LETTERS OF CREDIT

The old definition of letters of credit has now been rendered obsolete. The governing
rules now involving letters of credit is Uniform Customs and Practices for
Documentary Credits adopted by the International Chamber of Commerce which is
applicable also here in our jurisdiction.

Modern day LC transactions are bank to bank transactions so the old definition
under Commerce Code is no longer applicable.

What is a LC?

- Historically LC was developed by merchants to facilitate sale of goods between

buyers and sellers who are unfamiliar.
Ex. Buyer in PH Seller abroad. (Buyer and seller are located in different places
– there’s no trust between them yet)
- Essentially it is a bank to bank transaction
- An engagement by a bank who undertakes to honor drafts or other forms of
demands for payment issued by the bank upon request of the customer.
Engaging that once the draft is issued by the seller he will undertake to honor
and pay the draft also upon issue of certain documents of fulfillment of certain
conditions specified in the LC.
- It reconciles the seemingly irreconcilable interest of the seller and the buyer,
in a way that when a bank issues a LC it substitutes its promise to pay for
that of the promise to pay of its customer or in this case buyer with the
corresponding promise from the buyer to reimburse the bank as soon as the
goods are shipped or he obtains the possession of the cargo.
- LC is not only applicable to sale of goods but also applicable to contracts
involving services (ex. Contracts of construction of loan agreements, etc).

How does it work?

- Applying it in the sale of goods, we have:

BUYER ---→ SELLER
BUYER’S BANK ---→ SELLER’S BANK
So between Buyer and Seller there should be a contract of SALE.

Ex. Buyer Seller

Buyer refuses to pay
Seller refuses to deliver until he receives the goods, until he is paid.

How do we break the deadlock/ impasse?

Under the LC the Buyer would now be required to contact a bank and request for
the issue of an LC in favor of seller. Once seller is informed that the LC has already
been issued in his favor, the seller now will be assured of payment. The bank will
undertake to pay the seller as soon as he issues the draft and submits the
documents specified in the LC.

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 What are these documents?
Documents evidencing shipment ( Bill of Lading, Invoice, Insurance contract,
Warehouse receipt, delivery receipt, certification of quality, it DEPENDS ON THE
STIPULATION OF THE PARTIES, certificate of origin of goods (because you might
need it for customs purposes). Basically documents of title evidencing OWNERSHIP
and FACT that goods have been shipped.

What does Seller do?

He would now ship the goods and secure the necessary documents of title -> Bring
these documents and issue a draft (Bill of Exchange BOE drawn on the bank) ->
Presents it on the issuing bank -> Issuing bank checks if the documents are in
order -> If in order, obtain possession of such documents -> Pay Seller

How is transaction completed?

Although documents are addressed or consigned to the Buyer, he cannot obtain
possession of the goods until he has the documents of title. To get possession of
the documents, he must go to the issuing bank to reimburse it in exchange for the
documents of title – then the transaction is completed.

BUT in cases where the Buyer and Seller is located in different places/
countries:

Buyer (Cebu) Seller (US)

Issuing Bank --------------------→ Correspondent Bank (located in the place

where the seller is; or seller’s bank)

- It is important for the Buyer to choose an issuing bank, to make sure that the
issuing bank is large, strong enough and well known in international trading.
Kung gamay imo banko there is a tendency that it does not have a
correspondent bank. It becomes complicated now when there is a
correspondent bank.

Why would a bank issue a LC? Does it get revenue out of it? YES.

- The buyer when it contracts for a LC with issuing bank, aside from the credit
extended it has also to pay fees or service fees.

Basically, that is how a LC works especially in a sale of goods.

Who are the parties?

