Letter of Credit; Definition and Nature of Letter of Credit

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.
[1] (Transfield Philippines, Inc. vs. Luzon Hydro Corporation, et al., G.R. No. 146717,
November 22, 2004, [Tinga])

In Metropolitan Waterworks and Sewerage System vs. Daway[2], we have

also defined a letter of credit as 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.[3]

The letter of credit evolved as a mercantile specialty, and the only way to
understand all its facets is to recognize that it is an entity unto itself. The
relationship between the beneficiary and the issuer of a letter of credit 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. Nor is it a third-party beneficiary
contract, because the issuer must honor drafts drawn against a letter regardless of
problems subsequently arising in the underlying contract. Since the bank's
customer cannot draw on the letter, it does not function as an assignment by the
customer to the beneficiary. Nor, if properly used, is it a contract of suretyship or
guarantee, because it entails a primary liability following a default. 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.[4] (supra)

Letters of credit were developed for the purpose of insuring to a seller

payment of a definite amount upon the presentation of documents[5] 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.[6] 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.[7] 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.[8] They are definite undertakings
to pay at sight once the documents stipulated therein are presented. (Metropolitan
Waterworks and Sewerage System vs. Daway, G.R. No. 160732, June 21, 2004
[Azcuna])

LETTERS OF CREDIT- Negotiable Instruments

NATURE AND IMPORTANCE

> 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 the 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, 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.
INDEPENDENCE PRINCIPLE
> What characterizes letters of credit, as distinguished from other accessory
contract, is the ENGAGEMENT OF THE ISSUING BANK TO PAY THE SELLER
ONCE THE DRAFT AND THE REQUIRED SHIPPING DOCUMENTS ARE PRESENTED
TO IT. In turn, this arrangement ASSURES THE SELLER OF PROMPT
PAYMENT, INDEPENDENT OF ANY BREACH OF THE MAIN SALES CONTRACT.
LAWS GOVERNING A LETTER OF CREDIT TRANSACTION

> Uniform Customs and Practice for Documentary Credits (UCP) issued by the
International Chamber of Commerce
PARTIES TO A LETTER OF CREDIT TRANSACTION
1. Buyerprocures 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 bankusually the buyers 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. Sellerin 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 hasnt given the bank any
direct consideration for the banks promises contained in the instrument
4. Correspondent bank/advising bankto 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
RESPONSIBILITIES OF BANKS IN COMMERCIAL CREDIT TRANSACTIONS
> If the beneficiary is to be advised by the issuing bank by cable, the
services of an ADVISING OR NOTIFYING BANK must always be utilized
> The responsibility of the NOTIFYING BANK is merely to convey or transmit
to the seller or beneficiary the existence of the credit. However, if the
beneficiary requires that the obligation of the issuing bank shall also be made the
obligation of the bank to himself, there is what is known as a CONFIRMED
COMMERCIAL CREDIT and the bank notifying the beneficiary of the credit
shall become a CONFIRMING BANK. In this case, the liability of the confirming
bank is primary and it is as if the credit were issued by the issuing and confirming
banks jointly, thus giving the beneficiary or a holder for value of drafts drawn under
the credit, the right to proceed against either or both banks, the moment the credit
instrument has been breached.
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> The paying bank on which the drafts are to be drawn it may be the
issuing bank or the advising bank. If the beneficiary is to draw and receive
payment in his own currency, the advising bank may be indicated as the
paying bank also. When the draft is to be paid in this manner, the paying bank
assumes no responsibility but merely pays the beneficiary and debits the
payment immediately to the account which the issuing bank has with it. IF
THE ISSUING BANK HAS NO ACCOUNT WITH THE PAYING BANK, the paying bank
reimburses itself by drawing a bill of exchange on the issuing bank, in dollars, for
the equivalent of the local currency paid to the beneficiary, at the buyeing rate for
dollar exchange. The beneficiary is entirely out of the transaction because his
draft is completely discharged by the payment, and the credit arrangement
between the paying bank and issuing bank
doesnt concern him.
> If the draft contemplated by the credit instrument, is to be drawn on the issuing
bank or on other designated banks not in the city of the seller, any bank in
the city of the seller which buys or discounts the draft of the beneficiary
becomes a negotiating bank. As a rule, whenever, the facilities of an advising
or notifying bank are used, the beneficiary is apt to offer his drafts to the
advising bank for negotiation, thus giving the advising bank the
character of a negotiating bank becomes an endorser and bona fide holder
of the drafts and within the protection of the credit instrument. It is also
protected by the drawers signature, as the drawers contingent
liability, as drawer, continues until discharged by the actual payment of the bills of
exchange.
LIABILITY IN COMMERCIAL CREDIT TRANSACTIONS
> A commercial bank which departs from what has been stipulated under the letter
of credit, as when it accepts a faulty tender, acts on its own risk, and it may not
thereafter be able to recover from the buyer or issuing bank, as the case
may be, the money thus paid to the beneficiary
> In the case of a discounting arrangement, wherein a negotiating bank pays the
draft of a beneficiary of a letter of credit in order to save such beneficiary from the
hardship of presenting the documents directly to the issuing bank, the
negotiating bank can seek reimbursement of what has been paid to the
beneficiary who as drawer of the draft continues to assume a contingent
liability thereon. Thus, the negotiating bank has the ordinary right of recourse
against the seller or beneficiary in the event of dishonor by the issuing bank.
PROTOTYPE EXPORT TRANSACTION
1. PROFORMA INVOICEall the particulars for the proposed shipment
which are then known to the buyer
2. PRICE QUOTATION FAS AND CIFFAS stands for free along side which means
that the seller will be responsible for the cost and risks of the goods along
side an overseas vessel at the stated location: the buyer bears the costs and
risks from that point. CIF on the other hand means cost, freight and
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insurance, that in exchange for this stated price, the seller undertakes not
only to supply the goods but also to obtain and pay for insurance and bear
the freight charges to the stated pointy.
3.

