INDEPENDENCE

NATURE AND
PRINCIPLE
IMPORTANCE > What characterizes letters of credit, as distinguished from
> A letter of credit is a financial device developed by other accessory contract, is the ENGAGEMENT OF THE
merchants as a convenient and relatively safe mode of dealing ISSUING BANK TO PAY THE SELLER ONCE THE DRAFT
with sales of goods to satisfy the seemingly irreconcilable AND THE REQUIRED SHIPPING DOCUMENTS ARE
interests of the seller, who refuses to part with his goods PRESENTED TO IT. In turn, this arrangement ASSURES
before he is paid, and a buyer, who wants to have control of THE SELLER OF PROMPT PAYMENT, INDEPENDENT OF
the goods before paying ANY BREACH OF THE MAIN SALES CONTRACT.
> To break the impasse, the buyer may be required to contract a
bank to issue a letter of credit, the issuing bank can
authorize the seller to raw drafts and engage to pay
them upon their presentment simultaneously with the tender
of documents required by the letter of credit. The buyer and
LAWS GOVERNING A
seller agree on what documents are to be presented for
payment, but ordinarily they are documents of title evidencing LETTER OF CREDIT
or attesting to the shipment of the goods to the buyer
> Once the letter of credit is established, the seller ships
the goods to the buyer and in the process secures the required
TRANSACTION
shipping documents and documents of title. To get paid, > Uniform Customs and Practice for Documentary Credits
the seller executes a draft and presents it together with the (UCP) issued by the International Chamber of Commerce
required documents to the issuing bank
> The issuing bank redeems the draft and pays cash to
the seller if it finds that the documents submitted by the
seller conform with what the letter of credit requires. The bank
then obtains possession of the documents upon paying the PARTIES TO A LETTER
seller. The transaction is completed when the buyer
reimburses the issuing bank and acquires the documents
entitling him to the goods. The seller gets paid only if he delivers
OF CREDIT
the documents of title over the goods while the buyer
acquires the said documents and control over the goods TRANSACTION
only after reimbursing the bank.
1. Buyer—procures the letter of credit and obliges himself
to reimburse the issuing bank upon receipt of the documents of
title. He is the one initiating the operation of the transaction as
buyer of the merchandise and also of the credit instrument.
His contract with the bank which is to issue the instrument and is
represented by the Commercial Credit Agreement form which
he signs, supported by the mutually made promises
contained in the agreement
2. Opening bank—usually the buyer’s bank which issues the
letter of credit and undertakes to pay the seller upon receipt
of the draft and proper documents of titles to surrender the
documents to the buyer upon reimbursement. As it is the
one issuing the instrument, it should be a strong bank, well
known and well regarded in international trading circles.
3. Seller—in compliance with the contract of sale, ships the
goods to the buyer and delivers the documents of title and
draft to the issuing bank to recover payment. He is also the
beneficiary of the credit instrument because the instrument is
addressed to him and is in his favor. While the bank cannot
compel the seller to ship the goods and avail of the benefits of
the instruments, however, the seller may recover from the bank
the value of his shipment is made within the terms of the
instrument, even though he hasn’t given the bank any direct
consideration for the bank’s promises contained in the
instrument
4. Correspondent bank/advising bank—to convey to the
seller the existence of the credit or a confirming bank which
will lend credence to the letter of credit issued by the lesser
known issuing bank or paying bank which undertakes to encash
the drafts drawn by the exporter. Furthermore, another bank
known as the negotiating bank may be approached by the
buyer to have the draft discounted instead of going to the place
of the issuing bank to claim payment
RESPONSIBILITIES OF
BANKS IN
COMMERCIAL CREDIT
TRANSACTIONS
> If the beneficiary is to be advised by the issuing bank by
cable, the services of an ADVISING OR NOTIFYING BANK must
always be utilized
> The responsibility of the NOTIFYING BANK is merely to
convey or transmit to the seller or beneficiary the existence
of the credit. However, if the beneficiary requires that the
obligation of the issuing bank shall also be made the obligation of
the bank to himself, there is what is known as a CONFIRMED
COMMERCIAL CREDIT and the bank notifying the
beneficiary of the credit shall become a CONFIRMING
BANK. In this case, the liability of the confirming bank is primary
and it is as if the credit were issued by the issuing and confirming
banks jointly, thus giving the beneficiary or a holder for value of
drafts drawn under the credit, the right to proceed against either
or both banks, the moment the credit instrument has been
breached.
