Mercantile Law

Transfield Philippines, Inc. v. Luzon Hydro Corporation, G.R. No. 146717, Nov. 22, 2004 “Independence Principle” and “Fraud Exception Rule” in Letters of Credit

FACTS:

Petitioner and respondent LHC entered into a Turnkey Contract whereby petitioner, was given the sole responsibility for the design, construction, commissioning, testing and completion of the a seventy (70)-Megawatt hydro-electric power station Project.

To secure performance of petitioner’s obligation on or before the target completion date, petitioner opened in favor of LHC two (2) standby letters of credit as “Securities”.

In the course of the project, petitioner requested several extensions allegedly due to force majeure occasioned by typhoon Zeb, barricades and demonstrations. 

LHC denied the requests. 

Meanwhile, foreseeing that LHC would call on the Securities pursuant to the Contract, petitioner advised respondent banks of the pending arbitration proceedings in connection with its alleged default in the performance of its obligations. 

Asserting that LHC had no right to call on the Securities, petitioner warned respondent banks that any transfer, release, or disposition of the Securities in favor of LHC would constrain it to hold respondent banks liable for liquidated damages. 

However, both banks informed petitioner that they would pay on the Securities if and when LHC calls on them.

LHC declared petitioner in default/delay in the performance of its obligations and demanded from petitioner the payment for each day of delay until actual completion of the Project. 

LHC likewise served notice that it would call on the securities for the payment of liquidated damages for the delay.

Petitioner filed a Complaint for Injunction.

However, employing the principle of “independent contract” in letters of credit, the trial court ruled that LHC should be allowed to draw on the Securities for liquidated damages.

On appeal, the CA issued a temporary restraining order, enjoining LHC from calling on the Securities.

Immediately after the expiration of the Injunction, LHC withdrew the total amount of US$4,950,000.00 from ANZ Bank.

The appellate court expressed conformity with the trial court’s decision that LHC could call on the Securities.

Hence, the instant Petition for Review.

ISSUE:

Whether the “Independence Principle” on letters of credit may be invoked by a beneficiary thereof.

RULING:

At the core of the present controversy is the applicability of the “independence principle” and “fraud exception rule” in letters of credit.

This Court reiterates that pursuant to the independence principle, the banks were under no obligation to determine the veracity of LHC’s certification that default has occurred. Neither were they bound by petitioner’s declaration that LHC’s call thereon was wrongful. 

To repeat, respondent banks’ undertaking was simply to pay once the required documents are presented by the beneficiary.

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. 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.

Given the nature of letters of credit, petitioner’s argument that it is only the issuing bank that may invoke the independence principle on letters of credit does not impress this Court. 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.

Letters of credit are employed by the parties desiring to enter into commercial transactions, not for the benefit of the issuing bank but mainly for the benefit of the parties to the original transactions. With the letter of credit from the issuing bank, the party who applied for and obtained it may confidently present the letter of credit to the beneficiary as a security to convince the beneficiary to enter into the business transaction. On the other hand, the other party to the business transaction, i.e., the beneficiary of the letter of credit, can be rest assured of being empowered to call on the letter of credit as a security in case the commercial transaction does not push through, or the applicant fails to perform his part of the transaction. It is for this reason that the party who is entitled to the proceeds of the letter of credit is appropriately called “beneficiary.”

Petitioner invokes the “fraud exception” principle, and averred that LHC’s call on the Securities is wrongful because it fraudulently misrepresented to ANZ Bank and SBC that there is already a breach in the Contract knowing fully well that this is yet to be determined by the arbitral tribunals.

Most writers agree that 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. 

The remedy for fraudulent abuse is an injunction. However, injunction should not be granted unless: (a) there is clear proof of fraud; (b) the fraud constitutes fraudulent abuse of the independent purpose of the letter of credit and not only fraud under the main agreement; and (c) irreparable injury might follow if injunction is not granted or the recovery of damages would be seriously damaged.

In the instant case, petitioner 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.

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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