Article

Factual Summary:

To pay for the purchase of 30,000 dozen cotton rompers (an article of children's clothing), buyer caused the issuance of a commercial credit in favor of seller, a Chinese textile manufacturer. Upon beneficiary's request, the credit was subsequently amended to include a red clause. The clause authorized the beneficiary to draw upon the credit for the purpose of purchasing raw materials to fill the applicant's order.

The beneficiary made two draws on the credit. Upon each draw, the nominated bank sent telexes to the issuer demanding reimbursement. The telexes stated that the nominated bank had made advances on the credit, and included statements from the beneficiary to the effect that the advances were being used to purchase raw materials. The opinion does not indicate whether the issuer reimbursed the nominated bank. After the beneficiary had allegedly partially completed the applicant's order, a typhoon struck and damaged the merchandise at the beneficiary's plant. The beneficiary informed the applicant, and requested that a second letter of credit be issued to enable it to purchase new raw materials so that it could complete the project. The applicant complied with this request and caused the issuance of a second letter of credit. The second credit also contained a red clause. The beneficiary made two draws on the second credit. As it did in connection with the draws under the first credit, the nominated bank sent telexes to the issuer demanding reimbursement. The telexes included beneficiary's statements regarding the use of the advances. The opinion does not indicate whether the issuer reimbursed the nominated bank.

The beneficiary never fulfilled its obligations under the contract and eventually informed the applicant that financial difficulties prevented it from performing under the contract. The beneficiary also informed the applicant that it had used the red clause advances to reduce the debts it owed to the nominated bank.

The applicant then brought this action against the beneficiary and the nominated bank, alleging nine separate causes of action: common law fraud; conversion; fraud in the transaction, under Article 5 of the Uniform Commercial Code; conspiracy;violations of the Racketeer Influenced and Corrupt Organization Act (RICO), 18 U.S.C.A. - - 1961- 1968; negligent misrepresentation; breach of fiduciary duty; breach of contract; and tortious inducement. The nominated bank then moved to dismiss the claims against it. The opinion only addresses the applicant's claims against the nominated bank and did not address the applicant's claims against the beneficiary.


Legal Analysis:

1. Inapplicability of the UCC: According to the court, the claims brought by the applicant raised an issue of first impression in the Commonwealth of Pennsylvania: whether an applicant may proceed under both statutory and common law claims against a nominated bank for advances made to a beneficiary under a red clause in a letter of credit. To resolve this issue, the trial court first discussed the classification of the functions performed by the nominated bank.

The court found that the UCC does not address the activities performed by the nominated bank. In order to avail itself of the protection afforded by the UCC, namely the independence principle, the nominated bank characterized itself as an advising bank (it was listed in the LC as the "second advisory bank"). The court did not agree with this characterization because the nominated bank actually paid under the credit. It reasoned that under the UCC, advising banks are not authorized to pay but may only verify communications and render advice to assure the beneficiary of the authenticity of the issuer's transmissions. Further, the court found that the nominated bank did not satisfy the UCC's definition of a confirming bank because, although it was authorized to pay under the red clause, it was not obligated to do so. The court noted that the functions performed by the nominated bank were specifically described by the UCP. UCP 500 Article 49 defines a red clause credit as one that authorizes a nominated bank to make advances to the beneficiary before presentation of the documents that are required by the credit. Nonetheless, finding that the nominated bank performed functions that were not described in the UCC, the court concluded that the UCC was not applicable to the transaction in the instant case. Therefore, without the protection from liability provided by the independence principle, the applicant was not precluded from asserting common law causes of action against the nominated bank.

Since the court found the instant transaction to be outside the scope of UCC Article 5, it also found the applicant's claim against the nominated bank for fraud in the transaction under UCC Article 5 to be inapplicable. The court granted the nominated bank's motion to dismiss the applicant's claim for fraud in the transaction.

2. Fraud: The applicant had asserted a cause of action against the nominated bank for common law fraud. The court noted that common law fraud involved: (i) a specific false representation of material fact; (ii) knowledge by the person who made it of its falsity; (iii) ignorance of its falsity by the person to whom it was made; (iv) the intention that it should be acted upon; and, (v) that the plaintiff (applicant) acted upon it to his damage.

