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Standby letters of credit and the independence principle.

A standby letter of credit is a valuable risk mitigation tool available to trade creditors. The bank issuing the letter of credit agrees to pay a letter of credit beneficiary who presents all of the documents required by the letter of credit. One of the central tenets of letter of credit law is the independence principle. A letter of credit is distinct from the underlying contract it is supposed to backstop. Any disputes concerning the beneficiary's performance of its obligations under the contract with its counterparty, and/or any issues between the issuing bank and the contract counterparty, who frequently arranges for the bank's issuance of the letter of credit, including the counterparty's bankruptcy filing or inability to reimburse the bank for any letter of credit drawings, have no bearing on the bank's obligation to pay the beneficiary once the beneficiary presents conforming documents under the letter of credit.

The independence principle was spotlighted in a recent decision by the United States District Court for the Southern District of Alabama in U.S. Bank vs. BankPlus. The issuing bank conceded that the letter of credit beneficiary had timely presented all of the documents required by the letter of credit. The issuing bank, nevertheless, refused to pay the beneficiary because of the bank's customers' bankruptcy filing and the alleged conflicting and competing claims regarding the validity of, and entitlement to payment under, the letter of credit.

The court held that the issuing bank had wrongfully dishonored the beneficiary's request for payment of the letter of credit. The bank had no right to dishonor the beneficiary's presentation of documents that complied with the letter of credit. The court relied on the independence principle and the well-accepted principle that a letter of credit and its proceeds are not property of its customers' bankruptcy estate. The bank's obligation to honor a conforming letter of credit draw is unaffected by the bank's customers' bankruptcy filing and is independent of any disputes between the beneficiary and the bank's customers under their contract, and/or between the bank and its customers under their contract, including the customers' bankruptcy filing.

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The issuing bank was directed to pay the amount of the letter of credit draw, together with interest and the beneficiary's reasonable attorneys' fees incurred in prosecuting its wrongful dishonor claim against the bank. The court's decision provides a valuable lesson to the trade: the issuing bank must pay a letter of credit beneficiary who presents documents complying with the letter of credit, regardless of the bankruptcy filing by the bank's customer.

Overview of Standby Letters of Credit

Trade creditors frequently rely on standby letters of credit as a backstop to protect them from a default in their transactions with a third party, usually the bank's customer, the letter of credit applicant. A letter of credit arrangement typically involves three parties and three independent contracts.

The first contract is the contract between the letter of credit applicant and the beneficiary. Their agreement could be a sale of goods or provision of services, a lease, license, note, or other agreement. In U.S. Bank vs. BankPlus, the standby letter of credit served as the earnest money deposit that the purchasers of a condominium unit were required to post under their agreement with the seller.

The second contract is the issuing bank's agreement with its customer, the letter of credit applicant. This includes the bank's agreement to issue the letter of credit, the terms of the letter of credit, the customer's obligation to reimburse the bank for payments made to the beneficiary upon the presentation of conforming documents, the bank's charges and commissions earned from issuing the letter of credit, and the collateral security for the customer's reimbursement obligation to the bank. In U.S. Bank v. BankPlus, these agreements included a note in the amount of the letter of credit that the issuing bank's customers had executed in the bank's favor, and the customers' deed of trust that granted the bank a mortgage on their property to secure their obligation to reimburse the bank for any payment made on the letter of credit.

The third contract is the standby letter of credit that the bank issues in favor of the beneficiary. When the beneficiary submits documents to the issuing bank, the bank's only duty is to examine the documents and determine whether they comply with the terms and conditions of the letter of credit. When the bank determines that the beneficiary has presented all of the documents required by the letter of credit, the issuing bank must pay the amount requested by the beneficiary. If the bank rejects a beneficiary's presentation of conforming documents, the bank is in breach of its obligation to pay on the letter of credit and is subject to the beneficiary's assertion of a wrongful dishonor claim.

One of the central tenets of letter of credit law is the independence principle. Each of the contracts in a letter of credit transaction is independent of the other. Therefore, if the beneficiary presents all of the documents required by the letter of credit, the issuing bank must honor the beneficiary's request for payment. The bank must pay the beneficiary regardless of the beneficiary's performance of the underlying transaction backstopped by the letter of credit, or the existence of disputes between the beneficiary and the bank's customer/applicant, and/or between the customer/applicant and the issuing bank, including the customer's/applicant's inability to reimburse the issuing bank for letter of credit payments and charges. And if the issuing bank makes payment to the beneficiary based upon the beneficiary's presentation of noncomplying documents, the bank's customer/applicant is not obligated to reimburse the bank for that payment.

A letter of credit issuing bank must also determine whether the beneficiary presented documents that comply with the terms of the letter of credit. The bank deals only in documents presented by the beneficiary when deciding whether to pay on a letter of credit. If the documents comply, the bank must pay the beneficiary; if the documents do not comply, the bank cannot make payment to the beneficiary, unless the applicant agrees otherwise. Most courts follow the strict compliance standard in determining compliance--the presented documents must strictly comply with the letter of credit's documentary requirements before the issuing bank can pay the beneficiary.

The court in U.S. Bank v. BankPlus focused on the independence principle. The court addressed the beneficiary's wrongful dishonor claim against the letter of credit issuing bank. Specifically, the court considered whether the issuing bank could refuse to honor a beneficiary's request for payment based on its customers' bankruptcy filing, despite the beneficiary's presentation of documents that complied with the terms of the letter of credit.

