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LETTERS OF CREDIT

Abstract

Letters of credit 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 transactions. With the letter of credit from the issuing bank, the
party who applied for and obtained it may confidently present the letter of credit to the
beneficiary as a security to convince the beneficiary to enter into the business
transaction. On the other hand, the other party to the business transaction, i.e., the
beneficiary of the letter of credit, can be rest assured of being empowered to call on the
letter of credit as a security in case the commercial transaction does not push through,
or the applicant fails to perform his part of the transaction. It is for this reason that the
party who is entitled to the proceeds of the letter of credit is appropriately called
“beneficiary.” (Transfield Philippines, Inc. vs. Luzon Hydro Corporation, et al., G.R. No.
146717, November 22, 2004,)

In commercial transactions involving letters of credit, the functions assumed by a


correspondent bank are classified according to the obligations taken up by it. The
correspondent bank may be called a notifying bank, a negotiating bank, or a confirming
bank. (Feati Bank & Trust Company vs. CA, G.R. No. 94209, April 30, 1991)

In case of a notifying bank, the correspondent bank assumes no liability except to


notify and/or transmit to the beneficiary the existence of the letter of credit. (Kronman
and Co., Inc. v. Public National Bank of New York, 218 N.Y.S. 616 [1926]; Shaterian,
Export-Import Banking, p. 292, cited in Agbayani, Commercial Laws of the Philippines,
Vol. 1, p. 76). A negotiating bank, on the other hand, is a correspondent bank which
buys or discounts a draft under the letter of credit. 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. (Scanlon v. First National Bank of Mexico, 162 N.E. 567 [1928])

In the case of a confirming bank, the correspondent bank assumes a direct


obligation to the seller and its liability is a primary one as if the correspondent bank itself
had issued the letter of credit. (Shaterian, Export-Import Banking, p. 294, cited in
Agbayani Commercial Laws of the Philippines, Vol. 1, p. 77)

A 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. It follows therefore that when the petitioner refused to
negotiate with the private respondent, the latter has no cause of action against the
petitioner for the enforcement of his rights under the letter. (Kronman and Co., Inc. v.
Public National Bank of New York)

As earlier stated, there must have been an absolute assurance on the part of the
petitioner that it will undertake the issuing bank’s obligation as its own. Verily, the loan
agreement it entered into cannot be categorized as an emphatic assurance that it will
carry out the issuing bank’s obligation as its own.

The case of Scanlon v. First National Bank perspicuously explained the


relationship between the seller and the negotiating bank, viz:

It may buy or refuse to buy as it chooses. Equally, it must be true that it owes no
contractual duty toward the person for whose benefit the letter is written to
discount or purchase any draft drawn against the credit. No relationship of agent
and principal, or of trustee and cestui, between the receiving bank and the
beneficiary of the letter is established. (P.568)

Whether therefore the petitioner is a notifying bank or a negotiating bank, it


cannot be held liable. Absent any definitive proof that it has confirmed the letter
of credit or has actually negotiated with the private respondent, the refusal by the
petitioner to accept the tender of the private respondent is justified.

The relationship between the issuing bank and the notifying bank, on the
contrary, is more similar to that of an agency and not that of a guarantee. It may be
observed that the notifying bank is merely to follow the instructions of the issuing bank
which is to notify or to transmit the letter of credit to the beneficiary. (See Kronman v.
Public National Bank of New York). Its commitment is only to notify the beneficiary. It
does not undertake any assurance that the issuing bank will perform what has been
mandated to or expected of it. As an agent of the issuing bank, it has only to follow the
instructions of the issuing bank and to it alone is it obligated and not to buyer with whom
it has no contractual relationship.

In fact the notifying bank, even if the seller tenders all the documents required
under the letter of credit, may refuse to negotiate or accept the drafts drawn thereunder
and it will still not be held liable for its only engagement is to notify and/or transmit to the
seller the letter of credit.

