Professional Documents
Culture Documents
Submitted to:
Prof. Rocky Alejandro Reyes
Introduction
The Code of Commerce, through a Royal Decree of Queen Maria Christina of
Spain in 1888, originally codified the rules relating to commerce in the Philippines; the
code governed everything from insurance contracts to bankruptcies. The code used to
govern a substantial portion of the field of credit transactions, with its provisions on
commercial loans, commercial deposits, and commercial guarantees.
However, due to the passage of the New Civil Code and special laws, the code
has become much lesser in scope. The Code of Commerce now only remains
applicable for the topics on Merchants, Commercial Registries, Book of Merchants,
General Provisions on Commercial Contracts under Book I of the Code, Joint Accounts,
Transfer of Non-Negotiable Credits, Overland Transportation, and Letters of Credit
under Book II, and the entire Book III on Maritime Commerce.
Contracts under the Code of Commerce are commercial contracts, which are
valid in whatever form they appear1, unless otherwise provided for by law. Relevant to
Credit Transactions, letters of credit and loans on bottomry and respondentia are
required to be in writing. 2 They are consensual contracts and are perfected upon
meeting of the minds of the parties, or upon the moment the offeror learns about the
acceptance of his offer by the offeree.3
Definition and purpose of letters of credit
Letters of credit are governed by Articles 567 to 572 of the Code of Commerce.
These are instruments where a writer or issuer, more often than not a bank, authorizes
the addressee, the beneficiary to deliver money or goods to a third party; the writer
assumes then responsibility over payment of debts therefor to the addressee (or
beneficiary). With such an instrument, the banks, on behalf of their customers (or
applicants), authorize beneficiaries to draw drafts or demands to be presented to the
bank, if drawn in accordance with the terms of the letters of credit. 4 The issuer shall then
honor the draft or demand regardless of whether underlying obligations between
1 Articles. 51 and 52, New Civil Code
2 Article 267, New Civil Code
3 Article 1409, New Civil Code
4 Prudential Bank vs. IAC, G.R. No. 74886 (1992)
applicant and beneficiary are satisfied. Article 567 of the Code of Commerce also
defines these as instruments ”issued by one merchant to another for the purpose of
attending to a commercial transaction”; However, this definition is already considered
obsolete as modern letters of credit are now bank-to-bank transactions.
It serves as a convenient and safe financial device to guarantee clients’ ability to
pay for goods or services, and while satisfying seemingly irreconcilable interests of the
seller, who would normally refuse to release goods before being paid, and the buyer,
who wants to obtain the goods before paying. 5 It (the bank) therefore substitutes its own
financial ability, for that of the buyer or importer (applicant), to pay under a certain
arrangement, and provides an expectation of payment in the seller or exporter
(beneficiary), so that the latter is convinced to transact with the former. The beneficiary
may call upon such an instrument as security in case the applicant fails to perform its
obligation. In effect, the risk of non-payment.
Nature of letters of credit
Under the principle of independent contracts, letters of credit may be
described as follows: they ensure prompt payment in favor of the beneficiary, regardless
of any possible breach against the main contract; and it prevents the bank from
determining the success of the main contract. Both the bank and the beneficiary may
invoke this principle. Banks are mere custodians of the funds and are obligated to
transfer the same to the beneficiary, as long as the latter presents a certification or proof
of its claims.6
In other words, as long as the beneficiary complied with the credit, it does not
matter whether or not he or she complied with the underlying contract. The bank deals
with the relevant documents only; they are not qualified to deal with goods. The letter of
credit is also not a condition for the perfection of such a contract.
Note that letters of credit may also be used in non-sale settings (such as in this
instant case). These credits used in non-sale transactions are called standby credits.
An LOC is not a negotiable instrument as it does not involve an unconditional
promise to pay a certain sum of money; instead, the letter of credit is conditioned upon
submission of relevant documents and compliance with the terms of the letter of credit.
Also, It is issued in favor of a definite person and not to order.
The mere opening of a letter of credit does NOT involve a specific appropriation
of a sum of money in favor of the beneficiary. It only signifies that the beneficiary may
be able to draw funds upon the letter of credit up to the designated amount specified
therein. Iit does not convey the notion that a particular sum of money has been
specifically reserved or has been held in trust. 7
8 Keng Hua Paper Products Co. Inc. vs. Court of Appeals, G.R. No. 116863 (1998)
9 Feati Bank vs. Court of Appeals, G.R. No. 94209 (1991)
10 ICC Uniform Customs and Practice for Documentary Credits. ICC. Retrieved 29 May
2020.