U.S. Bank v. BankPlus

On May 10, 2005, Charles and Mecia Wood (the "Woods") had entered into an agreement to purchase a condominium unit located in Orange Beach, AL from Turquoise Place (the "Seller") for approximately $1.4 million. The Woods obtained the earnest money deposit required by their purchase agreement with the Seller by having their bank, BankPlus, issue an irrevocable standby letter of credit in the amount of $277,180.00, in favor of U.S. Bank, as escrow agent for the Seller (the Seller and U.S. Bank are hereafter collectively referred to as the "Beneficiary").

The letter of credit was set to expire on November 1, 2009. The Beneficiary had to present a sight draft, and a statement indicating that the Woods had defaulted under their agreement with the Seller to purchase the condominium unit, in order to obtain payment under the letter of credit.

The Woods filed for bankruptcy on September 16, 2009 and defaulted under their agreement with the Seller to purchase the condominium. On October 27, 2009, prior to the November 1, 2009 expiration date of the letter of credit, the Beneficiary had timely presented a sight draft in the amount of $207,885 and a statement that the Woods were in default of their obligations under their agreement with the Seller.

The issuing bank refused to tender payment to the Beneficiary, and, instead, commenced a lawsuit in the Woods' bankruptcy case against the Woods, their bankruptcy trustee and the Beneficiary. The issuing bank argued that its customers' bankruptcy filing prevented the bank from making any payment to the Beneficiary, despite the Beneficiary's presentation of documents conforming to the letter of credit. The bank sought to interplead (pay into the bankruptcy court) the funds payable under the letter of credit to allow the bankruptcy court to determine who was entitled to payment of the funds. The Beneficiary moved for dismissal of the lawsuit, which the bankruptcy court ultimately granted.

At the same time, the Beneficiary commenced suit against the issuing bank, alleging that the bank had wrongfully dishonored the Beneficiary's demand for payment of sums due under the letter of credit. The Beneficiary moved for summary judgment on its wrongful dishonor claim. It argued that it had timely presented all of the documents required by the letter of credit, to wit, a sight draft and the Beneficiary's statement confirming the Woods' default under their contract with the Seller. The issuing bank was, therefore, required to honor the Beneficiary's drawing on the letter of credit. Neither the Woods' bankruptcy filing nor the issuing bank's commencement of its lawsuit to interplead the funds owing under the letter of credit excused the issuing bank from its obligation to honor the Beneficiary's demand for payment of the letter of credit based on the Beneficiary's presentation of conforming documents.

The issuing bank responded that it had refused to honor the Beneficiary's sight draft because of its customers' bankruptcy filing. The bank had commenced a lawsuit in the Woods' bankruptcy case to interplead the amount payable under the letter of credit with the bankruptcy court because the bank was faced with competing claims regarding the validity of, and payment of sums due on, the letter of credit.

The court sided with, and granted summary judgment in favor of, the Beneficiary, ruling that the issuing bank had wrongfully dishonored the Beneficiary's request for payment of the letter of credit. The court noted that the Beneficiary could prove its wrongful dishonor claim by showing an issued and outstanding letter of credit, the Beneficiary's timely presentation of the documents required by the letter of credit, and the issuing bank's refusal to pay the Beneficiary's compliant drawing. The court ruled that the Beneficiary had proven its wrongful dishonor claim based on the issuing bank's concession that the Beneficiary had timely presented all of the documents required by the letter of credit and the bank's subsequent refusal to honor the drawing and pay the Beneficiary.

It did not matter that the issuing bank's customer, the Woods, had filed for bankruptcy. The court concluded that the letter of credit and its proceeds were not property of, and were entirely separate from, the Woods' bankruptcy estate. The issuing bank was obligated to pay the Beneficiary upon the Beneficiary's presentation of conforming documents that was independent of any agreement between the Beneficiary and the Woods or between the Woods and the issuing bank. The bank's obligation was also independent of, and not impacted by, the Woods' bankruptcy filing.

The court awarded the Beneficiary damages in the amount of the Beneficiary's sight draft of $207,885, presented to the issuing bank, together with interest. The Beneficiary was also awarded payment of its reasonable attorneys' fees as the prevailing party in its wrongful dishonor action. The court relied on section 5-111 (e) of the Uniform Commercial Code, which grants the prevailing party recovery of its reasonable attorney's fees and other expenses incurred in connection with its letter of credit lawsuit.

Conclusion

A standby letter of credit is a valuable risk mitigation device that a trade creditor can use to increase the likelihood of payment of its claim. A creditor, as a beneficiary under a standby letter of credit, is entitled to payment of its drawing when it presents all of the documents complying with the letter of credit. The bank cannot invoke its customer's bankruptcy filing as a basis for dishonoring the beneficiary's compliant drawing.

In U.S. Bank v. BankPlus, the Beneficiary had presented conforming documents and was able to take advantage of the independence principle to prevail on a wrongful dishonor claim against the issuing bank, regardless of the bank's customers' bankruptcy filing. As a result, the bank was obligated to pay the full amount of the payment that the Beneficiary had requested, together with interest and the Beneficiary's reasonable attorney's fees.

Bruce Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandler PC. He is a member of NACM and is on the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI's Unsecured Trade Creditors Committee. He can be reached via email at bnathan@lowenstein.com.

Bruce Nathan, Esq.
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Title Annotation:SELECTED TOPIC
Author:Nathan, Bruce
Publication:Business Credit
Date:Sep 1, 2011
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