Factual Summary:

Bank issued a US$ 6.5 million standby LC to assure payment for purchases of raw steel from the beneficiary. Two shipments of slab steel worth $1,620,871 were delivered to the applicant within 18 days after it was placed in involuntary bankruptcy. When the applicant failed to pay, the beneficiary drew on the standby for amounts including the two shipments, and the issuer honored but did not obtain an assignment of beneficiary's rights against applicant.

Claiming subrogation to the beneficiary's rights and a corresponding administrative priority in the bankruptcy proceedings, the bank filed a proof of claim, brought this action, and, within ten days of the two shipments, took steps to reclaim the goods from applicant pursuant to UCC Section 2-702(b), which provides that the seller must give the buyer a written notice of demand in which the seller attempts to reclaim the goods from an insolvent buyer. The applicant resisted reclamation as the steel had been utilized in its business.

The Bankruptcy Court granted summary judgment to the applicant. On appeal affirmed.

Legal Analysis:

1. Subrogation under Bankruptcy Code: Issuer Subrogated to Beneficiary's Rights: The Bankruptcy Court concluded that the issuer was not entitled to equitable subrogation under the Bankruptcy Code. It concluded that the technical requirements of the Code were not met in that the obligation of the issuer did not have the same status as the seller/beneficiary. The appellate court, relying on the separate and independent character of the letter of credit obligation as distinct from the sale contract that gave rise to it, concluded that the issuer "does not automatically obtain, merely upon honor of that letter of credit and after giving [the buyer/applicant] timely notice of its assertion of its right of reclamation, a statutory or equitable right under Texas law or the Bankruptcy Code to be subrogated to the rights of the seller/beneficiary to reclaim goods sold and delivered post-petition (but not paid for) to an insolvent [buyer/ applicant], who is a debtor-in-bankruptcy."

The appellate court also ruled that the issuer was not entitled to invoke equitable principles of subrogation, agreeing with the Bankruptcy Court that the issuer "was never jointly liable with the [applicant] but was primarily liable on the letter of credit" and was "not a guarantor, endorser, or surety of the customer's debt to the steel supplier." The court was unimpressed by the fact that the debtor was able to use the steel without paying for it. It regarded this use as "the natural and foreseeable result of the deal made when the Bank agreed to issue an unsecured but irrevocable standby letter of credit."


Whatever the appropriate result may be under the Bankruptcy Code, it appears that the court is unable to make some important distinctions. It fails to understand that the principle of independence is applicable pre-honor but not post-honor. While there is an important issue of finality with respect to payments by the issuer to the beneficiary, that principle is not defeated by obtaining an assignment of the beneficiary's rights against the applicant. Nor can it be defeated by equitable subrogation to those rights. The concept of primary liability is relative. With respect to the LC, the issuer is primarily liable. With respect to the function or role of the LC in the underlying transaction, that role is the functional equivalent of a suretyship or insurance undertaking and, in that sense, is secondary. The court seemed to misunderstand these principles.



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.