Factual Summary:

In order to have a residential subdivision plat approved by the local (county) government/beneficiary, the builder agreed to build the subdivision's infrastructure and obtain a standby to assure performance. When the builder/applicant failed to perform, "the bank refused to allow the county to draw on all of the funds pursuant to the letter of credit." The issuer and beneficiary agreed subsequently that the beneficiary could draw upon the LC for completion of the roads of the subdivision. Upon approval of the roads, the issuer would issue another LC to the beneficiary for the installation of a central water system for the subdivision.

When the issuer "refused to allow" the beneficiary to draw on the second LC, the lot owners of the subdivision brought an action against the issuer and the beneficiary, alleging that they were the intended third-party beneficiaries of the LC. The lot owners claimed that the issuer had breached its "contract" by not permitting the beneficiary to draw upon the LC, and the beneficiary breached its contract by not drawing on the LC. The issuer and the beneficiary each moved to dismiss for failure to state a claim and the trial court granted both motions. The issuer's motion was granted with prejudice and without leave to amend, and the beneficiary's motion was granted without prejudice and with leave to amend. The appeal of the award of the beneficiary's motion was dismissed since it was not an order able to be appealed and the award of the issuer's motion to dismiss for failure to state a claim was affirmed.

Legal Analysis:

1. LC is not a Contract: The lot owners based their claim on the theory that they were third-party beneficiaries of the letter of credit, which they characterized as a contract between the issuer and beneficiary. As a result, the lot owners claimed that they were entitled to relief under the LC since the underlying transaction that it supported, the subdivision improvements, were intended for their benefit. The appellate court rejected this characterization, noting that "[a]lthough a letter of credit is often referred to as an agreement or contract, as between the issuer and the beneficiary it is more accurate to say that it is a document that creates certain duties between the parties. These duties are statutory, not contractual." The opinion cited White & Summers for the proposition that "[t]his undertaking in the letter of credit is sometimes called a contract, but most letter of credit specialists prefer to refer to it ... as an 'undertaking' and not as a contract." Uniform Commercial Code § 20-1(a), at 698 (5th ed. 2000).

2. LC Independent of Underlying Contracts: The lot owners claimed a right under the letter of credit because they were injured with respect to the underlying agreement. Disagreeing, the court recited the independence principle, which it described as a "fundamental rule embodied in the UCP and UCC ...".

"The independence rule and the other principles previously discussed are based on the practical considerations that the issuer lacks control over the underlying agreement and the selection of the beneficiary named in the letter of credit. Furthermore, in most cases, the issuer does not even know of the existence of the underlying agreement. This lack of control distinguishes the letter of credit from most other types of financial instruments used in commercial transactions and gives it independence from the law of contracts, negotiable instruments, guaranty, and most importantly to this case, from the law relating to intended third-party beneficiaries."

3. Independence Principle: The lot owners also cited a county ordinance requiring completion of required improvements as a basis for permitting relief against the issuer. Noting that the letter of credit was subject to the UCP which prohibits "liability of the issuer for breach of the underlying agreement", the court rejected this argument. It stated "any party injured by breach of the underlying agreement between the customer/buyer and the beneficiary must seek recourse against one of those parties, not the issuer of a letter of credit. To hold otherwise would vitiate the efficacy of the letter of credit in commercial transactions and frustrate its salutary purpose of enhancing efficiency and confidence in financial arrangements between buyer and seller."


1. One is left to puzzle over the attitude of the beneficiary and the reaction of the issuer. Perhaps the court or attorneys misunderstood what was asserted, but it appears from the opinion that the issuer "refused" to allow drawings on the LC. Because the opinion is sound on the issue of an LC not being a contract and with respect to the implications of the independence principle, one must assume that the court was silent as to this strange reference because the parties did not make it an issue. Nonetheless, one wonders what the bank thought it was issuing and what the municipality thought it was securing if the bank was allowed to "refuse" a complying drawing.

2. Nonetheless, these intended third-party beneficiaries were properly turned out of court on their LC claim. What is left for them is to seek to turn out in the next election the politicians who evidently failed to uphold their interests.



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.