LETTERS OF CREDIT
of documents required by the letter of credit. The buyer and the seller agree
A. Definition and nature
Prudential Bank v. IAC, (1992). A letter of credit is an instrument issued by a
bank that guarantees its client’s ability to pay for imported goods or services,
authorizing an individual or a firm to draw drafts on the bank or on its
correspondents for bank’s account under conditions specified in the credit.
Reliance Commodities, Inc. v. Daewoo Industrial Co. Ltd., (1993). The primary
purpose of L/C is to substitute for, and therefore support, the agreement of
the buyer-importer to pay money under a contract or other arrangement; but
it does not necessarily constitute as a condition for the perfection of such
arrangement.
Transfield Phil. Inc. v. Luzon Hydro Corp., (2004). By definition, a letter of
credit is a written instrument whereby the writer requests or authorizes the
addressee to pay money or deliver goods to a third person and assumes
responsibility for payment of debt therefor to the addressee. A letter of credit,
however, changes its nature as different transactions occur and if carried
through to completion ends up as a binding contract between the issuing and
honoring banks without any regard or relation to the underlying contract or
disputes between the parties thereto.
Bank of America v. CA, (1993). A L/C is a financial device developed by
merchants as a convenient and relatively safe mode of dealing with sales of
goods to satisfy the seemingly irreconcilable interests of a seller, who refuses
to part with his goods before he is paid, and a buyer, who wants to have
control of the goods before paying.
To break the impasse, the buyer may be required to contract a bank to issue a
L/C in favor of the seller so that, by virtue of the L/C, the issuing bank can
authorize the seller to draw drafts and engage to pay them upon their
presentment simultaneously with the tender of documents required by the
L/C. The buyer and the seller agree on what documents are to be presented
for payment, but ordinarily they are documents of title evidencing or attesting
to the shipment of the goods to the buyer.
Asian Terminals, Inc. v. Philam Insurance Co., (2013). However, L/C are
employed by the parties desiring to enter into commercial transactions, not
for the benefit of the issuing bank but mainly for the benefit of the parties to
the original transaction, the seller and the buyer. Hence, the buyer should be
regarded as the person entitled to delivery of the goods. Accordingly, for
purposes of reckoning when notice of loss or damage should be given to the
carrier or its agent, the date of delivery to the buyer is controlling.
Feati Bank v. CA, (1991). Mere opening of a L/C, does not involve a specific
appropriation of a sum of money in favor of the beneficiary. It only signifies
that the beneficiary may be able to draw funds upon the L/C up to the
designated amount specified therein. It does not convey the notion that a
particular sum of money has been specifically reserved or has been held in
trust.
2012 Bar, Q. 1 (MCQ): Letters of Credit are financial devices in commercial
transactions which will ensure that the seller of the goods is sure to be paid
when he parts with the goods and the buyer of the goods gets control of the
goods upon payment. Which statement is most accurate?
a. The use of the Letter of Credit serves to reduce the risk of nonpayment
of the purchase price in a sale transaction.
b. The Letters of Credit can only be used exclusively in a sales transaction.
c. The Letters of Credit are issued for the benefit of the seller only.
d. (a), (b) and (c) are all correct.
2012 Bar, Q. I(b): Explain the nature of Letters of Credit as a financial devise.
A: A letter of credit is a financial device developed by merchants as a
convenient and relatively safe mode of dealing with sales of goods to satisfy
the seemingly irreconcilable interests of a seller, who refuses to part with his
goods before he is paid, and a buyer, who wants to have control of the goods
before paying. To break the impasse, the buyer may be required to contract a
bank to issue a letter of credit in favor of the seller so that, by virtue of the
latter of credit, the issuing bank can authorize the seller to draw drafts and
PI SIGMA/ PI SIGMA DELTA ‘18
engage to pay them upon their presentment simultaneously with the tender
on what documents are to be presented for payment, but ordinarily they are
documents of title evidencing or attesting to the shipment of the goods to the
buyer.
Once the credit is established, the seller ships the goods to the buyer and in
the process secures the required shipping documents or documents of title.
To get paid, the seller executes a draft and presents it together with the
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 seller. The transaction is
