Factual Summary: When insured failed to collateralize a US$ 25,000 per claim deductible as required by the insurance company, agents of the insurance brokerage firm that sold the policies obtained standbys issued in favor of the insurer as collateral. To reimburse itself for the outstanding deductible due when the policy expired, the beneficiary/insurer drew on the LCs, but the issuer dishonored. The issuer brought an action in the state court of Alabama for declaratory judgment on its obligation. The beneficiary's subsequent action for wrongful dishonor in U.S. federal court was dismissed without prejudice since the exclusive questions of state law raised by the case were addressed in a parallel state action. Whereupon the beneficiary counterclaimed for wrongful dishonor in the state action. Applying the law of suretyship, the state trial court granted summary judgment in favor of the issuer and applicant under a state statute requiring that an action be commenced against the principal debtor shortly after the beneficiary's receipt of notice by a surety. On appeal, the summary judgment was reversed and the case was remanded for further proceedings consistent with the appellate opinion.

Legal Analysis:

1. Independence: The trial court ruled that the LC beneficiary was prevented from recovery on the LCs for failure to comply with a state statute protecting suretys by promptly commencing an action against the principal debtor. Relying on its prior decisions in Southern Energy Homes, Inc. v. AmSouth Bank, 709 So. 2d 1180 (Ala. 1998) and AmSouth v. Martin, 559 So. 2d 1058 (Ala. 1990), the appellate court stated that, "the letters of credit are independent of the underlying transaction and are properly viewed as distinct from the parties' surety arrangements." It concluded that the LC obligation was separate from the underlying suretyship obligation and governed by LC law.

2. Suretyship: The appellate court ruled that a state statute applicable to the beneficiary of a suretyship contract is inapplicable to the beneficiary of a standby even though the LC serves a similar function to a suretyship contract.

Comment: This decision correctly allocates principles of suretyship law to the sidelines in an LC dispute. The suretyship doctrine at issue reflects 19 th Century American populist sentiments sympathetic to sureties who commonly were friends and neighbors of the principal debtor and typically not compensated. In its statutory form, the rule requires that a beneficiary of a suretyship undertaking promptly commence litigations against the principal debtor once served with notice by the surety as a condition to any action directly against the surety. Such a defense, however, would limit the utility of an LC and is properly ignored. The drafters of the Restatement of Suretyship would reach a similar conclusion. It provides that "this Restatement does not govern letters of credit-standby or otherwise. The reason for this exclusion is practical. The law governing letters of credit is quite well developed, and is generally understood to govern all letters of credit, both traditional and standby. No good purpose would be served by disturbing that state of affairs." Restatement (Third) of the Law, Suretyship and Guaranty § 4 cmt. c (1996).


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.