Letters of Credit As a Way of Securing Obligations by wuxiangyu


									                   Letters of Credit As a Way of Securing Obligations


                                     Bryan D. Hull
                                    Professor of Law
                             Loyola Law School, Los Angeles

        In this class, we have been focusing on the securing of obligations by taking
security interests in personal property collateral under UCC Article 9. Another way to
secure obligations is through the use of letters of credit.

        Under a letter of credit, the issuer of the letter of credit will agree to pay the
beneficiary of the letter of credit upon presentation to the issuer of certain specified
documents. Letters of credit are often used in sale of goods transactions. The buyer will
arrange for a bank essentially to step in for the buyer and make payment upon proof that
the goods have been shipped. The buyer is referred to as the “applicant” for the letter of
credit. The letter of credit will provide that the seller (the “beneficiary” of the letter of
credit) must present specified documents to the bank issuing the letter of credit (called the
“issuer”) in order to be paid.. Typically, the documents will include a bill of lading
issued by the carrier showing that the goods have been handed to the carrier and are being
shipped to the buyer, invoices, certificates of inspection and certificates of insurance. If
the documents on their face comply with the requirements of the letter of credit, the bank
is required to make payment to the seller. This payment must be made even if it turns out
that the goods do not conform to the contract of sale, in which case the buyer must seek
recourse from the seller. The seller is thus assured that it will be paid even if the buyer is
insolvent or dissatisfied with the goods. This type of letter of credit is called a
“commercial” letter of credit.

         Another type of letter of credit is called the “stand-by” letter of credit, pursuant to
which the bank agrees to pay a specified sum of money in the event one of the parties
fails to perform. These types of letters of credit are often seen in construction contracts,
in which the owner of the project may require a contractor to post a stand-by letter of
credit naming the owner as the beneficiary in the event that the contractor does not
complete the project in a timely fashion. In a sale of goods transaction, a buyer might
require a seller to post a stand-by letter in the event that the seller does not deliver the
goods on time. The stand-by letter of credit requires that the issuing bank pay the
beneficiary upon certification, perhaps by the beneficiary itself, that the event triggering
payment has occurred (for example, the goods have not been delivered by the specified
date). The bank has no obligation to determine whether the triggering event has in fact
occurred; it is obligated to pay upon being presented with the demand for payment
specified by the letter of credit. In these materials, we will focus primarily on “stand-by”
letters of credit and will leave the consideration of “commercial” letters of credit to a
class in sales of goods.

        Other banks besides the bank issuing the letter of credit may also be involved in

the transaction. If the seller prefers to deal with a bank other than the bank that is issuing
the letter of credit, perhaps because the issuer is located overseas, the seller may ask to
have a local bank “confirm” the letter of credit. This means that the “confirming bank”
will agree to pay the letter of credit as if it were the issuer, and the issuer will agree to
reimburse the confirming bank if it pays the beneficiary in accordance with the terms of
the letter of credit. A bank may also be asked by the issuer or the confirmer to advise the
beneficiary regarding the terms of the letter of credit. If the bank agrees to so advise, it is
called an advising bank and is not required to honor the letter of credit. It is only
required to accurately advise the beneficiary regarding its terms. For example, the bank
used by the seller in its business transactions may not be willing to confirm the letter of
credit but it may be willing to advise its customer, the seller, regarding its terms.1

        Letters of credit are similar to guarantees in that a third party is essentially
guaranteeing payment on behalf of the principal obligor. There is a very significant
difference between guarantees and letters of credit, however, in that the issuing bank’s
obligation to pay does not depend on performance of the underlying contract. The bank’s
obligation is independent of the underlying contract. This is the so-called “independence
principle” of letters of credit. The bank is contractually obligated to pay the beneficiary
upon presentation of the documents called for by the letter of credit. The documents may
be false and the goods may be non-conforming, but the bank’s obligation is based on
whether the documents conform on their face. Defenses that are typically available to
guarantors are not available to banks liable on letters of credit.

        The law governing letters of credit in the United States is Article 5 of the Uniform
Commercial Code. Article 5 was last revised in 1995; in these materials citations to the
revised article are to “Revised UCC §5- .” In addition and of equal or more importance,
many letters of credit are governed by the Uniform Customs and Practice for
Documentary Credits (“UCP”), which is a compendium of bank practices (trade usages)
in dealing with letters of credit. The UCP is promulgated by the International Chamber
of Commerce, and its current edition is referred to as UCP 500 (effective January 1,
1994). Letters of credit will often state that they are to be governed by the UCP. The
UCP contains rules regarding how banks will determine if documents presented comply
with the terms of the letter of credit. See UCP 500 Art. 13. The UCP and Article 5 are
largely complementary, but to the extent that they conflict the UCC generally yields to
the UCP. Revised UCC § 5-116(c).

         Stand-by letters of credit may also be subject to UCP 500, but the International
Chamber of Commerce has also promulgated rules that are particularly suited to those
types of letters of credit, the International Standby Practices (ISP 98), effective January 1,
1999. For international standby letters of credit, UNCITRAL has promulgated the
Convention on Independent Guarantees and Standby Letters of Credit. As of the time of
this writing, this Convention has been ratified by six nations and has been signed, but not
yet ratified, by the United States.2 This Convention will apply if two parties to the overall

 See UCC § 5-107 for the duties of advising and confirming banks.
 For the list of countries ratifying or signing the Convention, see the UNCITRAL website at

letter of credit transaction have places of business in different countries. In addition, the
country in which the issuer is located must have acceded to the Convention or the rules of
private international law must lead to the application of the law of a nation that has
acceded to the Convention. See Convention on International Guarantees and Standby
Letters of Credit at Article 4.

       1. Has a Letter of Credit Been Issued?

        The first question that must be analyzed is whether a letter of credit has in fact
been issued. In analyzing this issue, please look at Revised UCC §§ 5-102(10), 5-103 &
5-104. The following case demonstrates the different treatment of a letter of credit as
compared to a guarantee.

                     OF SAN FRANCISCO

                       United States District Court, N.D. California
                                 343 F. Supp. 332 (1971)

This action arises from a Complaint filed herein on May 4, 1965, by the Wichita Eagle
and Beacon Publishing Company, Inc. ["Wichita Eagle"] against the Pacific National
Bank of San Francisco ["Bank"].


 Beginning in 1962, Wichita Eagle had been a lessee of certain property ["Property"]
located in downtown Wichita, Kansas, upon which were three buildings used by the
Wichita Eagle for its publication business. In 1960, the then-Wichita Eagle had
purchased the assets of a rival newspaper, the Wichita Beacon, and had proceeded to
merge the Wichita Beacon into the Wichita Eagle. Among the assets purchased by the
Wichita Eagle was a new publishing plant owned by the Wichita Beacon. The Wichita
Eagle decided to move its operations to this new plant after the merger and thus freed the
Property, upon which its old plant remained, for other development.

 Following a period of negotiations, on February 28, 1962, Marcellus M. Murdock and
others, lessors of the Property ["Lessors"], entered into a 99-year lease ["Lease"] with
Circular Ramp Garages, Inc. ["Circular Ramp"] of the Property. By subsequent
amendment the date of the Lease was changed to April 28, 1962.

 Paragraph IV(a) of the Lease required Circular Ramp to exercise due diligence to obtain
necessary permits and to commence and complete construction on the Property of a
parking garage in accordance with a specified time schedule and having a minimum
value of $500,000.

 Paragraph IV(b) of the Lease required Circular Ramp to deposit cash or government
bonds in the amount of $250,000 in a Kansas bank or provide a surety bond, letter of

credit, or other form of guaranty in the same amount to guarantee Circular Ramp's
performance of paragraph IV(a) of the Lease. Pursuant to this provision, Circular Ramp
arranged for the Bank to issue to the Lessors and the Wichita Eagle as beneficiaries an
instrument [hereinafter sometimes "instrument"] dated May 9, 1962, and designated
"Letter of Credit No. 17084" [see Appendix hereto for full text of the Instrument]. The
Bank made and received its usual letter of credit charge for issuing the Instrument.

[The court determines that Circular Ramp did not exercise due diligence under Paragraph
IV(a) of the Lease. No parking garage was ever built by Circular Ramp.]

 Because of the defalcation of Circular Ramp, the Lessors executed a new lease of the
Property to Macy's on October 30, 1964, the term of which was to start on November 1,
1964. The Macy's lease was for a 30-year period with renewal options to be available for
six 10-year periods with contemplated renegotiations of the rental provisions. Also on
October 30, 1964, the Lessors and Wichita Eagle executed a "Termination Agreement"
and an assignment to the Wichita Eagle of all rights under the letter of credit. During the
period from November 1, 1962 to October 30, 1964, Wichita Eagle as lessee of the
Property had paid to the Lessors rent in the amount of $226,000 before credit of

 On March 17, 1965, counsel for the Wichita Eagle wrote the Bank and enclosed notices
sent to Circular Ramp and Pacific Company pursuant to the enforcement provisions of
the Instrument. Counsel for the Wichita Eagle indicated that the Wichita Eagle proposed
to draw a draft pursuant to the Instrument within a few weeks from that date.

 On May 3, 1965, Wichita Eagle, as the assignee of the Lessors, presented to the Bank a
$250,000 draft drawn upon the "Letter of Credit No. 17084" together with documents
specified therein. The Bank refused payment.

 In a joint pre-trial order filed herein on December 9, 1969, and approved by another
judge of this court, said judge ruled as a matter of law that the "Letter of Credit No.
17084" was not a letter of credit at all, but was in fact a performance bond or surety
agreement subject to the law of performance bonds and surety agreements. Upon transfer
of this case to the undersigned for trial, however, the issue of the nature of the "Letter of
Credit No. 17084" was reopened and the ruling of the transferor judge was vacated.
Upon reopening the Bank offered expert testimony concerning the nature of the
Instrument, and the parties submitted additional written authorities in support of their
respective positions.

 A letter of credit may be broadly defined as an engagement by a bank or other person at
the request of a customer that the issuer will honor drafts or other demands for payment
upon compliance with the conditions specified in the credit.

