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I.

Letters of Credit

1. Definition and Nature of Letter of Credit

A financial device developed by merchants as a convenient and relatively safe mode of


dealing with sales of goods.

Purpose: to satisfy irreconcilable interests of the seller and the buyer

2. Nature of letter of credit

Absolute undertakings to pay the money advanced or the amount for which credit is given on
the faith of the instrument. They are primary obligations and not accessory contracts and while
they are security arrangements, they are not converted thereby into contracts of guaranty.
What distinguishes letters of credit from other accessory contracts, is the engagement of the
issuing bank to pay the seller once the draft and other required shipping documents are
presented to it. They are definite undertakings to pay at sight once the documents stipulated
therein are presented. (MWSS v. Daway)

(2012 Bar) 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

Answer: Letter A

3. Governing law

Uniform Customs and Practice for Documentary Credits (UCP) issued by the International
Chamber of Commerce

Feati Bank and Trust Company v. Court of Appeals and Bank of America NT & SA v.
Court of Appeals

To the extent that they are pertinent, the application in our jurisdiction of the international credit
regulatory set of rules known as the UCP, which we said in Bank of the Philippine Islands v.
Nery was justified under Art. 2 of the Code of Commerce, which states: “Acts of commerce,
whether those who execute them be merchants or not, and whether specified in this Code or
not should be governed by the provisions contained in it; in their absence, by the usages of
commerce generally observed in each place; and in the absence of both rules, by those of the
civil law.”

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Question:

“S” (seller) from Manila agreed to sell to “B” (buyer) from Hong Kong logs at $27.00 per cubic
meter FOB. “B” opened an LC in favor of “A” in ABC HK Bank. The LC was mailed to XYZ MLA
Bank.

The LC provides that the draft to be drawn should be accompanied by a Certification from “A”
stating that the goods have been approved prior to shipment in accordance with terms and
conditions of corresponding Purchase Order.

After the goods were delivered to “B”, “B” refused to issue the certification despite several
requests made by “S”. Because of the lack of certification, ZYX MLA Bank refused to advance
the payment on the LC.

“S” brought an action for mandamus and specific performance against “B” and ZYX MLA Bank.
The trial court ruled that “B” as well as XYZ MLA Bank should be made to pay on the basis of
“B’s” evident bad faith while the bank’s liability is based on estoppel.

Is it correct to rule that XYZ MLA Bank should be held liable to pay in this case?

Suggested answer:

No. XYZ MLA should not be held liable in this case.

It is a settled rule in commercial transactions involving letters of credit that the documents
tendered must strictly conform to the terms of the letter of credit. The tender of documents by
the beneficiary (seller) must include all documents required by the letter.

WHAT IF THE QUESTION IS ABOUT THE LAW THAT SHOULD APPLY -

Question:

SAME FACTS.

ARGUMENT AGAINST THE BANK – The Uniform Customs and Practice for Documentary
Credit (UCP) was not incorporated in the LC, hence the Civil Code should apply.

Is it correct to rule that XYZ MLA Bank should be held liable to pay in this case?

Suggested answer:

No. XYZ MLA should not be held liable in this case.

Even if the UCP was not incorporated in the letter of credit, it was already ruled that the
observance of the UCP in this jurisdiciton is justified by Art. 2 of the Code of Commerce. (BPI
v. De Nery 1970) Said law enunciates that in the absence of any particular provision in the
Code of Commerce, commercial transactions shall be governed by the usages and customs
generally observed.

WHAT IF THE LC IS IRREVOCABLE -

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Question:

SAME FACTS.

ARGUMENT AGAINST THE BANK – The LC issued was irrevocable.

Is it correct to rule that XYZ MLA Bank should be held liable to pay in this case?

Suggested answer:

No. XYZ MLA should not be held liable in this case.

The mere fact that a letter of credit is irrevocable does not necessarily imply that the
correspondent bank in accepting the instructions of the issuing bank has also confirmed the
letter of credit.

An irrevocable credit refers to the duration of the letter of credit. What is simply means is that
the issuing bank may not without the consent of the beneficiary (seller) and the applicant
(buyer) revoke his undertaking under the letter. There must be a categorical declaration in the
letter of credit that the bank is to honor all drafts drawn in conformity with the letter of credit in
order for the bank to be considered a confirming bank.

Note:

IRREVOCABLE LC – the bank may not, without the consent of the beneficiary and the
applicant, revoke its undertaking under the LC.

CONFIRMED LC - 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 condition of
the credit.

WHAT IF THE ARGUMENT WAS THAT THERE WAS TRUST CREATED -

Question:

SAME FACTS.

ARGUMENT AGAINST THE BANK – It was argued that when XYZ MLA Bank accepted its
role as the notifying and negotiating bank for and in behalf of the ABC HK Bank (issuing bank),
it in effect accepted a trust reposed on it, and became a trustee in relation to plaintiff as the
beneficiary of the letter of credit.

Is it correct to rule that XYZ MLA Bank should be held liable to pay in this case?

Suggested answer:

No. XYZ MLA should not be held liable in this case.

There is no legal basis to hold that the bank (XYZ) became a "trustee in relation to the “S” as
the beneficiary of the letter of credit. The concept of a trust presupposes the existence of a
specific property which has been conferred upon the person for the benefit of another. The
mere opening of a letter of credit does not involve a specific appropriation of a sum of money in
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favor of the beneficiary. It only signifies that the beneficiary may be able to draw funds upon
the letter of credit up to the designated amount specified in the letter. It does not convey the
notion that a particular sum of money has been specifically reserved or has been held in trust.