> The paying bank on which the drafts are to be drawn it
may be the issuing bank or the advising bank. If the
beneficiary is to draw and receive payment in his own
currency, the advising bank may be indicated as the paying
bank also. When the draft is to be paid in this manner, the
paying bank assumes no responsibility but merely pays the
beneficiary and debits the payment immediately to the
account which the issuing bank has with it. IF THE
ISSUING BANK HAS NO ACCOUNT WITH THE PAYING
BANK, the paying bank reimburses itself by drawing a bill of
exchange on the issuing bank, in dollars, for the equivalent of the
local currency paid to the beneficiary, at the buyeing rate for
dollar exchange. The beneficiary is entirely out of the
transaction because his draft is completely discharged by the
payment, and the credit arrangement between the paying bank
and issuing bank
doesn’t concern him.
> If the draft contemplated by the credit instrument, is to be drawn
on the issuing bank or on other designated banks not in
the city of the seller, any bank in the city of the seller
which buys or discounts the draft of the beneficiary
becomes a negotiating bank. As a rule, whenever, the
facilities of an advising or notifying bank are used, the beneficiary
is apt to offer his drafts to the advising bank for
negotiation, thus giving the advising bank the character
of a negotiating bank becomes an endorser and bona fide
holder of the drafts and within the protection of the credit
instrument. It is also protected by the drawer’s signature,
as the drawer’s contingent
liability, as drawer, continues until discharged by the actual
payment of the bills of exchange.
LIABILITY IN
COMMERCIAL CREDIT
TRANSACTIONS
> A commercial bank which departs from what has been
stipulated under the letter of credit, as when it accepts a faulty
tender, acts on its own risk, and it may not thereafter be able
to recover from the buyer or issuing bank, as the case may
be, the money thus paid to the beneficiary
> In the case of a discounting arrangement, wherein a negotiating
bank pays the draft of a beneficiary of a letter of credit in order to
save such beneficiary from the hardship of presenting the
documents directly to the issuing bank, the negotiating bank
can seek reimbursement of what has been paid to the
beneficiary who as drawer of the draft continues to assume
a contingent liability thereon. Thus, the negotiating bank has
the ordinary right of recourse against the seller or beneficiary in
the event of dishonor by the issuing bank.
PROTOTYPE EXPORT
TRANSACTION
1. PROFORMA INVOICE—all the particulars for the
proposed shipment which are then known to the buyer
2. PRICE QUOTATION FAS AND CIF—FAS stands for “free
along side” which means that the seller will be responsible
for the cost and risks of the goods “along side” an
overseas vessel at the stated location: the buyer bears the
costs and risks from that point. CIF on the other hand means
“cost, freight and insurance”, that in exchange for this stated
price, the seller undertakes not only to supply the goods
but also to obtain and pay for insurance and bear the freight
charges to the stated pointy.
BUYER’S PURCHASE ORDER
3.
4. LETTER OF CREDIT
a. One way for a seller to be assured of payment is to ship
goods under a negotiable bill of lading and arrange for a bank in
buyer’s city to hold the bill of lading until the buyer pays
the draft in the usual foreign sale this arrangement for
securing payment of the price is not adequate
b. In some situations, sellers may need assurance of
payment even before the time of payment. This problem arises
in contracts which call for the manufacture of goods to the
buyer’s specifications.
c. Although the proforma invoice may not specify, the seller
will expect the letter of credit to be confirmed by the local
bank in its location. But why does a local bank confirm
rather than issue a letter of credit? The bank that issues the
letter of credit needs assurance that it will be reimbursed by the
buyer, on whose behalf it pays the seller. The buyer’s bank
can take steps to minimize or
remove the hazards. It will receive the negotiable bill of lading
controlling the goods which will provide security for the
customer’s obligation to reimburse the bank; in addition, the
buyer’s own bank can judge in the light of its knowledge of his
financial standing whether added security is needed and can
insist on such security before it issues the letter of credit
d. To meet the seller’s letter of credit requirements, the
buyer will request its bank to arrange for the issuance of a letter
of credit which will comply with the terms of the proforma
invoice. The buyer will then sign a detailed application
and agreement for commercial credit prepared by the
bank. The issuing bank, after approving the buyer’s credit
standing transmits a letter of credit by cable to the confirming
bank. This confirming bank will then deliver to seller a
document advising the latter that the issuing bank opened a letter
of credit in its favor and adding the confirming bank’s
confirmation. In this arrangement, the seller is assured of
payment of its sight drafts drawn on the confirming bank in the
amount of the total amount of the sale, provided it presents
the documents called for in the letter of credit. An
examination of the letter of credit will also reveal that the bill of
lading is to be consigned to the order of the buyer’s bank,
thereby giving the bank control over the goods, with the
consequent security for its claim against the buyer.