While in a sense every letter of credit is a form of guaranty, the letter of credit differs
from the classical surety undertaking in that it is a primary obligation between the issuer
and the beneficiary. The issuer of the credit is not concerned with the arrangements

existing between the beneficiary and issuer's account party.

The Bank contends that the Instrument is not a letter of credit but is instead a
performance bond, surety agreement, or other such guaranty. The Bank argues that there
can be only two types of letters of credit, "clean" and "documentary." A clean letter of
credit requires only the submission of a draft (or drafts) for payment, while a
documentary letter of credit requires specified accompanying documents as well. The
Instrument here, however, is neither clean nor documentary, the Bank claims, since at
least two of its three stated conditions are not documentary. The Bank's approach is,
however, too parochial and exalts formalism over commercial reality and usage.

 The authorities are uniform, for example, that a letter of credit need be in no particular
form. Although letters of credit have been most commonly used in sales transactions,
they are certainly not unknown in the context of a construction contract, as here.

 One of the reasons behind the growth and spread of the letter of credit as a commercial
tool has been the willingness of the courts to align case law with progressive and current
commercial practice. The very type of letter of credit being questioned here by the Bank
as a radical departure from traditional usage is but another example of the commercial
community pouring old wines into new flasks.

  In finding the Instrument to be a letter of credit this court gives respect to one of the
oldest canons of contractual construction, namely giving effect wherever possible to the
intent of the contracting parties. Here the parties intended to enter into a letter of credit
arrangement; said letter was drafted by an attorney who was counsel for the Pacific
Company and later for Circular Ramp and approved by both the Wichita Eagle and the
Bank; the Bank charged and received its usual letter of credit charge; and the letter
clearly and conspicuously calls itself a letter of credit.

 Although the question is not free from doubt, the Instrument denominated "Letter of
Credit No. 17084" should be treated as a letter of credit and be subject to the law
respecting letters of credit to the extent applicable and appropriate.

 The letter of credit listed three conditions precedent to the payment of any sight drafts
presented against the letter: First, that Circular Ramp had failed to perform the terms and
conditions of paragraph IV(a) of the Lease; Second, that the payee have sent a written
notice to the Pacific Company and Circular Ramp specifying how Circular Ramp had
failed to perform the terms and conditions of said paragraph IV(a) of the Lease and have
delivered to the signatories for the Bank an affidavit signed by Marcellus M. Murdock
stating that the written notices required were sent to the Pacific Company and Circular
Ramp, such notices to have been sent more than thirty days prior to the date the draft is
drawn; and Third, that either Circular Ramp or the Pacific Company had failed during the
thirty days following the delivery of the notices to them to cure any actual default
existing under the terms of said paragraph IV(a) of the Lease as so specified in the
written notices.

 The Wichita Eagle complied with all the conditions precedent sufficient to require that
the Bank have honored its $250,000 draft drawn against the letter of credit.

[In the balance of the opinion, the court calculates the damages that should be awarded
for the wrongful refusal to pay the letter of credit and determines that due to mitigation of
damages, Wichita Eagle should only be entitled to recover $163,000 in damages.]


International Department

May 9, 1962

 Marcellus M. Murdock; Victor Delano; Katherine M. Henderson; Marsh Murdock and
Victoria Neff, as the Trustees of the Pearl Jane Murdock Trust; Wichita Eagle, Inc.; and
the Prairie Improvement Company, Inc.


 We hereby establish our Letter of Credit No. 17084 in your favor on the terms and
conditions herein set forth for the account of Circular Ramp Garages, Inc. for the total
sum of $250,000.00. available by drafts drawn at sight on the Pacific National Bank
providing that all of the following conditions exist at the time said draft is received by the

 1. That Circular Ramp Garages, Inc. has failed to perform the terms and conditions of
paragraph IV(a) of the lease dated February 28, 1962, as amended to April 28, 1962,
between all of you as Lessor and Circular Ramp Garages, Inc. as Lessee, a copy of which
lease is attached hereto.

 2. That you have sent by registered United States mail, return receipt requested, with all
postage and registration fees prepaid, a written notice to Circular Ramp Garage, Inc. at
343 Sansome Street, San Francisco 4, California, and to The Pacific Company Engineers
and Builders at 801 Cedar Street, Berkeley, California specifying how Circular Ramp
Garages, Inc. has failed to perform the terms and conditions of said paragraph IV(a) of
said lease and further that you have delivered to the undersigned an affidavit signed by
Marcellus M. Murdock stating

333 Montgomery Street California San Francisco 20, Cable Address: Panabank

  that he sent said written notice in such manner to the above Circular Ramp Garages,
Inc. and The Pacific Company Engineers and Builders, to which affidavit shall be

attached the return receipt from said registered mail delivery, which affidavit and any
attached return receipt shall show that said notice was delivered to said Circular Ramp
Garages, Inc. and The Pacific Company Engineers and Builders more than thirty days
prior to the date the draft is drawn by you against this Letter of Credit.

 3. That either Circular Ramp Garages, Inc. of The Pacific Company Engineers and
Builders has failed during said thirty days following the delivery of said notice to them to
cure any actual default existing under the terms of said paragraph IV(a) of said lease as so
specified in said written notice.

 The credit extended under this lease shall terminate at the time and upon the happening
of any of the following:

 a. At the time that the City of Wichita, Kansas refuses to issue a permit to construct a
circular ramp parking garage building in accordance with plans and specifications
submitted by Circular Ramp Garages, Inc. or its engineer or architect, on the property
subject to said lease and fails to issue said permit to either Circular Ramp Garages, Inc. or
the contractor hired to construct said building, provided, however, that said refusal is
accepted as a final refusal by Circular Ramp Garages, Inc. or by said contractor.
However, if Circular Ramp Garages, Inc. or said contractor has been unable to obtain
such a permit by October 28, 1962 and either of them wishes to continue trying to obtain
said permit, this Letter of Credit shall be automatically reduced at said date to a principal
sum of $50,000.00 until terminated by any of the following conditions or events.

 b. At the time that the contractor who is to construct said building obtains a performance
bond from a surety company licensed to conduct a bonding business in Kansas insuring
that said building will be completed in accordance with the plans and specifications
therefore within three years after Circular Ramp Garages, Inc. is obligated to take
possession of said premises or April 28, 1965, whichever date shall first occur.

 c. At the time after such permit from the City of Wichita, Kansas is obtained that no
construction loan or takeout loan to finance the construction of said building is
obtainable, if the reason that said loan is not obtainable is due to some provision in said
lease between you and Circular Ramp Garages, Inc. which you refuse to amend pursuant
to the requirements of said Lease. For the purposes of this paragraph it will be deemed
that no such construction loan or takeout loan is obtainable if such has not been obtained
after application to three lending companies which have theretofore made loans in Kansas
for the purpose of constructing buildings or amortizing the cost thereof, if Circular Ramp
Garages, Inc. then elects not to apply to any other lending company.

 d. At the time that Circular Ramp Garages, Inc. has performed or caused to be
performed the terms of said paragraph IV(a) of said lease.

e. At the end of three years from the date of this letter.

Upon termination of the credit established under this letter you are to return the letter to

the Pacific National Bank.

 This Letter of Credit shall be irrevocable from its date providing that you accept the
same within ten days from said date. Your acceptance is to be shown by the receipt by
the undersigned of a copy of this letter with your acceptance shown by signing below.

/s/ A. G. Cinelli

A. G. Cinelli       Vice President

/s/ D. Bannatyne

D. BANNATYNE for Cashier
The terms of the above Letter of Credit are accepted.

Dated May 17, 1962.

/s/ Marcellus M. Murdock


                     OF SAN FRANCISCO

                        United States Court of Appeals, Ninth Circuit
                                   493 F.2d 1285 (1974)

We do not agree with the district court that the instrument sued upon is a letter of credit,
though it is so labeled. Rather, the instrument is an ordinary guaranty contract, obliging
the defendant bank to pay whatever the lessee Circular Ramp Garages, Inc., owed on the
underlying lease, up to the face amount of the guaranty. Since the underlying lease
clearly contemplated the payment of $250,000 in case of default, and since this provision
appears to be a valid liquidated damages clause, the judgment below must be modified to
award the plaintiff $250,000 plus interest.

 We do not base our holding that the instrument is not a letter of credit on the fact that
payment was triggered by default rather than performance or on the fact that the
instrument was written in a lease context, for we recognize that the commercial use of
letters of credit has expanded far beyond the international sales context in which it
originally developed.

 The instrument involved here strays too far from the basic purpose of letters of credit,
namely, providing a means of assuring payment cheaply by eliminating the need for the
issuer to police the underlying contract. The instrument neither evidences an intent that

payment be made merely on presentation on a draft nor specifies the documents required
for termination or payment. To the contrary, it requires the actual existence in fact of
most of the conditions specified: for termination or reduction, that the city have refused a
building permit; for payment, that the lessee have failed to perform the terms of the lease
and have failed to correct that default, in addition to an affidavit of notice.

 True, in the text of the instrument itself the instruments is referred to as a 'letter of
credit,' and we should, as the district court notes, 'give effect wherever possible to the
intent of the contracting parties.' 343 F.Supp. at 338. But the relevant intent is
manifested by the terms of the agreement, not by its label. And where, as here, the
substantive provisions require the issuer to deal not simply in documents alone, but in
facts relating to the performance of a separate contract (the lease, in this case), all
distinction between a letter of credit and an ordinary guaranty contract would be
obliterated by regarding the instrument as a letter of credit.

 It would hamper rather than advance the extension of the letter of credit concept to new
situations if an instrument such as this were held to be a letter of credit. The loose terms
of this instrument invited the very evil that letters of credit are meant to avoid--
protracted, expensive litigation. If the letter of credit concept is to have value in new
situations, the instrument must be tightly drawn to strictly and clearly limit the
responsibility of the issuer.

