Bank thinks it issued a Guarantee, but Court finds it was a Letter of Credit

A recent case underscores the risks involved in drafting bank documents and the distinction between conditional guaranty contracts and letters of credit. In Teleport Communications Group, Inc. v. Barclay Fin. Group, Ltd., 176 F.3d 412 (1999), Barclay issued an instrument entitled "Letter of Credit" to Teleport Communications Group on behalf of a Barclay customer. At the request of its customer, Barclay inserted a provision stating that payment would not be made to the beneficiary Teleport if the bank believed that the beneficiary had committed fraud. The bank argued that because the instrument conditioned payment on something other than the presentation of specified documents, it could not be a letter of credit and, instead was no more than a conditional payment guaranty. However, the U.S. Court of Appeals for the Seventh Circuit found the instrument to be a letter of credit and ordered the bank to pay in full. The Court held that an instrument that is entitled "letter of credit," and whose terms may be construed as consistent with the purpose of a letter of credit, is a letter of credit.

The Court distinguished this case from Ninth Circuit and Texas appellate court cases that treated certain instruments entitled "letter of credit" as mere guaranty contracts. In those cases, the courts held that the instruments strayed too far from the basic purpose of letters of credit, namely "to assure payment cheaply by eliminating the need for the issuer to police the underlying contract." Teleport Communications Group, Inc., 176 F.3d at 414. The Court noted that the issuer must pay on a letter of credit if the proper documents are presented by the beneficiary, regardless of the status of the underlying contract between the customer and beneficiary. Id. The two cases the Court distinguished involved instruments that required the issuer-bank, in effect, to police the conduct of the beneficiary in performing the underlying contract between the beneficiary and the customer. See Wichita Eagle & Beacon Pub'l Co., Inc. v. Pacific Nat'l Bank of San Francisco, 943 F.2d 1285 (9th Cir. 1974) (instrument not letter of credit despite label because payment expressly conditioned on beneficiary's compliance with the terms of the underlying lease); Gunn-Olson-Stordahl Joint Venture v. Early Bank, 748 S.W. 2d 316 (Tex. App. 1988, writ denied) (instrument required issuer before paying to verify that beneficiary had factually performed on underlying contract).

The Court in Teleport Communications held that the fraud provision in the agreement before it was different because it could be construed to refer to the dealings between the beneficiary and the issuer as to the instrument, and not to the dealings between the beneficiary and the customer as to the underlying contract. The Court rejected the argument that the fraud provision required the issuer bank to police the underlying agreement between the beneficiary and customer. Instead, the Court found that the fraud provision in the instrument merely allowed the bank to refuse payment based on any fraudulent activity by the beneficiary in the presentation of a sight draft to the issuer. Thus, because the Court found that payment was conditioned only on the proper presentation of documents, the Court determined that the instrument was a letter of credit and thus, the bank was required to make payment in full to the beneficiary.

The Court further noted that if the bank and its customer were concerned about the ability of the beneficiary to perform on the underlying contract, they should have inserted clear language in the instrument conditioning payment on the satisfactory performance by the beneficiary, not on the absence of fraud. Such language would have required the issuer bank to police the underlying contract between its customer and the beneficiary, which would have prevented a finding that the instrument was a letter of credit. The case underscores the importance of careful drafting in the preparation of bank documents, and emphasizes that an instrument labeled a "letter of credit" is likely to be found to be a letter of credit if its ambiguous terms can be construed as consistent with the purpose of a letter of credit.