Article

Factual Summary:

A stock purchase agreement for sale of applicant's stock in two banks included an indemnification clause under which the applicant would indemnify the purchaser for any expenses arising out of any legal actions relating to the operation of the banks prior to the date of the stock purchase. The agreement included a choice of law provision which indicated that Illinois law would control any disputes.

In addition, the applicant had a revolving credit agreement with the beneficiary/negotiating bank (one of the banks being sold) under which the applicant could reborrow amounts for the sole purpose of making payments under the indemnifica-tion agreement.

To secure by a third party bank located in Wisconsin its obligations to the purchaser and to the acquired banks, the applicant had a standby LC issued for $1,157,576.42. The application for the standby had a choice of law provision which indicated that Wisconsin law would control except where conflicting with the UCP.

The applicant, during the time of the stock purchase agreement, was engaged in a lawsuit for which the applicant paid all expenses involving the acquired banks. When the opposing party prevailed in that case, it moved for sanctions against the applicant and the acquired banks. At that juncture, the acquired banks retained their own counsel to oppose the motion. The banks incurred $ 107,000 in expenses to settle the matter. The banks then demanded indemnification for those expenses from the applicant. The applicant borrowed the money to pay those expenses from the beneficiary/negotiating bank (itself one of the banks demanding indemnification). When the applicant later defaulted on its payments, the beneficiary made a drawing on the standby for $725,168.63 which included the $107,000 for the legal expenses.

The issuer initially honored the presentation; but one day later informed the beneficiary that it did not regard the inclusion of the amount for the legal expenses as being proper under the indemnification agreement. As such, the issuer set off $68,663.00 of the beneficiary's funds located at the issuer bank and demanded the balance of $38,377.00 plus interest.

The beneficiary then sued the issuer for wrongful dishonor, breach of contract (for the setting off of the funds in violation of the Correspondent Bank Resolution and Depositor's contract), and conversion. The issuer countersued for conversion, constructive fraud and actual fraud. The parties filed cross motions for summary judgments. Summary judgment was granted to the beneficiary and denied to the issuer.

Legal Analysis:

1. Choice of Law: The beneficiary argued that since the law of Illinois controlled the underlying note and purchase agreement, it should control the LC since it was silent on choice of law and was issued as part of the same transaction. The issuer, a Wisconsin bank, argued that Wisconsin law and the UCP, as provided for in the application, should control. The issuer also noted that the standby was specifically subject to the UCP. Sitting in diversity, the court looked to the choice of law provisions of the forum, Illinois. In so doing, the court noted that the choice of law provisions in UCC Article 5 as adopted by Illinois controlled the issue. Accordingly, under Revised Section 5-116(b) and (c) in effect in Illinois, the issuer's liability, absent a clear choice of law in the credit, was controlled by the location of the issuer (Wisconsin) and any rules of custom to which the credit was subjected (UCP 500).

2. Set Off: Wrongful Dishonor: The beneficiary argued that the set off taken by the issuer amounted to a wrongful dishonor of the credit. To support its argument, the beneficiary claimed that the issuer had waived its right to object to the demand after it had paid, that the documents complied, and that the issuer had not successfully asserted the defense of fraud. The issuer argued that it had not waived its right to object since it was based on fraud in the transaction since the beneficiary had no right to draw for the amounts related to the litigation under the indemnification agreement, and since a submitted certificate was fraudulent.

The court did not consider the argument of waiver because it found that under Wisconsin's version of prior UCC S-114(1), the statute in force, and UCP Articles 3, 4, 9 and 14(b), the submitted documents complied on their face with the terms of the standby. Accordingly, even if the issuer had not waived its right to object to discrepancies, it could not do so because the court found that there were none.

3. Fraud: Negotiating Bank: Turning to fraud, the court noted that the UCP did not address the issue and that Wisconsin's version of prior UCC 5-114(2) would control. The issuer argued that the litigation expenses and resulting loan that the applicant defaulted on were not covered by the indemnification agreement, and, as such, not backed by the letter of credit. Thus, it contended, the certificate of default which included those amounts was fraudulent because it was "based on a false claim of indemnity." The issuer also claimed that the applicant and the beneficiary had engaged in a joint effort to defraud the issuer by agreeing with each other that the legal expenses were covered by the indemnification agreement.

