At the core of the present controversy is the applicability of the independence principle and fraud exception rule in letters of credit. Thus, a discussion of the nature and use of letters of credit, also referred to simply as credits, would provide a better perspective of the case.chanroblesvirtuallawlibrary

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.[29]chanroblesvirtuallawlibrary

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.[30] 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.[31]chanroblesvirtuallawlibrary

There are three significant differences between commercial and standby credits. First, commercial credits involve the payment of money under a contract of sale.

Such credits become payable upon the presentation by the seller-beneficiary of documents that show he has taken affirmative steps to comply with the sales agreement. In the standby type, the credit is payable upon certification of a party's nonperformance of the agreement. The documents that accompany the beneficiary's draft tend to show that the applicant has not performed. The beneficiary of a commercial credit must demonstrate by documents that he has performed his contract. The beneficiary of the standby credit must certify that his obligor has not performed the contract.[32]chanroblesvirtuallawlibrary

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.[33] A letter of credit, however, changes its nature as different transactions occur and if carried through to completion ends up as a binding contract between the issuing and honoring banks without any regard or relation to the underlying contract or disputes between the parties thereto.[34]chanroblesvirtuallawlibrary

Since letters of credit have gained general acceptability in international trade transactions, the ICC has published from time to time updates on the Uniform Customs and Practice (UCP) for Documentary Credits to standardize practices in the letter of credit area. The vast majority of letters of credit incorporate the UCP.[35] First published in 1933, the UCP for Documentary Credits has undergone several revisions, the latest of which was in 1993.[36]chanroblesvirtuallawlibrary

In Bank of the Philippine Islands v. De Reny Fabric Industries, Inc.,[37] this Court ruled that the observance of the UCP is justified by Article 2 of the Code of Commerce which provides that in the absence of any particular provision in the Code of Commerce, commercial transactions shall be governed by usages and customs generally observed. More recently, in Bank of America, NT & SA v. Court of Appeals,[38] this Court ruled 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 UCP is undeniable.chanroblesvirtuallawlibrary

Article 3 of the UCP provides that credits, by their nature, are separate transactions from the sales or other contract(s) on which they may be based and banks are in no way concerned with or bound by such contract(s), even if any reference whatsoever to such contract(s) is included in the credit. Consequently, the undertaking of a bank to pay, accept and pay draft(s) or negotiate and/or fulfill any other obligation under the credit is not subject to claims or defenses by the applicant resulting from his relationships with the issuing bank or the beneficiary. A beneficiary can in no case avail himself of the contractual relationships existing between the banks or between the applicant and the issuing bank.chanroblesvirtuallawlibrary

Thus, the engagement of the issuing bank is to pay the seller or beneficiary of the credit once the draft and the required documents are presented to it. The so-called independence principle assures the seller or the beneficiary of prompt payment independent of any breach of the main contract and precludes the issuing bank from determining whether the main contract is actually accomplished or not. Under this principle, banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any documents, or for the general and/or particular conditions stipulated in the documents or superimposed thereon, nor do they assume any liability or responsibility for the description, quantity, weight, quality, condition, packing, delivery, value or existence of the goods represented by any documents, or for the good faith or acts and/or omissions, solvency, performance or standing of the consignor, the carriers, or the insurers of the goods, or any other person whomsoever.[39]chanroblesvirtuallawlibrary

The independent nature of the letter of credit may be: (a) independence in toto where the

credit is independent from the justification aspect and is a separate obligation from the underlying agreement like for instance a typical standby; or (b) independence may be only as to the justification aspect like in a commercial letter of credit or repayment standby, which is identical with the same obligations under the underlying agreement. In both cases the payment may be enjoined if in the light of the purpose of the credit the payment of the credit would constitute fraudulent abuse of the credit.[40]chanroblesvirtuallawlibrary

Can the beneficiary invoke the independence principle?chanroblesvirtuallawlibrary

Petitioner insists that the independence principle does not apply to the instant case and assuming it is so, it is a defense available only to respondent banks. LHC, on the other hand, contends that it would be contrary to common sense to deny the benefit of an independent contract to the very party for whom the benefit is intended. As beneficiary of the letter of credit, LHC asserts it is entitled to invoke the principle.chanroblesvirtuallawlibrary

As discussed above, in a letter of credit transaction, such as in this case, where the credit is stipulated as irrevocable, there is a definite undertaking by the issuing bank to pay the beneficiary provided that the stipulated documents are presented and the conditions of the credit are complied with.[41] Precisely, the independence principle liberates the issuing bank from the duty of ascertaining compliance by the parties in the main contract. As the principles nomenclature clearly suggests, the obligation under the letter of credit is independent of the related and originating contract. In brief, the letter of credit is separate and distinct from the underlying transaction.chanroblesvirtuallawlibrary