Parties to a Letter of Credit

Parties to a commercial letter of credit include (a) the buyer or the importer, (b) the seller, also
referred to as beneficiary, (c) the opening bank which is usually the buyer’s bank which
actually issues the letter of credit, (d) the notifying bank which is the correspondent bank of the
opening bank through which it advises the beneficiary of the letter of credit, (e) negotiating
bank which is usually any bank in the city of the beneficiary. The services of the notifying bank
must always be utilized if the letter of credit is to be advised to the beneficiary through cable, (f)
the paying bank which buys or discounts the drafts contemplated by the letter of credit, if such
draft is to be drawn on the opening bank or on another designated bank not in the city of the
beneficiary. As a rule, whenever the facilities of the opening bank are used, the beneficiary is
supposed to present his drafts to the notifying bank for negotiation and (g) the confirming bank
which, upon the request of the beneficiary, confirms the letter of credit issued by the opening
bank.

(1) Buyer (importer) – one who procures the letter of credit and obliges himself to reimburse
the issuing bank upon receipt of documents of title.

(2) Seller (beneficiary) – one who ships the goods to the buyer in compliance with a contract of
sale and delivers the documents of title and draft to the issuing bank to recover payment.

(3) Issuing Bank (or Opening bank) – the bank which undertakes: (a) to pay the seller upon
receipt of the draft and proper documents of title; and (b) to surrender the documents to the
buyer upon reimbursement.

Other parties:

(1) Advising/Notifying Bank – the bank which conveys to the seller the existence of the credit.
Liability - No liability except to notify and/or transmit to the seller the existence of the letter
of credit.
Reason: Notifying bank is not a privy to the contract of sale between the buyer and the
seller. Its relationship is only with that of the issuing bank and not with the beneficiary to
whom he assumes no liability.
Note - The bank may suggest to the seller its willingness to negotiate, but this fact alone
does not imply that the notifying bank promises to accept the draft drawn under the
documentary credit [Feati Bank and Trust Co. (1991)]

(2) Confirming Bank – the bank which lends credence to the letter of credit issued by a lesser
known issuing bank.
Liability - The bank assumes a direct obligation to the seller and its liability is a primary one
as if the bank itself had issued the letter of credit [Feati Bank]

(3) Negotiating Bank – the bank which discounts the draft presented by the seller.

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Liability - Its liability is dependent upon the stage of the negotiation. If BEFORE negotiation,
it has no liability with respect to the seller but AFTER negotiation, a contractual relationship
will then prevail between the negotiating bank and the seller [Feati Bank]

(4) Paying Bank – the bank which undertakes to encash the drafts drawn by the seller.

Basic Principles of Letter of Credit

2010 BAR - 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.

1. Doctrine of Independence

Banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness,
falsification or legal effect of any documents, or for the general and/or particular conditions
stipulated in the documents or superimposed thereon, nor do they assume any liability or
responsibility for the description, quantity, weight, quality, condition, packing, delivery, value or
existence of the goods represented by any documents, or for the good faith or acts and/or
omissions, solvency, performance or standing of the consignor, the carriers, or the insurers of
the goods, or any other person whomsoever [Transfield Philippines v. Luzon Hydro, G.R. No.
146717 (2004]

2008 BAR - X Corporation entered into a contract with PT Construction Corp. for the latter to
construct and build a sugar mill with 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.

Suggested Answer:

No, Atlantic Bank cannot refuse payment due to the said unresolved controversy.

Under the Doctrine of Independence, an irrevocable letter of credit is independent of the


contract between the buyer-applicant and the seller-beneficiary.
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2. Fraud Exception Principle

The principle that limits the application of the independence principle only to instances where it
would serve the commercial function of the credit and not when fraud attends the transaction.

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 of
injunction is available when the following are present:

(1) Clear proof of fraud;

(2) Fraudulent abuse of the independent purpose of the letter of credit and only fraud under
the main agreement and

(3) Irreparable injury might follow if injunction is not granted or the recovery of damages would
be seriously damaged

3. Doctrine of Strict Compliance

The settled rule in commercial transactions involving letters of credit requires that the
documents tendered by the seller must strictly conform to the terms of the letter of credit.

Otherwise, the issuing bank or the concerned correspondent bank is not obliged to perform its
undertaking under the contract.

COMMERCIAL LC vs. STANDBY LC (or DEMAND GUARANTY)

COMMERCIAL LC STANDBY LC
Transaction Sale Non-sale (e.g. construction)
secured
Purpose Reduce risk of non-payment Reduce risk of non-
performance
Payment Upon presentation of Upon certification of non-
documents (draft) performance
Beneficiary Must strictly comply with the Must certify that obligor has
requirements not performed the contract

TYPES OF DEMAND GUARANTEES

1. Tender or bid guarantee - safeguard the beneficiary against breach of such an


undertaking

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2. Performance guarantee - guarantee of the central performance of the contract from
commencement to completion

3. Advance payment or repayment guarantee - 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 - 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

5. Maintenance or warranty guarantee -


retention moneys are to be retained for a specified period to cover the cost of any de
fects or malfunction which become manifest during that period

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