The beneficiary argued, and the court found, that under prior 5-114(2)(a), the issuer, even in the face of fraud "must honor the draft or demand for payment if honor is demanded by a negotiating bank." The beneficiary in this instance claimed that it was a negotiating bank and the issuer had not disputed that fact. Accordingly, the court found that even if the certificate was fraudulent, the issuer had a duty to honor the presentation.

4. Damages: Noting that the prior UCP did not deal with remedies for wrongful dishonor, the court turned to Wisconsin's version of UCC 5-115 and held that the beneficiary was entitled to the amounts set offby the issuer plus 5% interest. Having found for the beneficiary on its wrongful dishonor claim, the court dismissed the beneficiary's other claims as moot.

Comment:

1. This case has the honor of being the first case to apply Revised UCC Article 5 other than by analogy. The court looks to the choice of law rules of Revised Section 5-116 to conclude that the substantive law of the issuer should govern. Since that law (Wisconsin) is prior UCC Article 5, the case applies the substantive law of the prior version of the UCC. Interestingly, the opinion also notes that the letter of credit is governed by the UCP under Revised Section 5-116(c). This provision clarifies the extraordinary role of rules of practice where letters of credit are issued subject to them and places them on a par with rules of law as if they were a choice of law provision. In this case, at least, the provision had the desired effect as the court gave due respect to UCP 500 to which the credit was subjected.

The only question to be asked is how a LC issued in 1993 can be subject to a choice of law rule which did not take effect in Illinois until 1 January 1996 and which provides that it is applicable to LCs issued subsequent to that date. The court did not concern itself with the issue and it may well have disregarded it since the choice of law rule under prior case law was identical, there being no statutory provision other than UCC Section 1-105, the UCC's general choice of law provision which gave no guidance on the matter. On the other hand, reference to the current law for choice of law questions may well be appropriate even if that law referred one to the prior version for substantive law.

2. Having disposed nicely of the choice of law question, the decision turns to the delicate issue of the applicability and scope of the fraud defense. Wisely, the court penetrates to the essence ofthe issuer's argument which turns on fraud since the documents conformed on their face. Without considering whether or not the alleged fraud in the transaction was present, the court determined that the issuer could not resist payment to the negotiating bank on the basis of fraud. In doing so, it concluded that the language of prior Section 5-114(2)(a) entitled a negotiating bank to payment without regard to proof of its holder in due course status.

In this interpretation of the meaning of Section 5-1 1 4(2)(a), the court is not only literally correct but accurately reflects the presumption inherent in banking practice that negotiating banks are entitled to the presumption that their payments are proper. While this matter is not entirely clear because bankers rarely articulate their assumptions with respect to fraud, it does reflect the importance and reverence given to correspondent banking relation-ships. The assumption is that any correspondent would behave with honor and not jeopardize the correspondent relationship or its reputation by falsely stating that it had acted as a negotiating bank. In this respect, however, it must be recognized that there is considerable room for maneuver since there is little agreement as to what constitutes a negotiating bank.

However that may be, the presumption begins to break down when the negotiating bank is also the beneficiary who is accused of making the fraudulent statement. In this case, it is impossible to determine from the opinion the extent to which it is the negotiating bank which initiated the allegedly fraudulent statement but it is difficult to move beyond this point. The entire issue turns on precisely who is the alleged fraudster. If it is the negotiating bank and if there is proof of such fraud, the presumption that a negotiating bank should be entitled to reimbursement evaporates and the negotiating bank should be required to prove that it has not engaged in fraudulent conduct. Unfortunately, this analysis is clouded by the remnants of negotiable instrument law and holder in due course analysis which is largely irrelevant to the problems of letter of credit law. In any event, the court's assumption that a negotiating bank is entitled to reimbursement per se cannot be correct.

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