Factual Summary: As a requirement for bidding successfully for three timber contracts with Local Government in 2005, Contractor/Applicant was required to obtain three letters of credit, one for each of the three contracts in amounts USD 23,872.20, USD 10,300.20, and USD 10,552.50, each naming Local Government as beneficiary. The standbys each required presentation of "a sight draft accompanied by a County Officer's statement that: 'Sums claimed are due and payable as Turrie Forest Products, Inc., has not performed as per agreement (identify and enclose agreement) with the Florence County Forestry and Parks.'"

Each contract required completion of logging by 31 December 2009. After beginning the first contract, Contractor/Applicant subsequently defaulted in 2006 by failing to pay required stumpage fees. Local Government/Beneficiary informed Applicant it was drawing on the first standby in September 2006. Despite Contractor/Applicant's payments against the balance, USD 18,000 remained outstanding as of 2010. Local Government/Beneficiary would not permit Contractor/Applicant to begin work on the other two logging contracts while a balance remained on the first contract.

In January 2010, Local Government/Beneficiary demanded payment on the remaining two letters of credit, submitting demands for payment to Issuer again on 15 March 2010. Issuer refused to honor either standby, insisting that Local Government/ Beneficiary's prevention of Contractor/Applicant from performing on the second and third contracts while a balance remained from the first amounted to fraud.

Local Government/Beneficiary subsequently sued Issuer for wrongful dishonor. Since there was no dispute as to whether Contractor/Applicant had defaulted or whether there was proper presentment by Beneficiary to Issuer, the sole issue was potential fraud in the underlying transaction. The trial court held that Issuer had wrongfully dishonored the presentation. On appeal affirmed.

Legal Analysis:

1. Independence Principle: Issuer suggested that Prior UCC Article 5 (to which the LC was subject) did not recognize the independence principle. Citing prior Wisconsin cases and Prior US UCC § 5-114(1), the Judge disagreed. The Judge observed that "the independence principle requires that the issuer 'pay now, argue later.'" The Judge observed that upon proper presentation of the required demand documents, the obligation of Issuer to pay is independent of any other claims among the parties to the letter of credit, or to material performance of the underlying contract.

2. Issuer's Obligation: The Judge noted that since the bank had not claimed that the presentation did not comply, "the Bank's obligation was simply to determine whether the documents presented appeared on their face to be in accordance with the terms of the credit." The Judge observed that in the absence of obvious and egregious fraud, it is the Issuer's duty to pay the Beneficiary, and where there is suspected fraud, the Issuer must honor the demand when properly presented and wait for the courts to "enjoin such honor" when and where they deem it appropriate.

3. LC Fraud: Issuer argued that Beneficiary's fraud in the transaction excused its LC obligation, citing Prior UCC § 5-114(2). Noting that the statute did not define "fraud," Issuer argued that the trial court "set the bar too high by requiring elements of bad faith, intentional conduct, and economic benefit." The Judge responded that the standard for LC fraud was "quite high", distinguishing it from breach of contract. Reasoning that LC fraud originates in the beneficiary's conduct towards the Applicant, the Judge concluded that the statute "permits an issuer, by implication, to refuse to honor a demand for payment when it has been notified by its customer of these defects." Since Applicant had not claimed LC fraud, the Judge concluded that Issuer's "own suppositions about the existence of fraud in the transaction between the beneficiary and the customer cannot provide a basis for refusal to honor a letter of credit." The Judge explained,

"Permitting a bank to speculate as to the existence of fraud in the underlying transaction and dishonor a letter of credit on the basis of that speculation would effectively eviscerate the independence principle, without which the bank improperly becomes a surety or guarantor of another party's performance... The customer, not the issuer, is in the better position to assess whether inequitable conduct has occurred. In addition, the customer, whose property is usually collateralized, will generally have additional incentive to ensure that no fraudulent demands are honored."

4. Wrongful Dishonor: The Judge noted that Contractor/Applicant had not notified Bank/Issuer of any suspected fraud, and stated that it was wrongful dishonor for Bank/Issuer to refuse to allow Local Government/Beneficiary to draw on the letters of credit when presented with proper demand in such a situation. As Issuer, it was not the bank's job to find fraud or determine when it would honor the obligation it had for issuing a letter of credit to the Beneficiary.

Comment(s): While the court is correct that the standard for LC fraud is rigorous and appears to have reached the correct result in this case, in that the local government appeared to have a colorable basis for drawing on the standbys, the Judge's comments about the need for a complaint by the applicant to the bank go too far. For example, such a rule would leave an issuer vulnerable to collusion between the applicant and beneficiary and helpless when the applicant is insolvent, unable to reimburse the issuer, and does not care about a fraudulent drawing.

The error is apparent in reflecting on the Judge's opinions that a bank/issuer must passively await entry of an injunction. This position is not the law for LCs. An issuer can refuse honor based on LC but, should it do so, it must prove that there is fraud. Prior UCC § 5-114(2)(b) (Issuer's Duty and Privilege to Honor; Right to Reimbursement) so provides as does Revised UCC § 5-109(a)(2) (Fraud and Forgery).



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.