BUYERS PURCHASE ORDER

4. LETTER OF CREDIT
a. One way for a seller to be assured of payment is to ship goods under a
negotiable bill of lading and arrange for a bank in buyers city to hold the bill
of lading until the buyer pays the draft in the usual foreign sale this
arrangement for securing payment of the price is not adequate
b. In some situations, sellers may need assurance of payment even before
the time of payment. This problem arises in contracts which call for the
manufacture of goods to the buyers specifications.
c.
Although the proforma invoice may not specify, the seller will expect the
letter of credit to be confirmed by the local bank in its location. But why
does a local bank confirm rather than issue a letter of credit? The bank that
issues the letter of credit needs assurance that it will be reimbursed by the buyer,
on whose behalf it pays the seller. The buyers bank can take steps to
minimize or
remove the hazards. It will receive the negotiable bill of lading controlling the
goods which will provide security for the customers obligation to reimburse
the bank; in addition, the buyers own bank can judge in the light of its
knowledge of his financial standing whether added security is needed and can
insist on such security before it issues the letter of credit
d. To meet the sellers letter of credit requirements, the buyer will request its
bank to arrange for the issuance of a letter of credit which will comply with the
terms of the proforma invoice. The buyer will then sign a detailed
application and agreement for commercial credit prepared by the bank.
The issuing bank, after approving the buyers credit standing transmits a letter of
credit by cable to the confirming bank. This confirming bank will then deliver
to seller a document advising the latter that the issuing bank opened a letter of
credit in its favor and adding the confirming banks confirmation. In this
arrangement, the seller is assured of payment of its sight drafts drawn on the
confirming bank in the amount of the total amount of the sale, provided it
presents the documents called for in the letter of credit.
An
examination of the letter of credit will also reveal that the bill of lading is to be
consigned to the order of the buyers bank, thereby giving the bank control
over the goods, with the consequent security for its claim against the buyer.
5. ACCEPTANE; SHIPMENT
a. On the receipt of the confirmed letter of credit, the seller will send the order
acknowledgment. This document will repeat the description and price of the
goods which has also appeared on the proforma invoice and states the
number and expiration date of the letter of credit.
b. Further, the arrival of the letter of credit is the go-signal for the seller to send
the goods. The seller then prepares the COMMERCIAL INVOICE which provides a
complete record of the transaction and is an important source of information
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to such interested parties as a bank discounting a draft or an