11 Bank of America vs. CA, G.R. No. 105395 (1993)
Seller-beneficiary. The one who ships the goods to the buyer and delivers the
documents of title and draft to the issuing bank to recover payment. As beneficiary, the
instrument is addressed to him and in his favor.
Correspondent bank.12 Other parties may include the following:
Advising (notifying) bank. The notifying bank serves as an agent of the issuing
bank in transmitting the LOC, and in notifying the beneficiary of the same. It has no
privity to the sale, and has a relationship only with the issuing bank; it therefore is not
liable to pay drafts drawn against the LOC.
Its only obligation is to check the apparent authenticity of the LC. 13
Confirming bank. The confirming bank lends credence to the LOC issued by a
lesser known issuing bank. The confirming bank is directly liable to pay the seller-
beneficiary, as if the correspondent bank itself issued the LOC.
In contrast to the notifying bank, the latter may also serve as a negotiating bank,
but not a confirming bank, hence not liable to the beneficiary. To be liable, there must
be an undertaking of the issuing bank’s obligation as its own.
If the confirming bank confirms, the beneficiary then becomes entitled to proceed
against either or both banks.
Paying bank. The task of the paying bank is to encash the drafts drawn by the
beneficiary-seller. It could be the opening or issuing bank, or even any other bank..
Negotiating bank. Instead of going to the place of the issuing bank to claim
payment, the buyer may approach another bank for the latter to buy or discount the
seller’s draft.14
Its liability depends on the stage of the negotiation: If before negotiation, such
that it suggests willingness to negotiate, then it has no liability with respect to the seller;
If after negotiation, then a contractual relationship exists between the negotiating bank
and the seller. It has a right of recourse against the issuing bank - that is, until the
negotiating bank is reimbursed, drawer of the draft which is the issuer is still
contingently liable.15
The process goes as follows: the buyer-applicant secures an LOC, promising to
reimburse the issuing bank upon receipt of the documents of title. The issuing bank then
issues the LOC in favor of seller-beneficiary, which may result in either of two situations:
(1) Seller ships goods to the buyer and delivers documents of title and the draft to
the issuing (or negotiating) bank to recover payment; or
18 Johannes Schuback & Sons vs. Court of Appeals, G.R. No. 105387 (1993)
19 Transfield Phils. vs. Luzon Hydro Corp, G.R. NO. 146717 (2004)
were issued by the issuing and confirming bank jointly. The confirming bank and issuing
bank are jointly and equally liable and the seller-beneficiary may proceed against either
or both banks the moment that the credit instrument is breached.
The confirming bank is liable only when the documents are submitted and gets
reimbursed by the issuing bank, as there is no privity of contract with the buyer-
applicant. If the beneficiary files an action against the confirming bank, the latter may
seek reimbursement from the issuing bank. On the other hand, if the seller-beneficiary
goes directly against the confirming bank; then it may no longer collect from the issuing
bank.
Although a notifying bank may become a confirming bank, it cannot go the other
way around, and the confirming bank cannot become a notifying bank. The former’s
liability is primary, while the latter’s liability arises only after negotiation has taken place.
Obligations of issuing bank; of seller-beneficiary
According to Article 569 of the New Civil Code: The drawer (issuing bank) of a
letter of credit = shall be liable to the person on whom it was issued, for the amount paid
by virtue thereof, within the maximum fixed therein. Letters of credit may not be
protested even should they not be paid, nor shall the bearer thereof acquire any right of
action by reason of such non-payment against the person who issued it.
A letter of credit constitutes the primary obligation, and not merely an accessory
contract, of the issuing bank from the underlying contract that it may support. It is also
their solidary obligation along with the applicant-buyer. It is their absolute and definite
obligation to pay the seller-beneficiary upon presentation of relevant documents.
Therefore, under the independence principle, the issuing bank is free from the
duty to determine compliance by the parties to the main contract, as their obligation
under the letter of credit is separate and independent of the originating contract. 20 They
also assume no responsibility over the form, sufficiency, accuracy, genuineness, falsity,
or legal effect of any such documents, or over the general and particular conditions
stipulated in such documents. Nor do they assume any responsibility over the quantity,
quality, condition, value, or even existence of the goods. Nor are they responsible to
determine good faith, acts or omissions, solvency, standing, etc. of parties to the main
contract.
If the goods turn out to be defective, the issuing bank has no excuse and still
must make payment to the seller-beneficiary. The buy-applicant also has no cause of
action against the issuing bank for defective goods, but may go against the seller
instead. Remember that the issuing bank does not deal with the goods, but with the
documents.
Article 569 NCC does, however, provide the issuing bank the power to annul the
letter of credit, under the obligation of informing the bearer (seller-beneficiary).
