PURPOSE OF LETTERS OF CREDIT

The primary purpose of a letter of credit is to substitute for,

IN GENERAL
DEFINITION and LAWS GOVERNING
LETTERS OF CREDIT
A letter of credit is a letter from a merchant or bank in one
place, addressed to another, in another place or country,
requesting the addressee to pay money or deliver goods to a
third party named, therein, the writer of the letter undertaking
to provide him the money for the goods or to repay him.
It is a letter requesting one person to make advance to a third
person on the credit of the writer. (De Leon)
A. CODE OF COMMERCE
ART. 567. Letters of Credit are those issued by one merchant
to another, or for the purpose of attending to a commercial
transaction.
ART. 568. The essential conditions of letters of credit shall be:
1. To be issued in favor of a determined person and
not to order.
2. To be limited to a fixed and special amount, or to
one or more indeterminate amounts, but all within
a maximum sum the limit of which must be exactly
stated.
Letters of credit which do not have one of these conditions
shall be considered simply as letters of recommendation.
TRADITIONAL DEFINITION: Arts. 567 to 572 of the Code of
Commerce on Letters of Credit i.e. “those issued by one
merchant to another, or for the purpose of attending to a
commercial transaction,” are obsolete.
MODERN DEFINITION: Modern letters of credit are strictly
bank-to-bank transactions. (Villanueva)
B. UNIFORM CUSTOMS AND PRACTICE (UCP) BY
THE ICC
Letters of credit of credit have gained a general acceptability
in international trade transactions.
• The International Chamber of Commerce has published
from time to time updates on the Uniform Customs and
Practice (UCP) for Documentary Credits to standardize
practices in area of letters of credit.
Observance of the UCP is justified under Art. 2 of the Code of
Commerce, which provides that “in the absence of any
particular provision therein, commercial transactions shall be
governed by usages and customs generally accepted.”
(Villanueva citing Transfield Philippines, Inc. v. Luzon Hydro
Corp.)
and therefore support, the agreement of the buyer-importer
to pay money under a contract or other arrangement; but it
does not necessarily constitute as a condition for the
perfection of such arrangement. (Reliance Commodities, Inc.
v. Daewoo Industrial Cp. Ltd)
The use of credits in commercial transactions serves to reduce
the risk of nonpayment of the purchase price under the
contract for the sale of goods. However, letters of credits are
also used in non-sale settings where they serve to reduce the
risk of non-performance.
(Transfield Philippines Inc. v Luzon Hydro Corp.)
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 interest of a
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 with a bank to issue a letter of credit in favor of the
seller so that, by virtue thereof, the issuing bank authorizes
the seller to draw draft and engage to pay them upon their
presentment simultaneously with the tender of documents
required by the letter of credit, which basically are the
shipping documents of the goods purchased. (Bank of
America v. CA)
CHARACTERISTICES OF A LETTER OF CREDIT
(Villanueva)
1. Non-contractual relationship between the seller
and the issuing bank.
Relationship between Beneficiary-Seller and the Issuer is not
strictly contractual, because nth privity and a meeting of the
minds are lacking, yet strict compliance with its terms is an
enforceable right.
2. Not a third-party beneficiary contract.
Nevertheless, the letter of credit is not a third-party
beneficiary contract (pour atrui), because Issuer must honor
drafts drawn against the letter of credit regardless of
problems subsequently arising in the underlying contract;
3. Not an assignment.
Since the bank’s customer (Applicant-Buyer) cannot draw on
the the letter, it does not function as an assignment by the
customer to the Beneficiary;
4. Not a contract of surety and guarantee.
If properly used, letter of credit is not a contract of suretyship
or guarantee, because it entails primary liability on the part of
issuer following a default.
5. Non-negotiable instrument.
Finally, letter of credit is not a negotiable instrument, because
it is not payable to order or to bearer and is generally
conditional; yet, the draft presented under it is often
negotiable.
 Under Art. 568, a letter of credit must be issued in
favor of a definite person, and not to order. Under our
law therefore, a letter of credit cannot be negotiable
because it may not contain the words of negotiability.
A letter of credit may be, and is oftentimes, issued for an
undetermined amount, the only requirement of the Code of
Commerce being that a maximum amount should be stated –
this again will prevent it from being a negotiable instrument
because it will not be for a “sum certain” in money as
understood under the Negotiable Instruments Law. (Campos)

PARTIES TO A LETTER OF CREDIT

It is an instrument which the issuer (usually a bank), at a

customer’s request (the applicant), agrees to honor a draft or
other demand for payment made by a third party (the
beneficiary) as long as the draft or demand complies with
specified conditions, and regardless or whether any
underlying obligation between the applicant ad beneficiary
satisfied. (Gomez-Somera)

