LETTER OF CREDIT; DEFINITION AND NATURE OF LETTER OF CREDIT

By definition, a letter of credit is a written instrument whereby the writer requests or

authorizes the addressee to pay money or deliver goods to a third person and assumes
responsibility for payment of debt therefor to the addressee. (Transfield Philippines, Inc.
vs. Luzon Hydro Corporation, et al., G.R. No. 146717, November 22, 2004, [Tinga])
In Metropolitan Waterworks and Sewerage System vs. Daway , 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.
The letter of credit evolved as a mercantile specialty, and the only way to understand all
its facets is to recognize that it is an entity unto itself. The relationship between the
beneficiary and the issuer of a letter of credit is not strictly contractual, because both
privity and a meeting of the minds are lacking, yet strict compliance with its terms is an
enforceable right. Nor is it a third-party beneficiary contract, because the issuer must
honor drafts drawn against a letter regardless of problems subsequently arising in the
underlying contract. Since the banks customer cannot draw on the letter, it does not
function as an assignment by the customer to the beneficiary. Nor, if properly used, is it
a contract of surety ship or guarantee, because it entails a primary liability following a
default. Finally, it is not in itself a negotiable instrument, because it is not payable to
order or bearer and is generally conditional, yet the draft presented under it is often
negotiable. (supra)
Letters 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 and not
accessory contracts and while they are security arrangements, they are not converted
thereby into contracts of guaranty. What distinguishes letters of credit from other
accessory contracts, is the engagement of the issuing bank to pay the seller once the
draft and other required shipping documents are presented to it. They are definite
undertakings to pay at sight once the documents stipulated therein are presented.
(Metropolitan Waterworks and Sewerage System vs. Daway, G.R. No. 160732, June 21,
2004 [Azcuna])

LETTERS OF CREDIT; PARTIES TO A LETTER OF CREDIT; RIGHTS AND

OBLIGATIONS OF PARTIES
Letters of credit are employed by the parties desiring to enter into commercial
transactions, not for the benefit of the issuing bank but mainly for the benefit of the
parties to the original transactions. With the letter of credit from the issuing bank, the

party who applied for and obtained it may confidently present the letter of credit to the
beneficiary as a security to convince the beneficiary to enter into the business
transaction. On the other hand, the other party to the business transaction, i.e., the
beneficiary of the letter of credit, can be rest assured of being empowered to call on the
letter of credit as a security in case the commercial transaction does not push through,
or the applicant fails to perform his part of the transaction. It is for this reason that the
party who is entitled to the proceeds of the letter of credit is appropriately called
beneficiary. (Transfield Philippines, Inc. vs. Luzon Hydro Corporation, et al., G.R. No.
146717, November 22, 2004, [Tinga])
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. (Feati Bank & Trust Company vs. CA, G.R. No. 94209, April 30, 1991, [Gutierrez,
Jr.])
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. (Kronman
and Co., Inc. v. Public National Bank of New York, 218 N.Y.S. 616 [1926]; Shaterian,
Export-Import Banking, p. 292, cited in Agbayani, Commercial Laws of the Philippines,
Vol. 1, p. 76). 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. (Scanlon v. First National Bank of Mexico, 162 N.E. 567 [1928];
Shaterian, Export-Import Banking, p. 293, cited in Agbayani, Commercial Laws of the
Philippines, Vol. 1, p. 76)
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. (Shaterian, Export-Import Banking, p. 294, cited in
Agbayani Commercial Laws of the Philippines, Vol. 1, p. 77)
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 issuing bank and not with the beneficiary to
whom he assumes no liability. It follows therefore that when the petitioner refused to
negotiate with the private respondent, the latter has no cause of action against the
petitioner for the enforcement of his rights under the letter. (See Kronman and Co., Inc.
v. Public National Bank of New York, supra)
As earlier stated, there must have been an absolute assurance on the part of the
petitioner that it will undertake the issuing banks obligation as its own. Verily, the loan
agreement it entered into cannot be categorized as an emphatic assurance that it will
carry out the issuing banks obligation as its own. (supra)
The case of Scanlon v. First National Bank (supra) perspicuously explained the
relationship between the seller and the negotiating bank, viz:
It may buy or refuse to buy as it chooses. Equally, it must be true that it owes no
contractual duty toward the person for whose benefit the letter is written to discount or
purchase any draft drawn against the credit. No relationship of agent and principal, or of
trustee and cestui, between the receiving bank and the beneficiary of the letter is
established. (P.568)
Whether therefore the petitioner is a notifying bank or a negotiating bank, it cannot
be held liable. Absent any definitive proof that it has confirmed the letter of credit or has
actually negotiated with the private respondent, the refusal by the petitioner to accept
the tender of the private respondent is justified. (supra)
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 a guarantee. It may be observed that
the notifying bank is merely to follow the instructions of the issuing bank which is to
notify or to transmit the letter of credit to the beneficiary. (See Kronman v. Public
National Bank of New York, supra). Its commitment is only to notify the beneficiary. It
does not undertake any assurance that the 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 the