underwriting extending issuance.
c.
As the time of shipment approaches, the seller will contact its forwarder
and give its shipping instructions. It will inform that to comply with the
requirements of the letter of credit, the bill of lading must be made to the
order of the issuing bank. It will also send copies of the commercial invoice, a
packing list, and a Shippers export declaration.
When the forwarder
receives these documents, he takes over all further documentation as the
agent of the shipper, the latter merely has to dispatch the goods from the
factory in accordance with the forwarders instructions.
d. The seller will then send the truck to the pier where they are delivered to the
ocean carriers receiving clerk who signs the dock receipt. The dock receipt
is a form supplied by the ocean carrier which contains information relevant to
the shipping of the bearings such as the number of the pier, and the name of
the ship. The dock receipt is NON-NEGOTIABLE and serves as a temporary
receipt for the goods until they are loaded on board.
e. The ocean carrier is soon ready to receive the cargo. When the goods are
loaded on board, the steamship line issues a bill of lading which, to comply with the
letter of credit, is CONSIGNED TO ORDER OF THE ISSUING BANK. The bill of lading is
initially prepared by the forwarder on a form supplied by the ocean carrier, it
sets forth the markings and numbers of the packages, description of the
goods, and the number and weight of the packages. On its dorsal side, it will state
that the goods are received for shipment, but a statement FREIGHT PREPAID ON
BOARD is initiated by a representative of the steamship line after loading. The
forwarder then delivers the bill of lading and the commercial invoice to the seller.
6.

INSURANCE

7. PAYMENT; THE DRAFT.

a. The confirming bank stated in their letter that the estimated CIF price
would be available by your drafts on us at sight when accompanied by the listed
documents
b. Seller accordingly draws a sight draft on the confirming bank. The sight
draft together with the commercial invoice, insurance certificate, full set of
bills of lading, and the packing list are presented to the confirming bank.
When the bank receives these documents, it issues its bank draft to sellers
order and transmits the documents by air mail to issuing bank, which will
reimburse the confirming bank.
c.
The documents, sent by airmail, will reach the buyers bank well ahead
of the ocean shipment. The time for release of the documents to buyer and
reimbursement to the bank will depend upon the arrangement which was
made between the bank and buyer when the letter of
credit was initially established.
d. If the buyer plans to resell the goods, he may not be able to reimburse the
bank until the goods arrive and he resells the goods. In this event, the
issuing bank may need to take further steps to secure its claim against the buyer.