Finally, even if we assume that the petitioner is a confirming bank, the petitioner
cannot be forced to pay the amount under the letter. As we have previously explained,
there was a failure on the part of the private respondent to comply with the terms of the
letter of credit. (Feati Bank & Trust Company vs. CA, G.R. No. 94209, April 30, 1991)

Laws Governing LC

It is the Uniform Customs and Practice (UCP) for documentary Credits for International
Chamber of Commerce governs the Letters of credit (Metropolitan Waterworks vs.
Daway, G.R. No. 160723, July 21, 2004).

Articles 567 to 572 of the Code of Commerce on Letters of Credit are obsolete.
However, in the absence of any provision in the Code of Commerce, commercial
transaction shall be governed by the usages and customs generally observed. (Sec. 2,
Code of Commerce)

1. Three separate transactions in LC

(a)Issuing bank and 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. Unless the contrary is provided for, the liability of the issuing bank is
solidary with the buyer

(b) Issuing bank and beneficiary/seller/exporter- Their relationship is governed by


the terms of the letter of credit issued by the bank, and

(c) Applicant and beneficiary – Their relationship is governed by the sales


contract.

Process:

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 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.

Once the letter of credit is established, the seller ships the goods to the
buyer and in the process secures the required shipping documents and
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. The
seller gets paid only if he delivers the documents of title over the goods while
the buyer acquires the said documents and control over the goods only
after reimbursing the bank.
2. Explain “banks are responsible for examining documents…” in LC

The issuing bank in determining compliance with the terms of the letter of credit
is required to examine only the shipping documents presented by the seller and
is precluded from determining whether the main contract is actually
accomplished or not. This arrangement assures the seller of prompt payment,
independent of any breach of the main sales contract.

3. Definition of LC

A letter of credit is basically an open letter of request whereby one person


requests another to advance money or give credit to a third person for a certain
amount and promises to repay the person advancing the money.

4. What does LC facilitate?

They are intended generally to facilitate the purchase and sale of goods by
providing assurance to the seller of prompt payment upon compliance with
specified conditions or presentation of stipulated documents without the seller
having to rely upon the solvency and good faith of the buyer.

5. What are the modes of payment?

Payment can be made in several different ways: by the buyer remitting cash
with his order; by open account whereby the buyer remits payment at an agreed
time after receiving the goods; or by documentary collection through a bank in
which case the buyer pays the collecting bank for account of the seller in
exchange for shipping documents which would include, in most cases, the
document of title to the goods. In the aforementioned methods of payment, the
seller relies entirely on the willingness and ability of the buyer to effect payment.

6. What are the benefits?

General: LC is a substitute for, and therefore support, the agreement of the


buyer-importer to pay money under a contract or other arrangement. This
instrument is basically a credit security through availment of credit facilities of
the participating banks.
To The Exporter/Seller:
• Letters of credit open doors to international trade by providing a secure
mechanism for payment upon fulfilment of contractual obligations.
• A bank is substituted for the buyer as the source of payment for goods or
services exported.
• The issuing bank undertakes to make payment, provided all the terms and
conditions stipulated in the
letter of credit are complied with.
• Financing opportunities, such as pre-shipment finance secured by a letter of
credit and/or discounting ofaccepted drafts drawn under letters of credit, are
available in many countries.
• Bank expertise is made available to help complete trade transactions
successfully.
• Payment for the goods shipped can be remitted to your own bank or a bank
of your choice.

To the Importer/Buyer
• Payment will only be made to the seller when the terms and conditions of
the letter of credit are complied with.
• The importer can control the shipping dates for the goods being purchased.
• Cash resources are not tied up.

7. Two kinds of LC

A. LOCAL- 3 parties are involved

(a) The Buyer- he is the one who procures the letter of credit and obliges
himself to reimburse the issuing bank upon receipt of the documents of
title
(b) The Issuing Bank- is the bank from whom the letter of credit is
procured and which undertakes to pay the seller upon receipt of the draft
and proper documents of titles and to surrender the documents to the
buyer upon reimbursement, and
(c) The seller- who in compliance with the contract of sale ships the
goods to the buyer and deliver the documents of title and draft to the
issuing bank to recover payment.

