Letter of credit

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 honordrafts or other demands for payment upon compliance with
the conditions specified in the credit. Through a letter of credit, the bankmerely substitutes its
own promise to pay for one of its customers who in return promises to pay the bank the amount
of funds mentionedin the letter of credit plus credit or commitment fees mutually agreed upon.A
letter of credit is a financial device developed by merchants as a convenient and relatively safe
mode of dealing with sales of goods tosatisfy the seemingly irreconcilable interests of a seller,
who refuses to part with his goods before he is paid, and a buyer, who wants tohave 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 infavor of the seller so that, by virtue of the letter of credit, the issuing
bank can authorize the seller to draw drafts and engage to pay themupon their presentment
simultaneously with the tender of documents required by the letter of credit. The buyer and the
seller agree onwhat documents are to be presented for payment, but ordinarily they are
documents of title evidencing or attesting to the shipment ofthe goods to the buyer.Once the
credit is established, the seller ships the goods to the buyer and in the process secures the
required shipping documents ordocuments of title. To get paid, the seller executes a draft and
presents it together with the required documents to the issuing bank. Theissuing bank redeems
the draft and pays cash to the seller if it finds that the documents submitted by the seller conform
with what theletter of credit requires. The bank then obtains possession of the documents upon
paying the seller. The transaction is completed whenthe buyer reimburses the issuing bank and
acquires the documents entitling him to the goods. Under this arrangement, the seller getspaid
only if he delivers the documents of title over the goods, while the buyer acquires said
documents and control over the goods onlyafter reimbursing the bank.
DISTINGUISHED LETTER OF CREDIT FROM OTHER ACCESSORY CONTRACTS
What characterizes letters of credit, as distinguished from other accessory contracts,
is the engagement of the issuing bank to pay theseller of the draft and the required shipping
documents are presented to it.
In turn, this arrangement assures the seller of promptpayment, independent of any breach of the
main sales contract. By this so-called
"independence principle,"
the bank determinescompliance with the letter of credit only by examining the shipping
documents presented; it is precluded from determining whether themain contract is actually
accomplished or not.
PARTIES IN A LETTER OF CREDIT
There would at least be three (3) parties:(a)

the
buyer
, who procures the letter of credit and obliges himself to reimburse the issuing bank upon
receipts of the documentsof title;(b)

the
bank issuing the letter of credit
, which undertakes to pay the seller upon receipt of the draft and proper document of titlesand 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 delivers the
documents of title and draftto the issuing bank to recover payment.The number of the parties
may be increased. Thus, the services of an
advising (notifying) bank
may be utilized to convey to the sellerthe existence of the credit; or, of a
confirming bank
which will lend credence to the letter of credit issued by a lesser known issuing bank;or, of a
paying bank,
which undertakes to encash the drafts drawn by the exporter. Further, instead of going to the
place of the issuingbank to claim payment, the buyer may approach another bank, termed the
negotiating bank,
to have the draft discounted.
OBLIGATIONS OF THE PARTIES
In commercial transactions involving letters of credit, the functions assumed by a correspondent
bank are classified according to theobligations taken up by it. The correspondent bank may be
called a notifying bank, a negotiating bank, or a confirming bank.In case of a notifying bank, the
correspondent bank assumes no liability except to notify and/or transmit to the beneficiary the
existenceof the letter of credit.A negotiating bank, on the other hand, is a correspondent bank
which buys or discounts a draft under the letter of credit. Its liability isdependent upon the stage
of the negotiation. If before negotiation, it has no liability with respect to the seller but after
negotiation, acontractual relationship will then prevail between the negotiating bank and the
seller.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 ifthe correspondent bank itself had issued the letter of
credit.
The notifying bank may suggest to the seller its willingness to negotiate, but this fact alone does
not imply that the notifying bankpromises to accept the draft drawn under the documentary
credit.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 issuingbank and not with the beneficiary to whom he
assumes no liability. It follows therefore that when the petitioner refused to negotiate withthe
private respondent, the latter has no cause of action against the petitioner for the enforcement of
his rights under the letter.The loan agreement is more reasonably classified as an isolated
transaction independent of the documentary credit.The mere opening of a letter of credit, it is to
be noted, does not involve a specific appropriation of a sum of money in favor of thebeneficiary. It
only signifies that the beneficiary may be able to draw funds upon the letter of credit up to the designated amount
specifiedin the letter. It does not convey the notion that a particular sum of money has been
specifically reserved or has been held in trust.What actually transpires in an irrevocable credit is
that the correspondent bank does not receive in advance the sum of money from thebuyer or the
issuing bank. On the contrary, when the correspondent bank accepts the tender and pays the amount stated in the
letter, themoney that it doles out comes not from any particular fund that has been advanced by the issuing bank,
rather it gets the money from itsown funds and then later seeks reimbursement from the issuing
bank.Granting that a trust has been created, still, the petitioner may not be considered a trustee.
As the petitioner is only a notifying bank, itsacceptance of the instructions of the issuing bank
will not create estoppel on its part resulting in the acceptance of the trust. Precisely, asa notifying
bank, its only obligation is to notify the private respondent of the existence of the letter of credit. How then can
such createestoppel when that is its only duty under the law?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 thecredit agreement
between the issuing bank and the buyer.
THE CONCEPT OF GUARANTEE VIS-A-VIS THE CONCEPT OF AN
IRREVOCABLE CREDIT ARE INCONSISTENT WITHEACH OTHER.
In the first place, the guarantee theory destroys the independence of the bank's responsibility
from the contract upon which it was opened.In the second place, the nature of both contracts is mutually in
conflict with each other. In contracts of guarantee, the guarantor'sobligation is merely collateral and it arises only
upon the default of the person primarily liable. On the other hand, in an irrevocable creditthe bank undertakes
a primary obligation.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 aguarantee. It may be observed that
the notifying bank is merely to follow the instructions of the issuing bank which is to notify or
totransmit the letter of credit to the beneficiary. Its commitment is only to notify the beneficiary.
It does not undertake any assurance thatthe 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 theinstructions 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 acceptthe 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 letterof credit.