Quick answer

A letter of credit is the standard financing device in trade, particularly where a seller will not part with goods before payment and a buyer will not pay before shipment. Its structure involves at least three distinct contracts that must never be conflated: the CONTRACT OF SALE between the buyer (applicant) and the seller (beneficiary); the CONTRACT between the buyer and the ISSUING BANK, under which the bank agrees to issue the credit and the buyer to reimburse it; and the LETTER OF CREDIT itself, the bank's undertaking to pay the beneficiary upon presentation of the stipulated documents. A correspondent bank may also participate as an advising bank, which merely transmits the credit without undertaking to pay; a confirming bank, which adds its own undertaking; or a negotiating bank, which buys the drafts. Two principles govern. The first is the INDEPENDENCE PRINCIPLE: the letter of credit is independent of the underlying contract of sale, and the bank's obligation to pay arises upon the presentation of conforming documents regardless of any dispute between buyer and seller about the goods. Banks deal in DOCUMENTS, not in goods, services, or performance; a buyer's complaint that the goods are defective is therefore not a ground to enjoin the bank from paying, and the buyer's remedy is against the seller under the sale. The second is STRICT COMPLIANCE: the documents presented must conform strictly to the terms of the credit, and the bank may and must refuse a presentation that deviates, since it cannot bind the applicant to reimburse on documents the credit did not call for; the tolerance for discrepancy is narrow. The recognized exception to independence is FRAUD: where there is clear proof of fraud in the transaction, such as forged or fraudulent documents or fraud by the beneficiary amounting to an abuse of the credit, courts may enjoin payment, but the fraud must be established and not merely alleged, precisely because routine injunctions would destroy the commercial utility of the instrument. A related device is the STANDBY letter of credit, which functions as a guarantee: it is drawn upon only when the applicant DEFAULTS, yet it retains the independence principle, so the issuer pays against the beneficiary's stipulated statement of default without adjudicating the underlying dispute. So a letter of credit obliges the bank to pay against strictly conforming documents independently of the sale, subject only to a narrow fraud exception.

Three Contracts, Not One

The Other Banks

An advising bank merely transmits; a confirming bank adds its own undertaking; a negotiating bank buys the drafts.

The Independence Principle

The credit is INDEPENDENT of the underlying sale. Banks deal in DOCUMENTS, not goods, so a buyer's complaint that the goods are defective is NOT a ground to enjoin payment — the buyer's remedy is against the seller.

Strict Compliance

The documents must conform STRICTLY to the credit's terms. A deviating presentation may and must be refused, since the bank cannot bind the applicant to reimburse on documents the credit never called for. Tolerance for discrepancy is narrow.

The Fraud Exception and Standby Credits

Clear proof of FRAUD — forged or fraudulent documents, or abuse of the credit by the beneficiary — may justify enjoining payment, but it must be established, not merely alleged. A STANDBY letter of credit works as a guarantee, drawn only on the applicant's DEFAULT, yet still independent.

Frequently Asked Questions

Can a buyer stop a bank from paying under a letter of credit? Generally no. Under the independence principle the bank pays against conforming documents regardless of disputes about the goods. Only clear proof of fraud in the transaction may justify enjoining payment.

What does it mean that banks deal in documents? That the bank's obligation is determined solely by whether the documents presented conform to the credit, not by the quality, quantity, or delivery of the goods or the performance of the underlying contract.

What is strict compliance? The rule that documents presented under a letter of credit must conform strictly to its terms. A presentation that deviates may and must be refused, because the bank cannot bind the applicant to reimburse on non-conforming documents.

What is a standby letter of credit? One that functions as a guarantee, drawn upon only when the applicant defaults. It retains the independence principle, so the issuer pays against the beneficiary's stipulated statement of default.

This commentary is for general informational purposes only and does not constitute legal advice. For guidance specific to your situation, please consult a licensed attorney.

If you have questions about your rights or options under Philippine law, our firm is available to assist. You may reach us via Viber or WhatsApp, call us at 0995 433 5550, or send an email to vivasnobles@gmail.com. We look forward to hearing from you.