completed when the buyer reimburses the issuing bank and acquires the
documents entitling him to the goods. Under this arrangement, the seller gets
paid only if he delivers the documents of title over the goods, while the buyer
acquires said documents and control over the goods only after reimbursing
the bank (Bank of America NT & SA v. CA, et. al., G.R. No. 105395, December
10, 1993)
However, letters of credit are also used in non-sale settings where they serve
to reduce the risk of non-performance. Generally, letters of credit in non-sale
settings have come to be known as standby letters of credit (Transfield
Philippines, Inc. v. Luzon Hydro Corporation, G.R. No. 146717, November 22,
2004)
CASE: Transfield vs. Luzon Hydro, 22 November 2004
Facts:
1. Transfield Phil. Inc. (TPI) as contractor under a turnkey construction
agreement, submitted to Luzon Hydro Corp. (LHC) standby L/C to secure
the performance of its (TPI) obligations.
2. Delays in the completion of the project resulted in the filing of arbitration
proceedings on whether TPI could benefit from force majeure (storm)
for non-completion of the project on due date.
3. While the arbitral proceedings were pending, and despite TPI’s notice to
the banks that LHC cannot call on the L/C until final settlement of the
issues, nevertheless the banks notified TPI that they would pay on the
L/C upon demand of LHC, based on the delay of completion
Issue:
(1) WON LHC call on the L/C despite the pendency of the resolution of the
issue on whether TPI has defaulted in its obligations to complete the
project on due date
(2) WON only the issuing bank and not LHC can claim the “independent
principle
Held:
WON LHC can call on the L/C
1. Precisely, the independence principle liberates the issuing bank from the
duty of ascertaining compliance by the parties in the main contract.
2. As the principle's nomenclature clearly suggests, the obligation under
the L/C is independent of the related and originating contract. In brief,
the L/C is separate and distinct from the underlying transaction.
3. The argument that any dispute must first be resolved by the parties
through negotiations or arbitration before the beneficiary is entitled to
call on the L/C in essence would convert the L/C into a mere guarantee.
WON the Independent Principle can be invoked by LHC
4. To say that the independence principle may only be invoked by the
issuing banks would render nugatory the purpose for which the L/C are
used in commercial transactions.
5. As it is, the independence doctrine works to the benefit of both the
issuing bank and the beneficiary.
Transfield Phil. Inc. v. Luzon Hydro Corp., (2004). The independent nature of
the letter of credit may be:
(a) Independence in toto where the credit is independent from the
justification aspect and is a separate obligation from the underlying
agreement like for instance a typical standby; or
(b) Independence may be only as to the justification aspect like in a
commercial letter of credit or repayment standby, which is identical with
the same obligations under the underlying agreement.
In both cases the payment may be enjoined if in the light of the purpose of the
credit the payment of the credit would constitute fraudulent abuse of the
credit.
Most writers agree that fraud is an exception to the independence principle.
Professor Dolan opines that the untruthfulness of a certificate accompanying
a demand for payment under a standby credit may qualify as fraud sufficient
to support an injunction against payment. The remedy for fraudulent abuse is
an injunction. However, injunction should not be granted unless:
(a) There is clear proof of fraud;
(b) The fraud constitutes fraudulent abuse of the independent purpose of
the letter of credit and not only fraud under the main agreement; and
(c) Irreparable injury might follow if injunction is not granted or the recovery
of damages would be seriously damaged.
B. Parties to a letter of credit (LOC)
Transfield Phil. Inc. v. Luzon Hydro Corp., (2004). L/C are employed by parties
desiring to enter into commercial transactions, not for the benefit of the
issuing bank but mainly for the benefit of the parties to the original
transactions. With the L/C from the issuing bank, the party who applied for an
obtained it may confidently present it to the beneficiary as a security to
convince the beneficiary to enter into the business transaction. The
beneficiary can be rest assured of being empowered to call on the L/C as a
security in case the commercial transaction does not push through, or the
applicant fails to perform his part of the transaction. That is the reason why
the party entitled to the proceeds is appropriately called “beneficiary”
Keng Hua Paper Products v. CA, (1998). In a letter of credit, there are three (3)
distinct and independent contracts:
