Type of Lawsuit: Lender sued guarantor for breach of loan guarantee.

Parties: Plaintiff/Appellant/Lender- First Tennessee Bank National Association (Counsel: J. Hicks) Defendant/Guarantor- Small Business Administration (Hector V. Barreto, as Administrator of S.B.A.) (Counsel: R. Watson) Beneficiary/Borrower/Seller- Telware International, Inc. Issuer- Beogradska Banka in Yugoslavia Applicant/Buyer- Centrocoop

Underlying Transaction: A guarantee agreement backing a loan financing the sale of beans to a Yugoslavian company.

LC: Line of credit for US$ 882,350. Silent as to governing rules.

Decision: The U.S. Court of Appeals for the Sixth Circuit, Norris, J., Suhrheinrich, J., and Rice, C.D.J., affirmed judgment of the U.S. District Court for the Middle District of Tennessee, Campbell, J., in favor of the guarantor.

Rationale: Notwithstanding wrongful dishonor by LC issuer, a government-owned guarantor is excused from its guarantee on loan if the lender has failed to review the borrower/ seller's LC in advance and failed to follow up the wrongful dishonor seeking to persuade the issuer to honor. beneficiary was required to litigate to obtain its funds should have entitled it to the portion of the fees required in responding to the bank on the LC issues regardless of whether or not it sought refuge in an interpleader action. This award should have been against the bank. While the court correctly grasps the technical issue that the beneficiary has not made a warranty until honor, it misses the point of Section 5-111(e). If the court concluded that the drawing was without colorable basis, then the applicants (or possibly, the issuer) should have been awarded the fees related to the LC issue. In either eventuality, an award of fees would have been appropriate. As it stands, the opinion rewards banks that avoid making the hard LC decisions that are part of the business and, in effect, undermines Revised Section 5-111(e) which was intended to introduce further rigor into the system.2001 LC CASE SUMMARIES

Prior History: First Tennessee Bank v. Alvarez, No. 3:92-1019 (M.D. Tenn.), abstracted at 1999 Annual Survey 343.

Factual Summary: Lender and governmental guarantor entered into a loan guarantee agreement in which Guarantor conditionally guaranteed a percentage of certain loans made by Lender to small business borrowers. The guarantee covered only loans duly approved by Lender and Guarantor subject to Guarantor's rules and regulations. The agreement also required Lender to follow accepted standards on loan servicing employed by prudent lenders in order to protect the interests of both Lender and Guarantor. In this context, Guarantor issued an authorization and loan agreement to Lender, agreeing to guarantee 85% of a line of credit loan to Borrower, subject to the terms of the guarantee agreement. After the loan transaction was entered into, Borrower successfully used the guaranteed revolving line of credit for several export transactions. Borrower subsequently received a commercial LC in the amount of $1,235,000 naming it as beneficiary in payment for a pending shipment of goods. Lender advanced funds to the beneficiary, enabling the purchase of goods for resale. Guarantor, in consultation with Lender, waived the requirement of export insurance and of a local confirmation. The beneficiary assigned its interest in the LC proceeds to Lender to repay the loan and shipped. When the Borrower/beneficiary presented documents to issuer on the LC, the issuer failed to honor the documents, claiming that certain bills of lading were improperly endorsed. Lender failed to review any relevant documents until after the LC expired and failed to take further actions to protect its interests and the interests of the guarantor, though expert witnesses for both the lender and guarantor agreed that the dishonor was wrongful. After the issuer dishonored the LC, Borrower liquidated its inventory, realizing a substantial loss on the shipment and defaulted on the loan. Lender then requested that Guarantor repurchase 85% of the outstanding balance, which it refused to do, contending that Lender had materially breached the terms of its agreement by not prudently servicing the loan. Lender sued Guarantor for breach of contract. The trial court awarded judgment for Guarantor. On appeal, affirmed.

Legal Analysis:

1.Lending: Prudent Loan Servicing, Burden of Proof: The lender argued that "state law necessarily governs the allocation of the burden of proof" when "a plaintiff's failure to satisfy a contractual condition precedent is an affirmative defense." As such, it contended that the lender would not be obligated to demonstrate significant performance of its contractual obligations, but rather the guarantor would need to prove the lender's substantial non-performance. The court rejected this argument, however, allocating the burden of proof of contractual performance on the lender, in accordance with pertinent regulations supplied by the SBA in the Code of Federal Regulations. The relevant guidelines provided that: "Guarantor shall be released from obligation to purchase its share of the guaranteed loan unless the Lender has substantially complied with all the provisions of these regulations, the Guaranty Agreement and the Loan Authorization..." The court interpreted this guideline to impose the responsibility of proving "substantial compliance" with the terms of the loan guarantee agreement on the lender.

2. Lending: Prudent Loan Servicing: The lender contended that "its failure to act after issuer's initial dishonor of the letter of credit did not cause the SBA's loss or increase the risk of such a loss." The SBA argued that "the loan guaranty agreement required the lender to act, consistent with prudent banking practices, to protect the interests of the guarantor." The trial court ruled that the lender's failure to intervene on the beneficiary's behalf after the issuer had dishonored the LC, take a more active role in the tender of documents, and alert the lender's international department constituted breaches of 'prudent banking practices' sufficient to release the guarantor from its obligations. Indeed, the guarantor's guidelines expressly provide: "It is anticipated that the lender's commercial loan officer will work with its international department (or with the international division of its correspondent) in the implementation of an export revolving line of credit.

The complexities of export finance warrant the services of banking experts in this field." The appellate court ruled that, while the lender's deficiencies were not the initial cause of the default (the issuer's dishonor was the primary cause of default) and there was "no evidence suggesting that lender could have forced issuer to honor the letter of credit...'additional prudent action may well have helped'", and the lack of further action by the lender was sufficient to release the guarantor from its duties.

3. Expert Witness Qualifications: The lender argued that the trial court erred by allowing the SBA's expert witness to testify at trial, indicating that he was unqualified to offer expert testimony and that his testimony should have been barred through the court's "'gatekeeping' function, guaranteeing that evidence is both relevant and reliable." The lender contended that the SBA's witness' opinions were not subject to "the crucible of peer review" and that they could not be empirically confirmed. In affirming the trial court's decision to allow the witness' testimony, the appellate court relied heavily on the witness' extensive employment in bank management, with responsibilities for LC transactions. While the witness possessed "absolutely no experience in the lender-borrower relationships and, therefore, was unqualified to offer an opinion about whether lender had followed prudent banking practices with respect to servicing the loan", the appellate court noted with approval the trial judge's statement that "any weaknesses in his background will go to the weight to be accorded to his opinion ... He has sufficient specialized knowledge to be helpful in understanding this process. That doesn't mean I will necessarily believe everything he tells me."

Comment: Banks that participate in SBA guaranteed loan programs: beware. "Prudent practices" require that you make every possible effort even if in your professional judgment and that of others such an effort would have no effect on a bank that has deliberately dishonoured a complying presentation. In this case, the (remote) possibility that contacting the Yugoslav issuer that had wrongfully dishonoured a complying presentation might change the issuer's mind resulted in an excuse for the guarantor that had waived an original requirement of insurance or local confirmation.


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.