20 Transfield Phils. vs. Luzon Hydro Corp, G.R. NO. 146717 (2004)
The seller-beneficiary of a letter of credit issued to secure payment of a loan
must make use of the same within the following periods, otherwise, it shall be void in
fact and in law, according to Article 572 of the New Civil Code: (1) within the period
agreed upon with the issuing bank; or (2) within 6 months counted from its date if
executed within the Philippines, or within 12 months if outside of the Philippines.
As for its rights, the beneficiary may collect the amount in its entirety, even if the
borrower claims to have already made partial payments. The supreme court adds that
the beneficiary may also invoke the principle; otherwise, it would negate the purpose of
letters of credit in commercial transactions.21 The independence doctrine works to the
benefit both of the issuing bank and the beneficiary.
Fraud as exception to the independence principle 22
The independent principle is a basic rule in letters of credit, and has been
discussed several times in the above sections already. Under it, the buyer-applicant
cannot enjoin the payment of the obligation of the issuing bank under a letter of credit,
on the ground of any irregularity or non-performance of an obligation. There is an
exception to this rule, however, when there is fraud or forgery in the underlying
transaction or the manner of tendering of documents. In such a case, the remedy is an
injunction, which should be granted only if there is a clear proof of fraudulent abuse of
the independent purpose of the LOC, and not just fraud relating to the main contract;
AND there is potential irreparable injury if injunction is not granted.
Kinds of letters of credit23
There are primarily two kinds of letters of credit: commercial and traveller’s.
Commercial. In a commercial letter of credit, a bank, for the account of a buyer-
applicant, provides formal evidence to a seller-beneficiary of its willingness to allow the
latter to draw bills or demands against the bank, and that such bills will be honored
upon presentation.
Traveller’s. Letters of credit may also support non-sales contracts - for instance,
a traveller’s LOC, which is a letter from a bank addressed to its correspondents stating
that any draft up to a stipulated sum drawn by the seller-beneficiary shall be honored by
such bank.
Other kinds. Aside from commercial and traveller’s letters of credit, there are
also other kinds of LOC:
Confirmed. This is when the seller-beneficiary stipulates that the obligation of
the opening bank to him or her shall also be the obligation of the notifying bank. Please
see discussion on confirmed letters of credit above.
21 Transfield Phils. vs. Luzon Hydro Corp, G.R. NO. 146717 (2004)
22 Transfield Phils. vs. Luzon Hydro Corp, G.R. NO. 146717 (2004)
23 Sundiang, J. R., & Aquino, T. B. (2017). Reviewer on commercial law. Manila,
Philippines: Published & distributed by Rex Book Store.
Irrevocable. There is a definite undertaking on the part of the issuing bank and
constitutes the engagement of that bank to the beneficiary and bona fide holders of
drafts drawn and/or documents presented thereunder, that the provisions for payment,
acceptance or negotiation contained in the credit will be duly fulfilled, provided that all
terms and conditions of the credit are complied with.
In order to revoke an irrevocable LOC, the issuing bank has to obtain the
consent of the beneficiary and the applicant. The consent of both is so vital in an
irrevocable LOC that it cannot be cancelled even by a court order.
Note that an irrevocable LOC is not synonymous with a confirmed LOC. That a
letter of credit is irrevocable does not mean that the correspondent bank who accepts
the instructions of the issuing bank also confirms the letter of credit. This also means
that the issuing bank cannot be compelled to pay if the letter of credit requires a
certification from the beneficiary, and no such certification has issued.
Revolving. In this type of LOC, as soon as the opening bank has advised that
the drafts drawn by the beneficiary have been reimbursed by the buyer, renewed credit
becomes available.
Back-to-Back. This involves two letters of credit with identical documentary
requirements and covering the same merchandise, except for a difference in the price of
the merchandise. The first LOC has to be negotiated before the second can be
negotiated.
Standby. It is a letter of credit drawn up essentially as a security. A standby
LOC may be issued in lieu of a performance bond in order to guarantee fulfillment of an
obligation. Thus, the beneficiary has to prove that the obligor failed to perform the
obligation so that the LOC can be drawn against.
LOANS ON BOTTOMRY AND RESPONDENTIA
The Code of Commerce establishes a special kind of loan for the maritime
industry and maritime trade. Loans on bottomry and respondentia are loans payable
only when the vessel that has been given in security has successfully completed its
voyage and safely arrived at its destination. These loans are governed by Articles 719-
736 of the Code of Commerce.