STANDBY LETTERS OF CREDIT OR GUARANTEES

HISTORY AND PURPOSE

> Sometime ago, it is common in international dealings to require the
furnishing of a cash deposit as security, but with the expansion of
international trade this became prohibitively expensive for the
counterparty and in due course gave way to a more convenient safeguard,
the provision of a written undertaking by a bank in favor of the buyer or employer
payable on demand
> Demand guarantees as substitute for cash are designed to provide the
beneficiary with a speedy monetary remedy against the counterparty to the
underlying contract and to that end are primary in form and documentary in
character.
> The demand guarantee is expressed to be payable solely on
presentation of a written demand and any other specified documents. Accordingly,
any demand within the maximum amount stated must in principle be paid by the
guarantor, regardless whether the underlying contract has in fact been broken
and regardless of the loss actually suffered by the beneficiary
A CONCISE DEFINITION: DEMAND GUARANTEES
> Undertaking given for payment of a stated or maximum sum of money on
presentation to the party giving the undertaking of a demand or payment
and such other documents as may be specified in the guarantee within the
period and in conformity with the other conditions of the guarantee
> Procured by the seller in favor of the buyer for the latter to be paid in case the
seller doesnt comply with contract provisions. The economic burder is upon the
party who breaches the contract
> Employed typically in construction contracts and contracts for
international sale of goods
> Demand guarantees are intended to safeguard the other party against nonperformance or late or defective performance by the supplier or contractor
GUARANTEE STRUCTURES AND TERMINOLOGY: DIRECT (3RD PARTY)
GUARANTEES
> Involves a minimum of three parties
1. Account party/principalparty to the underlying contract whose
performance is required to be covered by the guarantee and who gives
instruction for its
2. Issuer/guarantorthe bank or other party issuing the guarantee on
behalf of the customer the principal
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3. The beneficiarythe other party to the underlying contract, in whose favor the
guarantee is issued
> Usually the guarantee in the 3-party structure is the principals bank and
carries on business in the same country as the principal, whilst the beneficiary
carries on business in a foreign country
> Known as direct guarantees because the guarantee is issued to directly by the
principals bank, not by the local bank in the beneficiarys country
PRINCIPAL TYPES OF DEMAND GUARANTEES
1. Tender or bid guarantee
a. Where tenders are invited it is often a condition of consideration of the
tender that the tenderer undertakes to sign the contract if its awarded to him, to
procure the issue of any performance or other guarantee required by the guarantee
and not to modify or withdraw his tender in the meantime
b. Purposesafeguard the beneficiary against breach of such an undertaking
c.
If the tenderer is successful and fails to sign the contract and to furnish
the requisite performance or other guarantee, or withdraws his tender before
its expiry, the beneficiary can call upon the guarantor to pay a specified sum
designed to compensate him for the trouble and
expense he suffered in reawarding the contract, as well as any additional cost
of the contract
2. Performance guarantee
a. Guarantee of the central performance of the contract from commencement
to completion
b. Given for a specified percentage of the contract sum
c.
But there are stages in the relationship between the parties which
precede and follow the central performance, and there may be distinct
segments of liability to be covered within that performance
3. Advance payment or repayment guarantee
a. Underlying contract may entitle the principal to payment of stated sums in
advance of performance
b. The advance payment guarantee is designed to secure the beneficiarys
right to repayment of the advance if the performance to which it relates is not
furnished
4. Retention guarantee
a. Construction contracts usually provide for stage payments against
architects or engineers 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
b. The employer may be willing to release such retention moneys against
a retention guarantee securing repayment of the released retention
moneys if defects are later found or if the contractor fails to complete the
contract
5. Maintenance or warranty guarantee
a. Construction contracts usually provide that on completion part of the
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retention moneys are to be retained for a specified period to cover the cost
of any defects or malfunction which become manifest during that period
GUARANTEES NOT GUARANTEED BY UNDERLYING CONTRACT
> Not all guarantees are meant to be in favor of a party in the underlying contract
> For example are customs guarantees which are issued to the customs to cover
any duty that may become payable when imported goods which would be
exempt from duty if reexported within a specified time are not in fact reexported
within that time
THE LEGAL NATURE OF A DEMAND GUARANTEE
> A demand guarantee is an abstract payment undertaking that is, a
promise of payment which, though intended to preserve the beneficiary
from loss in connection with the underlying transaction is detached from
the underlying contract between principal and beneficiary and is in form a
primary undertaking between the guarantor and beneficiary which becomes
binding solely by virtue of its issue
> A secondary guarantee is both secondary in form and intent. The intention
of the parties is that the guarantor will be called upon to pay only if the principal
defaults in performance, and then only to the extent of the principals liability
and subject to any defenses available to the principal
> A documentary credit is both primary in intent and form. The parties to the
underlying contract intend that the bank issuing the credit is a to be the first port
of call for payment, and this is the effect of the agreement between them.
Whereas in the case of a suretyship guarantee, the beneficiary cannot look
to the guarantor without establishing default by the principal, the reverse is
true of the documentary credit. The parties have designated payment by the
bank as the primary payment method and only if it fails without fault on the part of
the beneficiary is entitled to > DEMAND GUARANTEE STANDS BETWEEN
THE SURETYSHIP GUARANTEE AND THE DOCUMENTARY CREDIT
SECONDARY IN INTENT AND PRIMARY IN FORM. Performance is due in the
first instance from the principal, and the guarantee is intended to be resorted
to only if the principal has failed to perform. But though this is the intent of the
parties, the guarantee isnt in form linked to default under the underlying
contract, nor there is any question of performance to hold the beneficiary
harmless up to the agreed maximum; and the sole condition of the guarantors
payment liability is the presentation of a demand and other documents
specified in the guarantee in the manner of and within the period of the guarantee
> THE GUARANTOR HAS NO CONCERN WITH THE UNDERLYING CONTRACT
AND IF DEMAND IS DULY PRESENTED, PAYMENT MUST BE MADE DESPITE
ALLEGATIONS BY THE PRINCIPAL HAS FULLY PERFORMED THE CONTRACT
IN THE ABSENCE OF ESTABLISHED FRAUD OR OTHER EVENT CONSTITUTING
GROUND FOR NON-PAYMENT
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STANDBY LETTERS OF CREDIT