 The bank contends that whatever the nature of the instrument, by its terms it had either
reduced to $50,000 or terminated entirely by the time the draft was drawn. But the
district court found that the lessee 'failed to use due diligence to obtain the necessary
building permits,' and the lease provides that the lessee must 'use due diligence to obtain
all permits necessary.' Since the instrument is a guaranty rather than a letter of credit, the
bank should not be able to interpose a defense not available to the lessee unless such an
intent is clear in the instrument. Therefore, we interpret the termination provisions to be
subject to the duty of due diligence imposed by the lease. Since the lessee did not
proceed with due diligence, it was not entitled to regard the building permit as refused,
and the bank was not entitled to terminate the instrument because of the lessee's
representations to that effect.

Since the instrument is not a letter of credit, the amount due depends upon what the
lessee owes for the admitted breach. The underlying lease contemplates forfeiture of the
entire $250,000 security in the event of total breach. The issue is whether the forfeiture
clause is a valid provision for liquidated damages, or provides for a penalty and is
therefore unenforceable.

 The district court found that the lessor's damages 'might well have been the face amount
of the draft presented, $250,000.' We take this to be a finding that the amount of actual
damages that would flow from a total breach was uncertain and that the amount set was a
reasonable forecast of such damages. Indeed, the defendant bank seems to concede that
these two criteria for enforceable stipulated damages have been met; it argues only that
no 'intent' to liquidate damages was proven. Brief for Appellee and Cross-Appellant at

23- 30.

 But 'intent' to liquidate damages, as opposed to intent to provide a penalty for breach,
does not appear to be an independent element for enforcement of liquidation clauses in
either Kansas or California. Although the California courts sometimes talk in terms of
intent, in fact the cases turn solely on the reasonableness of the estimate and the difficulty
of determining actual damages.

 The district court's fact finding on the necessary prerequisites for enforcing a stipulated
damages clause is supported by the evidence. We therefore hold the stipulated damages
clause to be valid, and plaintiff is entitled to judgment for the amount stipulated. And
since the claim is for a liquidated amount, plaintiff is also entitled to an award of interest
from the date of the bank's refusal to honor the draft.

 Reversed and remanded, with directions to enter judgment for plaintiff and against
defendant in the amount of $250,000 together with interest thereon at the legal rate from
and after May 3, 1965.
                                 Notes and Questions

1) The result by the Ninth Circuit Court of Appeals was approved by the drafters of
Revised Article 5. See Revised UCC § 5-102, official comment 6.

Problem 1 - If the bank’s undertaking was to pay $250,000 upon receipt of a certification
by the beneficiary that Circular Ramp Garages, Inc. had failed to comply with Paragraph
IV(a) of the lease rather than being conditioned on whether there had in fact been a
failure to comply, would the undertaking be a “letter of credit” as defined in Revised
UCC § 5-102(a)(10)? Would the bank be required to pay even if there was no default
under the lease? Revised UCC § 5-108(a). If the undertaking is a letter of credit, does it
matter if the $250,000 was a reasonable liquidated damages amount, or can the policy
against penalty clauses in contracts be circumvented via a letter of credit? See Telenois,
Inc. v. Village of Schaumburg, 628 NE2d 581, 23 UCC Rep. Serv. 862 (I.. App. 1993);
Balboa Ins. Co. v. Coastal Bank, 42 UCC Rep. Serv. 1716 (S.D. Ga. 1986); McLaughlin,
Standby Letters of Credit and Penalty Clauses: An Unexpected Synergy, 43 Ohio St. L.J.
1 (1982).

       2. Has the Documentary Presentation Complied with the Terms of the Letter
of Credit?

        Revised UCC § 5-108 describes the issuer’s duties when presented with a demand
to pay under a letter of credit. The issuer is required to use standard banking practices in
examining the documents presented and must determine whether they strictly comply
with the terms of the letter of credit. If they do comply, the issuer is generally required to
honor the presentation and pay. The issuer is then entitled to reimbursement from the
applicant, i.e. the party who requested the issuance of the letter of credit (e.g. a buyer of
goods). If the documents do not comply, the issuer should not pay unless the applicant
waives any discrepancies. If the issuer pays on a non-complying presentation, the issuer

may not be entitled to reimbursement. The following case demonstrates the principle of
“strict compliance.”


                             Court of Appeals of Michigan
                       205 Mich. App. 686, 517 N.W.2d 742 (1994)

Plaintiff appeals from a judgment of the circuit court entered in favor of defendant on
plaintiff's claim against defendant for wrongful dishonor of a letter of credit. We affirm.

 The essential facts are not in dispute. On May 17, 1989, at the request of its customer,
Swenehart's Zero Foods, Inc., defendant issued an irrevocable stand-by letter of credit for
the benefit of plaintiff. The letter of credit provided that defendant would honor one or
more sight drafts, not exceeding $150,000 in total, accompanied by:

   1. Copy of unpaid invoice(s) from May 16, 1989 or subsequently.

    2. An Affidavit purportedly executed by an officer of Osten Meat Co. reading exactly
as follows:

  Reference is made to Letter of Credit No. 65469 issued by First of America Bank-
Southeast Michigan, N.A. in favor of Osten Meat Co.

  The undersigned deposes and says:

  1. Sweneharts Zero Foods has failed to pay in full for the shipment of merchandise
described in the attached invoice(s).

 2. The amount of the attached sight draft is not in excess of the amount owed to Osten
Meat Co. by Sweneharts Zero Foods.

   On or about January 25, 1990, plaintiff requested a full draw of $150,000 pursuant to
the letter of credit. With the request, plaintiff submitted: 1. A sight draft in the amount
of $150,000. 2. Copies of invoices from plaintiff to Swenehart's after May 16, 1989. 3.
An affidavit of Werner Osten, the president of plaintiff.

  In a letter dated February 5, 1990, defendant advised plaintiff that it would not honor the
letter of credit because of the following discrepancies:

  1) Documents inconsistent with one another:

  Invoices reference Letter of Credit Number different than sworn affidavit.

  2) Invoices 57040-00 $6,076.69 marked PAID 48439-00 $24,384.26 marked PAID,

Check #2248 55922-00 $7,000.00 marked PAID, Personal Money Order # 501548

 Plaintiff did not resubmit documents before the letter of credit expired.

  This dispute concerns whether the inconsistencies in the documentation supplied by
plaintiff in support of its draw on the letter of credit were sufficient to warrant defendant's
dishonoring the draft. The trial court concluded that it did, while plaintiff obviously
argues that the documentation was sufficient to warrant payment of the draft. To resolve
this dispute, we must first determine the Michigan standard for determining whether
documents submitted in conjunction with a draw on a letter of credit are sufficient. Two
standards have emerged in other jurisdictions, namely, (1) strict compliance with the
terms of the letter of credit and (2) mere substantial compliance. This appears to present
a question of first impression in Michigan. However, we are persuaded that defendant is
correct that we should follow the rule of strict compliance.

 A letter of credit is a contract between the bank and the beneficiary of the credit that is
separate and distinct from the commercial contract between the beneficiary, usually the
seller, and the bank's customer, usually the buyer. The letter of credit is not tied to or
dependent upon the underlying commercial transaction, and in determining whether to
pay, the bank looks only at the letter and the documentation the beneficiary presents to
determine whether the documentation meets the requirements in the letter.

  There is no Michigan statute or case law that illuminates what standard is to be used in
determining whether documents submitted by a beneficiary are in compliance with the
terms of the letter of credit. Nor is there a standard set forth in the Uniform Customs and
Practice for Documentary Credits (1983 rev), International Chamber of Commerce,
Brochure No. 400 (UCP), which frequently governs letters of credit and which does so in
this case. Articles 15 and 16(b) of the UCP provide only:

  Article 15

  Banks must examine all documents with reasonable care to ascertain that they appear
on their face to be in accordance with the terms and conditions of the credit....

  Article 16

                                      * * * * * *

   b. If, upon receipt of the documents, the issuing bank considers that they appear on
their face not to be in accordance with the terms and conditions of the credit, it must
determine, on the basis of the documents alone, whether to take up such documents, or to
refuse them and claim that they appear on their face not to be in accordance with the
terms and conditions of the credit.

 Case law outside Michigan is split on the issue. The majority position is that the
standard is one of strict compliance: the papers, documents, and shipping descriptions

must be as stated in the letter of credit. This standard leaves "no room for documents
which are almost the same, or which will do just as well." Courtaulds North America,
Inc. v. North Carolina Nat'l Bank, 528 F.2d 802, 806 (CA 4 1975), quoting from
Equitable Trust Co. of New York v. Dawson Partners, Ltd., 27 Lloyd's List Law Rpts 49,
52 (1926).

  A minority of cases do hold that a beneficiary's reasonable or substantial performance of
the letter's requirements will do. We are persuaded that the majority position that a letter
of credit must be strictly construed and performed precisely in accordance with its terms
is the appropriate rule and should be followed in Michigan.

  In a letter of credit transaction, the issuing bank's duty with respect to a letter of credit
is purely ministerial. The bank's representative, who knows nothing of the parties, the
underlying transaction, or the practices of the industry concerned, checks presented
documents carefully against the requirements of the credit. Under a strict compliance
standard, if the documents comply, the draft is paid. If there is a discrepancy between the
requirements of the letter of credit and the submitted documents, the draft is not paid and
the beneficiary is notified of the reason for the dishonor. The beneficiary then has the
right to resubmit the correct documents before the credit expires.

  A substantial-compliance standard would impose a duty on the bank to investigate the
underlying transaction whenever a discrepancy is found between the documents
submitted and the credit to determine whether a discrepancy is significant. Such a duty
would negate the credit's advantages, that is, its independence from the underlying
transaction and the predictability and swiftness of the determination to honor or dishonor
a draw request.

  The development of wire communications diminishes the efficacy of the argument that
commercial parties cannot live with the strict compliance rule. Freight forwarders,
trading company subsidiaries of bank holding companies, and importers themselves have
begun the process of modernizing the production of documents called for by letters of
credit. Most document discrepancies arise in commercial credits, particularly in bills of
lading. By permitting parties to generate bills and similar documents by wire, these
efforts at modernization permit a beneficiary or his agent to correct defects promptly. It
would be unfortunate if courts reject the strict compliance rule at a time when
commercial practices are rendering it a simple rule for the commercial parties to observe.

