New York Court Vindicates Independence Principle and Construes Letter of Credit Against Issuer New York Court Vindicates Independence Principle and Construes Letter of Credit Against Issuer

New York Court Vindicates Independence Principle and Construes Letter of Credit Against Issuer

Many consider standby letters of credit to be the gold standard of third-party credit support documents.  Among the reasons this is so are that the payment obligations of the issuer are not subject to the same sorts of defenses that a guaranty is subject to, and because the conditions precedent to payment are documentary in nature (that is, they depend on the delivery of documents), rather than conditions which depend on the occurrence of non-documentary events or the existence of non-documentary facts.[1]
A recent decision of a New York intermediate appellate court, BasicNet S.p.A. v. CFP Services Ltd.,[2] illustrates how the advantages of a letter of credit for a beneficiary might have been lost through the inclusion of an unusual condition that the issuer argued gave it the sole power to determine whether the beneficiaries’ obligations in the underlying transaction had been performed.
The court rejected the issuer’s argument, for the principal reason that this argument was inconsistent with the independence principle, a fundamental underpinning of letter of credit law.  The court also applied a rule construing the letters of credit against the issuer, and also stated that the issuer could have been estopped from enforcing the condition in a manner consistent with its argument based on what the court found to be improper communications between the issuer and the LC applicant.
On or about October 6, 2010, CFP Services issued two standby letters of credit (“LCs”) to BasicNet and a related company, Basic Properties (collectively, the “Basic Entities”).  CFP issued the LCs to support the obligations of Kappa North America to make royalty payments to the Basic Entities under a trademark license agreement among the Basic Entities, as licensors, and Kappa, as licensee.
In addition to requiring the Basic Entities, as beneficiaries of the LCs, to deliver certain documents to the issuer as a condition precedent to drawing under the LCs, the LCs contained an unusual condition that CFP must have delivered a SWIFT message to the beneficiaries’ bank “confirming Beneficiary’s fulfillment of their commitment towards [Kappa] . . .” and that the beneficiaries must have delivered a copy of this SWIFT message to the issuer (the “Issuer Confirmation Requirement”).
As separate conditions to drawing, the Basic Entities were required to deliver to CFP (i) signed statements that they had discharged all their obligations to Kappa and that Kappa had failed to discharge its obligations under the license agreement, (ii) copies of default notices sent to Kappa and (iii) a statement from an accountant that Kappa had defaulted on its minimum royalty payments.
The LCs stated that they were governed by New York law and the International Standby Practices (“ISP 98”).
On or about October 14, 2010, the Basic Entities and Kappa entered into an amendment to the license agreement, whereby Kappa agreed to cause CFP to issue a SWIFT message to the beneficiaries’ bank confirming that the beneficiaries’ commitment towards Kappa had been fulfilled.  On November 6, 2010, CFP sent a SWIFT message confirming that CFP had received the amended licensing agreement.
On July 1, 2011, Kappa executed a waiver and release agreement in which it acknowledged that it was in “significant and material default” of the license agreement.
On September 29, 2011, the Basic Entities made draw requests under the two LCs.  On October 6, 2011, CFP refused to honor the draw requests.  On December 8, 2011, CFP sent a SWIFT message to the beneficiaries’ bank stating that CFP’s November 6, 2010 SWIFT message did not satisfy the Issuer Confirmation Requirement, that CFP had contacted Kappa, that Kappa had informed CFP that a dispute existed between Kappa and the Basic Entities and that the Basic Entities had not “fulfilled their commitment towards [Kappa]” as contemplated by the terms of the Issuer Confirmation Requirement.
There was evidence that CFP had been in discussions with Kappa concerning these matters prior to when the draw requests were made.  At CFP’s request, Kappa provided a letter to CFP dated October 14, 2010 which set forth the terms of the Issuer Confirmation Requirement and stated that “[w]e agree that you shall have no obligation whatsoever to send the Swift Message [referred to in the Issuer Confirmation Requirement] or issue any amendments.”[3]  The Basic Entities had no knowledge of this letter until the litigation was underway.