B. INTERNATIONAL
(a) The Customer- who is the party who applies to a bank in one country
for the opening of a letter of credit in favor of the seller in another country
(b) The Issuing Bank- is the bank in the country of the customer to which
the customer applies for the issuance of a letter of credit
(c) The Beneficiary- who is the party in another country who is the
creditor of the customer. Usually, he is the one selling goods to the
customer
(d) The Advising Bank – is the bank in the country of the beneficiary
which communicates to the beneficiary the notice of the credit issued by
the issuing bank
(e) The Confirming/Correspondent Bank- is the bank that undertakes
that the letter of credit will be fully paid. Usually the confirming bank is
also the advising bank, otherwise it is utilized to lend credence to the
letter of credit issued by a lesser known issuing bank and is directly liable
to the beneficiary.

8. STATE OF PERPETAUL SEPARATION

It is clearly settled in law that there are thus three contracts which make up the
letter of credit transaction: The contract between buyer and seller, buyer and
issuing bank, and the letter of credit proper. These transactions are to be
maintained in a state of perpetual separation.

9. INDEPENDENCE PRINCIPLE

The issuing bank in determining compliance with the terms of the letter of credit
is required to examine only the shipping documents presented by the seller and
is precluded from determining whether the main contract is actually
accomplished or not. This arrangement assures the seller of prompt payment,
independent of any breach of the main sales contract. This known as the
independence principle in a letter of credit transaction.

The relationship of the buyer and the bank is separate and distinct from the
relationship of the buyer and seller in the main contract; the bank is not required
to investigate if the contract underlying the LC has been fulfilled or not because
in transactions involving LC, banks deal only with documents and not goods (BPI
v. De Reny Fabric Industries, Inc., L-2481, Oct. 16, 1970). In effect, the buyer
has no course of action against the issuing bank.

10. STRICT COMPLIANCE DOCTRINE


The rule of strict compliance in a letter of credit transaction means that the
documents tendered by the seller or beneficiary must strictly conform to the
terms of the letter of credit, i.e., they must include all documents required by the
letter of credit such as: (a) a draft which is also called a bill of exchange, is an
order written by an exporter/seller instructing an importer/buyer or its agent to
pay a specified amount of money at a specified time (b) a bill of lading, which is a
document issued to the exporter by a common carrier transporting the
merchandise, and (c) invoices.

Thus, a correspondent bank which departs from what has been stipulated under
the LC acts on its own risk and 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. (Feati Bank and Trust Company v. CA, G.R. No. 940209, Apr. 30,
1991)

11. FRAUD EXCEPTION PRINCIPLE

By way of exception to the independence principle, the “Fraud exception rule”


provides that the untruthfulness of a certificate accompanying a demand for
payment under a standby letter of credit may qualify as fraud sufficient to support
an injunction against payment. (Transfield v. Luzon Hydro, G.R. No. 146717,
Nov. 22, 2004)

Requisites:

(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.

12. ESSENTIAL REQUISITES of LC

(a) That it be issued in favor of a definite person and not to order;


(b) and That it be limited to a fixed and specified amount, or to one or more
undetermined amounts, but within a maximum the limits of which has to be
stated exactly.
Hence, a letter of credit is not a negotiable instrument because it is required
to be drawn in favor of a definite person.

Those which do not have any of the essential conditions shall be considered
merely as a letter of recommendation.

13. WAIVER TO ANNUL LC

The bank or drawer of a letter of credit shall be liable to the person on whom it
was issued for the amount paid by virtue thereof, within the maximum fixed
therein, while a notifying bank does not incur any liability except to notify the
beneficiary of the letter of credit. Before paying, it shall have the right to demand
the proof of the identity of the person in whose favor the letter of credit is issued.

The drawer of a letter of credit may annul it, informing the bearer and the person
to whom it is addressed of such revocation. The waiver of the right to annul
makes the letter of credit irrevocable.

