I.

LETTERS OF CREDIT

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.

It is an engagement by a bank or other person made at the request of a customer that the issuer
shall honor drafts or other demands of payment upon compliance with the conditions specified in the
credit. 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.

Letters of credit were developed for the purpose of insuring to a seller payment of a definite
amount upon the presentation of documents and is thus a commitment by the issuer that the party in
whose favor it is issued and who can collect upon it will have his credit against the applicant of the
letter, duly paid in the amount specified in the letter. They are in effect 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.

II. PARTIES TO A LETTER OF CREDIT TRANSACTION

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

III. Independent Contracts

a. Independence Principle
The obligation of an issuing bank to honor a drawing request under a letter of
credit is independent of the transaction that the letter of credit supports. When
deciding whether to make a payment, the issuing bank is concerned only with the terms
of the letter of credit and the documents presented by the beneficiary.

f the beneficiary presents documents that comply with the terms of the letter of
credit, the issuing bank must honor the drawing request and pay the beneficiary. The
issuing bank does not look beyond the face of the documents. It cannot consider
extraneous matters, such as the contract between the applicant for the letter of credit
and the beneficiary, or any changes to it.

Disputes between the applicant and the beneficiary about the beneficiary's
performance are also not relevant to the issuing bank's decision. The sole exception to
the independence principle is where there is clear evidence of fraud on the face of the
presented documents. Only then can the issuing bank refuse to make payment on
conforming

b. Fraud Exception
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.

The exception is a fraud affecting the documents presented by the beneficiary (for
example if they have been forged) or, in the case of a standby LoC, if the beneficiary had
no honest belief in the validity of its demand.

To prove that a demand under a standby LoC is fraudulent, the applicant for an
injunction (for example a buyer of the goods who alleges that the goods sold were
defective) must show that the seller knows that the demand is fraudulent, or that the
circumstances around the demand are such that the only reasonable interference is that
the demand is fraudulent.
 c. Doctrine of Strict Compliance
The documents tendered by the seller/beneficiary must strictly conform to the terms of
the letter of credit. The tender of documents must include all documents required by
the letter. 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.

The legal principle that entitles the bank to reject documents which do not strictly
comply with the terms of LC. Benefits the seller by providing fast payment. The seller
does not have to wait until the goods shipped safely reach the buyer before claiming
payment. The seller can claim payment for the goods sold by presenting to the bank the
documents required by the buyer once the goods have been shipped to the buyer.

IV. Kinds of Letters of Credit

1. Commercial- Standard letter of credit, also called as documentary credit.

2. Export/Import- Letter of credit dependent on the way the goods are being traded
3. Transferable- It can be moved to the next supplier in chain and allows that the
beneficiary to provide its own documents. The beneficiary is only an intermediary for
actual supplier.
4. Untransferable- The beneficiary is the recipient and cannot further use letter of credit to
pay anyone. He is unable to move it to third parties.
5. Revocable- Can be altered at any time by the issuing bank or buyer without informing
the seller. Not used frequently, no shield to seller.
6. Irrevocable- Without consent of seller, no alterations can be made by anyone.
7. Standby- It ensures the payment to seller if anything wrong happens
8. Confirmed- When the advising bank also guarantees the payment to the beneficiary, it is
called confirmed
9. Unconfirmed- this is assured only by issuing bank and not in need of a second bank
10. Revolving- these can be used for many payments instead of issuing for each of them
11. Back to back- two letters of credit are issued- on by the bank of the buyer to the
intermediary and a second by the bank of an intermediary to the seller.
12. Red clause- Partial payment before the goods are shipped like an advance against a
written confirmation from the seller and the receipt
13. Green clause- Partial payment before the goods are shipped like an advance against a
written confirmation from the seller and the receipt with a proof of warehousing also
given to the seller.