The claimed fraud was the statements made by the nominated bank in its telexes to the issuer to the effect that the advances under the red clause would be used to purchase raw materials to enable the beneficiary to fulfill its contractual obligation to the applicant. The nominated bank characterized those statements to be future promises, not present or pre-existing facts and, therefore, contended that the applicant failed to establish an element of fraud. The court did not agree, noting case law to the effect that a cause of action for fraud may be predicated on a misrepresentation of a future promise.

The nominated bank argued that the applicant's claim of fraud was flawed because it owed no duty to the applicant, and that it was under no obligation to refuse the beneficiary's instructions to apply the advances made under the red clause or to monitor the intended use of the advances. In addition the applicant asserted that the statements contained in the telexes to the issuer demanding reimbursement for the advances did not contain any false statements and that the nominated bank did not make any representations regarding the accuracy of the statements made by the beneficiary. The court noted, however, that if the nominated bank knew that its statements were false at the time they were made, a jury could find fraud.

The nominated bank also argued that it did not owe the applicant a duty and, therefore, the applicant could not prove an essential element to common law fraud. The nominated bank based this argument on the fact that it did not make any representations to the applicant. Further, because no representations were made to the applicant, it could not claim reliance on the representations the nominated bank made to the issuer. The court rejected this argument on the ground that the nominated bank offered no authority in support of its argument. Therefore, the court held that a jury could find that a nominated bank owes a party that is not in privity with it a duty in the context of common law fraud.

Accordingly, the court found adequate evidence in the record to create a genuine issue of material fact as to whether the nominated bank perpetrated fraud through misrepresentations and concealment, and whether the applicant actually relied on those misrepresentations and non-disclosures.

3. Conversion: Under Pennsylvania law, conversion is defined as the deprivation of another's right of property in, or use or possession or, a chattel, without the owner's consent and without lawful justification. The nominated bank argued that since the applicant could not succeed on a claim for conversion because it did not have an immediate and unconditional right to the funds under the letter of credit. The court agreed, noting that although an applicant may challenge the disposition of funds under a letter of credit, it has no right to possess or draw upon a letter of credit. Accordingly, the trial court granted the nominated bank's motion for summary judgment with respect to applicant's claim of conversion.

4. Civil Conspiracy: Although the nominated bank moved for summary judgment with respect to the applicant's claim of civil conspiracy, it made no argument in support of its motion. In the absence of an argument, the court declined to rule on the nominated bank's motion with respect to the civil conspiracy claim

5. Tortious Inducement: The applicant asserted a cause of action against the nominated bank for tortious inducement. The court noted the elements of tortious inducement to be the following: (i) the existence of a contractual relationship; (ii) an intent on the part of the defendant (nominated bank) to harm the plaintiff (applicant) by interfering with that contractual relationship; (iii) the absence of a privilege or justification for such interference; and (iv) damages resulting from the defendant's (nominated bank's) conduct.

The nominated bank argued that the applicant's claim for tortious inducement failed because the record contained no evidence of any intent on the part of the nominated bank to harm the applicant. The applicant countered by arguing that the intent of the nominated bank can be deduced from its knowledge that the red clause advances were required by the beneficiary to purchase raw materials, that the beneficiary was in poor economic health, that the funds were not used to purchase raw materials, and that a direct harm would result to the applicant from the misappropriation of the red clause advances. With minimal discussion the court denied the nominated bank's motion for summary judgment with respect to the applicant's claim of tortious inducement.

6. Negligent Misrepresentation: The nominated bank moved for summary judgment on the applicant's claim for negligent misrepresentation on the ground that it owed neither a statutory or common law duty to the applicant. The court agreed, yet qualified its opinion by stating that it did not agree with the nominated bank's contention with respect to fraud. That is, the court reasoned that a jury could find fraud if the nominated bank intentionally made falsestatements to the issuer, but could not find negligent misrepresentation because the nominated bank made no representations to the applicant. The court granted the nominated bank's motion for summary judgment with respect to the applicant's claim of negligent misrepresentation.

7. RICO - Racketeer Influenced and Corrupt Organizations Act: The federal RICO statute prohibits persons from receiving or deriving income through either a pattern of racketeering activity or the collection of an unlawful debt. The nominated bank moved to dismiss the applicant's RICO claim because it was not engaged in a pattern or racketeering activity.