  Indeed, ultimately, a strict-compliance standard should prove to make the processing of
letter of credit transactions more efficient rather than less because a beneficiary will
know precisely what documentation must be submitted in support of the draw on the
letter of credit and may promptly correct any defects found in those documents. On the
other hand, accepting a mere "substantial compliance" standard would cause the waters to
be muddied. Each transaction would open itself to questions by the issuer of the letter of
credit whether the documentation submitted was sufficient. This would result in delays
because it would not be sufficient to answer the question whether there is strict
compliance with the terms and conditions of the letter of credit. Rather, a determination

would have to be made whether the less-than-full compliance would nevertheless be
sufficient, a question that might often require the solicitation of legal advice. Similarly,
such disputes might often end in litigation, further impairing the efficacy of letter of
credit transactions. In the long run, we are persuaded that the majority rule of strict
compliance makes sense and will make the handling of letter of credit transactions more
efficient, both from a commercial and a legal viewpoint.

 Accordingly, for the above reasons, we choose to follow the rule that strict compliance
with the terms and conditions of a letter of credit is required.

 Having resolved that the appropriate standard is one of strict compliance, we turn to the
question whether the reasons cited by defendant for refusing to honor the sight draft do,
in fact, demonstrate that plaintiff failed to strictly comply with the terms of the letter of

 Defendant's dishonor of the sight draft was proper if any of the defects cited as reasons
for the dishonor are appropriate.

 One reason cited by defendant for dishonoring the draft was that certain invoices
submitted with the draft had been marked paid, while the terms of the letter of credit
allowed for a draft to be made only for payment of unpaid invoices. Thus, defendant
argues, the representation in the affidavit that the invoices were unpaid and the notation
on the invoices that they were, in fact, paid created an inconsistency that warranted
dishonoring the draft.

 Plaintiff had submitted twenty-nine invoices, three of which were marked "Paid,"
invoices 57040-00, 55922-00, and 48439-00. Invoice 48439-00 had the further notation
"Check # 2248" with the figure 30384.26 below this notation. Attached to this invoice
was a copy of Sweneharts Zero Lockers, Inc., check 2248, made out to Osten Meat Co. in
the amount of $30,384.26. The check was stamped "NSF" and "DO NOT PRESENT

 The total amount of the twenty-six unpaid invoices was approximately $145,000, less
than the amount of the $150,000 draft. Thus, the properly presented invoices cannot be
considered alone because the draft would be defective under the terms of the letter of
credit inasmuch as it would be for an amount in excess of the amount of the unpaid
invoices. On appeal, the focus is on Invoice 48439-00, in the amount of $24,384.26, and
for which a copy of an NSF check was attached, because that invoice, in connection with
the other twenty-six unpaid invoices, would, if it were acceptable, be sufficient to raise
the total of the unpaid invoices to about the $150,000 amount, notwithstanding the two
remaining nonconforming invoices.

 The trial court, in granting defendant's motion for summary disposition, stated:

  There isn't any question but that there were, in fact, discrepancies. We're not here to
argue that they could not have been corrected, that they could not have been discovered

with investigation. They could have been, but it would have required investigation, and I
don't find that the bank has this burden, not in the law as I see it.

  If you place that burden on the bank, you have no more letters of credit. They cannot
possibly operate because of the multitude and verify actions in these contracts-in these
contractual relationships between large companies.

                                      * * * * * *

  I think there was sufficient variance to put the bank on notice that there was something
wrong and they had to be assured by a proper presentation. It's just that basis, and I think
you're entitled to summary disposition.

  A beneficiary is in strict compliance if there is only a misspelling or other flyspeck
discrepancy as long as the deviation from the letter's terms could not possibly have
misled any issuer.

 Plaintiff cites Atari, Inc. v. Harris Trust & Savings Bank, 599 F.Supp. 592
(N.D.Ill.1984), rev'd in part on other grounds 785 F.2d 312 (CA 7 1986), and American
Airlines, Inc. v. F.D.I.C., 610 F.Supp. 199 (D.Kan.1985), to support its argument that the
submission of Invoice 48439-00, together with a copy of a bounced check, strictly
complied with the requirement of the letter of credit that copies of unpaid invoices be

 While standing for the proposition that documents presented by a beneficiary can have a
slight discrepancy and remain in strict compliance with the terms of the credit, the
opinion in American Airlines, is off point because it discusses a circumstance where there
was a typographical error in the sight draft's reference to the letter of credit number.

 Atari is factually closer to the instant case. In Atari, the beneficiary submitted a
certificate stating that enclosed invoices were due and unpaid along with invoices, some
of which were stamped "Void." The issuing bank dishonored the draft request because
the certificate and the invoices were inconsistent. The United States District Court held
that the beneficiary's submission of void invoices was not inconsistent with the
beneficiary's certificate because, in each instance where the beneficiary included a voided
invoice, the beneficiary also presented the correcting debit and credit memorandums
together with the final corrected invoice.

 While the facts in Atari initially resemble the facts in the instant case, an important
distinction is that the beneficiary in Atari submitted a corrected invoice that was
consistent with the certificate's statement that the invoice be due and unpaid. In the
instant case, plaintiff did not submit a corrected invoice indicating that the amount was

 Defendant cites the opinion in Courtaulds, supra, which is factually closer to this case
and which controls the result in this case. In Courtaulds, the letter of credit required the

beneficiary to submit invoices stating that the packages shipped contained one hundred
percent acrylic yarn. The beneficiary submitted invoices describing the goods as
"Imported Acrylic Yarn," to each of which was stapled a packaging list that indicated that
the goods were one hundred percent acrylic yarn. The bank refused to honor the letter of
credit. The United States Court of Appeals held that, although the packing lists attached
to invoices disclosed on their faces that the packages contained one hundred percent
acrylic yarn, the lists could not be considered part of the invoice by reason of their being
appended to it, nor could the invoices be read as one with the lists.

  Courtaulds clearly held that invoices submitted by the beneficiary cannot be read in
conjunction with other submissions but must comply with the requirements of the letter
of credit on their face. Under this standard, plaintiff's submission of Invoice 48439-00
failed to comply with the requirements of the letter of credit because on its face it was
marked "Paid." Because the invoice, on its face, did not strictly comply with the letter of
credit, the bank did not wrongfully dishonor plaintiff's draft. Plaintiff had the option of
submitting a corrected invoice, but chose not to do so.

 Furthermore, while it might be argued that the sworn statement in the affidavit
submitted with the documentation that all the attached invoices were, in fact, unpaid
should be given precedence over an unsworn notation on the invoice that it had been
paid, such discrepancies are nevertheless sufficient to warrant rejection of the
documentation. The letter of credit adopted by reference the UCP, supra. Article 15 of
the UCP provides as follows:

  Banks must examine all documents with reasonable care to ascertain that they appear
on their face to be in accordance with the terms and conditions of the credit. Documents
which appear on their face to be inconsistent with one another will be considered as not
appearing on their face to be in accordance with the terms and conditions of the credit.

 Thus, the letter of credit, through its adoption of the UCP, requires that all documents
submitted with the draft in support of the letter of credit be consistent on their face and
that the submission of inconsistent documents is not in accordance with the terms and
conditions of the letter of credit. Thus, the letter of credit did require that all
documentation being submitted be consistent with each other on their face. Because the
notations on the invoices indicating that they had been paid were inconsistent with the
statement in the affidavit that all the attached invoices were unpaid, as well as being
inconsistent with the requirements of the letter of credit that the invoices be unpaid, those
invoices do not conform with the consistency requirement found in article 15.
Accordingly, they did not strictly comply with the terms and conditions of the letter of
credit, and defendant acted properly in refusing to consider those invoices in determining
whether there was compliance with the letter of credit.

 Moreover, the mere attaching of a copy of a returned check to the invoice in question on
appeal is not sufficient to rehabilitate that invoice. Rather, attaching a copy of an NSF
check does not cure the inconsistency on the face of the invoice caused by having it
marked "paid." This is particularly true inasmuch as the amount of the NSF check was

different than the amount of the invoice to which it was attached.

 What plaintiff should have done was to generate new invoices that had not been marked
paid and, if in fact those invoices remained unpaid, submit those conforming invoices as
part of the documentation in support of the sight draft drawn against the letter of credit.
Plaintiff, however, failed to do that.


                                   Notes and Questions

1) Note that this case was decided under pre-revision Article 5. As the court indicates,
there was a split of authority before Article 5 was revised. The revision adopts the “strict
compliance” rule. See Revised UCC § 5-108, official comment 1.

Problem 2 - How “strict” does “strict compliance” have to be? Assume that the letter of
credit requires that drafts drawn under it make reference to “Letter of Credit No. 95 –
922.” The draft presented makes reference to “Letter of Credit No. 95-9222.” The
bank’s letter of credit numbering system does not go higher than 95-999. Is the
beneficiary entitled to payment? See Revised UCC § 5-108, official comment 1. See also
E & H Partners v. Broadway Nat’l Bank, 39 F. Supp. 2d 275 (S.D.N.Y. 1998). If the
bank wishes to dishonor the letter of credit, how soon must it do so and what must it tell
the beneficiary regarding its reasons for dishonor? Revised UCC § 5-108(b) & (c).

Problem 3 - The documents presented to the issuing bank did not comply with the terms
of the letter of credit. The bank contacted the applicant and asked if the discrepancies
would be waived. The applicant responded that it would try to work things out with the
beneficiary, but that for now it would not waive the discrepancies. The original
presentation was thus properly dishonored. Subsequently, the applicant sent a letter to
the issuing bank stating that if the beneficiary signed a letter, a copy of which was
provided to the bank, the applicant would waive the discrepancies. The beneficiary then
re-presented the documents along with a signed copy of the letter. The issuing bank
contacted the applicant again, and was now told that the applicant would not waive the
discrepancies. The bank thus dishonored the presentation and the letter of credit expired
before a conforming presentation could be made. Did the bank properly dishonor the
presentation? Marsala International Trading Co. v. Comerica Bank, 976 P.2d 275, 39
UCC Rep Serv 2d 217 (Colo. App. 1998).

