LETTERS OF CREDIT is to issue the instrument and is represented by the
Commercial Credit Agreement form which he signs,
NATURE AND IMPORTANCE
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 the 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. (Transfield
Philippines v. Luzon Hydro Co.) To break the impasse,
the buyer may be required to contract a bank to issue a
letter of credit, the issuing bank can authorize the seller
to draw drafts and engage to pay them upon their
presentment simultaneously with the tender of
documents required by the letter of credit. The buyer and
seller agree on what documents are to be presented for
payment, but ordinarily they are documents of title
evidencing or attesting to the shipment of the goods to
the buyer.
Once the letter of credit is established, the seller ships
the goods to the buyer and in the process secures the
required shipping documents and documents of title. To
get paid, the seller executes a draft and presents it
together with the required documents to the issuing
bank.
The issuing bank redeems the draft and pays cash to the
seller if it finds that the documents submitted by the
seller conform to what the letter of credit requires. The
bank then obtains possession of the documents upon
paying the seller. The transaction is completed when the
buyer reimburses the issuing bank and acquires the
documents entitling him to the goods. The seller gets
paid only if he delivers the documents of title over the
goods while the buyer acquires the said documents and
control over the goods only after reimbursing the bank.
INDEPENDENCE PRINCIPLE
What characterizes letters of credit, as distinguished
from other accessory contract, is the engagement of the
issuing bank to pay the seller once the draft and the
required shipping documents are presented to it. In turn,
this arrangement assures the seller of prompt payment,
independent of any breach of the main sales contract.
LAWS GOVERNING A LETTER OF CREDIT
TRANSACTION
Uniform Customs and Practice for Documentary Credits
(UCP) issued by the International Chamber of
Commerce
PARTIES TO A LETTER OF CREDIT TRANSACTION
1. Buyerprocures the letter of credit and obliges
himself to reimburse the issuing bank upon receipt of the
documents of title. He is the one initiating the operation
of the transaction as buyer of the merchandise and also
of the credit instrument. His contract with the bank which
supported by the mutually made promises contained in
the agreement.
2. Opening bankusually the buyers bank which issues
the letter of credit and undertakes to pay the seller upon
receipt of the draft and proper documents of titles to
surrender the documents to the buyer upon
reimbursement. As it is the one issuing the instrument, it
should be a strong bank, well known and well regarded
in international trading circles.
3. Sellerin compliance with the contract of sale, ships
the goods to the buyer and delivers the documents of
title and draft to the issuing bank to recover payment. He
is also the beneficiary of the credit instrument because
the instrument is addressed to him and is in his favor.
While the bank cannot compel the seller to ship the
goods and avail of the benefits of the instruments,
however, the seller may recover from the bank the value
of his shipment is made within the terms of the
instrument, even though he hasnt given the bank any
direct consideration for the banks promises contained in
the instrument.
4. Correspondent bank/advising bankto convey to the
seller the existence of the credit or a confirming bank
which will lend credence to the letter of credit issued by
the lesser known issuing bank or paying bank which
undertakes to encash the drafts drawn by the exporter.
Furthermore, another bank known as the negotiating
bank may be approached by the buyer to have the draft
discounted instead of going to the place of the issuing
bank to claim payment
RESPONSIBILITIES OF BANKS IN COMMERCIAL
CREDIT TRANSACTIONS
If the beneficiary is to be advised by the issuing bank by
cable, the services of an ADVISING OR NOTIFYING
BANK must always be utilized.
The responsibility of the NOTIFYING BANK is merely to
convey or transmit to the seller or beneficiary the
existence of the credit. However, if the beneficiary
requires that the obligation of the issuing bank shall also
be made the obligation of the bank to himself, there is
what is known as a confirmed commercial credit and the
bank notifying the beneficiary of the credit shall become
a confirming bank. In this case, the liability of the
confirming bank is primary and it is as if the credit were
issued by the issuing and confirming banks jointly, thus
giving the beneficiary or a holder for value of drafts
drawn under the credit, the right to proceed against
either or both banks, the moment the credit instrument
has been breached.