In order to satisfy the pattern requirement, person must engage in a pattern of related acts that either amount to or pose a threat of continued criminal activity. That is, the illegal activities must be related and continuous. Isolated or discrete events are not within the scope of RICO. The applicant argued that the nominated bank commitment wire fraud through the telexes that it sent to the issuer and, further, that such acts satisfied both the relatedness and continuity requirements of RICO. The court agreed, noting that the record could support a finding that the activities of the nominated bank were subject to RICO. The court denied the nominated bank's motion for summary judgment with respect to the applicant's RICO claim.

Comment:

1. It is painful to follow this lengthy opinion as it winds its way through extensive research and analysis from mistaken conclusion to further mistake, building to a sad crescendo which is totally at odds with letter of credit practice and misunderstands letter of credit law. It is even more unfortunate that the opinion stands due to the settlement of the case so that there will not be an opportunity for appellate review and (hopefully) correction of the opinion. While the absence of prior litigation regarding red clauses offers some hope that the case will have little practical import, the continual references to other correspondent relationships makes this possibility unlikely.

2. Ultimately, it is apparent that the judge could not figure out the role of a negotiating bank in a letter of credit transaction. Necessarily, it would follow that he would be unable to understand the role of a bank acting under a red clause.

3. In part, the error is due to his inability to understand that the categories of banks in letter of credit practice are not mutually exclusive. To be sure, the UCC is not clear that a confirmer is an advising bank which undertakes to honor the LC and even less clear that an advising bank may be nominated to pay or negotiate. Absent the fundamental working understanding of LC practice and operating from abstract definitions, the court is like a person who has never encountered a square attempting to create one based on written instructions. It is little surprise that the result is a circle.

4. Instead of seeking to understand the role and obligations of a bank acting pursuant to a red clause under standard LC practice, the court blundered through a series of definitions, ultimately reaching the interim (and somewhat obvious) conclusion that the situation was not addressed by UCC Article 5. What followed, however, from this conclusion was mind boggling. The court concluded that, as a result, the matter was not governed by UCC Article 5 or subject to letter of credit law. Shockingly, it supported this result by reference to Prior UCC Section 5-102(3) which recognizes that the statute does not address all the situations which would arise. This provision has long been understood to mean that such matters as are not addressed should be approached in a manner consonant with the approach and principles laid down in Article 5. To conclude that red clause practice is not practice within the scope of letter of credit law is simply absurd.

5. The real question, though, is what is the proper role of a red clause bank and what obligations does it undertake and to whom. The last place that one would expect to find answers to these questions is common law--the very place to which the court looked. The source of any meaningful understanding must come from letter of credit practice.

6. Under LC practice, a request to a bank to advance funds and compliance with that request does not of itself change that proposition that the transaction is documentary. The advance of funds under a red clause is against documents. The bank which advances the funds is not in a position to know whether the documents are correct or true and makes no representations with regard to them. The fact that the bank forwards the documents to the issuer and that they contain a certification regarding the use of the funds does not change this equation. The bank is not in a position to police the transaction and should not be required to do so. Even if the funds were used to repay other debt owed the bank, it does not necessarily follow that the bank has acted in an improper manner. It is to be expected that a bank-customer relationship exists between the red clause bank and the beneficiary. It is also to be expected that there is a correspondent relationship between the red clause bank and the issuer and other banks which is the source of that bank's international reputation.

7. How the beneficiary allocates its cash flow and utilizes funds is not the responsibility of the bank. Of course, if it has actively engaged in fraudulent conduct or has actual knowledge of fraud (i.e. that there was no colorable possibility that the transaction was valid), the bank would have committed letter of credit fraud. Short of such fraud, the red clause bank owes no duty whatsoever to the applicant and its duty to the issuer is to handle the advance in accordance with standard letter of credit practice and the terms and conditions of the LC.

8. A helpful analogy may be had from guarantee standby practice in which one deals with two independent undertakings somewhat inter-related but in which a drawing on one is measured only by facial compliance. The willingness of banks to advance funds under a red clause -- a risk that should be borne by the applicant and not the banks because it is that applicant that benefits -- is only predicated upon the ability to claim reimbursement upon payment against a complying advance drawing. To say that this opinion muddies that proposition is an understatement. Perhaps its one positive contribution will be to force the international operations community to articulate more clearly these principles as they apply to red clause payments.

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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 ICC or the other partners in DC-PRO.