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Letters of Credit in Banking Transactions

ANNOTATION

LETTERS OF CREDIT IN BANKING TRANSACTIONS

By
SEVERIANO S. TABIOS

—————

§ I. Introduction, p. 378
§ II. Nature and Importance of Letters of Credit, p. 379
§ III. Laws Governing A Letter of Credit Transaction, p.
380
§ IV. Parties To A Letter of Credit Transaction, p. 381
§ V. Responsibilities of Banks in Commercial Credit
Transactions, p. 382
§ VI. Liability in Commercial Credit Transactions, p. 384

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§ I. Introduction

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The decision of the Supreme Court in Bank of America vs.

Court of Appeals, G.R. No. 105395, December 10, 1993, gives
bankers and their clients very instructive guidelines on the use of
letters of credit in banking transactions in international trade. In
that case, which involves an interpretation of the rights of parties
to a letter of credit, whereby Bank of America sought
reimbursement of the amount it had paid to Inter-Resin
Industrial Corporation on a letter of credit received by the bank
by registered mail, which turned out to be spurious, the Supreme
Court after giving a very instructive discourse on the nature of
letters of credit in international trade declared that the bank
could recover from Inter-Resin Industrial Corporation on the
latter’s partial availment as beneficiary of the letter of credit,
because on the basis of evidence the bank did not assume the

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responsibility of a confirming bank.

Because of the importance of letters of credit in banking
transactions involving international trade, this brief study is
presented to guide advocates in handling letters of credit for
their clients.

§ II. Nature and Importance of Letters of Credit

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. (Bank of
America vs. Court of Appeals, supra, citing William S.
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Shaterian, Export-Import Banking: The Instruments and

Operations Utilized by American Exporters and Importers and
their Banks in Financing Foreign Trade [The Ronald Press
Company: New York, 1947, pp. 284-374], James J. White &
Robert S. Summers (eds), Uniform Commercial Code [West
Publishing Co.: St. Paul, 1988] pp. 806-883, and John H. Jacson
and William J. Davey, Legal Problems of International
Economic Relations: Cases, Materials and Text on the National
and International Economic Relations, 2nd Ed., [West
Publishing Co.: St. Paul] pp. 52-63). To break the impasse, the
buyer may be required to contract a bank to issue a letter of
credit in favor of the seller so that, by virtue of the 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 the 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.
(Bank of America vs. Court of Appeals, et al., supra.)
Once the letter of credit is established, the seller ships the
goods to the buyer and in the process secures the required
shipping documents or 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 with what the letter of credit

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requires. The bank then obtains possession of the documents

upon paying the seller. The transaction is completed when the
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buyer reimburses the issuing bank and acquires the documents

entitling him to the goods. Under this arrangement, 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. (Bank of
America vs. Court of Appeals, et al., supra.)
What characterizes letters of credit, as distinguished from
other accessory contracts, 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. By this so-called “independence principle”,
the bank determines compliance with the letter of credit only by
examining the shipping documents presented; it is precluded
from determining whether the main contract is actually
accomplished or not. (Bank of America vs. Court of Appeals, et.
al., supra.)

§ III. Laws Governing A Letter of Credit Transaction

According to the Supreme Court, since the impact of

commercial credit instruments transcends national boundaries, it
being a product of international commerce, it is thus not
uncommon to find a dearth of national law that can adequately
provide for its governance. Our own Code of Commerce
basically introduces only its concept under Articles 567 to 572,
It is no wonder then why great reliance has been placed on
commercial usage and practice, which, in any case, can be
justified by the universal acceptance of the autonomy of
contracts rule. The rules were later developed into what is now
known as the Uniform Customs and Practice for Documentary
Credits (“U.C.P.”) issued by the International Chamber of
Commerce. It is by no means a complete text by itself, for, to be
sure, there are other principles, which, although part of lex

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mercatoria, are not dealt with in the U.C.P. (Bank of America vs.
Court of Appeals, et, al., supra.)
The Uniform Customs and Practices for documentary credits
were first published in 1933. The current version was adopted
by the International Chamber of Commerce Council in 1983 and

