Transfield Philippines, Inc.

vs Luzon Hydro Corporation

Summary Cases:

● Transfield Philippines vs Luzon Hydro, et al

Subject:

Letter of Credit (nature, independence principle, and fraud exception principle); Standby letter of credit

Facts:

The parties entered into a Turnkey Contract whereby Transfield, as Contractor, undertook to construct,
on a turnkey basis, a 70-Megawatt hydro-electric power station at the Bakun River in the provinces of
Benguet and Ilocos Sur (‘Project’).

To secure performance of its obligation on the target completion date, Transfield opened in favor of
Luzon Hydro Corp. (LHC) two standby letters of credit (‘securities’), each in the amount of USD 8.98
Million, with ANZ Bank and Security Bank.

In the course of the construction of the project, Transfield sought various extensions of time to complete
the Project citing several delaying factors such as the typhoon Zeb. LHC denied the requests. LHC
initiated arbitration proceedings against Transfield to determine the fact of default on the part of
Transfield.

Anticipating that LHC would call on the securities, Transfield wrote to the banks to warn them against
releasing any funds under the securities until after the arbitration dispute has been resolved. However,
both banks informed Transfield that they would pay on the Securities if and when LHC calls on them

Transfield filed an injunction action in court to restrain LHC and the banks from calling on and paying
under the standby letters of credit. Although the court initially granted a TRO, it denied Transfield’s right
to the injunction writ applying the principle of ‘independent contract’ in letters of credit.

Transfield contends that only the issuing banks, and not LHC, may invoke the independence principle.
Also, that the case falls under the ‘fraud exception rule’ of the independence principle because LHC
deliberately misrepresented the supposed existence of delay despite its knowledge that the issue was
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still pending arbitration.

Held:

Letter of Credit is not an ordinary contract

1. The letter of credit evolved as a mercantile specialty, and 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.

Letter of Credit is not an contract with stipulation pour autrui

2. A letter of credit is not 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 bank's
customer cannot draw on the letter, it does not function as an assignment by the customer to the
beneficiary.

Letter of Credit is not a contract of suretyship or guarantee

3. A letter of credit is not a contract of suretyship or guarantee, because it entails a primary liability
following a default.

Letter of Credit is not a negotiable instrument

4. A letter of credit 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.

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Definition of Letter of Credit

5. 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.

6. 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.

7. The use of credits in commercial transactions serves to reduce the risk of non-payment of the
purchase price under the contract for the sale of goods.

Standby Letter of Credit

8. However, credits are also used in non-sale settings where they serve to reduce the risk of
non-performance. Generally, credits in the non-sale settings have come to be known as standby credits.

Commercial L/C vs. Standby L/C

9. 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 non-performance 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.
Governing Law on Letters of Credit

10. Since letters of credit have gained general acceptability in international trade transactions, the
International Chamber of Commerce (ICC) has published from time to time updates on the Uniform
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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.

11. In Bank of the Philippine Islands v. De Reny Fabric Industries, Inc., the 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.

12. More recently, in Bank of America, NT & SA v. Court of Appeals, the 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.

Independence Principle

14. 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.

15. Consequently, the undertaking of a bank to pay, accept and pay drafts 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. 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.

16. A beneficiary can in no case avail himself of the contractual relationships existing between the banks
or between the applicant and the issuing bank.

17. The so-called ‘independence principle’ assures the seller /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.

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18. 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.

19. In a letter of credit transaction 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. Precisely, the independence principle
liberates the issuing bank from the duty of ascertaining compliance by the parties in the main contract.
The letter of credit is separate and distinct from the underlying transaction.

20. Petitioner's argument that any dispute must first be resolved by the parties, whether through
negotiations or arbitration, before the beneficiary is entitled to call on the letter of credit in essence would
convert the letter of credit into a mere guarantee. Jurisprudence has laid down a clear distinction
between a letter of credit and a guarantee in that the settlement of a dispute between the parties is not a
pre-requisite for the release of funds under a letter of credit. If a letter of credit is drawable only after
settlement of the dispute on the contract entered into by the applicant and the beneficiary, there would
be no practical and beneficial use for letters of credit in commercial transactions.

Issuing Bank and Beneficiary may invoke the independence principle

21. Given the nature of letters of credit, to say that the independence principle may only be invoked by
the issuing banks would render nugatory the purpose for which the letters of credit are used in
commercial transactions. As it is, the independence doctrine works to the benefit of both the issuing
bank and the beneficiary.

22. The party who is entitled to the proceeds of the letter of credit is appropriately called ‘beneficiary’.

23. Moreover, a careful perusal of the Turnkey Contract reveals the intention of the parties to make the
Securities answerable for the liquidated damages occasioned by any delay on the part of Transfield.
Thus, even without the use of the ‘independence principle,’ the Turnkey Contract itself bestows upon
LHC the right to call on the Securities in the event of default.

Fraud exception principle

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24. Fraud is an exception to the independence principle. Professor Dolan opines that the untruthfulness
of a certificate accompanying a demand for payment under a standby credit may qualify as fraud
sufficient to support an injunction against payment.

25. The remedy for fraudulent abuse is an injunction. However, injunction should not be granted unless:

there is clear proof of fraud;

the fraud constitutes fraudulent abuse of the independent purpose of the letter of credit and not only
fraud under the main agreement; and
irreparable injury might follow if injunction is not granted or the recovery of damages would be seriously
damaged.
26. Transfield failed to show that it has a clear and unmistakable right to restrain LHC's call on the
Securities which would justify the issuance of preliminary injunction. By petitioner's own admission, the
right of LHC to call on the Securities was contractually rooted and subject to the express stipulations in
the Turnkey Contract.

27. The pendency of the arbitration proceedings would not per se make LHC's draws on the Securities
wrongful or fraudulent for there was nothing in the Contract which would indicate that the parties
intended that all disputes regarding delay should first be settled through arbitration before LHC would be
allowed to call upon the Securities.

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