       3. Fraud

        As previously noted, the obligation of the issuer to pay under the letter of credit is
independent of the underlying contract. If the documents comply on their face, it doesn’t
matter if the goods that are shipped are non-conforming. The issuer is required to pay,
and the buyer’s recourse is against the seller. What happens, however, if the buyer learns
before the letter of credit is honored that the seller has forged the necessary documents or
has shipped empty boxes? Should the bank pay any attention to the buyer’s allegations

of fraud? The following famous case deals with this issue.

                  SZTEJN v. J. HENRY SCHRODER BANK CORP.

                               New York Supreme Court
                          177 Misc. 719, 31 N.Y.S.2d 631 (1941)

This is a motion by the defendant, the Chartered Bank of India, Australia and China,
(hereafter referred to as the Chartered Bank), made pursuant to Rule 106(5) of the Rules
of Civil Practice to dismiss the supplemental complaint on the ground that it fails to state
facts sufficient to constitute a cause of action against the moving defendant. The plaintiff
brings this action to restrain the payment or presentment for payment of drafts under a
letter of credit issued to secure the purchase price of certain merchandise, bought by the
plaintiff and his coadventurer, one Schwarz, who is a party defendant in this action. The
plaintiff also seeks a judgment declaring the letter of credit and drafts thereunder null and
void. The complaint alleges that the documents accompanying the drafts are fraudulent
in that they do not represent actual merchandise but instead cover boxes fraudulently
filled with worthless material by the seller of the goods. The moving defendant urges
that the complaint fails to state a cause of action against it because the Chartered Bank is
only concerned with the documents and on their face these conform to the requirements
of the letter of credit.

 On January 7, 1941, the plaintiff and his coadventurer contracted to purchase a quantity
of bristles from the defendant Transea Traders, Ltd. (hereafter referred to as Transea) a
corporation having its place of business in Lucknow, India. In order to pay for the
bristles, the plaintiff and Schwarz contracted with the defendant J. Henry Schroder
Banking Corporation (hereafter referred to as Schroder), a domestic corporation, for the
issuance of an irrevocable letter of credit to Transea which provided that drafts by the
latter for a specified portion of the purchase price of the bristles would be paid by
Schroder upon shipment of the described merchandise and presentation of an invoice and
a bill of lading covering the shipment, made out to the order of Schroder.

 The letter of credit was delivered to Transea by Schroder's correspondent bank in India,
Transea placed fifty cases of material on board a steamship, procured a bill of lading
from the steamship company and obtained the customary invoices. These documents
describe the bristles called for by the letter of credit. However, the complaint alleges that
in fact Transea filled the fifty crates with cowhair, other worthless material and rubbish
with intent to simulate genuine merchandise and defraud the plaintiff and Schwarz. The
complaint then alleges that Transea drew a draft under the letter of credit to the order of
the Chartered Bank and delivered the draft and the fraudulent documents to the
'Chartered Bank at Cawnpore, India, for collection for the account of said defendant
Transea'. The Chartered Bank has presented the draft along with the documents to
Schroder for payment. The plaintiff prays for a judgment declaring the letter of credit
and draft thereunder void and for injunctive relief to prevent the payment of the draft.

 For the purposes of this motion, the allegations of the complaint must be deemed

established and 'every intendment and fair inference is in favor of the pleading' Madole v.
Gavin, 215 App.Div. 299, at page 300, 213 N.Y.S. 529, at page 530; McClare v.
Massachusetts Bonding & Ins. Co., 266 N.Y. 371, 373, 195 N.E. 15. Therefore, it must
be assumed that Transea was engaged in a scheme to defraud the plaintiff and Schwarz,
that the merchandise shipped by Transea is worthless rubbish and that the Chartered
Bank is not an innocent holder of the draft for value but is merely attempting to procure
payment of the draft for Transea's account.

  It is well established that a letter of credit is independent of the primary contract of sale
between the buyer and the seller. The issuing bank agrees to pay upon presentation of
documents, not goods. This rule is necessary to preserve the efficiency of the letter of
credit as an instrument for the financing of trade. One of the chief purposes of the letter
of credit is to furnish the seller with a ready means of obtaining prompt payment for his
merchandise. It would be a most unfortunate interference with business transactions if a
bank before honoring drafts drawn upon it was obliged or even allowed to go behind the
documents, at the request of the buyer and enter into controversies between the buyer and
the seller regarding the quality of the merchandise shipped. If the buyer and the seller
intended the bank to do this they could have so provided in the letter of credit itself, and
in the absence of such a provision, the court will not demand or even permit the bank to
delay paying drafts which are proper in form. Of course, the application of this doctrine
presupposes that the documents accompanying the draft are genuine and conform in
terms to the requirements of the letter of credit.

  However, I believe that a different situation is presented in the instant action. This is
not a controversy between the buyer and seller concerning a mere breach of warranty
regarding the quality of the merchandise; on the present motion, it must be assumed that
the seller has intentionally failed to ship any goods ordered by the buyer. In such a
situation, where the seller's fraud has been called to the bank's attention before the drafts
and documents have been presented for payment, the principle of the independence of the
bank's obligation under the letter of credit should not be extended to protect the
unscrupulous seller. It is true that even though the documents are forged or fraudulent, if
the issuing bank has already paid the draft before receiving notice of the seller's fraud, it
will be protected if it exercised reasonable diligence before making such payment.
However, in the instant action Schroder has received notice of Transea's active fraud
before it accepted or paid the draft. The Chartered Bank, which under the allegations of
the complaint stands in no better position than Transea, should not be heard to complain
because Schroder is not forced to pay the draft accompanied by documents covering a
transaction which it has reason to believe is fraudulent.

  Although our courts have used broad language to the effect that a letter of credit is
independent of the primary contract between the buyer and seller, that language was used
in cases concerning alleged breaches of warranty; no case has been brought to my
attention on this point involving an intentional fraud on the part of the seller which was
brought to the bank's notice with the request that it withhold payment of the draft on this
account. The distinction between a breach of warranty and active fraud on the part of the
seller is supported by authority and reason. As one court has stated: 'Obviously, when

the issuer of a letter of credit knows that a document, although correct in form, is, in point
of fact, false or illegal, he cannot be called upon to recognize such a document as
complying with the terms of a letter of credit.' Old Colony Trust Co. v. Lawyers' Title &
Trust Co., 2 Cir., 297 F. 152 at page 158, certiorari denied 265 U.S. 585, 44 S.Ct. 459, 68
L.Ed. 1192.

  No hardship will be caused by permitting the bank to refuse payment where fraud is
claimed, where the merchandise is not merely inferior in quality but consists of worthless
rubbish, where the draft and the accompanying documents are in the hands of one who
stands in the same position as the fraudulent seller, where the bank has been given notice
of the fraud before being presented with the drafts and documents for payment, and
where the bank itself does not wish to pay pending an adjudication of the rights and
obligations of the other parties. While the primary factor in the issuance of the letter of
credit is the credit standing of the buyer, the security afforded by the merchandise is also
taken into account. In fact, the letter of credit requires a bill of lading made out to the
order of the bank and not the buyer. Although the bank is not interested in the exact
datailed performance of the sales contract, it is vitally interested in assuring itself that
there are some goods represented by the documents.

 On this motion only the complaint is before me and I am bound by its allegation that the
Chartered Bank is not a holder in due course but is a mere agent for collection for the
account of the seller charged with fraud. Therefore, the Chartered Bank's motion to
dismiss the complaint must be denied. If it had appeared from the face of the complaint
that the bank presenting the draft for payment was a holder in due course, its claim
against the bank issuing the letter of credit would not be defeated even though the
primary transaction was tainted with fraud. This I believe to the better rule despite some
authority to the contrary.

 The plaintiff's further claim that the terms of the documents presented with the draft are
at substantial variance with the requirements of the letter of credit does not seem to be
supported by the documents themselves.

Accordingly, the defendant's motion to dismiss the supplemental complaint is denied.


Problem 4 - If the issuing bank is told by the applicant of a fraud, either in terms of
forgery of the documents or similar to the situation described in Sztejn, what are its
options if the documents comply on their face? Is Sztejn still good law? See Revised
UCC § 5-109. What is the bank’s exposure in the event that it dishonors the presentation
and it turns out that the applicant was lying? Can the bank be liable for consequential
damages or attorney’s fees? Revised UCC § 5-111.

Problem 5 – Bank A is the issuer of the letter of credit while Bank B is the confirming
bank. Beneficiary makes a conforming presentation of documents to Bank B, which duly
pays Beneficiary under the letter of credit. Before Bank B makes presentment to Bank A

to obtain reimbursement, Applicant moves for an injunction and can prove that
Beneficiary committed a material fraud. Can the court lawfully enjoin Bank A from
paying Bank B? See UCC § 5-109(a)(1)(i).

Problem 6 – Contract to provide airplanes and crews by Company A for a charter airline
service run by Company B. If Company B was in default under the contract, the contract
required Company A to send a “ten day default notice” which would permit Company B
to cure the default. In the event of failure to cure within the 10 day period, Company A
could declare a default and terminate the contract. The contract also provided for
$50,000 in liquidated damages that was to be secured by a stand-by letter of credit
naming Company A as beneficiary. The letter of credit indicated that it would be paid
upon presentation to the issuing bank of a copy of the notarized ten day default notice.
Company A and Company B got into a dispute over performance under the contract, and
Company A sent the requisite notarized ten day default notice. Company A was prepared
to present the copy of the notice to the issuing bank for payment on the letter of credit,
but Company B sued, seeking an injunction. Company B claims that it isn’t in default on
the underlying contract and that Company A’s attempt to obtain payment on the letter of
credit is fraudulent. Assume that Company A is acting in good faith in asserting its right
to payment, although it is unclear whether Company A or Company B is in breach of the
contract. Should the court grant the injunction? Should the underlying merits of the
contract dispute be determined before the bank is required to honor or dishonor the
presentment under the letter of credit? See Ground Air Transfer, Inc. v. Westates
Airlines, 899 F.2d 1269 (1st Cir. 1990).