> Undertaking primary in form but intended to be used only as a fallback in the
event of default by the principal under the underlying contract
> Standby credit in legal perspective is simply another term for demand
guarantees
> The standby credit has developed into an all-purpose financial support
instrument embracing a much wider range of uses than the normal demand
guarantee. Thus, standby credits are used to support financial and nonfinancial obligations of the principal and to provide credit enhancement for the
primary financial undertaking
KEY ELEMENTS IN A DEMAND GUARANTEE
1. The parties
2. A reference to the underlying contract
3. The amount or maximum amount of the guarantee and any agreement
for reduction or increase
4. The currency of payment
5. The documents, if any, to be presented for the purpose of a demand or
of reduction or expiry
6. The expiry date or other expiry provisions as well as any agreement for
extension
> Where it is intended that the guarantee shall not commence until
presentation of a particular document, this fact should be specified
> Direct guarantee: principal, guarantor, and beneficiary should be identified
> Indirect guarantee: principal, instructing party, beneficiary, and counterguarantee
> Central to the demand guarantee is its documentary character: the rights
and obligations it creates are to be determined solely from the terms of the
guarantee and from any document presented in accordance with the
guarantee, without the need to ascertain external facts
DISTINCT NATURE OF CONTRACTUAL RELATIONSHIPS
> Guarantors commitment to the beneficiary arises solely by virtue of the
issue of the guarantee and his duty to pay is conditioned only on presentation of
demand and other specified documents in conformity with the terms and within
the duration of the guarantee
> Principal is not concerned with the contract between the guarantor and
beneficiary
> Beneficiary has no concern with the contract between the principal and
guarantor
> The relationship of principal and guarantor has an internal mandatethe
guarantor is obliged to act in accordance with the terms of the contract,
failing which he may forfeit his right to reimbursement but those terms are
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of no concern to the beneficiary, whose right to payment depends solely on his

acting on conformity with the terms of the guarantee
> In indirect contracts, there is an additional mandate which has 2 facets
the mandate from the instructing party to the guarantor as to the issue of the
guarantee, which the guarantor as mandatory must comply with if he
accepts the instruction; and two, the counter-guarantee which the guarantor
exacts from the instructing party as a precondition of issuing the guarantee and
which is separate from the mandate
1. Abstract character of the payment undertakingbinding solely by
virtue of issue of the guarantee, subject to the beneficiary not rejecting it
2. Independence of the guarantee from the underlying transaction
> Guarantee is separate from that contract and the rights and obligations
created by the guarantee are independent of those arising under the
underlying contract
> In the absence of established fraud by the beneficiary, the guarantor
is not entitled to refuse payment and the principal is not entitled to have
payment restrained merely because of a dispute between the principal and
beneficiary
3. Independence of the guarantee from the principal-guarantor relationship
the guarantee is separate from the contract between the principal and the
guarantor is not entitled to invoke a breach of that contract
4. Documentary character of guaranteeamount and duration of the duty to pay,
the conditions of payment and termination of payment obligation depend solely
on the terms of the guarantee itself and presentation of required documents
5. Requirement of compliance of the demand with the terms of the guarantee
6. Guarantors duty of examination limited to apparent good order of the
document
7. Guarantors duty limited the exercise of good faith and reasonable care
8. Independence of counter-guarantee from guarantee
9. Independence of counter-guarantee from mandate received from instructing
party

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