Notes on Negotiable Instruments.

What is a letter of credit?

A letter of credit is 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.

How does a letter of credit work?

The buyer and the seller agree on what documents must be presented. Buyer
secures a letter of credit, in favor of the seller from his bank. This bank is called the
issuing or opening bank.

Once the credit is established, seller ships the goods to the buyer, and in the
process, obtains the tender documents.

To obtain payment for the goods, seller executes a draft, and presents it to the
bank, along with tender documents. Bank pays the seller, and obtains possession of the
documents of title.

The buyer reimburses the bank for the payment it had made to the seller. The
bank gives the buyer the documents of title, upon reimbursement. Buyer obtains title
over the goods he purchased from the seller.

The issuing or opening bank, may contract the facilities of one of its
correspondent banks, for the purpose of advising the seller of the credit. This
correspondent is also known as the advising, or notifying bank.

The seller may not trust the opening bank, as this is usually a foreign, or
unfamiliar bank. In this case, he may use the facilities of another, better known or bigger
bank, called the confirming bank. The confirming bank usually carries a dollar account
maintained by the opening bank, and thereby assumes the obligation of paying the
seller upon presentment of the tender documents. The seller may now proceed against
the confirming bank for the payment of the credit. In this regard, the confirming banks
liability is primary, as if the credit was issued by it and the opening bank jointly.
 Another bank, known as the negotiating bank, may buy or discount a draft
drawn against the letter. If the draft contemplated by the letter of credit is to be drawn
on the opening bank or on another designated bank not found in the city of the seller,
any bank in the sellers city which buys or discounts the drafts becomes a negotiating
bank.

The paying bank is the bank against whom the drafts are to be drawn. It may or
may not be the opening bank

Who are the parties in a letter of credit?

The parties in a letter of credit are:

1. The buyer;
2. The seller or beneficiary;
3. The opening bank.

What are the transactions involved in a letter of credit?

The transactions in a letter of credit are:

1. The contract of sale of goods, between the buyer and the seller.
2. The contract of the buyer with issuing bank, whereby the issuing bank
promises to pay drafts drawn the seller, and the buyer reciprocally
promises to reimburse the issuing bank.
3. The letter of credit proper.

What is the independence principle?

The independence principle is a doctrine embodied in the Uniform Customs and

Practice for Documentary Credits (UCP) adopted by the International Chamber of
Commerce, which essentially holds that the contracts involved in a letter of credit
arrangement are to be maintained in a state of perpetual separation.

The parties to these different transactions may not co-opt the rights of recourse or
remedies found in each transaction, nor are they obligated to go beyond the respective
responsibilities of each of the transactions in order to determine the propriety or
validity of the others.

Is the issuing bank, the only party who may invoke the independence principle?

No, the other parties such as the beneficiary, in the proper case, may invoke the
principle.

What is the fraud exception?

An exception to the independence principle, which holds that when the

beneficiary, for the purpose of drawing on the credit, fraudulently presents documents
to the confirming or paying bank which contain material representations of fact that are
untrue, and which the beneficiary was aware of, the buyer may seek an injunction
against payment.

The requisites are:

1. There is clear proof of fraud;

2. It is an abuse of the independent purpose of the letter of credit, and not
merely fraud under the main agreement;
3. Irreparable injury might follow if injunction is not granted, or the
recovery of damages would be severely impaired.