       4. Subrogation Rights


                       United States Court of Appeals, Third Circuit
                                   968 F.2d 357 (1991)

At issue in this case is which party is entitled to a fund of $594,000 paid into the district
court. To settle this dispute we must determine whether a bank which has honored a
letter of credit may be equitably subrogated to the rights of its customer vis-a-vis funds
paid to the customer by a party unrelated to the original letter of credit. We conclude
that because the issuing bank was satisfying its own primary liability rather than the
liability of another when it made payment under the letter of credit, it may not avail itself
of the common-law remedy of equitable subrogation. We will affirm the order of the
district court granting summary judgment in favor of Green Hill Investors.


 The $594,000 fund which is the subject of this diversity dispute was paid into the district
court by United States Fidelity and Guaranty Company ("USF & G"). This lawsuit began
when Green Hill Associates ("Associates") sued USF & G for the proceeds of

performance bonds issued by USF & G. York Excavating Co. ("York"), Dauphin
Deposit Bank and Trust Company ("Dauphin Deposit") and Green Hill Project Investors
("Investors") subsequently intervened in the action, claiming an interest in the bond
proceeds. The action itself arises from the construction of a multi-family residential
development in Susquehanna Township ("the Township"), Dauphin County,
Pennsylvania. Dauphin Deposit appeals the district court's order granting summary
judgment in favor of Investors.

 Associates was the owner and developer of a subdivision construction project, known as
the Green Hill Project ("the Project"). Susquehanna Construction Corporation ("SCC")
was a general manager of the Project under a written agreement entered into with
Associates and as such undertook to construct certain buildings and complete certain
other improvements on the site. USF & G issued two performance bonds guaranteeing
the faithful and timely performance of all of SCC's duties under the contract with
Associates ("the USF & G bonds"). The aggregate amount of these bonds totaled

 Eastern Consolidated Utilities, Inc. ("ECU") also entered into a contract with Associates
for certain work on the Project. Under that contract, ECU agreed to construct such
improvements as internal roadways, parking areas and storm drainage systems. ECU's
responsibilities under this contract were guaranteed by performance bonds issued by
Employers Insurance of Wausau ("the Wausau bonds").

 In order to begin work on the Project, Associates needed the approval of the Township.
Therefore, Associates entered into an agreement with the Township ("the Subdivision
Agreement") to complete various improvements on the site of the proposed subdivision.
These improvements included the construction of grading, roads, driveways, and parking
and recreation areas. The Subdivision Agreement required Associates to provide either a
bond or a standby letter of credit guaranteeing the completion of the specified

 Associates applied for an irrevocable standby letter of credit from Dauphin Deposit in
order to satisfy the Subdivision Agreement. Dauphin Deposit accepted Associates'
application and issued a letter of credit in favor of the Township for the account of
Associates. The face amount of the letter was $1,088,646. The letter provided that it
would be payable upon the Township's certification that the required site improvements
had not been completed as required by the Subdivision Agreement. Dauphin Deposit
received a fee of $75 plus 1.5% per annum of the face amount of letter of credit.
Associates also agreed to reimburse Dauphin Deposit if Dauphin honored the letter of
credit ("the reimbursement agreement"). The reimbursement agreement did not include
an assignment of Associates' rights in the USF & G bonds in the event of honor.

 As security in the event of honor, Dauphin Deposit received a collateral note executed by
the Tudor Development Group ("Tudor"), Associates' general partner on the project, and
an assignment of the proceeds of the Wausau performance bonds. As noted, Dauphin
Deposit did not obtain an assignment of the USF & G bonds nor did it file financing

statements perfecting its security interest in any of the collateral it did obtain in
connection with the issuance of the letter of credit.

 Sometime in May, 1987, SCC defaulted under its contract with Associates.
Subsequently, Associates was declared in default of its obligations to build the site
improvements under the subdivision agreement with the Township. As a result, on April
6, 1988, the Township issued its draft in the amount of $800,202 against the Dauphin
Deposit letter of credit. Dauphin Deposit paid on the Township's draft. To date,
Dauphin Deposit has not been reimbursed by Associates for its payment under the letter
of credit.

 Following SCC's default, Associates submitted a claim to USF & G for payment under
the USF & G performance bonds. On September 14, 1989, Associates' bond claims
against USF & G were settled, with USF & G agreeing to make a payment totalling
$609,000. In exchange for this payment, Associates executed a release and assignment
under which USF & G was freed from any and all claims arising from the Project. Of
this settlement, $594,000 was paid into the district court to be held pending resolution of
the various parties' claims to the fund.

 Associates presently asserts a claim against the fund as obligee under the USF & G
bonds. As a part of its settlement with USF & G, Associates assigned a portion of its
rights in the bonds to Investors. Thus Investors now claims the proceeds of the fund
based on Associates' partial assignment of the bond proceeds. Dauphin Deposit
contends that it is equitably subrogated to Associates' interest in the fund by reason of its
payment to the Township under the letter of credit, for which it has not been reimbursed.
Furthermore, Dauphin Deposit claims that the partial assignment by Associates to
Investors could not divest Dauphin Deposit of its rights to the fund because its right to be
equitably subrogated attached at the time it honored the letter, which was prior to the time
of Associates' partial assignment to Investors.

 Dauphin Deposit obtained a judgment against Tudor under the collateral note which it
obtained as security but has not executed that judgment. Dauphin Deposit has neither
sought nor obtained a judgment against Associates.

 The district court, on cross-motions for summary judgment by Investors and Dauphin
Deposit, concluded that there were no disputed issues of material fact and granted
summary judgment in favor of Investors. The district court concluded that a bank which
issues a standby letter of credit cannot accede to the rights of its customer on a theory of
equitable subrogation and that even if such relief were available, the undisputed facts did
not support granting Dauphin Deposit an equitable interest in the USF & G bond
proceeds. This appeal followed.


 The most salient feature of a letter of credit and the principal reason for its use in
commercial transactions is the "independence principle." This means that the letter of
credit is a commercial instrument completely separate from the underlying contract
between the customer and the beneficiary. The independence principle obliges the issuer
to honor the draft when the beneficiary presents conforming documents without reference
to compliance with the terms of the underlying contract between the customer and the
beneficiary. This "independence" means that should disagreement arise between
customer and beneficiary, the dispute is resolved with the money already in the pocket of
the beneficiary. It also means that when an issuer makes payment under a letter of
credit, the issuer is satisfying its own primary obligation to the beneficiary, without
reference to the rights of its customer under the underlying contract with the beneficiary.

 In contrast, a guarantor is subject to liability only if the beneficiary has sought and has
been unable to obtain payment from the party who is primarily liable on the debt.
Therefore a guarantor is actually liable for the debt of another party which that party has
failed to satisfy.

 In this case, the customer in the letter of credit transaction was Associates. The contract
underlying the letter of credit was the subdivision agreement entered into by Associates
and the Township, and the Township was the beneficiary of the letter of credit.
Dauphin Deposit, the issuer, was obligated under the terms of the letter to honor the
Township's demand for payment when the Township certified that the agreed upon
improvements had not been made by Associates. Once Dauphin Deposit honored the
letter, Associates, as its customer, had an immediate statutory obligation to reimburse
Dauphin, the issuer, and was also obligated to do so under the terms of the
reimbursement agreement.

 While UCC § 5-114(c) states that the issuer shall be reimbursed, there are no comparable
statutory provisions indicating the manner in which such reimbursement shall occur.
The method of reimbursement is a matter left to negotiations between the parties. In this
case, the reimbursement obligation was memorialized contractually in the reimbursement
agreement entered into by Associates and Dauphin Deposit. In addition, Dauphin
Deposit negotiated for assignment rights in certain collateral held by Associates, namely
its rights under the Wausau performance bonds and also looked to the Tudor promissory
note as collateral in its dealings with Associates.


 The classic explanation of the doctrine of equitable subrogation is as follows:

 Where property of one person is used in discharging an obligation owed by another or a
 lien upon property of another, under such circumstances that the other would be
 unjustly enriched by the retention of the benefit thus conferred, the former is entitled to
 be subrogated to the position of the obligee or lien-holder.

Gladowski v. Felczak, 346 Pa. 660, 31 A.2d 718, 720 (1943) (quoting Restatement of

Restitution § 162 (1937)). Generally, the following five prerequisites must be satisfied
before a claimant may avail itself of the remedy of equitable subrogation: (1) the
claimant paid the creditor to protect his own interests; (2) the claimant did not act as a
volunteer; (3) the claimant was not primarily liable for the debt; i.e., secondary liability;
(4) the entire debt has been satisfied; and (5) allowing subrogation will not cause
injustice to the rights of others. See, e.g., United States Fidelity and Guaranty Co. v.
United Penn Bank, 362 Pa.Super. 440, 524 A.2d 958, 963-64, alloc. denied, 517 Pa. 609,
536 A.2d 1333 (1987).

 Pennsylvania law offers little guidance, however, on the question of whether the doctrine
is applicable in the context of letters of credit. This dearth of state case law is best
explained by the simple fact that the question of subrogation usually arises in the
bankruptcy setting. The issuer which has honored a demand for payment under a letter
of credit has an immediate and unconditional statutory right to reimbursement from its
customer and has usually secured adequate collateral to make itself whole in the event of
honor. If the customer becomes bankrupt, however, the issuer's only practical recourse
is asserting a claim in the bankruptcy proceeding. Therefore, most of the law related to
the issue presented in this appeal comes from the bankruptcy courts rather than state
courts. We look, then, to those cases for guidance.