What is a “bottomry”? It's an arrangement where the ship owner borrows money
for the use, equipment, or repair of the vessel, and pledges the keel or “bottom” of the
ship as security. The ship is forfeit if the owner is unable to repay the loan and the
interest. What makes a bottomry loan unique is that if the ship is lost during the voyage,
the owner is released from his obligation to pay and the lender loses his money.
A loan on respondentia is similar, but it concerns the cargo or the merchandise.
The loan is secured by the owner of the cargo and becomes payable upon safe arrival
at the destination.
Implicit in the nature of the bottomry or respondentia loan is the existence of risk,
primarily that of the perils or risks of the sea. The presence of these risks justifies some
of the special provisions governing these loans. Also, these risks make bottomry and
respondentia loans overlap with maritime insurance. However, the purpose of insurance
is to secure the risk, while the primary purpose of bottomry is the loan of money.
In what form must these loans appear? Under Art. 720 of the Code of
Commerce, a loan on bottomry may be executed by means of a (a) public instrument,
(b) bond signed by the contracting parties and the broker taking part therein, or (c)
private instrument. If the loan was not reduced into writing, it cannot be made basis of
judicial action.The same article also provides that the loan must be entered into the
certificate of registry of the vessel and in the commercial registry, otherwise the loan
loses its preference in relation to other credits. Non-registration in the commercial
registry also means that loan does not have any effect with regard to third persons.
Finally, Art. 721 of the Code of Commerce provides the specific information that must
be stated in the bottomry or respondentia bond.
Now, how does a loan on bottomry relate to simple loans? What differences are
there?
First, a loan on bottomry has additional requisites that a simple loan need not
have. A bottomry or respondentia loan requires the presence of a marine risk, while
there is no need for such risk in the case of a simple loan. This risk justifies the special
provisions in bottomry loans, primarily that it is no longer payable when the vessel is lost
during voyage. Also, these kinds of loans require a specific kind of security, in this case
the ship/vessel or the cargo/merchandise. Simple loans need not have security.
Second, simple loans do not require a specific form or manner in order to
become effective. In contrast, bottomry or respondentia loans require that a specific
form or manner be complied with.24 There is also a need to register bottomry loans,
while simple loans have no such requirement. Non-registration means that the
preference of bottomry and respondentia loans over other credits is lost, and such loans
does not affect third persons if unregistered.
Third, due to the nature of bottomry and respondentia loans, usury laws have no
effect on them. Due to the high risk nature of these loans, there is no ceiling on the rate
of interest that the parties may agree to. In contrast, simple loans are subject to the laws
on usury. While at present there is no law punishing usury and no ceiling on the interest
rate that may be agreed upon, it would be easier for Congress or the Monetary Board to
reimpose such laws on simple loans as compared to loans on bottomry or respondentia.
Finally, in simple loans, it is the first lender that is preferred. The first lender is
paid first in simple loans. In contrast, the last lender is preferred in bottomry or
respondentia loans. Article 730 of the Code of Commerce provides that loans made
during the voyage are prefered over those made prior to the clearing of the vessel,
graduated by the inverse order of their dates. Also, loans made for the last voyage are
prefered over loans for prior voyages.
24 Articles 720, 721, Code of Commerce
While there are very fundamental differences between simple and bottomry
loans, there are situations when a bottomry or respondentia loan is regarded as a
simple loan. In general, these situations occur when one of the elements or
characteristics of a bottomry loan is lost.
The first situation when a bottomry loan is considered a simple loan is when the
lender loans an amount larger than the value of the security, and he/she loaned such
excess due to the fraudulent means of the borrower. 25
Second, Article 727 provides that when the full amount of the loan is not used for
the cargo, the surplus has to be returned in the same manner as a simple loan. This
also occurs with regard to goods taken as a loan if they could not all have been loaded.
Finally, when the good or the vessel has not been subjected to the risk stipulated
on the loan, the contract becomes an ordinary loan. 26.
CONCLUSION
While letters of credit and loans on bottomry seem to be significant and
expansive contracts and instruments, in reality, their use seems to be of lesser import at
this day and age. Modern letters of credit are strictly bank-to-bank transactions. Sources
of credit are numerous that loans on bottomry and respondentia are becoming less
common. The situation wherein the above discussion becomes important is steadily in
question.
The Code of Commerce, with its provisions on commercial loans and commercial
deposits, used to form a substantial part of credit transaction law. But with its provisions
repealed and superseded by the New Civil Code and special laws, the code is steadily
becoming less relevant in the field of credit transactions. Indeed, the ability of a law
which took effect in our country during the late 1800’s to be responsive to today’s
modern challenges is questionable at best. But as long as the Code remains in our
books, there is a need to study its provisions and learn how it can affect the way we do
credit transactions specifically, and commercial law in general.