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published as Publication No. 400 in July of that year. This

current version has the blessing of the United Nations
Commission on International Trade Law (UNCITRAL). The
Uniform Customs and Practices are not “law” because of the act
of any legislative or court, but because they have been explicitly
and implicitly made part of the contract of letters of credit.
Many of the letters of credit in the United States are governed by
the Uniform Customs and Practices and not by the UCC
(Uniform Commercial Code). (White & Summers, Op. Cit., pp.
881-883).
In the case of Bank of P.I. vs. De Nery, 35 SCRA 256 (1970),
the Supreme Court declared that the observance of the U.C.P. is
justified by Article 2 of the Code of Commerce which expresses
that, in the absence of any particular provision in the Code of
Commerce, commercial transactions shall be governed by
usages and customs generally observed. It further observed that
there being no specific provisions which govern the legal
complexities arising from transactions involving letters of credit
not only between or among banks themselves but also between
banks and the seller or the buyer, as the case may be, the
applicability of the U.C.P. is undeniable. Furthermore, in the
case of FEATI Bank and Trust Co. vs. Court of Appeals, 196
SCRA 576 (1991), the Supreme Court accepted the application
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of the international commercial credit regulatory set of rules in

our jurisdiction to the extent of their pertinency.

§ IV. Parties to A Letter of Credit Transaction

There are several parties to a letter of credit transaction. These

parties are the following:

1. The Buyer who procures the letter of credit and obliges

himself to reimburse the issuing bank upon receipt of
the documents of title. He is the party who initiates the
operation of the letter of credit transaction as buyer of
the merchandise and also of the credit instrument. His
contract is with the bank which is to issue the
instrument and is represented by the Commercial Credit
of Agreement form which he signs, supported by the
mutually made promises contained in the Agreement.
(Shaterian, Op. Cit., pp. 291-292).
2. The Opening Bank which is usually the buyer’s bank
which issues the letter of credit and undertakes to pay
the seller

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upon receipt of the draft and proper documents of titles

and to surrender the documents to the buyer upon
reimbursement. Also known as the Issuing Bank,
because it actually issues the instrument, it should be a
strong bank, well known and well regarded in
international trading circles. In this connection, the

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purposes of commercial credit may not be readily

accomplished unless the opening bank is well known
and well regarded. (Shaterian, Op. Cit., p. 292)
3. The Seller who in 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 called 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 as beneficiary of the letter of credit 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 if made within the terms of the
instrument, even though he has not given the bank any
direct consideration for the bank’s promises contained
in the instrument. In this regard, in order to support the
instrument as a two-sided contract, supported by
mutually given considerations, the courts seem to hold
that the commission paid or to be paid by the buyer to
the bank is also the consideration flowing from the
seller to the bank. (Shaterian, Op. Cit., p. 292).
4. The Correspondent Bank which may be an Advising
Bank to convey to the seller the existence of the credit
or a Confirming Bank which will lend credence to the
letter of credit issued by a lesser known issuing bank or
a Paying Bank which undertakes to encash the drafts
drawn by the exporter. Furthermore, another bank
known as 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.

§ IV. Responsibilities of Banks in Commercial Credit

Transactions
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The responsibilities of the different banks involved in

commercial credit transactions vary, depending on their
respective roles in the transactions. Thus, if the beneficiary is to
be advised by the issuing bank by cable, the services of an
Advising or Notifying
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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 a 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 situation, 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. In other words, the Confirming Bank
assumes primary liability to the seller as if it had issued the letter
of credit. (FEATI Bank & Trust Co. vs. Court of Appeals, 196
SCRA 576 (1991). In this regard, the Confirming Bank receives
a commission for its confirmation from the Issuing Bank which
the Issuing Bank, in turn, passes on to the buyer of the
merchandise. (Shaterian, Op. Cit., pp. 294-295).
Moreover, 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.
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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 maintains 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 the Issuing Bank does not concern him. (Shaterian,
Op. Cit., pp. 293-294).
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

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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 also. By negotiating
the beneficiary’s drafts, the 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
drawer’s signature, as the drawer’s contingent liability, as
drawer, continues until discharged by the actual payment of the
bills of exchange. (Shaterian, Op. Cit., p. 293).

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§ VI. Liability in Commercial Credit Transactions

It is a settled rule in commercial transactions involving letters of

credit that the documents tendered must strictly conform to the
terms of the letter of credit. The documents tendered by the
beneficiary must include all documents required by the letter. A
correspondent 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 the issuing bank, as the case may be, the money
thus paid to the beneficiary. Thus, the rule of strict compliance
where no discretion to waive any requirements is allowed should
be followed. (FEATI Bank & Trust Co. vs. Court of Appeals,
196 SCRA 576 (1991).
However, 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 had 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. (Bank
of America vs. Court of Appeals, et al., supra.)

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