(1) The contract of sale between the buyer and the seller;
(2) The contract of the buyer with the issuing bank, and
(3) The letter of credit proper in which the bank promises to pay the seller
pursuant to the terms and conditions stated therein
The three contracts which make up the letter of credit arrangement are to be
maintained in a state of perpetual separation." A transaction involving the
purchase of goods may also require, apart from a letter of credit, a contract of
transportation specially when the seller and the buyer are not in the same
locale or country, and the goods purchased have to be transported to the
latter.
2002 Bar, Q. III: Explain the three (3) distinct but intertwined contract
relationships that are indispensable in a letter of credit transaction.
A: The three (3) distinct but intertwined contract relationships that are
indispensable in a letter of credit transaction are:
1. Between the applicant/buyer/importer and the
beneficiary/seller/exporter – The applicant/buyer/importer is the one
who procures the letter of credit and obliges himself to reimburse the
issuing bank upon receipt of the documents of title, while the
beneficiary/seller/exporter is the one who 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 for the goods.
Their relationship is governed by the contract of sale.
2. Between the issuing bank and the beneficiary/seller/exporter – The
issuing bank is the one that issues the letter of credit and undertakes to
pay the seller upon receipt of the draft and proper documents of title
and to surrender the documents to the buyer upon reimbursement.
Their relationship is governed by the terms of the letter of credit issued
by the bank.
3. Between the issuing bank and the applicant/buyer/importer – Their
relationship is governed by the terms of the application and agreement
for the issuance of the letter of credit by the bank.
PI SIGMA/ PI SIGMA DELTA ‘18
Bank of America v. CA, (1993). There would be at least three (3) parties to a
L/C arrangement:
(a) Buyer (Applicant) – one who procures the L/C and obliges himself to
reimburse Issuing Bank upon receipt of the documents of title
(b) Issuing Bank – one issuing the L/C, which undertakes to pay Seller upon
receipt of the draft and proper documents of titles and to surrender the
documents to Buyer upon reimbursement; and
(c) Seller (Beneficiary) – one who 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
Other Parties:
(d) Advising (notifying bank) – to convey to Seller the existence of the credit
(e) Confirming bank – one which will lend credence to the L/C issued by a
lesser known Issuing Bank
(f) Paying bank – undertakes to encash the drafts drawn by the exporter; or
(g) Negotiation bank – one where instead of going to the place of the Issuing
Bank to claim payment, Seller may approach Negotiating Bank to have
draft discontinued
1994 Bar, Q. I(3): In letters of credit in banking transactions, distinguish the
liability of a confirming bank from a notifying bank.
A: In case anything wrong happens to the letter of credit, a confirming bank
incurs liability for the amount of the letter of credit, while a notifying bank
does not incur any liability.
Right and obligations of parties
(a) Special Relations Created; Special Rules Applicable
Transfield Phil. Inc. v. Luzon Hydro Corp., (2004). The L/C evolved as a
mercantile specialty, and the only way to understand all its facets is to
recognize that it is an entity unto itself
(a) The relationship between the beneficiary and the issuer of a L/C is not
strictly contractual, because both privity and a meeting of the minds are
lacking, yet strict compliance with its terms is an enforceable right;
(b) Nor is it a third-party beneficiary contract (pour autrui), because the
issuer must honor drafts drawn against a letter regardless of problems
subsequently arising in the underlying contract;
(c) Since the bank's customer (Applicant-Buyer) cannot draw on the letter,
it does not function as an assignment by the customer to the beneficiary;
(d) Nor, if properly used, is it a contract of suretyship or guarantee, because
it entails a primary liability following a default;
(e) Finally, it is not in itself a negotiable instrument, because it is not payable
to order or bearer and is generally conditional, yet the draft presented
under it is often negotiable.
Feati Bank v. CA, (1991). It is a fundamental rule that an irrevocable credit is
independent not only of the contract between the buyer-applicant and the
seller-beneficiary, but also of the credit agreement between the issuing bank
and the buyer-applicant.
The non-compliance by buyer with its contract with issuing bank has no
bearing with the agreement between the buyer and the seller. The
relationship between the issuing bank and the notifying bank, on the other