instructions 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 accept the 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 letter of credit.
Finally, even if we assume that the petitioner is a confirming bank, the petitioner
cannot be forced to pay the amount under the letter. As we have previously explained,
there was a failure on the part of the private respondent to comply with the terms of the
letter of credit. (Feati Bank & Trust Company vs. CA, G.R. No. 94209, April 30, 1991,
[Gutierrez, Jr.])
LETTERS OF CREDIT; DEFINITION AND NATURE OF LETTERS OF CREDIT
In commercial transactions, 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 interests 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.[1]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,
credits are also used in non-sale settings where they serve to reduce the risk of
nonperformance. Generally, credits in the non-sale settings have come to be known as
standby credits.[2] (Transfield Philippines, Inc. vs. Luzon Hydro Corporation, et al., G.R.
No. 146717, November 22, 2004, [Tinga])

Definition and Nature of Letter of Credit

By definition, a letter of credit is a written instrument whereby the writer requests or

authorizes the addressee to pay money or deliver goods to a third person and assumes
responsibility for payment of debt therefor to the addressee.[3] (Transfield Philippines,
Inc. vs. Luzon Hydro Corporation, et al., G.R. No. 146717, November 22, 2004, [Tinga])

In Metropolitan Waterworks and Sewerage System vs. Daway[4], 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.[5]

The letter of credit evolved as a mercantile specialty, and the only way to
understand all its facets is to recognize that it is an entity unto itself. The relationship
between the beneficiary and the issuer of a letter of credit is not strictly contractual,
because both privity and a meeting of the minds are lacking, yet strict compliance with
its terms is an enforceable right. Nor is it a third-party beneficiary contract, because the
issuer must honor drafts drawn against a letter regardless of problems subsequently
arising in the underlying contract. Since the banks customer cannot draw on the letter, it
does not function as an assignment by the customer to the beneficiary. Nor, if properly
used, is it a contract of suretyship or guarantee, because it entails a primary liability

following a default. Finally, it is not in itself a negotiable instrument, because it is not

payable to order or bearer and is generally conditional, yet the draft presented under it
is often negotiable.[6] (supra)

Letters of credit were developed for the purpose of insuring to a seller payment of
a definite amount upon the presentation of documents[7]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.[8]They are in effectabsolute undertakings to pay the money advanced or the
amount for which credit is given on the faith of the instrument. They are primary
obligations and not accessory contracts and while they are security arrangements, they
are not converted thereby into contracts of guaranty.[9]What distinguishes letters of
credit from other accessory contracts, is the engagement of the issuing bank to pay the
seller once the draft and other required shipping documents are presented to it.[10]They
are definite undertakings to pay at sight once the documents stipulated therein are
presented. (Metropolitan Waterworks and Sewerage System vs. Daway, G.R. No.
160732, June 21, 2004 [Azcuna])
INDEPENDENCE PRINCIPLE
The bank in determining compliance with the terms of the LC is required only to
examine the shipping document presented by the seller and is precluded from
determining whether the main contract is accomplished or not
DOCTRINE OF STRICT COMPLIANCE
The document tendered by the seller must strictly conform to the terms of the LC . The
correspondent bank which departs from what has been stipulated under the LC, as
when it accepts a faulty tender , acts on his own risk and may not thereafter recover
from the buyer or issuing bank , the money paid to the benefic
In short, the documents presented must comply w/ those stipulated on. In a LC, the
banks only deals w/ documents and not w/ goods.
Can a breach of contract be invoked against the Issuing Bank?
NO. Because if all the documents stipulated have been submitted and the IB finds that
they conform w/t the LC requires, then the IB must pay the seller. In a LC transaction
the banks deal only w/ documents not goods, so banks pays if the documents are OK
and gets reimbursed by the buyer. This relationship is independent so if ever the goods
are in bad condition, the applicant still pays the bank.
Note: A loan transaction may give rise to LC. An LC does not arise only because of
sale or importation. Example: Standby LC.
Standby Letter of Credit (SLC) it is a bank issued option on loan involving 3 parties:
the bank issuing the credit, the party requesting for such issuance (otherwise known as
the account party) and the beneficiary.
Under the terms of a SLC, the beneficiary has the right to trigger the loan option
(referred to as TAKING DOWN THE LOAN) if the account party fails to meet its
commitment, in w/c case the issuing bank disburses a specified sum to the beneficiary
and books an equivalent loan to its customer.

SLCs may support non-financial obligations such as those of bidders, or financial

obligations such as those of borrowers. In the latter case, the borrower purchases an
SLC and names the lender as beneficiary. Should the borrower default, the beneficiary
has the right to take down the SLC and receive the principal balance from the issuing
bank. The borrowers loan obligation is then passed to the bank.