MAIN PARTIES
1. The Buyer (Applicant) – the one who procures the letter
of credit and obliges himself to reimburse Issuing Bank
upon receipts of the documents of title;
2. The Issuing Bank – the bank issuing the letter of credit,
which undertakes to pay Seller upon receipt of the draft
and proper documents of titles and to surrender the
documents to Buyer upon reimbursement;
3. The Seller (Beneficiary) – who in compliance with the
contract of sale ships he goods to Buyer and delivers the
documents of title and draft to the Issuing Bank to
recover payment. (Villanueva)
OTHER PARTIES
(a.k.a. CORRESPONDING BANKS)
1. Advising Bank (Notifying Bank) – to convey to Seller the
existence of Credit;
2. Confirming Bank – will lend credence to the letter of
credit issued by a lesser known issuing bank.
3. Paying Bank – undertakes to encash the drafts drawn by
the exporter; or
4. Negotiation Bank – where instead of going to the place
of the issuing bank to claim payment, Seller may
approach Negotiating Bank to have draft discounted.
(Villanueva)
CONTRACTS AND RELATIONSHIPS EXISTING
UNDER A LETTER OF CREDIT
(De Leon)
There are three distinct and independent contracts.
1. The contract of sale between the buyer and the
seller;
2. The contract of the buyer with the issuing bank;
and
3. The letter of credit proper in which the bank
promises to pay the seller pursuant to the terms
and conditions stated therein.
KINDS OF LETTERS OF CREDIT
(Gomez-Somera)
COMMERCIAL LETTERS OF CREDIT
In commercial transactions, a letter of credit is
used as method of payment in a contract of sale goods,
so that the seller (the beneficiary) can obtain payment
directly from the issuer instead of from the buyer (the
applicant and issuer’s customer).
It is a financial device developed by merchants
as a convenient and relatively safe mode of dealing with
the sale of goods to satisfy the seemingly “irreconcilable
difference” of a seller-beneficiary, who refuses to part
with its goods before it is paid, and a buyer-applicant,
who wants to have control of the goods before paying.
Thus, it serves to reduce the risk of nonpayment of the
purchase price under a contract of sale.
Because commercial credits involve the
payment of money under a contract of sale, they become
payable upon the presentation by the seller-beneficiary of
documents that show it has taken affirmative steps to
comply with the contract of sale. The seller-beneficiary of
a commercial credit must demonstrate by documents that
it has performed its obligations under the contract.
STANDBY LETTERS OF CREDIT.
In non-sale transactions, a letter of credit (or
standby letter of credit or standby credit) is used to
guarantee, or secure, either a monetary or nonmonetary
obligation, whereby the issuer agrees to pay the creditor
(beneficiary) if the debtor (the applicant or the issuer’s
customer), defaults on the obligation. It is used to reduce
the risk of nonperformance of a contractual obligation of
the debtor-applicant.
In a standby credit, the credit is payable upon
certification of the debtor-applicant’s nonperformance of
the obligation. The creditor-beneficiary of the standby
credit must certify that the debtor-applicant has not
performed the principal obligation.
RIGHTS AND OBLIGATIONS OF PARTIES
(Villanueva)
OBLIGATIONS OF THE APPLICANT;
OBLIGATIONS OF CORRESPONDENT BANK
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.
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
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.
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. (Villanueva)
OBLIGATIONS OF THE ISSUING BANK;
RIGHTS OF THE BENEFICIARY
Letter of Credit constitutes the primary obligation,
and not merely an accessory contract, of the issuing bank
separate from the underlying contract that it may support.
Consequently, beneficiary of a letter of credit issued to secure
payment of a loan may collect on its entirety, even if borrower
claims it made partial payments already. (Villanueva, citing
Insular Bank v CA)
Obligation of the banks issuing letters of credit is
solidary with that of the person or entity requesting for its
issuance, the same being a direct primary, absolute and
definite undertaking to pay the beneficiary upon the
presentation of the set of documents required therein.
(Villanueva, citing MWSS v Daway)
PRINCIPLES IN LETTERS OF CREDIT
(Gomez-Somera)
I. The Rule of Strict Compliance
It is a settled rule in commercial transactions
involving letters of credit that the documents tendered must
strictly conform to the terms of the letter of credit. The tender
of documents by the beneficiary-seller must include all
documents required, and that a correspondent bank which
departs from what has been stipulated under the letter of
credit, as when it accepts a faulty tender, a acts on its own risk
and it may not thereafter be able to recover from the byer of
the issuing bank, as the case may be, the money thus paid to
the beneficiary-seller. (Villanueva, citing Feati Bank v. CA)
II. Independence Principle
The independence principle in letters of credit
assures the beneficiary of prompt payment independent of
any breach of the underlying principal obligation and
precludes the issuer from determining whether the underlying
or principal obligation is actually accomplished or not. Under
this principle, issuers assume no liability or responsibility for
the form, sufficiency, accuracy, genuineness, falsification or
legal effect of any documents or superimposed thereon, nor
do they assume any liability or responsibility for the
description, quantity, weight, quality, condition, packing,
delivery, value, or existence of the goods represented by any
documents, or for the good faith or acts or omissions,
solvency, performance or standing of the consignor, the
carriers, or the issuers of the goods, or any other person.
In other words, the letter of credit is separate and
distinct from the underlying principal obligation. The
settlement of a dispute between the parties is not a pre-
requisite for the release of funds under a letter of credit. If a
letter of credit were drawable only after settlement of the
dispute on the underlying principal obligation entered into by
the applicant and the beneficiary, there would be no practical
and beneficial use for letters of credit in commercial
transactions.
The independence principle admits of an
exception, referred to as the fraud exception rule. The
untruthfulness of a certificate accompanying a demand for
payment under a letter of credit may qualify as fraud, sufficient
to support an injunction against payment. However,
injunction should not be granted unless:
1. There is clear proof of fraud;
2. The fraud constitutes abuse of the independent
purpose of the letter of credit and not only fraud
under the underlying obligation; and