The paying bank on which the drafts are to be drawn it
may be the issuing bank or the advising bank. If the
beneficiary is to draw and receive payment in his own
currency, the advising bank may be indicated as the
paying bank also. When the draft is to be paid in this
manner, the paying bank assumes no responsibility but
merely pays the beneficiary and debits the payment
immediately to the account which the issuing bank has
with it. If the issuing bank has no account with the paying
bank, the paying bank reimburses itself by drawing a bill
of exchange on the issuing bank, in dollars, for the
equivalent of the local currency paid to the beneficiary,
at the buying rate for dollar exchange. The beneficiary is
entirely out of the transaction because his draft is
completely discharged by the payment, and the credit
arrangement between the paying bank and issuing bank
does not concern him.
If the draft contemplated by the credit instrument, is to
be drawn on the issuing bank or on other designated
banks not in the city of the seller, any bank in the city of
the seller which buys or discounts the draft of the
beneficiary becomes a negotiating bank. As a rule,
whenever, the facilities of an advising or notifying bank
are used, the beneficiary is apt to offer his drafts to the
advising bank for negotiation, thus giving the advising
bank the character of a negotiating bank becomes an
endorser and bona fide holder of the drafts and within
the protection of the credit instrument. It is also protected
by the drawers signature, as the drawers contingent
liability, as drawer, continues until discharged by the
actual payment of the bills of exchange.
LIABILITY IN COMMERCIAL CREDIT
TRANSACTIONS
A commercial bank which departs from what has been
stipulated under the letter of credit, as when it accepts a
faulty tender, acts on its own risk, and it may not
thereafter be able to recover from the buyer or issuing
bank, as the case may be, the money thus paid to the
beneficiary.
In the case of a discounting arrangement, wherein a
negotiating bank pays the draft of a beneficiary of a letter
of credit in order to save such beneficiary from the
hardship of presenting the documents directly to the
issuing bank, the negotiating bank can seek
reimbursement of what has been paid to the beneficiary
who as drawer of the draft continues to assume a
contingent liability thereon. Thus, the negotiating bank
has the ordinary right of recourse against the seller or
beneficiary in the event of dishonor by the issuing bank.
PROTOTYPE EXPORT TRANSACTION
1. PROFORMA INVOICEall the particulars for the
proposed shipment which are then known to the buyer
2. PRICE QUOTATION FAS AND CIFFAS stands for
free alongside which means that the seller will be
responsible for the cost and risks of the goods
alongside an overseas vessel at the stated location:
the buyer bears the costs and risks from that point. CIF
on the other hand means cost, freight and insurance,
that in exchange for this stated price, the seller
undertakes not only to supply the goods but also to
obtain and pay for insurance and bear the freight
charges to the stated pointy.
3. BUYERS PURCHASE ORDER
4. LETTER OF CREDIT
a. One way for a seller to be assured of payment is
to ship goods under a negotiable bill of lading
and arrange for a bank in buyers city to hold the
bill of lading until the buyer pays the draft in the
usual foreign sale this arrangement for securing
payment of the price is not adequate.
b. In some situations, sellers may need assurance
of payment even before the time of payment.
This problem arises in contracts which call for
the manufacture of goods to the buyers
specifications.
c. Although the proforma invoice may not specify,
the seller will expect the letter of credit to be
confirmed by the local bank in its location. But
why does a local bank confirm rather than issue
a letter of credit? The bank that issues the letter
of credit needs assurance that it will be
reimbursed by the buyer, on whose behalf it
pays the seller. The buyers bank can take steps
to minimize or remove the hazards. It will
receive the negotiable bill of lading controlling
the goods which will provide security for the
customers obligation to reimburse the bank; in
addition, the buyers own bank can judge in the
light of its knowledge of his financial standing
whether added security is needed and can insist
on such security before it issues the letter of
credit.
d. To meet the sellers letter of credit requirements,
the buyer will request its bank to arrange for the
issuance of a letter of credit which will comply
with the terms of the proforma invoice. The
buyer will then sign a detailed application and
agreement for commercial credit prepared by
the bank. The issuing bank, after approving the
buyers credit standing transmits a letter of credit
by cable to the confirming bank. This confirming
bank will then deliver to seller a document
advising the latter that the issuing bank opened
a letter of credit in its favor and adding the
confirming banks confirmation. In this
arrangement, the seller is assured of payment of
its sight drafts drawn on the confirming bank in
the amount of the total amount of the sale,
provided it presents the documents called for in
the letter of credit. An examination of the letter of
credit will also reveal that the bill of lading is to
be consigned to the order of the buyers bank,
thereby giving the bank control over the goods,
with the consequent security for its claim against
the buyer.