The Basic Entities sued CFP for breach of contract, and moved for summary judgment.  The trial court denied the motion for summary judgment, and the Basic Entities appealed.
Although CFP asserted other defenses to payment, this memorandum will concentrate on the issues related to the Issuer Confirmation Requirement.  The Basic Entities took the position that, pursuant to the amendment to the license agreement, their only commitment to Kappa was to execute such amendment, and that the Issuer Confirmation Requirement was satisfied by CFP’s November 6, 2010 SWIFT message.  CFP argued that, under the LCs, it was to be “the sole arbiter” of whether the Basic Entities’ had fulfilled their commitment to Kappa under the amended license agreement.
The appellate court reversed, and directed that summary judgment be entered in favor of the Basic Entities.
Strict Compliance/Construction Against Issuer
New York courts have held that the beneficiary must prove that it strictly complied with the terms of the letter of credit in order to prevail on a claim that the issuer wrongfully dishonored a payment demand.[4]  As a corollary to that rule, New York courts have held that “the requirements in letters of credit must be explicit, and that all ambiguities are construed against the [issuer].”[5]
In BasicNet, the court determined that the Issuer Confirmation Requirement was ambiguous.  The court noted that the reference to the Basic Entities’ “commitment” to Kappa was “not defined” and did not refer to the underlying license agreement, in contrast to the other more specific documentary conditions, which required the Basic Entities to deliver certificates to the issuer stating that they had discharged their obligations under the license agreement and that Kappa had not discharged its obligations thereunder, as well as copies of default notices delivered to Kappa which related to the license agreement.
In construing this ambiguity, the court held that that the Basic Entities’ interpretation of the Issuer Confirmation Requirement –that their only commitment to Kappa was to execute the amended license agreement and that the requirement was satisfied by the November 6, 2010 SWIFT message—was  “the only reasonable and legally cognizable interpretation of the provision. . . .”  The court found that the purpose of the amended license agreement was to restructure the debt payable by Kappa to the Basic Entities as a result of Kappa’s default.  The court also found that the provision in the amendment to the license agreement whereby Kappa had agreed to cause CFP to issue a SWIFT message that complied with the Issuer Confirmation Requirement was evidence that the Basic Entities had fulfilled their obligations to Kappa.
Independence Principle
A fundamental principle of letter of credit law is the independence principle.  The independence principle provides that the issuer’s obligation to honor payment demands by the beneficiary is separate and independent from any obligation of the issuer’s customer to the beneficiary under the underlying contract, and is also separate and independent from any obligation under any agreement between the issuer and its customer for reimbursement of LC payments or otherwise.[6]  As the BasicNet court noted, “[f]rom the beneficiary’s perspective, the independence principle makes a letter of credit superior to a normal surety bond or guaranty because the issuer is primarily liable and is precluded from asserting defenses that an ordinary guarantor could assert.”
In BasicNet, the court held that CFP’s interpretation of the Issuer Confirmation Requirement –that it was to be the “sole arbiter” of whether the Basic Entities had fulfilled their “commitment” to Kappa“would impermissibly conflict with the Independence Principle” and “would make CFP’s obligations under the [LCs] truly illusory.”  The court held that, rather than simply making a ministerial determination whether the Basic Entities had submitted documents that complied with the requirements of the LCs, CFP sought to exercise “unfettered discretion to decide whether or not it will pay on the [LCs] based on its unilateral determination” of whether the Basic Entities had performed their obligations to Kappa.