5. ACCEPTANE; SHIPMENT
a. On the receipt of the confirmed letter of credit, the seller will
send the order acknowledgment. This document will repeat the
description and price of the goods which has also appeared
on the proforma invoice and states the number and expiration
date of the letter of credit.
b. Further, the arrival of the letter of credit is the go-signal for
the seller to send the goods. The seller then prepares the
COMMERCIAL INVOICE which provides a complete record
of the transaction and is an important source of information
to such interested parties as a bank discounting a
draft or an underwriting extending issuance.
c. As the time of shipment approaches, the seller will
contact its forwarder and give its shipping instructions. It will
inform that to comply with the requirements of the letter of
credit, the bill of lading must be made to the order of the
issuing bank. It will also send copies of the commercial invoice, a
packing list, and a Shipper’s export declaration. When the
forwarder receives these documents, he takes over all
further documentation as the agent of the shipper, the latter
merely has to dispatch the goods from the factory in
accordance with the forwarder’s instructions.
d. The seller will then send the truck to the pier where they are
delivered to the ocean carrier’s receiving clerk who signs
the dock receipt. The dock receipt is a form supplied by the
ocean carrier which contains information relevant to the
shipping of the bearings such as the number of the pier, and
the name of the ship. The dock receipt is NON-NEGOTIABLE
and serves as a temporary receipt for the goods until they are
loaded on board.
e. The ocean carrier is soon ready to receive the cargo.
When the goods are loaded on board, the steamship line issues a
bill of lading which, to comply with the letter of credit, is
CONSIGNED TO ORDER OF THE ISSUING BANK. The bill of
lading is initially prepared by the forwarder on a form supplied
by the ocean carrier, it sets forth the markings and
numbers of the packages, description of the goods, and the
number and weight of the packages. On its dorsal side, it will
state that the goods are received for shipment, but a
statement FREIGHT PREPAID ON BOARD is initiated by a
representative of the steamship line after loading. The
forwarder then delivers the bill of lading and the commercial
invoice to the seller.
6. INSURANCE
7. PAYMENT; THE DRAFT.
a. The confirming bank stated in their letter that the
estimated CIF price would be “available by your drafts on us at
sight” when accompanied by the listed documents
b. Seller accordingly draws a sight draft on the confirming
bank. The sight draft together with the commercial invoice,
insurance certificate, full set of bills of lading, and the
packing list are presented to the confirming bank. When
the bank receives these documents, it issues its bank draft
to seller’s order and transmits the documents by air mail to
issuing bank, which will
reimburse the confirming bank.
c. The documents, sent by airmail, will reach the buyer’s
bank well ahead of the ocean shipment. The time for
release of the documents to buyer and reimbursement to the
bank will depend upon the arrangement which was made
between the bank and buyer when the letter of
credit was initially established.
d. If the buyer plans to resell the goods, he may not be able to
reimburse the bank until the goods arrive and he resells the
goods. In this event, the issuing bank may need to take
further steps to secure its claim against the buyer.
STANDBY LETTERS OF
CREDIT OR
GUARANTEES
HISTORY AND
PURPOSE
> Sometime ago, it is common in international dealings to
require the furnishing of a cash deposit as security, but with
the expansion of international trade this became
prohibitively expensive for the counterparty and in due
course gave way to a more convenient safeguard, the
provision of a written undertaking by a bank in favor of the buyer
or employer payable on demand
> Demand guarantees as substitute for cash are designed to
provide the beneficiary with a speedy monetary remedy
against the counterparty to the underlying contract and to
that end are primary in form and documentary in character.
> The demand guarantee is expressed to be payable
solely on presentation of a written demand and any other
specified documents. Accordingly, any demand within the
maximum amount stated must in principle be paid by the
guarantor, regardless whether the underlying contract has in
fact been broken and regardless of the loss actually suffered
by the beneficiary
A CONCISE
DEFINITION: DEMAND
GUARANTEES
> Undertaking given for payment of a stated or maximum sum of
money on presentation to the party giving the undertaking of
a demand or payment and such other documents as may
be specified in the guarantee within the period and in
conformity with the other conditions of the guarantee
> Procured by the seller in favor of the buyer for the latter to be
paid in case the seller doesn’t comply with contract provisions.
