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Letters of Credit

Special Commercial Laws


Governing Laws
1. Code of Commerce on Letters of Credit
2. Customs, primarily those embodied in
the Uniform Customs and Practice for
Documentary Credit which was adopted
by the International Chamber of
Commerce.
Definition and Nature
• insuring to a seller payment of a definite amount
upon the presentation of documents (De Leon,
2010)
• an instrument issued by one merchant to
another, or for the purpose of attending to a
commercial transaction (Code of Commerce, Art.
567)
• An original undertaking by the issuer to
substitute its financial strength for that of
another (the applicant) with the undertaking to
be conditioned on the presentation of a draft or
demand for payment (by the beneficiary) (Dolan,
1991)
Definition and Nature
• A letter of credit is...
1. an instrument issued by a bank
2. that guarantees its client's ability to pay for...
goods or services
3. authorizing an individual or a firm to draw
drafts on the bank or on its correspondents
for bank's account under certain conditions
of the credit. (Villanueva)
Prudential Bank v. IAC (216 SCRA 257)
• A letter of credit is defined as an engagement
by a bank or other person made at the
request of a customer that the issuer will
honor drafts or other demands for payment
upon compliance with the conditions
specified in the credit.
• Once an issuing bank shall have paid the
beneficiary after the latter’s compliance with
the terms of the letters of credit, presentment
for acceptance to the customer/applicant is
not a condition sine qua non for
reimbursement.
Bank of America NT. & SA v. CA (G.R. No.
105395, December 10, 1993)
• 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.
MWSS v. Daway
(G.R. No. 160732, June 21, 2004)
• The concept of guarantee vis-à-vis the concept
of irrevocable letter of credit is inconsistent
with each other. Letters of Credit are primary
obligations and not security contracts.
• While they are security arrangements, they
are not converted into contracts of
guarantee.
• The liability of issuing bank is primary and
solidary. Neither is the issuing bank entitled
to the benefit of excussion.
Parties
Bank of America NT. & SA v. CA
(G.R. No. 105395, December 10, 1993)

• There would at least be three (3)


parties:
1. Buyer (Applicant)
2. Issuing bank (Buyer's Bank)
3. Seller (Beneficiary)
Illustration
• Most common in international transactions.
• Let's assume that Pinoy Company sells
furniture in the Philippines and Italiano
Company manufactures furniture in Italy.
Pinoy Company wants to import $100,000
worth of furniture manufactured by Italiano
Company , but Italiano Company is concerned
about Pinoy Company's ability to pay for
them.
• Who applies for the letter of credit?
• Pinoy Company from --
• It’s bank, ABC Bank. Indicating that—
• Pinoy Company will make good on the
$100,000 payment in the number of days
agreed or ABC Bank will pay the bill itself.
• ABC Bank will then send the letter of credit
to Italiano Company which then ships the
furniture.
• After shipment, Italiano Company or Italiano
Company’s Bank will then ask for payment of
its $100,000 by ---
• Presenting a written draft (also known as a bill
of exchange) to –
• ABC Bank.
• Who is protected/benefited in a letter of
credit? Seller or the buyer?
• Both.
• Seller: guarantee of payment.
• Buyer: protection of payment.
• Italiano Company must present ABC Bank
with written proof of the shipment in order to
get paid.
• Proof: commercial invoice, bill of lading or
airway bill.
• After ABC Bank pays Italiano Company, it turns
to Pinoy Company for reimbursement.
• Debit of account, usually with pledge of
securities or cash collateral.
• What’s in it for the bank?
Additional Parties
1. Advising (notifying) bank
- conveys to the seller the existence of the credit.
2. Confirming bank
- lends credence to the letter of credit issued by a
lesser known issuing bank.
3. Paying bank
- undertakes to encash the drafts drawn by the
exporter.
4. Negotiating bank
- discounts the draft instead of going to the place of
the issuing bank to claim payment
Perfection
• Belman Inc. v. Central Bank (104 Phil. 877)
• An irrevocable letter of credit granted by a bank,
which authorizes a creditor in a foreign country to
draw upon a debtor of another and to negotiate the
draft through the agent or correspondent bank or
any bank in the country of the creditor, is a
consummated contract, when the agent or
correspondent bank or any bank in the country of
the creditor pays or delivers to the latter the
amount in foreign currency, as authorized by the
bank in the country of the debtor in compliance
with the letter of credit granted by it.
In Relation to Contract of Sale
• Johannes Schuback & Sons v. CA (227 SCRA
717)
• The opening of a letter of credit in favor of a
vendor is only a mode of payment. It is not
among the essential requirements of a
contract of sale enumerated in Article 1305
and 1474 of the Civil Code, the absence of any
of which will prevent the perfection of the
contract from taking place.
Essential Conditions of a Letters of Credit:
1. Issued in favor of a definite person.
2. Limited to a fixed or specified amount, or to
one or more amounts, but with a maximum
stated limit.
Duration of Letters of Credit:
1. Upon the period fixed by the parties; or
2. If none is fixed, one year from the date of
issuance.
Independent Contracts Involved in a Letter of Credit
• Keng Hua Paper Products v. CA (286 SCRA 257)
• In a letter of credit, there are three 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 contract of carriage, as stipulated in the bill of lading
in the present case, must be treated independently of
the contract of sale between the seller and the buyer,
and the contract for the issuance of a letter of credit
between the buyer and the issuing bank.
• Feati Bank v. CA (196SCRA 576)
• It is a fundamental rule that an irrevocable
credit is independent not only of the contract
between the buyer and the seller but also of
the credit agreement between the issuing
bank and the buyer. The relationship between
the buyer and the issuing bank is entirely
independent from the letter of credit issued
by the latter. The contract between the two
has no bearing as to the non-compliance by
the buyer with the agreement between the
latter and the seller.
Rights and Obligations of Parties in
Letter of Credit
• Bank of Philippine Islands v. De Reny Fabric
Industries, Inc. (35 SCRA 256)
• The buyer-applicant cannot shift the burden
of loss to the correspondent bank on account
of the violation by the seller-beneficiary of its
obligation.
• Banks do not deal with the property to be
exported or shipped to the importer, but deal
only with the documents.
Rights and Obligations of Parties in a
Letter of Credit
• Insular Bank v. IAC (167 SCRA 450)
• Letter of credit constitutes the primary
obligation, and not merely an accessory
contract of the issuing bank separate from
the underlying contract that it may support.
Consequently, beneficiary of a letter of credit
issued to secure payment of a loan may
collect on its entirety, even if borrower claims
it made partial payments already.
Rights and Obligations of Parties in a
Letter of Credit
• Phil. Virginia Tobacco Adm. v. De los
Angeles (164 SCRA 543)
• An irrevocable letter of credit during its
lifetime cannot be cancelled or modified
without the express permission of the
beneficiary.
Obligations of Correspondent Bank
• Depending on the functions assumed:
1. Advising or Notifying Bank – no liability except to
notify and transmit to the beneficiary the existence
of the letter of credit.
2. Negotiating Bank – depends on the stage of
negotiation. Before: no liability. After: contractual
relation will exist.
3. Confirming Bank – direct obligation to the seller and
its liability is primary one as if the correspondent
bank itself issued the letter of credit.
4. Paying Bank – Direct obligation.
Consequence of Payment:
Expired Letter of Credit
• An issuing bank which paid the beneficiary
upon an expired letter of credit can recover
the payment from the applicant which
obtained the goods from the beneficiary to
prevent unjust enrichment. (Rodzssen Supply
Cp. V. Far East Bank and Trust Co., G.R. No.
109087, May 9, 2001)
Kinds of Letters of Credit
Commercial Standby
Involve the payment of money Does not involve the payment
under a contract of sale. of money.
Payable upon the presentation Payable upon certification of a
by the seller-beneficiary of party’s non performance of the
documents that show he has agreement. The documents
taken affirmative steps to that accompany tend to show
comply with the sales that the applicant has not
agreement. performed.
Demonstrate that the Certify that the beneficiary’s
beneficiary has performed his obligor has not performed the
contract. contract.
• An exporter sells goods to a foreign
buyer who promises to pay within 60
days.