14. STANDBYLETTER OF CREDIT

A standby letter of credit is a bank-issued option on a loan involving three parties:


the bank issuing the credit, the party requesting for such issuance (otherwise
known as the account party) and the beneficiary. Under the terms of standby
letter of credit (SLC), the beneficiary has the right to trigger the loan option
(referred to as taking down the loan) if the account party fails to meet its
commitment, in which case the issuing bank disburses a specified sum to the
beneficiary and books an equivalent loan to its customer. SLCs may support
nonfinancial obligations such as those of bidders, or financial obligations such as
those of borrowers. In the latter case, the borrower purchases an SLC and
names the lender as beneficiary. Should the borrower default, the beneficiary has
the right to take down the SLC and receive the principal balance from the issuing.

15. PRESCRIPTIVE PERIOD of LC

A letter of credit becomes void if the bearer of a letter of credit does not make
use thereof within the period agreed upon with the drawer, or, in default of a
period fixed,
a. within 6 months counted from its date, in any point in the Philippines,
b. within 12 months anywhere outside thereof, it shall be void in fact and in law.
16. RED CLAUSE LC

A red clause letter of credit incorporates a clause, traditionally written in red,


which authorizes the bank acting as the negotiating or paying bank to pay the
beneficiary in advance of shipment. This enables the purchase and accumulation
of goods from a number of different suppliers, and the arrangement of shipment
in accordance with the letter of credit terms. Such advances will be deducted
from the amount due to be paid when the documents called for are presented
under the letter of credit. If the beneficiary fails to ship the goods or cannot do so
before the expiry of the letter of credit, the issuing bank is bound to reimburse the
negotiating or paying bank, recovering its payment from the applicant.

17. BACK TO BACK LC

Back to Back Letter of Credit is a credit with identical documentary requirements


and covering the same merchandise as another letter of credit, except for the
difference in price of the merchandise as shown by the invoice and draft. The
second letter of credit can only be negotiated after the first is negotiated.

18. DEFERRED PAYMENT LC

Under a deferred payment letter of credit, the applicant does not pay until a
future date determined in accordance with the terms of the letter of credit.

19. TRANSFERRABLE LC

A transferable letter of credit allows the beneficiary to act as a middleman and


transfer his rights under a letter of credit to another party or parties who may be
suppliers of the goods. Depending on whether the letter of credit permits partial
shipments, fractional amounts may be transferred to more than one beneficiary.
The letter of credit however, can be transferred only once: the secondary
beneficiaries cannot transfer their rights to a third party. Transfer of a letter of
credit can be made on specific application by the original beneficiary to the
authorized transferring bank

To be transferable, a letter of credit must be so marked by the issuing bank


which can only do so on the applicant’s specific instructions. The applicant
should be aware that any second beneficiary, the probable supplier, is usually a
party not likely known to the applicant.
20. SIGHT OR TERM/USANCE

Letters of credit can permit the beneficiary to be paid immediately upon


presentation of specified documents (sight letter of credit), or at a future date as
established in the sales contract (term/usance letter of credit).

21. REVOCABLE/ IRREVOCABLE

An irrevocable letter of credit obligates the issuing bank to honor drafts drawn in
compliance with the credit and can be neither cancelled nor modified without the
consent of all parties, including in particular the beneficiary/exporter.

A revocable letter of credit can be cancelled or amended at any time before


payment; it is intended to serve as a means of arranging payment but not as a
guarantee of payment

22. UNCONFIRMED/ CONFIRMED LC

A letter of credit issued by one bank can be confirmed by another, in which case
both banks are obligated to honor drafts drawn in compliance with the credit.

An unconfirmed letter of credit is the obligation only of the issuing bank provided
all terms and condition of LC have been complied with.
Why would an exporter want a foreign bank’s letter of credit confirmed by a
domestic bank? One reason could be if he has doubts.

