreement to secure the extension of further financing, requiring additional collateral in the form of a standby letter of credit in the amount of US$250,000 in favor of Lender. Borrower obtained the standby through Surety/Applicant, who took a subordinated junior participation in the right to collateral in the maximum amount of US$250,000.

Surety/Applicant's rights under this subordination agreement were expressly without recourse to Lender/Beneficiary, and Lender/Beneficiary's liability to Surety/Applicant was expressly limited to its own willful misconduct or gross negligence.

The standby was set to expire 31 January 2009 and could be drawn on any time after 15 January 2009 in an amount "equal to any Overadvance then existing." The standby itself "could not count as an asset to reduce the amount of the Determined Overadvance."

On 31 December 2008, Borrower failed to make a scheduled payment to Lender of US$100,000. On 1 January 2009, per terms of the Loan Agreement, the Maximum Revolver Amount increased by US$1 million to a total of US$2.5 million. However by notice dated 9 January 2009, Lender advised that it had set an Availability Reserve against the borrowing base of US$900,000 as permitted by the Loan Agreement in view of a number of defaults on the part of the Borrower including failure to make the US$100,000 payment, failure to turn over customer credit card payments, failure to submit current copy of Borrower's business plan, failure to subject all Borrower's depositories to a Control Agreement by 7 November 2008, and over-projection of sales. Lender also offered at this time "to enter into a 'forbearance agreement' whereby 'Lender and Borrower could agree to Lender's forbearance on other than a day-to-day basis,' provided that [Borrower] cured the defaults, including by making the $100,000 payment immediately."

On 20 January 2009, Lender/Beneficiary certified to Issuer an overadvance of US$433,880, drawing the full US$250,000 standby. As per the subordination agreement, Surety/Applicant became entitled to its US$250,000 subordinated interest in any remaining collateral.

Surety/Applicant took the position that by establishing the US$900,000 Availability Reserve, Lender/Beneficiary had unfairly created the overadvance that permitted a drawing on the standby. Surety/Applicant therefore sued for breach of subordination agreement, breach of the covenant of good faith and fair dealing, unjust enrichment, money had and received, and breach of warranty under U.S. Revised U.C.C. § 5-110(a)(2). The trial court granted Defendant/Beneficiary/Lender's motion to dismiss. On appeal, affirmed.

Legal Analysis:

1. Revised U.C.C. § 5-110; Breach of Warranty: Applicant argued that there was a breach of warranty under U.S. Revised U.C.C. § 5- 110(a)(2). This provision states "(a) If its presentation [of a letter of credit] is honored, the beneficiary warrants: . . . (2) to the applicant that the drawing does not violate any agreement between the applicant and beneficiary or any other agreement intended by them to be augmented by the letter of credit." The trial court noted that the only agreement between Surety/Applicant and Lender/Beneficiary was the subordination agreement on which Applicant did not rely for its breach of warranty claim. Moreover, the trial court ruled that the documentary evidence demonstrated that Beneficiary's draw request was within its contractual rights.

The appellate court agreed, and stated that there was no contract by virtue of the standby or any other agreement between the parties, making it unclear if U.C.C. § 5-110 even applied. It assumed, however, that the loan agreement and amendment would qualify as an "other agreement intended to be augmented by the letter of credit" in the statute and concluded that there was no breach. The appellate court ruled that Lender/Beneficiary's draw request was within its discretionary contractual rights, not a breach of its duty of good faith, and that there was no breach of warranty.

[JEB/vjm]

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