3. Irreparable injury might follow if injunction is not
granted or the recovery of damages would be
seriously affected.
JURISPRUDENCE
FEATI BANK & TRUST COMPANY, petitioner, v.
COURT OF APPEALS and BERNARDO VILLALUZ,
respondents.
FACTS:
Bernardo Villaluz agreed to sell to Axel Christiansen, a ship
and merchandise broker, 2,000 cubic meters of lauan logs.
After inspecting the logs, AC issued a purchase order for the An irrevocable credit refers to the duration of the
said logs. Letter of Credit. What it simply means is that the issuing bank
On the arrangements made and upon the may not without the consent of the beneficiary (seller) and the
instructions of the consignee, Hanmi Trade Development, applicant (buyer) revoke his undertaking under the letter. The
Ltd. (HTDL), Santa Ana, California, the Security Pacific issuing bank does not reserve the right to revoke the credit.
National Bank (SPNB), California issued an Irrevocable Letter On the other hand, a confirmed Letter of Credit pertains to
of Credit available at sight in favor of Villauz for the total the kind of obligation assumed by the correspondent bank. In
purchase price of the logs. The Letter of Credit was mailed to this case, the correspondent bank gives an absolute
FEATI Bank and Trust Company (FBTC) with instruction that assurance to the beneficiary that it will undertake the issuing
the draft to be drawn is on SPNB and that it be accompanied bank's obligation as its own according to the terms and
by the following documents, among others: A Certification f conditions of the credit. Hence, the mere fact that a Letter of
rom to shipment in accordance with terms and conditions of Credit is irrevocable does not necessarily imply that the
corresponding purchase order. correspondent bank in accepting the instructions of the
Consequently, the logs were thereafter loaded to issuing bank has also confirmed the Letter of Credit.
the vessel chartered by Christiansen. After the loading of the
logs was completed, the Chief Mate of the vessel issued a METROPOLITAN WATERWORKS AND SEWERAGE
mate receipt of the cargo which stated the same are in good SYSTEM (MWSS), petitioner v. HON. DAWAY OF RTC-
condition. However, Christiansen refused to issue the QC and MAYNILAD WATER SERVICES, INC.
certification as required in the Letter of Credit despite several
(Maynilad), respondents.
requests made by Villaluz. Because of the absence of the
certification by Christiansesn, FBTC refused to advance the
FACTS:
payment on the Letter of Credit. It eventually lapsed without
Metropolitan Water and Sewerage System (MWSS) granted
Villaluz receiving any certification from Christiansen.
Maynilad Water Services, Inc. (MWSI), under a Concession
Since the demands of Villaluz for AC to execute the
Agreement (“agreement”), a 20-year period to manage,
certification proved futile, he Villaluz instituted an action for
operate, repair, decommission and refurbish the existing
mandamus and specific performance against Christiansen
MWSS water delivery and sewerage services in the West Zone
and FBTC before the then Court of First Instance (CFI) of Rizal.
Service Area, for which MWSI undertook to pay the
Unfortunately, while the case was pending, Christiansen left
corresponding concession fees on the dates agreed upon in
the Philippines without informing the CFI and his counsel;
said agreement which, among other things, consisted of
hence, Villaluz filed an amended complaint to make FBTC
payments of MWSS’s mostly foreign loans. To secure the
solidarily liable with Christiansen.
concessionaire’s performance of its obligations under the
agreement, MWSI was required to put up a bond, bank
ISSUE/s:
guarantee or other security acceptable to MWSS. In
Whether FBTC, as correspondent bank, is to be held liable
compliance with this requirement, MWSI arranged for a 3-year
under the Letter of Credit despite non-compliance by the
facility with a number of foreign banks, led by Citicorp
beneficiary, Villauz, with the terms thereof?
International Limited (CIL), for the issuance of an Irrevocable
Standby Letter of Credit in favor of MWSS for the full and
HELD:
prompt performance of MWSI’s obligations to MWSS.
NO. It is a settled rule in commercial transactions
A few years later, however, MWSI served upon
involving Letters of Credit that the documents tendered must
MWSS a Notice of Event of Termination, claiming that MWSS
strictly conform to its terms. The tender of documents by the
failed to comply with its obligations under the agreement and
beneficiary (seller) must include all documents required by the
an amendment thereto regarding the adjustment mechanism
Letter of Credit. A correspondent bank which departs from
that would cover MWSI’s foreign exchange losses.
what has been stipulated under the Letter of Credit, as when
Consequently, MWSI filed a Notice of Early Termination of the
it accepts a faulty tender, acts on its own risks and it may not
agreement, which was challenged by MWSS. This matter was
thereafter be able to recover from the buyer or the issuing
eventually brought by MWSS before the Appeals Panel, which
bank, as the case may be, the money thus paid to the
eventually ruled that there was no Event of Termination as
beneficiary.
defined under the agreement and that, therefore, MWSI
Moreover, under the Uniform Customs and
should pay the concession fees that had fallen due.
Practices for Documentary Credit, the bank may only
Upon the finality of the panel’s award, MWSS
negotiate, accept or pay, if the documents tendered to it are
submitted a written notice to CIL, as agent for the
on their face in accordance with the terms and conditions of
participating banks, that by virtue of MWSI’s failure to perform
the documentary credit. And since a correspondent bank
its obligations under the agreement, it was drawing on the
principally deals only with documents, the absence of any
Irrevocable Standby Letter of Credit and thereby demanded
document required in the documentary credit justifies the
payment. Prior to this demand, however, MWSI filed a petition
refusal by the correspondent bank to negotiate, accept or pay
for rehabilitation before the Regional Trial Court of Quezon
the beneficiary, as it is not its obligation to look beyond the
City – which resulted in the issuance of a Stay Order enjoining
documents. It merely has to rely on the completeness of the
MWSS from drawing on the Standby Letter of Credit.
documents tendered by the beneficiary.
ISSUE/s:
Is the Standby Letter of Credit within the in rem jurisdiction of
a rehabilitation court because it is a “claim against the debtor,
its guarantors and sureties not solidarily liable with the
debtor” and that since there is nothing in the Standby Letter
of Credit nor in law nor in the nature of the obligation that
would show or require the obligation of the banks with MWSI
is solidary?