23. CIRCULAR LC

The document is called a circular letter of credit when it is not addressed to any
particular correspondent. In effect, a letter of credit is a draft, save that the
amount is merely stated as a maximum not to be exceeded. Letters of credit,
mainly used by travellers, greatly simplify non-local business transactions.

24. NEGOTIATION LC

Under UCP 600 (Uniform Customs and Practice for Documentary Credits, 2007
revision, article 2) negotiation means the purchase by the nominated bank of
drafts (drawn on a bank other than the nominated bank) and/or documents under
a complying presentation, by advancing or agreeing to advance funds to the
beneficiary on or before the banking day on which reimbursement is due to the
nominated bank.
Unfortunately, the term "negotiable credit" is understood and applied in
different ways in different parts of the world.

25. REIMBURSEMENT LC

Any standard lc having special payment conditions that, the negotiating bank is
authorized to claim and get the payment against the lc directly from the opening
bank's nominated agency bank after presentation of credit confirmed documents
is known as reimbursement LC or direct reimbursement Lc. In most of the cases
payment of the import, thus is already effected prior to receipt of the documents
and consignment by the importer.

26. REVOLVING LC

Revolving Letter of Credit-one that provides for renewed credit to become


available as soon as the opening bank has advised the negotiating or paying
bank that the drafts already drawn by the beneficiary have been reimbursed to
the opening bank by the buyer.

Revolving letter of credit - is established when there are regular shipments of the
same commodity between supplier and customer. Eliminates the need to issue
an letter of credit for each transaction

27. CUMULATIVE/NON-CUMULATIVE

For a non-cumulative revolving letter of credit, the beneficiary can draw each
revolving amount for any given period, and any unused portions cannot be
drawn on the subsequent periods.

Cumulative revolving letter of credit means that the unused sums in the L/C
can be added to the upcoming shipments.

28. STRAIGHT CREDIT

A type of letter of credit. A straight credit can only be paid at the counters of the
paying bank or a named drawee bank that has been authorized to make
payment. Payment can only be made to the beneficiary named in the letter
of credit, and not to an intermediary or negotiating bank. The beneficiary named
in a straight credit must present documents at the paying bank or named drawee
bank on or before the expiration date stipulated in the letter of credit. The term is
derived from the fact that payment is made straight or directly to the beneficiary.
A straight credit differs from a negotiable credit because payment in the latter can
be made to a negotiating bank. A straight credit contains clauses such as “we
engage with you” that all drafts drawn in compliance with the credit terms will be
duly honored upon presentation, which basically highlight the restriction of
payment to the beneficiary only.

29. ACCEPTANCE LETTER OF CREDIT

An acceptance credit is a type of letter of credit that is paid by a time draft


authorizing payment on or after a specific date, if the terms of the letter of credit
have been complied with. There are two types of acceptance credit, confirmed
and unconfirmed. Unconfirmed acceptance credit means that the seller takes the
risk that payment will not be made, due to any number of contingencies such as
shipment non-delivery, confiscation by customs authorities, or any other
problems. Confirmed acceptance credit means that the bank upon which the
credit has been issued, essentially guarantees payment as long as the terms of
the letter of credit have been complied with.

30. DOCUMENTARY LC

A documentary letter of credit is an obligation of the bank that opens the letter of
credit (the issuing bank) to pay the agreed amount to the seller on behalf of the
buyer, upon receipt of the documents specified in the letter of credit. The letter of
credit is opened by the bank on the basis of the buyer’s (importer’s) instructions,
which are compiled in accordance with the terms of the contract. Both the
importer and exporter should take into account that the letters of credit constitute
a transaction separate from the purchase and sale agreement or other
agreements on which they are based. The bank’s obligations under the letter of
credit are set forth in the letter of credit itself, and the bank deals exclusively with
documents, not with goods or services.

Documentary letters of credit are the safest means for international trade
settlement both for importers and exporters of goods.

31. CLEAN LC

A letter of credit payable upon presentation of the draft, without any supporting
document being required.