hand is more similar to that of an agency and not that of a guarantee, since
the latter is merely to follow the instructions of the issuing bank which is to
notify or to transmit the L/C to the beneficiary.
1993 Bar, Q. VIII: BV agreed to sell to AC, a Ship and Merchandise Broker,
2,500 cubic meters of logs at $27 per cubic meter FOB. After inspecting the
logs, CD issued a purchase order.
On the arrangements made upon instruction of the consignee, H&T
Corporation of LA, California, the SP Bank of LA issued an irrevocable letter
of credit available at sight in favor of BV for the total purchase price of the
logs. The letter of credit was mailed to FE Bank with the instruction “to
forward it to the beneficiary.” The letter of credit provided that the draft to
be drawn is on SP Bank and that it be accompanied by, among other things,
a certification from AC, stating that the logs have been approved prior
shipment in accordance with the terms and conditions of the purchase order.
Before loading on the vessel chartered by AC, the logs were inspected by
custom inspectors and representatives of the Bureau of Forestry, who
certified to the good condition and exportability of the logs. After the loading
was completed, the Chief Mate of the vessel issued a mate receipt of the
cargo which stated that the logs are in good condition. However, AC refused
to issue the required certification in the letter of credit. Because of the
absence of certification, FE Bank refused to advance payment on the letter
of credit.
1. May Fe Bank be held liable under the letter of credit? Explain.
2. Under the facts above, the seller, BV, argued that FE Bank, by accepting
the obligation to notify him that the irrevocable letter of credit has
been transmitted to it on his behalf, has confirmed the letter of credit.
Consequently, FE Bank is liable under the letter of credit. Is the
argument tenable? Explain.
A:
1. No. The letter of credit provides as a condition a certification of AC.
Without such certification, there is no obligation on the part of FE Bank
to advance payment of the letter of credit. (Feati Bank v. CA)
2. No. FE Bank may have confirmed the letter of credit when it notified BV,
that an irrevocable letter of credit has been transmitted to it on its
behalf. But the conditions in the letter of credit must first be complied
with, namely that the draft be accompanied by a certification from AC.
Further, confirmation of a letter of credit must be expressed. (Feati Bank
v. CA)
(b) Rule of Strict Compliance
Feati Bank v. CA, (1991). It is a settled rule in commercial transactions
involving L/C that the documents tendered must strictly conform to the terms
of the L/C. The tender of documents by the beneficiary (seller) must include
all documents required by the letter. A correspondent bank which departs
from what has been stipulated under L/C, as when it accepts a faulty tender,
acts on its own risks and it may not thereafter be able to recover from the
buyer or the issuing bank, as the case may be, the money thus paid to the
beneficiary Thus the rule of strict compliance.
Commercial transactions involving letters of credit are governed by the rule of
strict compliance. An irrevocable credit is not synonymous with a confirmed
credit. An irrevocable L/C refers to the duration of the L/C, and simply means
that the issuing bank may not without the consent of the beneficiary (seller)
and the applicant (buyer) revoke his undertaking under the letter, because the
issuing bank does not reserve the right to revoke the credit.
A confirmed L/C pertains to the kind of obligation assumed by the
correspondent bank, which means that the correspondent bank gives an
absolute assurance to the beneficiary that it will undertake the issuing bank’s
obligation as its own according to the terms and conditions of the credit.
Hence, the mere fact that a L/C is irrevocable does not necessarily imply that
the correspondent bank in accepting the instructions of the issuing bank has
also confirmed the L/C. Consequently, if the terms of the L/C require a
certification from beneficiary, issuing bank cannot be compelled to pay when
no such certification is issued.
2012 Bar, Q. 3 (MCQ): At the instance of CCC Corporation, AAA Bank issued
an irrevocable Letter of Credit in favor of BBB Corporation. The terms of the
irrevocable Letter of Credit state that the beneficiary must present certain
documents including a copy of the Bill of Lading of the importation for the
bank to release the funds. BBB Corporation could not find the original copy
of the Bill of Lading so it instead presented to the bank a xerox copy of the
Bill of Lading. Would you advise the bank to allow the drawdown on the
Letter of Credit?
a. No, because the rule of strict compliance in commercial transactions
involving letters of credit, requiring documents set as conditions for the