5. ACCEPTANE; SHIPMENT
a. On the receipt of the confirmed letter of credit,
the seller will send the order acknowledgment.
This document will repeat the description and
price of the goods which has also appeared on
 the proforma invoice and states the number and
expiration date of the letter of credit.
b. Further, the arrival of the letter of credit is the
go-signal for the seller to send the goods. The
seller then prepares the commercial invoice
which provides a complete record of the
transaction and is an important source of
information to such interested parties as a bank
discounting a draft or an underwriting extending
issuance.
c. As the time of shipment approaches, the seller
will contact its forwarder and give its shipping
instructions. It will inform that to comply with the
requirements of the letter of credit, the bill of
lading must be made to the order of the issuing
bank. It will also send copies of the commercial
invoice, a packing list, and a Shippers export
declaration. When the forwarder receives these
documents, he takes over all further
documentation as the agent of the shipper, the
latter merely has to dispatch the goods from the
factory in accordance with the forwarders
instructions.
d. The seller will then send the truck to the pier
where they are delivered to the ocean carriers
receiving clerk who signs the dock receipt. The
dock receipt is a form supplied by the ocean
carrier which contains information relevant to the
shipping of the bearings such as the number of
the pier, and the name of the ship. The dock
receipt is non-negotiable and serves as a
temporary receipt for the goods until they are
loaded on board.
e. The ocean carrier is soon ready to receive the
cargo. When the goods are loaded on board, the
steamship line issues a bill of lading which, to
comply with the letter of credit, is consigned to
order of the issuing bank. The bill of lading is
initially prepared by the forwarder on a form
supplied by the ocean carrier, it sets forth the
markings and numbers of the packages,
description of the goods, and the number and
weight of the packages. On its dorsal side, it will
state that the goods are received for shipment,
but a statement freight prepaid on board is
initiated by a representative of the steamship
line after loading. The forwarder then delivers
the bill of lading and the commercial invoice to
the seller.
6. INSURANCE
7. PAYMENT; THE DRAFT
a. The confirming bank stated in their letter that the
estimated CIF price would be available by your
drafts on us at sight when accompanied by the
listed documents.
b. Seller accordingly draws a sight draft on the
confirming bank. The sight draft together with
the commercial invoice, insurance certificate, full
set of bills of lading, and the packing list are
presented to the confirming bank. When the
bank receives these documents, it issues its
bank draft to sellers order and transmits the
documents by air mail to issuing bank, which will
reimburse the confirming bank.
c. The documents, sent by airmail, will reach the
buyers bank well ahead of the ocean shipment.
The time for release of the documents to buyer
and reimbursement to the bank will depend
upon the arrangement which was made between
the bank and buyer when the letter of credit was
initially established.
d. If the buyer plans to resell the goods, he may
not be able to reimburse the bank until the
goods arrive and he resells the goods. In this
event, the issuing bank may need to take further
steps to secure its claim against the buyer.
STANDBY LETTERS OF CREDIT OR GUARANTEES
Sometime ago, it is common in international dealings to
require the furnishing of a cash deposit as security, but
with the expansion of international trade this became
prohibitively expensive for the counterparty and in due
course gave way to a more convenient safeguard, the
provision of a written undertaking by a bank in favor of
the buyer or employer payable on demand. Demand
guarantees as substitute for cash are designed to
provide the beneficiary with a speedy monetary remedy
against the counterparty to the underlying contract and
to that end are primary in form and documentary in
character. The demand guarantee is expressed to be
payable solely on presentation of a written demand and
any other specified documents. Accordingly, any
demand within the maximum amount stated must in
principle be paid by the guarantor, regardless whether
the underlying contract has in fact been broken and
regardless of the loss actually suffered by the
beneficiary.
