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Note: Deluxe Building Systems, Inc. (Subcontractor) agreed with Kirchhoff-Consigli Construction Management, LLC (General Contractor) to build modular dormitories at its facility in Berwick, Pennsylvania and deliver the units in connection with Pace University’s expansion of its Pleasantville, New York campus. The agreement required Subcontractor/Applicant to obtain a standby letter of credit to assure its performance. Accordingly, First Keystone Community Bank (Issuer) issued a standby for USD 1,000,000 in favor of General Contractor/Beneficiary. The standby required presentation of the original standby and a statement signed by an authorized representative of the General Contractor/Beneficiary that “the amount of the draft does not exceed the amount due and owing to the Beneficiary from the Account Party, and there has been a default by Account Party” under the terms of the subcontract. The standby also stated that Issuer “is not to be called upon to resolve issues of law or fact between the Beneficiary and Account Party. Any draft(s) drawn hereunder and in compliance with the terms of this Letter of Credit will be duly honored”.

When Subcontractor/Applicant defaulted on the underlying subcontract by failing to perform its obligations and pay amounts due to General Contractor/Beneficiary, an authorized representative of General Contractor/Beneficiary presented documents to Issuer certifying Subcontractor/Applicant was in default of the subcontract and at least USD 1,180,566 was owed to General Contractor/Beneficiary. Issuer honored the draw.

General Contractor/Beneficiary then sued Subcontractor/Applicant for breach of contract, replevin, injunctive relief, and conversion. Subcontractor/Applicant filed two counterclaims alleging breach of contract and unjust enrichment. Approximately one year after the complaint was filed, Subcontractor/Applicant moved to amend Counts I and II to include a claim for wrongful draw and add one alleging breach of warranty. The United States District Court, Middle District, Pennsylvania, Brann, J., granted Subcontractor’s motion to amend Counts I and II but denied its motion to add Count III.

The Judge found General Contractor would not be prejudiced by amendments to Counts I and II because the amendments would merely expand the factual allegations to include the standby. The Judge noted that “[t]he standby letter of credit differs from the traditional letter of credit in that the beneficiary may draw on the standby letter of credit only after the customer defaults on the underlying contract.”

Subcontractor/Applicant had also moved to add a third count that General Contractor/Beneficiary committed a breach of warranty by drawing on the standby under US UCC § 5-110 because General Contractor/Beneficiary defaulted under the subcontract. General Contractor/Beneficiary argued that the amended compliant failed to state a cause of action under UCC § 5-110. The Judge determined that General Contractor/Beneficiary did not commit a breach of warranty. The Pennsylvania§ 5-110 (Warranties), as provided by the opinion, states:

“(a) Warranties generally – If its presentation is honored, the beneficiary warrants:

(1) to the issuer, any other person to whom presentation is made and the applicant that there is no fraud or forgery of the kind described in section 5109(a) (relating to fraud and forgery generally)s; and

(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 Judge determined that Subcontractor/Applicant could only bring the claim under US UCC § 5-110 upon proof that the drawing violated the subcontract and not the standby itself. The Judge ruled that “[b]ecause the subcontract does not specify any acts that either entitle or disallow [General Contractor/Beneficiary] to make a draw, [Subcontractor/Applicant] cannot state a claim under the UCC for breach of warranty.”

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The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of the ICC or Coastline Solutions.