Factual Summary: As a condition of a loan commitment for a commercial real estate development plan and a subsequent agreement between applicant and beneficiary, applicant provided a letter of credit in the amount of CAD 8.7 million as "supplemental security." The LC provided that on "demand we shall honour without enquiring whether you have a right as between yourself and our said customer to make such a demand and without recognizing any claim of our said customer." The agreement between applicant and beneficiary contained several provisions that allowed for the reduction and release of the LC. As time passed, several of these requirements were met, but the beneficiary insisted that the LC be maintained to avoid debt-servicing risk pursuant to the agreement with applicant and, accordingly, the LC was automatically renewed twice. As the first project neared completion, the beneficiary extended further financing to the applicant for a second development plan. Beneficiary and applicant entered into a "cross-collateralization" agreement related to this second plan, making use of the LC from the previous agreement, but without obtaining the issuer's consent to its use in this manner. Following the start of the second project, applicant defaulted, and beneficiary made a compliant drawing, stating that it was made pursuant to the loan commitment for the first project, although it was for applicant's indebtedness on the second project. Issuer honored the beneficiary's presentation but subsequently began adversary proceedings against the beneficiary to recover CAD2,160,907 paid on the LC, alleging that the second agreement "amounted to amendment of material terms of the letter of credit to which it did not consent such that call on the letter of credit by beneficiary for purposes of the second project constituted fraud." The issuer's complaint was that "...issuer recovered nothing on its mortgage on [the first project] but if moneys under [the LC] had been applied to [the first project] instead of , overall indebtedness of the applicant would have been reduced thereby resulting in recovery to the issuer on it mortgage." On motion a by the beneficiary, the trial court dismissed the action. On appeal, affirmed 2001 LC CASE SUMMARIES

Legal Analysis

1. Fraud, Standard: The issuer argued that the trial court erred in concluding that the drawing on the LC for different purposes than it had been issued was not fraudulent. The appellate court rejected this argument, noting that the person making an allegation of fraud"faces a high hurdle". The issuer objected to the test formulated by the trial court, namely that a claim is fraudulent "only if it is 'not even colurable as being valid or has absolutely no basis in fact'". The issuer suggested that the test was "that the false representation was made knowingly, without an honest belief in its truth, or recklessly or carelessly wheter it be true or false", citing a 19 the century decision on fraud. While 'not disagreeing with the trial judge's formulation", the appellate court noted that the record indicated 'nothing surreptitious or underhanded about the beneficiary's call on the letter of credit." It observed that the beneficiary consulted with two independent law firms "about the wording of the letter of credit and the relationship between it and the cross-collateralization agreement between it and the applicant", both of whom advised it to proceed. The court concluded that "In light of the beneficiary's caution in this regard, it is simply unrealistic and unfair to seriously consider that its conduct was deserving of the labels 'dishonest' or 'reckless'." The appellate court also noted that the drawing "was proper from a documentary point of view and the application of the funds by the beneficiary is immaterial." It pointed out that "the Letter of Credit did not require the beneficiary to verify or attest to the accuracy of the call documents. It simply required the beneficiary to present the call documents in accord with the Letter of Credit and that was done."

Comment: It should be emphasized that the court did not endorse the test of LC fraud suggested by the issuer, but merely pointed out that it had not been met. That test is flawed because it is inherently subjective. The issue is whether there is any basis for a drawing and not the intent of the beneficiary. The trial court was correct. The test is whether there is a colorable basis for a drawing.


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.