DEMAND GUARANTEES
A demand guarantee is an undertaking given for
payment of a stated or maximum sum of money on
presentation to the party giving the undertaking of a
demand or payment and such other documents as may
be specified in the guarantee within the period and in
conformity with the other conditions of the guarantee. It
is procured by the seller in favor of the buyer for the
latter to be paid in case the seller doesnt comply with
contract provisions. The economic burder is upon the
party who breaches the contract; employed typically in
construction contracts and contracts for international
sale of goods; and intended to safeguard the other party
against non-performance or late or defective
performance by the supplier or contractor.
DIRECT THIRD PARTY GUARANTEES
A guarantee that involves a minimum of three parties:
1. Account party/principalparty to the underlying
contract whose performance is required to be
 covered by the guarantee and who gives
instruction for its
2. Issuer/guarantorthe bank or other party
issuing the guarantee on behalf of the customer
the principal.
3. The beneficiarythe other party to the
underlying contract, in whose favor the
guarantee is issued.
Usually the guarantee in the 3-party structure is the
principals bank and carries on business in the same
country as the principal, whilst the beneficiary carries on
business in a foreign country.
Known as direct guarantees because the guarantee is
issued to directly by the principals bank, not by the local
bank in the beneficiarys country
PRINCIPAL TYPES OF DEMAND GUARANTEES
1. Tender or bid guarantee
a. Where tenders are invited it is often a condition
of consideration of the tender that the tenderer
undertakes to sign the contract if its awarded to
him, to procure the issue of any performance or
other guarantee required by the guarantee and
not to modify or withdraw his tender in the
meantime.
b. Purposesafeguard the beneficiary against
breach of such an undertaking
c. If the tenderer is successful and fails to sign the
contract and to furnish the requisite performance
or other guarantee, or withdraws his tender
before its expiry, the beneficiary can call upon
the guarantor to pay a specified sum designed
to compensate him for the trouble and expense
he suffered in re-awarding the contract, as well
as any additional cost of the contract.
2. Performance guarantee
a. Guarantee of the central performance of the
contract from commencement to completion.
b. Given for a specified percentage of the contract
sum.
c. But there are stages in the relationship between
the parties which precede and follow the central
performance, and there may be distinct
segments of liability to be covered within that
performance.
3. Advance payment or repayment guarantee
a. Underlying contract may entitle the principal to
payment of stated sums in advance of
performance.
b. The advance payment guarantee is designed to
secure the beneficiarys right to repayment of
the advance if the performance to which it
relates is not furnished.
4. Retention guarantee
a. Construction contracts usually provide for stage
payments against architects or engineers
certificate and for a specified percentage of the
amount certified in each certificate to be retained
by the employer for a specified period of time as
safeguard against defects.
b. The employer may be willing to release such
retention moneys against a retention guarantee
securing repayment of the released retention
moneys if defects are later found or if the
contractor fails to complete the contract.
5. Maintenance or warranty guarantee
a. Construction contracts usually provide that on
completion part of the retention moneys are to
be retained for a specified period to cover the
cost of any defects or malfunction which become
manifest during that period.
GUARANTEES NOT GUARANTEED BY
UNDERLYING CONTRACT
Not all guarantees are meant to be in favor of a party in
the underlying contract. For example are customs
guarantees which are issued to the customs to cover
any duty that may become payable when imported
goods which would be exempt from duty if re-exported
within a specified time are not in fact re-exported within
that time
THE LEGAL NATURE OF A DEMAND GUARANTEE
A demand guarantee is an abstract payment undertaking
that is, a promise of payment which, though intended to
preserve the beneficiary from loss in connection with the
underlying transaction is detached from the underlying
contract between principal and beneficiary and is in form
a primary undertaking between the guarantor and
beneficiary which becomes binding solely by virtue of its
issue.
A secondary guarantee is both secondary in form and
intent. The intention of the parties is that the guarantor
will be called upon to pay only if the principal defaults in
performance, and then only to the extent of the
principals liability and subject to any defenses available
to the principal.
A documentary credit is both primary in intent and form.
The parties to the underlying contract intend that the
bank issuing the credit is a to be the first port of call for
payment, and this is the effect of the agreement between
them. Whereas in the case of a suretyship guarantee,
the beneficiary cannot look to the guarantor without
establishing default by the principal, the reverse is true
of the documentary credit. The parties have designated
payment by the bank as the primary payment method
and only if it fails without fault on the part of the
beneficiary is entitled to - demand guarantee stands
between the suretyship guarantee and the documentary
credit - secondary in intent and primary in form.