The economic burder is upon the party who breaches the
contract
> Employed typically in construction contracts and
contracts for international sale of goods
> Demand guarantees are intended to safeguard the other party
against non-performance or late or defective performance by
the supplier or contractor
GUARANTEE
STRUCTURES AND
TERMINOLOGY:
DIRECT (3RD PARTY)
GUARANTEES
> Involves a minimum of three parties
1. Account party/principal—party to the underlying contract
whose performance is required to be covered by the
guarantee and who gives instruction for its
2. Issuer/guarantor—the bank or other party issuing the
guarantee on behalf of the customer the principal
3. The beneficiary—the other party to the underlying contract, in
whose favor the guarantee is issued
> Usually the guarantee in the 3-party structure is the
principal’s bank and carries on business in the same country as
the principal, whilst the beneficiary carries on business in a
foreign country
> Known as direct guarantees because the guarantee is issued to
directly by the principal’s bank, not by the local bank in the
beneficiary’s country
PRINCIPAL TYPES OF
DEMAND GUARANTEES
1. Tender or bid guarantee
a. Where tenders are invited it is often a condition of
consideration of the tender that the tenderer undertakes to sign
the contract if its awarded to him, to procure the issue of any
performance or other guarantee required by the guarantee and
not to modify or withdraw his tender in the meantime
b. Purpose—safeguard the beneficiary against breach of
such an undertaking
c. If the tenderer is successful and fails to sign the contract
and to furnish the requisite performance or other
guarantee, or withdraws his tender before its expiry, the
beneficiary can call upon the guarantor to pay a specified sum
designed to compensate him for the trouble and
expense he suffered in reawarding the contract, as well as
any additional cost of the contract
2. Performance guarantee
a. Guarantee of the central performance of the contract
from commencement to completion
b. Given for a specified percentage of the contract sum
c. But there are stages in the relationship between the
parties which precede and follow the central
performance, and there may be distinct segments of liability
to be covered within that performance
3. Advance payment or repayment guarantee
a. Underlying contract may entitle the principal to payment of
stated sums in advance of performance
b. The advance payment guarantee is designed to secure
the beneficiary’s right to repayment of the advance if the
performance to which it relates is not furnished
4. Retention guarantee
a. Construction contracts usually provide for stage
payments against architect’s or engineer’s certificate and for a
specified percentage of the amount certified in each certificate to
be retained by the employer for a specified period of time as
safeguard against defects
b. The employer may be willing to release such retention
moneys against a retention guarantee securing
repayment of the released retention moneys if defects are
later found or if the contractor fails to complete the contract
5. Maintenance or warranty guarantee
a. Construction contracts usually provide that on completion
part of the retention moneys are to be retained for a
specified period to cover the cost of any defects or
malfunction which become manifest during that period
GUARANTEES NOT
GUARANTEED BY
UNDERLYING
CONTRACT
> Not all guarantees are meant to be in favor of a party in the
underlying contract
> For example are customs guarantees which are issued to the
customs to cover any duty that may become payable when
imported goods which would be exempt from duty if reexported
within a specified time are not in fact reexported within that time
THE LEGAL NATURE
OF A DEMAND
GUARANTEE
> A demand guarantee is an abstract payment undertaking
that is, a promise of payment which, though intended to
preserve the beneficiary from loss in connection with the
underlying transaction is detached from the underlying
contract between principal and beneficiary and is in form a
primary undertaking between the guarantor and beneficiary
which becomes binding solely by virtue of its issue
> A secondary guarantee is both secondary in form and
intent. The intention of the parties is that the guarantor will be
called upon to pay only if the principal defaults in
performance, and then only to the extent of the principal’s
liability and subject to any defenses available to the principal
> A documentary credit is both primary in intent and form. The
parties to the underlying contract intend that the bank issuing the
credit is a to be the first port of call for payment, and this
is the effect of the agreement between them. Whereas in
the case of a suretyship guarantee, the beneficiary cannot
look to the guarantor without establishing default by the
principal, the reverse is true of the documentary credit.