CFP argued that the terms of the LCs varied the independence principle and were nonetheless enforceable against the Basic Entities.  The court disagreed; although Article 5 of the UCC (which applies to letters of credit) is quite liberal in that it permits the parties to vary many of the terms of such Article by contract, the court noted that Article 5 does not permit the independence principle to be varied contractually.[7]  The court also noted that Rule 1.01(c) of ISP 98 permits the parties to a letter of credit transaction to expressly modify or exclude the application of the rules of ISP 98 to a letter of credit, but held that there was no such express modification or exclusion.[8]
There is New York precedent to the effect that an issuer may be estopped from asserting that it has a defense to honoring a draw request if the issuer improperly involves the LC applicant in the process of reviewing the documents presented in connection with such request.  In E & H Partners v. Broadway Nat’l Bank, [9] the leading case expressing this view, the court held that improper participation by the applicant in the document review process was inconsistent with the independence principle, as well as a violation of the issuer’s duty to act in good faith.[10]  In E & H, the court contrasted what it viewed as routine contacts between an issuer and an applicant to waive discrepancies in non-conforming documents with what the applicant did in that case: “[n]ot only did [the applicant] repeatedly urge [the issuer] to dishonor the draft, it also hired a lawyer to find errors in [the beneficiary’s] submissions.”
In BasicNet, the court stated that “[e]ven assuming, arguendo, that CFP’s interpretation of [the Issuer Confirmation Requirement] is correct and that the parties could contract out of [the independence principle], CFP would be estopped from enforcing [the Issuer Confirmation Requirement] based on the improper communications it had with Kappa relating to dishonoring the [LCs].”  The court noted that “[t]o evaluate [the Basic Entities’] presentations, CFP spoke to officers of Kappa and considered Kappa’s written notices of the dispute between itself and [the Basic Entities] and its objections to payment of [their] claims.”  The court also found that the October 14, 2010 letter from Kappa to CFP was further evidence of collusion.
Final Observations
Standby LCs frequently include documentary conditions precedent that are in addition to a simple draft demanding payment at sight.  For example, it is common for the conditions to drawing to include the delivery of a drawing certificate whereby the beneficiary certifies that an event has occurred that entitles the beneficiary to draw (such as a default under the underlying contract).  Other types of deliveries might include a certificate from a third party that a condition has been satisfied, as was the case here with the requirement that an accountant deliver a certificate.  If such certifications or other deliveries were materially fraudulent, it would be possible for the applicant to seek to have a court enjoin the requested draw.[11]
Although the beneficiaries prevailed in this case, the inclusion in the LCs of a condition which arguably gave discretion to the issuer caused a lot of difficulty which could have been avoided.
LC beneficiaries should take care not to accept LCs that include a condition that gives the issuer the opportunity to exercise discretion or judgment as to whether a state of facts exists that is extrinsic to the documents presented.  An issuer’s role should be limited to determining whether documents that comply with the LC’s drawing conditions have been delivered to it.  Allowing a condition that would give the issuer greater discretion may reduce the certainty of payment that an LC is supposed to provide, and may cause the expected advantages of an LC over other forms of credit support to be lost.
LC issuers should be aware that in some jurisdictions courts will construe ambiguous language in an LC against the issuer.  Issuers should also be mindful that they may be estopped from asserting defenses based on documentary issues if there is improper contact between the issuer and the applicant concerning the review of a documentary presentation, if the contact involves consulting with the applicant to deny the draw request.
To learn more, please contact John Lawlor or any member of Ice Miller’s Banking and Financial Services practice.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances. 

[1] UCC §5-102(a)(10) defines “letter of credit” to mean a “definite undertaking that satisfies the requirements of Section 5-104 by an issuer to a beneficiary at the request or for the account of an applicant or, in the case of a financial institution, to itself or for its own account, to honor a documentary presentation by payment or delivery of an item of value.”  See also ISP 98 Rule 1.06(a): “A standby is an irrevocable, independent, documentary and binding undertaking . . . .”  Official Comment 7 to ISP 98 Rule 1.06 states that: “This Rule emphasizes the principle that an issuer’s obligations turn only upon the presentation of documents.  The documentary character of a standby is closely linked to its independence.”  Under Rule 4.11 of ISP 98, nondocumentary conditions are to be disregarded.