Performance is due in the first instance from the
principal, and the guarantee is intended to be resorted to
only if the principal has failed to perform. But though this
is the intent of the parties, the guarantee isnt in form
linked to default under the underlying contract, nor there
is any question of performance to hold the beneficiary
harmless up to the agreed maximum; and the sole
condition of the guarantors payment liability is the
presentation of a demand and other documents
specified in the guarantee in the manner of and within
the period of the guarantee.
the guarantor has no concern with the underlying
contract and if demand is duly presented, payment must
be made despite allegations by the principal has fully
performed the contract - in the absence of established
fraud or other event constituting ground for non-
payment.
STANDBY LETTERS OF CREDIT
Undertaking primary in form but intended to be used
only as a fallback in the event of default by the
principal under the underlying contract.
Standby credit in legal perspective is simply another
term for demand guarantees.
The standby credit has developed into an all-
purpose financial support instrument embracing a
much wider range of uses than the normal demand
guarantee. Thus, standby credits are used to
support financial and non-financial obligations of the
principal and to provide credit enhancement for the
primary financial undertaking
KEY ELEMENTS IN A DEMAND GUARANTEE
1. The parties
2. A reference to the underlying contract
3. The amount or maximum amount of the
guarantee and any agreement for reduction or
increase
4. The currency of payment
5. The documents, if any, to be presented for the
purpose of a demand or of reduction or expiry
6. The expiry date or other expiry provisions as
well as any agreement for extension
Where it is intended that the guarantee shall not
commence until presentation of a particular
document, this fact should be specified.
Direct guarantee: principal, guarantor, and
beneficiary should be identified
Indirect guarantee: principal, instructing party,
beneficiary, and counter-guarantee
Central to the demand guarantee is its documentary
character: the rights and obligations it creates are to
be determined solely from the terms of the
guarantee and from any document presented in
accordance with the guarantee, without the need to
ascertain external facts
DISTINCT NATURE OF CONTRACTUAL
RELATIONSHIPS
Guarantors commitment to the beneficiary arises
solely by virtue of the issue of the guarantee and his
duty to pay is conditioned only on presentation of
demand and other specified documents in
conformity with the terms and within the duration of
the guarantee.
Principal is not concerned with the contract between
the guarantor and beneficiary.
Beneficiary has no concern with the contract
between the principal and guarantor.
The relationship of principal and guarantor has an
internal mandatethe guarantor is obliged to act in
accordance with the terms of the contract, failing
which he may forfeit his right to reimbursement but
those terms are of no concern to the beneficiary,
whose right to payment depends solely on his acting
on conformity with the terms of the guarantee.
In indirect contracts, there is an additional mandate
which has 2 facetsthe mandate from the
instructing party to the guarantor as to the issue of
the guarantee, which the guarantor as mandatory
must comply with if he accepts the instruction; and
two, the counter-guarantee which the guarantor
exacts from the instructing party as a precondition of
issuing the guarantee and which is separate from
the mandate.
1. Abstract character of the payment undertaking
binding solely by virtue of issue of the
guarantee, subject to the beneficiary not
rejecting it.
2. Independence of the guarantee from the
underlying transaction - Guarantee is separate
from that contract and the rights and obligations
created by the guarantee are independent of
those arising under the underlying contract. In
the absence of established fraud by the
beneficiary, the guarantor is not entitled to
refuse payment and the principal is not entitled
to have payment restrained merely because of a
dispute between the principal and beneficiary.
3. Independence of the guarantee from the
principal-guarantor relationshipthe guarantee
is separate from the contract between the
principal and the guarantor is not entitled to
invoke a breach of that contract.
4. Documentary character of guaranteeamount
and duration of the duty to pay, the conditions of
payment and termination of payment obligation
depend solely on the terms of the guarantee
itself and presentation of required documents.
5. Requirement of compliance of the demand with
the terms of the guarantee.
6. Guarantors duty of examination limited to
apparent good order of the document.
7. Guarantors duty limited the exercise of good
faith and reasonable care.
8. Independence of counter-guarantee from
guarantee.
9. Independence of counter-guarantee from
mandate received from instructing party