Published 20 July 2020, The Daily Tribune
The use of letters of credit (LC) has supported commercial transactions as far back as centuries ago. Back then, a letter of credit was exchanged between merchants, whereby the issuer of the letter promises payment and becomes liable to the addressee to enable the person named in the letter to procure goods or receive money in a commercial transaction. This arrangement has endured throughout history because of its hallmark reliability. Today, the letter of credit is facilitated through the banking system, and while it may operate differently from its centuries-old predecessor, it still fulfills the same purpose of assuring reliability and certainty of payment.
A letter of credit is any arrangement whereby a bank, acting upon the request of its client or on its own behalf, agrees to pay another against stipulated documents, provided that the terms of the credit are complied with. The Supreme Court has defined it as “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.” Generally, a commercial letter of credit involves the payment of money under a contract of sale, while a standby letter of credit involves non-sale transactions to secure the fulfillment of the applicant’s obligations.
There are three parties to a letter of credit: the applicant, the issuing bank, and the beneficiary. Thus, there are three distinct but intertwined contracts in a letter of credit transaction.
1. Between the applicant or the buyer and the beneficiary or the seller. The applicant procures the letter of credit, while the beneficiary undertakes to deliver the goods to the buyer and the documents of title to the bank in order to receive payment. This contract is governed by the law on sales for a commercial letter of credit, or the law on obligations for a standby letter of credit.
2. Between the beneficiary and the issuing bank. The issuing bank issues the letter of credit and undertakes to pay the beneficiary upon the latter’s strict compliance with the requirements in the letter of credit. This is governed by the terms of the letters of credit.
3. Between the applicant and the issuing bank. The applicant obliges himself to reimburse the bank upon receipt of the documents of title. This is governed by the terms of the application for the letter of credit
Letters of credit are commercial transactions which are governed, first and foremost, by their own provisions, by the Code of Commerce and laws specifically applicable to them, and by usage and custom.
Unlike accessory contracts, such as a surety or guarantee, letters of credit are distinct because they are governed by the Doctrine of Independence, or the Independence Principle. Under this doctrine, letters of credit are independent of the underlying transaction. Thus, as long as the proper documents are presented by the beneficiary, the issuing bank has the obligation to pay. The Independence Principle liberates the issuing bank from the duty of ascertaining compliance by the parties in the main contract. In short, it assures the beneficiary of certainty and promptness of payment, independent of any breach of the main contract.
There is, however, an exception to the doctrine of independence. The “Fraud Exception” exists when the beneficiary, for the purpose of drawing on the letter of credit, fraudulently presents to the confirming bank documents that contain, expressly or by implication, material representations of fact that to his knowledge are untrue. In this situation, the beneficiary may be prevented from collection on the letter of credit. In order for this exception to apply, the following essential elements must be present: 1) there is clear proof of fraud; 2) the fraud constitutes fraudulent abuse of the independent purpose of the letter of credit, and not only fraud under the main agreement; and 3) unless the beneficiary is restrained, irreparable injury might follow.
These universally recognized principles bolster the time-tested reliability of letters of credit. Their character of definiteness makes them more advantageous and desirable as security instruments, and indispensable in sustaining global trade and commerce.
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