Main

1. Buyer-Applicant (Importer) – the one who applies for a LC and who purchases
something
2. Seller-Beneficiary - the one who engages to sell the goods; the one who issues
the draft against bank so he will be paid for the shipment, and he is the one
who should secure the documents specified under the LC

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 3. Issuing Bank/ Opening Bank – the bank who issues the LC; undertakes to
pay the LC; the one primarily and solidarily liable with the Buyer to pay the
LC

Others

1. Correspondent Bank –could either act as an (a) advising or notifying bank; (b)
negotiating bank; or (c) confirming bank.
2. Advising Bank – notifies that such LC is issued; responsibility is simply to
inform or notify or convey to the beneficiary or seller that there is a LC issued
in his favor
3. Confirming Bank – bank who confirms that LC is good, genuine; nature of
obligation is solidary with that of the issuing bank you also undertake to pay
the LC or draft issued under the LC
Why do we have Confirming Bank when we already have issuing bank?
If issuing bank is not well-known and you only have correspondent bank,
aside from having correspondent bank the seller or beneficiary will request
that correspondent bank to confirm the LC.

Ex.
BDO -> Seller (foreign company not familiar with BDO)

Unless that bank confirms dili sila liable. If you only have an advising or
notifying bank and something goes wrong, the advising bank or notifying bank
does not undertake to pay. So if you’re the seller and you want to be assured
you would require that the correspondent bank will also be the confirming
bank.
4. Paying Bank – undertakes to pay or honor the draft; draft that will be drawn
to the seller will be drawn against the paying bank; it could either be the
notifying bank or confirming bank or other bank
5. Negotiating Bank - if the paying bank or confirming bank is located in a
different state where the seller or beneficiary is , instead of going to the place
where the paying or confirming bank is located, you will just have the draft
still drawn against either the paying or confirming bank negotiated with a
negotiating bank. (This is a negotiable bill of exchange, you have a drawee and
a drawer. You make it payable to yourself also and you’ll just have to indorse
in favor of the negotiating bank.) It acts as an indorsee, and eventually to get
money it will have to indorse to the paying bank.

• It is important to take note of the obligations and responsibilities of the

different correspondent banks because their liability would depend on those
obligs and responsibilities.

Between issuing bank and corresponding bank: Issuing bank would now issue a LC,
it will give correspondent bank a copy of that LC and in turn corresponding bank will
be the one to inform the seller If correspondent bank becomes paying bank or
confirming bank, it undertakes now to pay the seller -> he receives documents of title
-> forward these docs to issuing bank -> issuing bank could now reimburse the

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correspondent bank. It presupposes that between the issuing bank and
correspondent bank, there is an arrangement. There’s also an element of TRUST.

Does correspondent bank get any payment?

YES. Notifying fees, advising fees, confirming fees, negotiating fees, etc. There is
always a fee for everything, nothing is free ☺ Whatever fee is charged by the
correspondent bank it passes on to the issuing bank and issuing bank ultimately
passes it on to the buyer.

Marginal Deposit

- For example a LC that you applied for is for P5,000,000 assuming that is the
price of the goods you are importing, some banks require you to make a
marginal deposit. Out of the amount you will open, you should make a deposit
of let’s say P1,000,000. In effect the credit extended by the bank is only
P4,000,000.

Question: Is there a need for the issuing bank to get consent from the Buyer before
or when it contracts with a correspondent bank? Can the Buyer choose who the
correspondent bank will be?

In the process of applying for a LC, the issuing bank would already inform the
buyer that there’s a need to contract with a correspondent bank. The
arrangement is already made known to the buyer at the time he applies for an
LC. So consent, yes because it is already presented to the buyer that this will be
the arrangement, these will be the fees, charges, etc. But as to the choice of what
correspondent bank, pwede ka pili but it depends if the issuing bank has an
existing arrangement with the choice of the buyer.

Case: Pru Bank vs IAC

• Correspondent bank could either be

notifying bank, confirming bank, paying
bank or negotiating bank or combinations.
Liability will depend on obligation it
assumes.

Bank of America vs CA

• What is the obligation of an advising bank?

Only to advise. The fact that it paid the draft
does not necessarily make it a confirming
bank. Bank of America is only considered a
negotiating bank (merely an indorsee), it
does not become a confirming bank hence,
it does not warrant the genuineness and due
execution of the LC.
• It only warrants the APPARENT authenticity.