• A contractor agrees to complete a


construction project within a certain
timeframe. When the deadline arrives,
the project has not been completed.
REVOCABLE IRREVOCABLE

-LOC that may be - May not be revoked


revoked or modified for or amended without
any reason, at any time the agreement of the
by the issuing bank issuing bank, the
without notification confirming bank and
and cannot be the beneficiary.
confirmed.
• Confirmed (and Unconfirmed) Letters of Credit
• When a letter of credit is confirmed, another bank
(presumably one that the beneficiary trusts)
guarantees that payment will be made.

• Sight Letter of Credit


• Payment under a sight letter of credit occurs as soon
as the beneficiary submits acceptable documents to
the appropriate bank. The bank has a few days to
review the documents and ensure that they meet
the requirements in the letter of credit. If the
documents are compliant, payment is made
immediately.
Basic Principles of
Letter of Credit
• Doctrine of Independence
• Fraud Exception Principle
• Doctrine of Strict Compliance
• Transfield Philippines, Inc. v. Luzon Hydro
Corporation Australia, et. al.
• Doctrine of Independence
• The letter of credit is separate and distinct from
the underlying or principal obligation.
• The settlement of a dispute between the parties
is not a pre-requisite for the release of funds. If a
letter of credit is drawable only after settlement
of the dispute on the contract entered into by the
applicant and the beneficiary, there would be no
practical and beneficial use for letters of credit
in commercial transactions.
Fraud Exception Principle
• The untruthfulness of a certificate may qualify
as fraud, sufficient to support an injunction
against payment.
• However, injunction should not be granted
unless:
1) There is clear proof of fraud
2) The fraud constitutes fraudulent abuse of the
independent purpose of the letter of credit
and not only fraud under the underlying
obligation; and
3) Irreparable injury might follow if injunction is
not granted or the recovery of damages would
be seriously affected.
Doctrine of Strict Compliance
• Under this rule, the documents tendered by
the beneficiary must strictly conform to the
terms of the letter of credit.
• If the letter of credit requires a certification
from a beneficiary, issuing bank cannot be
compelled to pay when no such certification
is issued.
• If an honoring entity accepts a faulty tender,
it acts on its own risk and may not
thereafter recover from the applicant or
issuer the money paid to the beneficiary.
Letter of Credit-
Trust Receipt Transaction
• Bank extends a loan covered by the letter
of credit with trust receipt as security for
the loan.
• The two are separate and involve
different undertakings and obligations.