The parties have designated payment by the bank as the
primary payment method and only if it fails without fault on the
part of the beneficiary is entitled to > DEMAND GUARANTEE
STANDS BETWEEN THE SURETYSHIP GUARANTEE
AND THE DOCUMENTARY CREDIT—SECONDARY IN
INTENT AND PRIMARY IN FORM. Performance is due in
the first instance from the principal, and the guarantee is
intended to be resorted to only if the principal has failed to
perform. But though this is the intent of the parties, the guarantee
isn’t in form linked to default under the underlying contract,
nor there is any question of performance to hold the
beneficiary harmless up to the agreed maximum; and the sole
condition of the guarantors payment liability is the presentation
of a demand and other documents specified in the
guarantee in the manner of and within the period of the guarantee
> THE GUARANTOR HAS NO CONCERN WITH THE
UNDERLYING CONTRACT AND IF DEMAND IS DULY
PRESENTED, PAYMENT MUST BE MADE DESPITE
ALLEGATIONS BY THE PRINCIPAL HAS FULLY
PERFORMED THE CONTRACT—IN THE ABSENCE OF
ESTABLISHED FRAUD OR OTHER EVENT
CONSTITUTING GROUND FOR NON-PAYMENT
STANDBY LETTERS OF
CREDIT
> Undertaking primary in form but intended to be used only as a
fallback in the event of default by the principal under the
underlying contract
> Standby credit in legal perspective is simply another term for
demand guarantees
> The standby credit has developed into an all-purpose financial
support instrument embracing a much wider range of uses
than the normal demand guarantee. Thus, standby credits
are used to support financial and non-financial obligations of
the principal and to provide credit enhancement for the primary
financial undertaking
KEY ELEMENTS IN A
DEMAND GUARANTEE
1. The parties
2. A reference to the underlying contract
3. The amount or maximum amount of the guarantee and
any agreement for reduction or increase
4. The currency of payment
5. The documents, if any, to be presented for the purpose
of a demand or of reduction or expiry
6. The expiry date or other expiry provisions as well as
any agreement for extension
> Where it is intended that the guarantee shall not
commence until presentation of a particular document, this fact
should be specified
> Direct guarantee: principal, guarantor, and beneficiary
should be identified
> Indirect guarantee: principal, instructing party,
beneficiary, and counter-guarantee
> Central to the demand guarantee is its documentary
character: the rights and obligations it creates are to be
determined solely from the terms of the guarantee and
from any document presented in accordance with the
guarantee, without the need to ascertain external facts
DISTINCT NATURE OF
CONTRACTUAL
RELATIONSHIPS
> Guarantor’s commitment to the beneficiary arises solely by
virtue of the issue of the guarantee and his duty to pay is
conditioned only on presentation of demand and other
specified documents in conformity with the terms and within the
duration of the guarantee
> Principal is not concerned with the contract between the
guarantor and beneficiary
> Beneficiary has no concern with the contract between the order of the document
principal and guarantor 7. Guarantor’s duty limited the exercise of good faith and
> The relationship of principal and guarantor has an internal reasonable care
mandate—the guarantor is obliged to act in accordance with 8. Independence of counter-guarantee from guarantee
the terms of the contract, failing which he may forfeit his 9. Independence of counter-guarantee from mandate
right to reimbursement but those terms are of no concern to received from instructing party
the beneficiary, whose right to payment depends solely on his
acting on conformity with the terms of the guarantee
> In indirect contracts, there is an additional mandate which
has 2 facets—the mandate from the instructing party to the
guarantor as to the issue of the guarantee, which the
guarantor as mandatory must comply with if he accepts the
instruction; and two, the counter-guarantee which the
guarantor exacts from the instructing party as a precondition of
issuing the guarantee and which is separate from the mandate
1. Abstract character of the payment undertaking—
binding solely by virtue of issue of the guarantee, subject to
the beneficiary not rejecting it
2. Independence of the guarantee from the underlying
transaction
> Guarantee is separate from that contract and the rights
and obligations created by the guarantee are independent of
those arising under the underlying contract
> In the absence of established fraud by the beneficiary,
the guarantor is not entitled to refuse payment and the
principal is not entitled to have payment restrained merely
because of a dispute between the principal and beneficiary
3. Independence of the guarantee from the principal-
guarantor relationship—the guarantee is separate from the
contract between the principal and the guarantor is not
entitled to invoke a breach of that contract
4. Documentary character of guarantee—amount and duration
of the duty to pay, the conditions of payment and termination of
payment obligation depend solely on the terms of the
guarantee itself and presentation of required documents
5. Requirement of compliance of the demand with the terms of
the guarantee
6. Guarantor’s duty of examination limited to apparent good