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What is the nature of an obligation of an LC: Guaranty or Solidary?

The liability of the bank in an LC is primary and solidary as that of the buyer-
applicant and hence not covered by stay order.

Nature: Primary, direct and absolute.

Stages in Perfection of LC

1. Underlying contract
2. Apply for LC
3. Issuance of LC in favor of seller
4. Shipment of goods (commercial)
5. Seller to present necessary documents
6. Payment of issuing bank/ corresponding bank
7. Redemption of issuing bank from buyer

Is LC necessary for validity of underlying contract?

Answer: NO. Because an LC is only a mode of payment it is not one of the elements
of a contract.

Contracts involved in an LC (3 main)

1. Underlying contract – contract of sale or contract of service -> governs

relationship between buyer and seller or applicant and beneficiary
2. Contract between Buyer and Issuing Bank (Issuance of LC)– governed by
terms in application for a LC; separate contract
3. Contract of LC (LC proper) – governs relation of Issuing Bank and Seller

(Others)

• Insurance contract
• Contract of carriage

Principle (Contracts): Separate and distinct from each other. Maintained in a state
of PERPETUAL separation.

“Independence Principle” – LC is distinct and different from other contracts and vice
versa. Applies mainly in obligation of the bank, bank is precluded from determining
whether the underlying contract has been complied with. It is only limited to
checking if the documents stated in LC are complied with. One involving “paper
transaction” only look at the docs and see if it complies with docs required in the LC,
banker is not expected to go out in the field and check the cargoes whether it
complied with that stated on the Bill of Lading or Sales Document.

Regardless of the breach of the underlying contract, so long as the seller or

beneficiaries complies with the LC, then the obligation of the bank is to pay.

Bank is not liable for the accuracy, legal effect, or genuineness of shipping document.
It is not even liable for the quantity or quality, or whether or not the goods actually

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exist or the value is actually that as stated or correct. Its only obligation is simply to
look at the documents and determine whether they are complete and they are those
specified in LC.

Guaranty vs. LC
CASE: Filam vs Insular

Guarantor – Liable only if one primarily liable

cannot pay.

LC – absolute undertaking to pay

Kinds of LC

CASE: Phil. Virginia Tobacco

• Irrevocable LC – issuing bank cannot alter tenor of LC, cancel it or revoke

without conformity of the applicant and beneficiary or the consent of all
the parties (re: right of parties to cancel or revoke)
• Revocable LC – while it is a security arrangement it does not assure
payment because it can be revoked anytime
• Confirmed LC – correspondent bank confirms LC or undertakes the
obligation to pay; confirming bank becomes solidarily liable with issuing
bank and buyer
• Unconfirmed LC - only issuing bank can be held primarily and solidarily
liable (re: obligation of correspondent bank)
• Commercial - involves sale of goods; requires performance
• Standby – involves sale of service or service transaction (loan agreement,
contract of services); proof of non performance
• Revolving LC – secures several transactions (ex. Security of several
importations)
• Back-to-Back LC – normally in an LC transaction it only involves an
buyer-applicant, seller-beneficiary, and issuing bank, in this case, the
beneficiary also applies for a LC so seller-beneficiary also becomes a seller-
applicant and buyer-applicant now becomes buyer-beneficiary
• Cumulative LC – normally in a bank there exist a limit or threshold
amount, in this LC if you have not utilized the limit or threshold amount
it will be carried over to a next period

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 • Non Cumulative – if you are allowed a credit line for example of 1M and
you do not use it up, it cannot be carried over to the succeeding periods or
LC’s

IMPORTANT POINTS TO REMEMBER IN LETTERS OF CREDIT:

- 3 Principles: Independence Principle, Fraud Exception Rule, Strict

Compliance Rule
- Obligations of Diff. Correspondent Banks
- Nature of obligation under LC
- Cases on Letters of Credit

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