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Posted: March 21, 2015

First Department Analyzes Rules for Interpreting Letters of Credit

On March 17, 2015, the First Department issued a decision in BasicNet S.p.A. v. CFP Servs. Ltd., 2015 NY Slip Op. 02080, discussing the rules governing the interpretation of letters of credit.

In BasicNet, the plaintiffs brought an action against¬†a¬†bank that issued two letters of credit to which the plaintiffs were beneficiaries. The trial court denied the plaintiffs’ motion for summary judgment on their breach of contract claims. The First Department reversed, explaining:

Under New York law, in order to recover on its claim that the issuer wrongfully refused to honor its request to draw down on a letter of credit, the beneficiary must prove that it strictly complied with the terms of the letter of credit. The corollary to the rule of strict compliance is that the requirements in letters of credit must be explicit, and that all ambiguities are construed against the issuer. The reasoning is that since the beneficiary must comply strictly with the requirements of the letter, it must know precisely and unequivocally what those requirements are. Where a letter of credit is fairly susceptible of two constructions, one of which makes fair, customary and one which prudent men would naturally enter into, while the other makes it inequitable, the former interpretation must be preferred to the latter, and a construction rendering the contract possible of performance will be preferred to one which renders its performance impossible or meaningless.

(Emphasis added). The First Department went on to hold that one of the conditions that had served as the defendant bank’s reasons for refusing payment was ambiguous and construed that ambiguity against it. Moreover, the First Department held, the defendant’s “interpretation of” the condition would

impermissibly conflict with the Independence Principle, which is the foundation on which all letters of credit are built.

There are three parties to a [letter of credit], the applicant who requests the [letter of credit]; the beneficiary to whom payment is due upon the presentation of the documents required by the [letter of credit]; and the issuer which obligates itself to honor the [letter of credit] and make payment when presented with the documents the [letter of credit] requires. In turn, there are three corresponding agreements: the agreement between the applicant and the beneficiary, which creates the basis for the [letter of credit]; the agreement between the issuer and the applicant; and the [letter of credit] itself.

A fundamental principle governing these transactions is the doctrine of independent contracts, which provides that the issuing bank’s obligation to honor drafts drawn on a letter of credit by the beneficiary is separate and independent from any obligation of its customer to the beneficiary under the contract and separate as well from any obligation of the issuer to its customer under their agreement.

From the beneficiary’s perspective, the independence principle makes a letter of credit superior to a normal surety bond or guaranty because the issuer is primarily liable and is precluded from asserting defenses that an ordinary guarantor could assert. Indeed, a letter of credit would lose its commercial vitality if before honoring drafts the issuer could look beyond the terms of the credit to the underlying contractual controversy or performance between its customer and the beneficiary.

. . .

As interpreted by [the defendant], [the disputed condition] would conflict with the independence principle, as incorporated into both ISP 98 and UCC, and would make [the defendant’s] obligations under the [letters of credit] truly illusory. Rather than performing a ministerial function of determining whether the documents submitted by plaintiffs complied with the requirements of the [letters of credit], under [the defendant’s] interpretation[, it] has the unfettered discretion to decide whether or not it will pay on the [letters] based on its unilateral determination that plaintiffs did or did not fulfill their undefined commitment to [the defendant’s customer].

(Internal quotations and citations omitted) (emphasis added).

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