[2] 2015 WL 1182733 (N.Y. Supreme Court, Appellate Division, First Department, Mar. 17, 2015).
[3] The LCs initially also required that the issuer’s message to the beneficiaries’ bank also contain the statement “and that we are in funds.”  This additional language was subsequently removed from the LCs by an amendment dated on or about October 14, 2010.
[4] See Nissho Iwai Europe PLC v. Korea First Bank, 782 N.E. 2d 55 (N.Y. Ct. App. 2002);  and Marino Indus. Corp. v Chase Manhattan Bank, N.A., 686 F.2d 112 (2nd Cir 1982).  See also UCC §5-108(a) and Official Comment 1 to UCC §5-108.
[5] Marino, 686 F.2d 112, 115.  See also Venizelos, S.A. v. Chase Manhattan Bank, 425 F. 2d 461, 466 (2d Cir. 1970) (“ . . . as between the beneficiary of a letter of credit and the issuer . . . if ambiguity exists, the words are taken as strongly against the issuer as a reasonable reading will justify.”)  Courts in other jurisdictions may not apply this rule.  See Dolan, The Law of Letters of Credit, §4.08[4] (“A general review of the cases indicates that some courts construe the ambiguous credit against the drafter and some construe it against the issuer [citing cases]”).
[6] The independence principle is codified in UCC §5-103(d) (“Rights and obligations of an issuer to a beneficiary or a nominated person under a letter of credit are independent of the existence, performance, or nonperformance of a contract or arrangement out of which the letter of credit arises or which underlies it, including contracts or arrangements between the issuer and the applicant and between the applicant and the beneficiary.”)  Rule 1.06(c) of ISP 98 is consistent with this (“Because a standby is independent, the enforceability of an issuer’s obligations under a standby does not depend on: (i) the issuer’s right or ability to obtain reimbursement from the applicant; (ii) the beneficiary’s right to obtain payment from the applicant; (iii) a reference in the standby to any reimbursement agreement or underlying transaction; or (iv) the issuer’s knowledge of performance or breach of any reimbursement agreement or underlying transaction.”) as is Rule 1.07 of ISP 98 (“An issuer’s  obligations toward the beneficiary are not affected by the issuer’s rights and obligations toward the applicant under any applicable agreement, practice, or law.”)
[7] See UCC §5-103(c), which sets forth certain provisions of Article 5 of the UCC which may not be varied by contract.  As noted in Official Comment 2 to UCC §5-103, Article 5 of the UCC contemplates that parties in a letter of credit transaction may adopt standard rules of custom and practice, such as the Uniform Customs for Documentary Credits or ISP 98, to govern the letter of credit.  To the extent that such standard rules conflict with Article 5 of the UCC, such standard rules govern, unless the conflict is with one of the nonvariable provisions set forth in UCC §5-103(c).  UCC §5-116(c).
[8] See Rule 1.01(c) of ISP 98 (“An undertaking subject to these Rules may expressly modify or exclude their application”); Rule 1.04 of ISP 98 (“Unless the context otherwise requires, or unless expressly modified or excluded, these Rules apply as terms and conditions incorporated into a standby …”); and Rule 1.11(d)(iii) of ISP 98 (“Addition of the term ‘expressly’ … to the phrase ‘unless a standby otherwise states’ or the like emphasizes that the rule should be excluded or modified only by wording in the standby that is specific and unambiguous”).
[9] 39 F. Supp. 2d 275 (S.D.N.Y. 1998).
[10] “A bank has an independent obligation to the beneficiary; to permit the payor to pressure or collude with the bank to dishonor the draft destroys the very principle upon which the commercial utility of letters of credit rests.”  E & H, 39 F. Supp. 2d 275, 285.  See generally Dolan §6.06[2][c].
[11] UCC §5-109(b).  See generally White, Summers, & Hillman, Uniform Commercial Code §26:38.

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