Those courts which have considered the question presently before us have disagreed as to
whether the remedy of equitable subrogation is available. The minority view advocates
the availability of equitable subrogation, see In re Valley Vue Joint Venture, 123 B.R. 199
(Bankr.E.D.Va.1991); In re National Service Lines, Inc., 80 B.R. 144
(Bankr.E.D.Mo.1987); In re Sensor Systems, Inc., 79 B.R. 623 (Bankr.E.D.Pa.1987); In
re Minnesota Kicks, Inc., 48 B.R. 93 (Bankr.D.Minn.1985), whereas the majority of
courts to consider the issue, as well as the district court in this case, have refused to grant
the issuing bank equitable subrogation rights following honor under a letter of credit. See
In re Carley Capital Group, 119 B.R. 646 (W.D.Wis.1990); In re Agrownautics, Inc.,
125 B.R. 350 (Bankr.D.Conn.1991); In re East Texas Steel Facilities, Inc., 117 B.R. 235
(Bankr.N.D.Tex.1990); In re St. Clair Supply Co., Inc., 100 B.R. 263
(Bankr.W.D.Pa.1989); In re Kaiser Steel Corp., 89 B.R. 150 (Bankr.D.Colo. 1988); In
re Munzenrieder Corp., 58 B.R. 228 (Bankr.M.D.Fla.1986); In re Economic Enterprises,
Inc., 44 B.R. 230 (Bankr.D.Conn.1984); cf. In re Glade Springs, Inc., 826 F.2d 440 (6th
Cir.1987) (confirming bank (Chemical) which in effect guaranteed that issuing bank's
(UAB) letter of credit would be honored, may be equitably subrogated to the rights of the
issuing bank which had received security from its customer). We agree with the majority
view that a bank which issues a letter of credit may not accede to the rights of its
customer on a theory of equitable subrogation.

 Courts grappling with this issue have generally concluded that while there are some
superficial similarities between guarantees and letters of credit, their "legal"
characteristics remain quite distinct and thus the remedies available should remain
distinct as well. As noted by the district court, the key distinction between letters of
credit and guarantees is that the issuer's obligation under a letter of credit is primary
whereas a guarantor's obligation is secondary--the guarantor is only obligated to pay if

the principal defaults on the debt the principal owes. In contrast, while the issuing bank
in the letter of credit situation may be secondarily liable in a temporal sense, since its
obligation to pay does not arise until after its customer fails to satisfy some obligation, it
is satisfying its own absolute and primary obligation to make payment rather than
satisfying an obligation of its customer. Having paid its own debt, as it has contractually
undertaken to do, the issuer "cannot then step into the shoes of the creditor to seek
subrogation, reimbursement or contribution from the [customer]. The only exception
would be where the parties reach an agreement to the contrary." In re Kaiser Steel, 89
B.R. at 153.

 The UCC does contain one direct reference to the possibility of subrogation in the letter
of credit context: "[t]he customer will normally have direct recourse against the
beneficiary if performance fails, whereas the issuer will have such recourse only by
assignment of or in a proper case subrogation to the rights of the customer." UCC § 5-
109, official comment. This comment, however, is clearly limited to the possibility of
the issuer being subrogated to the customer's rights against the beneficiary. In the present
case, rather than seeking subrogation rights against the beneficiary of the letter, Dauphin
Deposit seeks subrogation rights against a stranger to the letter of credit issued in favor
of the Township. In any event, this comment merely suggests rather than mandates the
availability of subrogation in certain cases.

 Finally, we note that some courts have determined that equitable subrogation is not
available to a bank which has honored a letter of credit, but has not been reimbursed.
These courts have rejected the remedy of equitable subrogation in the belief that allowing
subrogation would abrogate the independence principle which is the cornerstone of letter
of credit law. The district court in this case disagreed with that assessment and
concluded that "the independence principle is technically not violated by allowing
Dauphin Deposit to proceed against its customer." We agree with the district court that
the vitality of the independence principle is unlikely to be substantially diminished were
we to allow subrogation in this situation. However, as noted, one of the principal
requirements of equitable subrogation has not been satisfied here--that the party seeking
subrogation have satisfied the debt of another--and therefore we conclude that the district
court correctly determined that the remedy cannot be invoked in this case. Moreover, as
will be discussed, the equities do not favor granting subrogation rights in this case.


 Even if we were to ignore the fact that Dauphin Deposit has failed to meet the technical
requirements to avail itself of the remedy of subrogation since it was satisfying its own
primary obligation in paying under the letter of credit, we would nevertheless be
compelled to reject its claimed right to the remedy of equitable subrogation on these
facts. As the district court concluded, the equities do not favor subrogation in this case.

 When Dauphin Deposit agreed to issue a letter of credit on behalf of its customer,
Associates, it was in a position to bargain for whatever security it thought appropriate. It
chose to contract for an assignment of rights in the Wausau bonds and received a

promissory note from Tudor. In addition, Dauphin Deposit received a large annual fee
for the service of issuing the credit based upon the face amount of the letter. It could
have contracted for an assignment of rights in the USF&G bonds but did not do so.

 Presumably, at the time these arrangements were made Dauphin was satisfied with the
collateral it received and the creditworthiness of its customer. However, now that
Dauphin has discovered that it made a poor business decision in not contracting for an
assignment of rights in the USF & G bonds, it seeks our help in gaining additional rights.
As the district court properly concluded, there is no apparent reason why the court should
exercise its equitable powers to rewrite the contract between the parties to give Dauphin
Deposit more security than it bargained to receive. In assessing the equities of the
situation, we must also look to the other parties who could or would be affected by a
decision to allow subrogation in this case. Those parties who engaged in business
dealings with Associates subsequent to the issuance of the letter of credit, including
Investors, to whom Associates assigned its rights in the USF & G bonds, assumed they
would be free from any future claims by Dauphin Deposit with respect to the letter of
credit. We do not believe the equities favor treating Dauphin Deposit in a manner which
would be detrimental to those parties who had subsequent dealings with Associates.

Finally, we note that as a general matter, equitable relief is not appropriate where a party
has an adequate legal or statutory remedy. Clark v. Pennsylvania State Police, 496 Pa.
310, 436 A.2d 1383, 1385 (1981). Here, Dauphin Deposit appears to have two legal
remedies and one statutory remedy: (1) seek judgment against Tudor on the promissory
note; (2) sue Associates directly under the Reimbursement Agreement; and (3) seek
reimbursement under UCC § 5-114(c) which provides that an issuer is entitled to
immediate reimbursement from its customer in the event of honor. In determining
whether a remedy is "adequate," we must look to its availability and not to the likelihood
of its success. Thus the fact that the remedies set forth above might not make Dauphin
Deposit whole does not mandate a finding that such remedies are inadequate, thereby
requiring this court to grant equitable relief.


 In sum, we conclude that equitable subrogation is not an appropriate remedy in this
situation, both because an issuing bank which honors a letter of credit makes good its
own primary obligation, rather than fulfilling the obligation of another, and because the
equities of the case before us do not warrant it. We will affirm the judgment of the
district court granting summary judgment in favor of Investors.

 BECKER, Circuit Judge, dissenting.

 This appeal presents a close, difficult, and important question that has divided both
courts and scholars. The majority concludes that, under Article 5 of the Uniform
Commercial Code and the common law, a bank that has issued a standby letter of credit
may never qualify for equitable subrogation to the rights of its defaulting customer in the
underlying commercial transaction. The majority opinion is a fine piece of advocacy for a

respectable position, one that has been adopted by a majority of the courts to face the
issue (although rejected by the only federal appellate court that has reached the question).
Nevertheless, I believe that the majority has backed the wrong horse. I would hold that
an issuer of a standby letter of credit may, in proper circumstances, obtain equitable
subrogation to the rights of its customer.

 The majority also concludes that, even assuming that equitable subrogation is available
in some cases, the equities in this case do not warrant it. Because I believe that genuine
issues of material fact remain on this issue, I would not decide it on summary judgment.
I would instead remand the case to the district court for further proceedings to determine
whether the facts and equities here weigh in favor of or against Dauphin Deposit's claim.
I therefore respectfully dissent.

                         LETTER OF CREDIT

 Investors offers three reasons why issuers of standby letters of credit should not be
entitled to subrogation. First, Investors argues that an issuer does not qualify for
subrogation as a matter of common law because the issuer is primarily liable on its
obligation to the beneficiary, not secondarily liable for the debt of another, as the
common law requires. Second, Investors contends that the principles undergirding
Article 5 of the U.C.C. bar subrogation by issuers of letters of credit. Finally, Investors
suggests that an issuer can (and Dauphin Deposit did) protect itself adequately by
insisting on security before agreeing to issue a letter of credit. In Investors' view,
subrogation should be denied because it would only protect the imprudent issuer.
Because each issue is close, difficult, and important, and because Article 5 of the U.C.C.
is under study for possible major revision, I will discuss all three.

A. Common Law Bar: Primariness of the Issuer's Obligation

 The centerpiece of the majority's position is that Dauphin Deposit was primarily liable
on its own obligation to the township under the letter of credit. In its view, Dauphin
Deposit, as a primary obligor paying its own debt rather than the debt of another, cannot
seek subrogation. In my view, the majority takes undue advantage of the ambiguity of
the terms "primary" and "secondary" liability.

 Certainly, Dauphin Deposit was "primarily" liable in one temporal sense, in that,
pursuant to the letter of credit arrangement, it had to pay the township immediately on the
township's proper demand, with (unlike a guarantor or surety) no right to assert any
defenses that Associates may have had. On the other hand, even the majority concedes
that Dauphin Deposit was temporally "secondarily" liable in the sense that its obligation
arose only after Associates failed to satisfy its obligation. [Majority op. at 362.] I agree
with the majority that Dauphin Deposit was "primarily" liable in the sense that (like a
surety) it was directly liable, under its own contractual agreement, to make a payment to
the township. But that is not the relevant meaning of "primary" liability in the
subrogation context, for if it were, then no guarantor or surety would ever qualify for

equitable subrogation.\

 In my view, the relevant question is whether Dauphin Deposit was "secondarily" liable
in the sense that it paid the debt of another, Associates. Investors, and the majority, have
failed to distinguish the primary liability of a debtor to its creditor to repay a loan and the
primary obligation of the issuer to its beneficiary to honor a letter of credit. When a
standby credit supporting a loan is honored, the issuer admittedly is satisfying its
obligation as a primary obligor to honor the standby credit, but at the same time it is in
fact satisfying a debt for which a person other than the issuer is primarily liable....