release of the fund, has to be strictly corn plied with or else funds will
not be released.
PI SIGMA/ PI SIGMA DELTA ‘18
b. Yes, because an irrevocable letter of credit means that the issuing bank
undertakes to release the fund anytime when claimed by the beneficiary,
regardless of the kind of document presented.
c. Yes, because the issuing bank can always justify to CCC Corporation that
xerox copies are considered as faithful reproduction of the original
copies.
d. Yes, because the issuing bank really has no discretion to determine
whether the documents presented by the beneficiary are sufficient or
not.
(c) Obligations of Applicant; Obligations of Correspondent Bank
C. Basic principles of LOC
1. Doctrine of independence
2015 Bar, Q. V(A): A standby letter of credit was issued by ABC Bank to secure
the obligation of X Company to Y Company. Under the standby letter of
credit, if there is failure on the part of X Company to perform its obligation,
then Y Company will submit to ABC Bank a certificate of default (in the form
prescribed under the standby letter of credit) and ABC Bank will have to pay
Y Company the defaulted amount. Subsequently, Y Company submitted to
ABC Bank a certificate of default notwithstanding the fact that X Company
was not in default. Can ABC Bank refuse to honor the certificate of default?
Explain.
A: No. Under the doctrine of independence in a letter of credit, the obligation
of the issuing bank to pay the beneficiary is distinct and independent from the
main and originating contract underlying the letter of credit. Such obligation
to pay does not depend on the fulfillment or non-fulfillment of the originating
contract. It arises upon tender of the stipulated documents under the letter of
credit. In the present case, the tender of the certificate of default entitles Y to
payment under the standby letter of credit, notwithstanding the fact that X
Company was not in default. This is without prejudice to the right of X
Company to proceed against Y Company under the law on contracts and
damages (Insular Bank of Asia and America v. IAC, G.R. No. 74834, November
17, 1988)
Alternative: Under the fraud exception principle, the beneficiary may be
enjoined from collecting on the letter of credit in case of fraudulent abuse of
credit. The issuance of a certificate of default, despite the fact that X Company
is not in default, constitutes fraudulent abuse of credit (Transfield Philippines
v. Luzon Hydro Corp., G.R. No. 146717, November 22, 2004)
2012 Bar, Q. 4 (MCQ): AAA Carmakers opened an irrevocable Letter of Credit
with BBB Banking Corporation with CCC Cars Corporation as beneficiary. The,
irrevocable Letter of Credit was opened to pay for the importation of ten (1
0) units of Mercedes Benz S class. Upon arrival of the cars, AAA Carmakers
found out that the cars were all not in running condition and some parts
were missing. As a consequence, AAA Carmakers instructed BBB Banking
Corporation not to allow drawdown on the Letter of Credit. Is this legally
possible?
a. No, because under the "Independence Principle", conditions for the
drawdown on the Letters of Credit are based only on documents, like
shipping documents, and not with the condition of the goods subject
of the importation.
b. Yes, because the acceptance by the importer of the goods subject of
importation is material for the drawdown of the Letter of Credit.
c. Yes, because under the "Independence Principle", the seller or the
beneficiary is always assured of prompt payment if there is no breach in
the contract between the seller and the buyer.
d. No, because what was opened was an irrevocable letter of credit and not
a confirmed letter of credit.
2010 Bar, Q. XVII: The Supreme Court has held that fraud is an exception to
the "independence principle" governing letters of credit. Explain this
principle and give an example of how fraud can be an exception.
A: The “independence principle” posits that the obligation of the parties to a
L/C are independent of the obligations of the parties to the underlying
transaction. Thus, the beneficiary of the L/C, which is able to comply with the
documentary requirements under the L/C, must be paid by the issuing or
confirming bank, notwithstanding the existence of a dispute between the
parties to the underlying transaction, say a contract of sale of goods where the
buyer is not satisfied with the quality of the goods delivered by the seller.
The SC in Transfield Philippines, Inc. v. Luzon Hydro Corp. (2004) for the first
time declared that fraud is an exception to the independence principle. For
instance, if the beneficiary fraudulently presents to the issuing or confirming
bank documents that contain material facts that, to his knowledge, are untrue,
then payment under the L/C may be prevented through a court injunction.

