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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 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. (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])

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 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.
[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])

[1] Bank of America v. Court of Appeals, G.R. No. 105395, 10 December 1993, 228 SCRA 357 citing William S.
Shaterian, Export-Import Banking: The Instruments and Operations Utilized by American Exporters and
Importers and Their Banks in Financing Foreign Trade, 284-374 (1947).
[2] E&H Partners v. Broadway Natl Bank, 39 F. Supp. 2d 275, (United States Circuit Court, S.D. New York) No. 96
Civ. 7098 (RLC), 19 October 1998 .
[3] 24 A Words and Phrases 590, Permanent Edition.
[4] G.R. No. 160732, June 21, 2004 [Azcuna]
[5] Prudential Bank v. Intermediate Appellate Court, 216 SCRA 257 (1992).
[6] Joseph, Letters of Credit: The Developing Concepts and Financing Functions, 94 Banking Law Journal 850-
851 [1977] cited in M. Kurkela, Letters of Credit under International Trade Law, 321 (1985).
[7] Ibid, p. 270.
[8] Isidro Climaco v. Central Bank of the Philippines, 63 O.G. No. 6, p. 1348.
[9] Insular Bank of Asia & America v. Intermediate Appellate Court, 167 SCRA 450 (1988).
[10] Bank of America, NT & SA v. Court of Appeals, 228 SCRA 357 (1993).

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.])