 [T]he notion that an issuer's obligation to honor the letter of credit is a "primary
 obligation" should be interpreted to mean that, under the independence principle, the
 issuer may not avoid its obligation to honor the credit by identifying deficiencies in
 underlying contracts or by otherwise asserting defenses that are typically available to
 parties who are generally considered to be "secondarily liable" such as guarantors and
 sureties. Thus ... the "primary obligation" language in the letter of credit context
 concerns itself with the issuer's ability to avoid honoring its letter of credit, whereas the
 "primary liability" language in the subrogation context concerns itself with whether the
 entity, after reducing a claim of a creditor, received the consideration from the creditor.

In re Valley Vue Joint Venture, 123 B.R. 199, 204, 206 (Bankr.E.D.Va.1991).

 In this case, Dauphin Deposit paid the debt of another when it satisfied Associates'
obligation. Associates was liable to the township to make site improvements. Dauphin
Deposit's letter of credit served as the township's backup in case Associates defaulted.
Associates did default, and Dauphin Deposit, pursuant to its obligation under the letter of
credit, satisfied Associates' obligation to the township.

 As the issuer of a letter of credit, Dauphin Deposit had fewer defenses than would the
issuer of a guaranty or performance bond, but the substance of Dauphin Deposit's
obligation was nevertheless essentially similar to that of a guarantor or surety. There can
be no doubt that all three parties considered Dauphin Deposit as a de facto surety and the
letter of credit as a substitute for a performance bond. Paragraph 5 of the subdivision
agreement provides:

 As a further condition to approval of said Plan, Subdivider shall furnish a * in the
 amount of One Million Eighty-eight Thousand Six Hundred Forty Six ($1,088,646.00)
 Dollars to guarantee the proper completion of the improvements required by the
 Ordinance. * Irrevocable Straight Letter of Credit No: S-10181 from Dauphin Deposit
 Bank and Trust Company

 The parties struck out the word "bond" and replaced it with a reference to the letter of
credit. Quite clearly, the parties intended the letter to serve the same economic role as a
performance bond would have: "to guarantee the proper completion of the
improvements required by the Ordinance" (emphasis added).

 Guarantors and sureties pay their own legal obligations, yet they are still entitled to seek
equitable subrogation as well as contractual subrogation. That is because in meeting
their own "primary" obligations, guarantors and sureties are also "secondarily" liable to
pay others' debts. So far as the common law is concerned, the same logic should apply to
issuers of letters of credit such as Dauphin Deposit.

 Thus I conclude that the common law by itself poses no bar to the assertion of
subrogation rights by issuers of letters of credit. I next turn to whether the U.C.C.'s
statutory provisions on letters of credit require a different result.

B. The U.C.C. Statutory Bar

 The recent American Bar Association/U.S. Council on International Banking Task Force
on the Study of U.C.C. Article 5 reached no definitive conclusion on when and whether
subrogation is available in the letter of credit context, although it agreed that statutory
resolution of the question would be useful. See its report, An Examination of U.C.C.
Article 5 (Letters of Credit) 21 (Sept. 29, 1989), reprinted in 45 Bus.Law. 1527 (1990).
The task force did agree, however, that "the question of the availability of subrogation is
one which must be regarded as being essentially outside of credit law and the letter of
credit transaction," and that "the primary factor in determining [subrogation's] availability
should be whether it would affect the integrity of principles vital to letter of credit law."

 As noted above, the cornerstone of the law of letters of credit is the independence
principle, and thus if granting subrogation to issuers of letters of credit would undermine
the independence principle, then such subrogation must not be permitted. In my view,
allowing the issuer of a letter of credit to subrogate to the rights of its customer would not
undermine the independence principle.

 The independence principle ensures the beneficiary of prompt payment and basically
determines that the beneficiary will have the dollars in its pocket if there is a dispute
between it and the customer over the underlying transaction. See, for example, Itek
Corp. v. First National Bank of Boston, 730 F.2d 19, 24 (1st Cir.1984). As discussed
above, this distinguishes a letter of credit from an ordinary guaranty: a guaranty is not
independent in this sense, and guarantors may generally assert defenses available to the
party whose obligation is guaranteed.

 The independence principle undoubtedly requires the issuer to pay first, without looking
through to the underlying transaction. Subrogation should therefore be unavailable
before the issuer has paid the beneficiary. Once the issuer has done so, however, as
Dauphin Deposit has here, the purpose of the independence principle has been served: the
beneficiary has the money.

 Insistence on perpetual separation is thus pointless formalism. On a more pragmatic
level, I would agree that if the possibility of subsequent subrogation would discourage
issuers from honoring already-issued letters of credit, then subrogation should not be

permitted, because that would undercut the purposes of Article 5. But I cannot see why
that would be so. If anything, the unavailability of subsequent subrogation might
discourage issuers from honoring the letters because they would have one less means of
obtaining reimbursement.

 In sum, the policies underlying Article 5 of the U.C.C. do not require courts to deny
subrogation to all issuers of standby letters of credit. The remaining question is whether
other policy considerations commend the per se rule argued by Investors and adopted by
the majority.

C. Other Policy Considerations

                    1. The Issuer's Ability to Protect Itself Contractually

 In my view, Investors' (and the majority's) best argument is that the issuer of a letter of
credit is perfectly able to protect itself contractually. That is, the issuer receives a
payment for its services and may also demand assignment rights to collateral in the event
that it is forced to pay on the letter. Investors argues that Dauphin Deposit made a deal
with Associates and received certain collateral rights, including assignment rights to the
other bonds involved in the Green Hill Project (the "Wausau bonds"). It is certainly fair
to ask why Dauphin Deposit should receive the additional right of subrogation, simply
because it made a bad gamble or wasn't wary enough when negotiating its reimbursement
agreement with Associates.

 Nevertheless, this argument, although powerful, proves too much. Generally applied,
the same argument would virtually eliminate equitable subrogation altogether, for it
would apply to every guaranty or suretyship contract. Moreover, in many cases this may
lead to the customer receiving an undeserved windfall. A customer may default on both
its obligation on the underlying transaction and its obligation to reimburse the issuer of
the letter of credit, yet retain any income deriving from the original transaction. In short,
the issuer's ability to protect itself may be a strong equity against it, as is the fact that it
receives a fee for its services, but countervailing equities may outweigh these
considerations in certain cases.
                                            2. Efficiency

 At bottom, what concerns me most is how the rule that courts adopt will affect incentives
to issue letters of credit in the first place. It is possible that if no equitable subrogation
were permitted, fewer banks would issue such letters, which would be commercially
undesirable. Given the vagaries of commerce, it may be difficult for the issuer to
forecast precisely which security will have value years down the road. If courts allow
traditional equitable subrogation, the transaction costs in negotiating letters of credit may
be lower than under a rule where the parties must specify subrogation rights

 On the other hand, with the law as unsettled as it now is, prudent would-be issuers may
already have reacted by demanding greater fees or security, and the system appears to be

functioning well. Parties may even be willing to incorporate the entire body of equity
jurisprudence by contractual reference. Perhaps in the long run, the rule that the majority
adopts will not make much of a difference, as good lawyers and prudent issuers will react
accordingly. I concede too that a bright-line no-subrogation rule would promote legal
certainty and thereby reduce litigation costs.

 The issue is very close, but on balance I think that the better rule is to retain subrogation
on a case-by-case basis and apply it sparingly. When the unexpected happens, as it so
often does, it is desirable to leave courts with equitable powers to avoid windfalls and to
achieve a result fair to all parties. Certainly that was the solution of the common law,
and I have found nothing in the U.C.C. as adopted in Pennsylvania that justifies my
predicting that the Pennsylvania Supreme Court would vote to oust the common law in
this field.

The relevant equities are those between Dauphin Deposit and the remaining claimant to
the USF & G bonds, Investors. I have already discussed the mixed equities in favor of
Dauphin Deposit. The parties also dispute the equities as to Investors. Investors claims
that it is an innocent assignee with no reason to expect that its assignment rights would be
subject to the subrogation claim of Dauphin Deposit. Dauphin Deposit counters that
Investors was not a good faith assignee for value, but the successor and affiliate of a
foreclosing creditor, Summit. According to Dauphin Deposit, Investors knew of
Dauphin Deposit's role from its participation at meetings with the township and is
benefiting from the windfall of improvements financed by the draft on Dauphin Deposit's
letter of credit.

 I have no idea which version is the more accurate or whose story is more compelling.
Because this balancing of the equities is quintessentially a matter for a trial court, and the
district court has not undertaken this task, I would remand the issue.

C. Scope of the USF & G Bonds

 Finally, the parties dispute whether the USF & G Bonds even covered the work that led
to the default that required Dauphin Deposit to pay on the letter of credit. Investors
argues that the USF & G bonds covered construction of buildings, not the site
improvements that were the subject of Dauphin Deposit's letter of credit. Dauphin
Deposit contends that the USF & G bonds covered the entire project, both buildings and
site improvements. The district court and the majority never reached this issue, although
Judge Garth, in concurring footnote 4 to the majority opinion, agrees with Investors.

 This question involves contractual construction that is not simple: the Susquehanna
Construction agreement is complex and probably ambiguous, and hearing parol evidence
and evidence of the parties' course of conduct may prove necessary. Simply because the
Wausau bonds covered only site improvements, it does not necessarily follow that the
USF & G bonds were entirely complementary and covered only buildings. Moreover,
Dauphin Deposit argues that Associates is estopped to deny that the USF & G bonds
covered the site improvements. Because the district court did not reach these issues, I

would remand them, too.

                                   III. CONCLUSION

 For the foregoing reasons, I would reverse the judgment of the district court and remand
for further proceedings.


How would this case be decided under Revised Article 5? See Revised UCC § 5-117,
official comment 1.


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