2008 Bar, Q. I: X corporation entered into a contract with PT Construction

Corp. for the latter to construct and build a sugar mill within six (6) months.
They agreed that in case of delay, PT Construction Corp. will pay X
Corporation P100,000 for every day of delay. To ensure payment of the
agreed amount of damages, PT Construction Corp. secured from Atlantic
Bank a confirmed and irrevocable letter of credit which was accepted by X
Corporation in due time. One week before the expiration of the six (6) month
period, PT Construction Corp. requested for an extension of time to deliver
claiming that the delay was due to the fault of X Corporation. A controversy
as to the cause of the delay which involved the workmanship of the building
ensued. The controversy remained unresolved. Despite the controversy, X
Corporation presented a claim against Atlantic Bank by executing a draft
against the letter of credit.
(a) Can Atlantic Bank refuse payment due to the unresolved controversy?
Explain.
(b) Can X Corporation claim directly from PT Construction Corp.? Explain.

A:
(a) Atlantic Bank cannot refuse to pay because in a letter of credit, where
the credit is stipulated as irrevocable, there is a definite undertaking by
the issuing bank to pay the beneficiary, provided that the stipulated
documents are presented and the conditions of the credit are complied
with. Under the “independence principle”, the issuing bank is not
obligated to ascertain compliance by the parties in the main contact. In
other words, where the legal relation arises from a letter of credit, such
letter of credit contains the entire contact of the parties and the resulting
obligations should be measured by its provisions. It is unaffected by any
breach of contract on the part of one of the parties or by any controversy
which may arise between them (Transfield Philippines, Inc. v. Luzon
Hydro Corp., 2004)
(b) Yes, X Corp. can claim directly from PT Construction Corp. The call upon
the letter of credit is not exclusive; it is merely an alternative remedy in
case of delay due to the fault of PT Construction Corp. (Transfield
Philippines, Inc. v. Luzon Hydro Corp., 2004)

2. Fraud exception principle

Under the fraud exception principle, the beneficiary may be enjoined from
collecting on the letter of credit in case of fraudulent abuse of credit. The
issuance of a certificate of default, despite the fact that X Company is not in
default, constitutes fraudulent abuse of credit (Transfield Philippines v. Luzon
Hydro Corp., G.R. No. 146717, November 22, 2004)

3. Doctrine of strict compliance

Feati Bank v. CA, (1991). It is a settled rule in commercial transactions
involving L/C that the documents tendered must strictly conform to the terms
of the L/C. The tender of documents by the beneficiary (seller) must include
all documents required by the letter. A correspondent bank which departs
from what has been stipulated under L/C, as when it accepts a faulty tender,
acts on its own risks and it may not thereafter be able to recover from the
buyer or the issuing bank, as the case may be, the money thus paid to the
beneficiary Thus the rule of strict compliance.

CASES: PNB vs. San Miguel, 15 January 2014

Bangayan vs. RCBC, 4 April 2011

LBP vs. Monet Export, 10 March 2005

PI SIGMA/ PI SIGMA DELTA ‘18