HELD:
NO. The concept of guarantee vis-à-vis the concept
of an irrevocable LETTER OF CREDIT are inconsistent with
each other. The guarantee theory destroys the independence
of the bank’s responsibility from the contract upon which it
was opened and the nature of both contracts is mutually in
conflict with each other. In contracts of guarantee, the
guarantor’s obligation is merely collateral and it arises only
upon the default of the person primarily liable. On the other
hand, in an irrevocable LETTER OF CREDIT, the bank
undertakes a primary obligation. 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.
LETTER 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 SOURCES AND REFERENCE
and not accessory contracts and while they are security
arrangements, they are not converted thereby into contracts
GOMEZ-SOMERA, STEPHANIE V., Credit
of guaranty. What distinguishes LETTER OF CREDIT from
other accessory contracts is the engagement of the issuing Transactions: Notes and Cases (2 Ed., Vol. I),
nd

bank to pay the seller once the draft and other required (2015).
shipping documents are presented to it. They are definite
undertakings to pay at sight once the documents stipulated
DE LEON, SR., H. AND DE LEON JR., H., The
therein are presented.
Taking into consideration our own rulings on the Philippine Negotiable Instruments Law (2010)
nature of LETTER OF CREDIT and the customs and usage
developed over the years in the banking and commercial VILLANUEVA, CESAR L. Commercial Law Review.
practice of LETTER OF CREDIT, we hold that except when a
(2012)
LETTER OF CREDIT specifically stipulates otherwise, the
obligation of the banks issuing LETTER OF CREDIT are
solidary with that of the person or entity requesting for its CAMPOS, J. AND LOPEZ-CAMPOS, M., Notes and
issuance, the same being a direct, primary, absolute and Selected Cases on Negotiable Instruments Law
definite undertaking to pay the beneficiary upon the
(1994)
presentation of the set of documents required therein.