Article

Factual Summary: To assure performance of a contract to manufacture a USD 17,299,135 order of railcars, Rail Authority required Contractor to obtain a standby LC in the amount of USD 3 million. Unable to obtain a standby, Contractor solicited investors organized in a bankruptcy-remote entity which acted as Applicant and obtained a standby issued by KeyBank (Issuer). The standby required certification that Applicant was in default. Only after the LC was issued did Beneficiary learn that Contractor was not the standby applicant. Since Applicant had no role in the underlying contract and Rail Authority/Beneficiary could not certify Applicant's default, Rail Authority/Beneficiary, Applicant, and Contractor executed a written modification (Modification 1) to the underlying contract that provided that Beneficiary could certify Applicant's default should Contractor default instead of amending the terms of the standby.

When Contractor experienced difficulties in producing the rail cars in a timely manner, Rail Authority/Beneficiary made advances to Contractor to enable it to proceed with the understanding that Rail Authority/Beneficiary would draw on the standby if Contractor did not perform. This agreement was embodied in a separate Project Monitoring Agreement (PMA) without the knowledge or consent of Applicant. Unaware of this agreement, Applicant agreed to an extension of the LC.

When Rail Authority/Beneficiary drew on the standby to reimburse itself for USD 3 million of advances, Applicant obtained an injunction against Rail Authority/Beneficiary in the federal courts in Oregon alleging that the drawing was fraudulent. Investors of Applicant also obtained an injunction against Issuer in the Iowa state courts which was removed to the federal courts and consolidated with the Oregon action. Rail Authority/Beneficiary counterclaimed and moved to dissolve the temporary injunction which was granted and its drawing was honored by Issuer.

In the subsequent proceedings, the trial court entered summary judgment in favor of Applicant, ruling that it was a surety which entitled it to exercise suretyship defenses due to the modification which could be asserted in an action for breach of its U.S. Revised UCC Section 5-110(a)(2) (Warranties) warranty that the drawing does not violate any agreement between Applicant and Beneficiary. On appeal, reversed and remanded.

Legal Analysis:

1. Surety: Applicant asserted that Modification 1 created a suretyship between Applicant and Contractor. The trial court agreed and ruled that the PMA increased Applicant's risk without its consent and that Applicant, as a surety, was entitled to raise the defense of discharge. The intermediate appellate court disagreed, however, stating that "a standby letter of credit itself does not create a suretyship." Applicant and Beneficiary shared a primary obligation on the LC. Since Applicant undertook no secondary liability with Modification 1, a suretyship was not created, and Beneficiary's drawing did not violate Revised UCC Section 5-110(a)(2) (Warranties).

The appellate opinion noted that "[a] standby letter of credit functions somewhat like a guaranty, given that it is the applicant's default that triggers the beneficiary's ability to draw on the letter of credit", but that "[f]irst and foremost, the issuer's obligation to pay upon presentation of conforming documents is a primary obligation, not a secondary one. Although default may trigger a draw, it is only upon proper certification of the applicant's default that the issuer is obligated to pay." The appellate court observed that in light of the independent character of the LC obligation, "it is widely recognized that the issuer is not a guarantor."

The appellate court noted that Applicant claimed that its relationship as a surety of Contractor impacted the ability of the Rail Authority/Beneficiary to draw on the standby in light of the unilateral modifications that affected its reimbursement rights against Contractor/Principal Debtor. Looking to the definition of "Surety" in the Restatement of the Law (Third) of Suretyship, Section 1, the trial court had ruled that "[Applicant] was at all material times a secondary obligor [and] . . . [a]rguably, [Applicant] became a surety at the time [Issuer] issued the Letter of Credit . . . ."

The appellate court stated that the conclusions of the trial court were erroneous. It stated:

"[T]he law on letters of credit is clear that simply entering into a letter of credit transaction does not a suretyship make. The hallmark of the surety is a secondary obligation. When we examine the three relationships in a letter of credit transaction there is typically no secondary liability. Instead, the applicant and beneficiary owe each other primary obligations on the underlying contract, the issuer is primarily obligated to honor the beneficiary's proper draw request, and the applicant is primarily obligated to reimburse the issuer for any payments made to the beneficiary. Under normal circumstances, and as contemplated by the Railcar Contract, [Contractor] would be the applicant and [Rail Authority] the beneficiary. Despite the fact that this transaction does not mirror normal circumstances, [Applicant]'s status as the applicant (on behalf of [Contractor]) on the Letter of Credit does not make it a surety because it has undertaken no secondary obligation in connection with the transaction. Agreeing to purchase the Letter of Credit for [Contractor] only resulted in a primary liability to [Contractor], just as purchasing the Letter only made [Applicant] primarily liable for reimbursing [Issuer] if it honored a draw on the Letter."

The appellate court also observed that the trial court erred in finding support in court decisions that allowed an issuer or an applicant to be subrogated to the rights of the beneficiary "payment is wholly different from holding that an applicant is a surety to a third-party contract." The appellate court noted that instead of seeking subrogation for payments to one or another party, Applicant "seeks to completely avoid any payment to the beneficiary, [Rail Authority], by asserting the surety defense of discharge. This difference is fatal to [Applicant]'s argument that it should be characterized as a surety." The appellate court observed that what was lacking in Applicant's characterization of the relationship as that of surety was the elements of recourse:

"Although [Applicant] purchased the Letter of Credit and its investors pledged their property as security, these obligations run strictly to [Issuer]. [Applicant] owes no duty to [Rail Authority/Beneficiary] under either the Letter of Credit or Modification No. 1. The only right those instruments give [Rail Authority/Beneficiary] is the right to draw on the Letter of Credit provided by [Issuer]; they do not give [Rail Authority/Beneficiary] recourse against [Applicant] for [Contractor]'s default on its primary obligations for [Rail Authority/Beneficiary]'s loss in excess of the $3 million stipulated in the Letter of Credit."

With respect to the effect of the modification, the appellate court stated:

"Modification No. 1 could not have created a surety relationship because it does not bind [Applicant] to the primary obligations of [Contractor]. If, for example, the Letter of Credit had not been extended, but had expired in November 2007, [Rail Authority/Beneficiary] would have had no right to pursue [Applicant] for the $3 million in the later event of [Contractor]'s default on the Railcar Contract. Nothing in Modification No. 1 changes this. [Applicant]'s participation was independent of [Contractor]'s duties under the Railcar Contract because it had no additional duties to perform or fulfill if [Contractor] failed to perform its primary obligation. Simply purchasing a letter of credit for security as part of another's performance contract does not raise the purchaser to the status of surety, entitled to assert attendant defenses."

[JEB/mkg]

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