November 22, 2004]

TRANSFIELD PHILIPPINES, INC. vs. LUZON HYDRO

CORPORATION, AUSTRALIA and NEW ZEALAND BANKING
GROUP LIMITED and SECURITY BANK CORPORATION
TINGA, J.:

FACTS:
Transfield entered into a Turnkey Contract with LHC. To secure
performance on or before the target completion date, Transfield
opened in favor of LHC two Standby Letters of Credit. Transfield
defaulted. They submitted the dispute to arbitration. Eventually,
LHC withdrew the securities for the payment of liquidated damages
for the delay. Transfield contends that LHC should have waited first
for the resolution of the arbitration. The Court upheld LHCs right to
collect pursuant to the independence principle.
DOCTRINE:
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.

Transfield and Luzon Hydro Corporation (LHC) entered into a

Turnkey Contract whereby Transfield as Turnkey Contractor,
undertook to construct, on a turnkey basis, a 70 Megawatt
hydro-electric power station (the Project).
The Turnkey Contract provides that: (1) the target
completion date of the Project shall be on 1 June 2000, or
such later date as may be agreed upon; and (2) Transfield is
entitled to claim extensions of time (EOT). Further, in case of
dispute, the parties are bound to settle their differences
through mediation, conciliation and such other means.
To secure performance on or before the target completion
date, or such other time agreed upon, Transfield opened in

favor of LHC two standby letters of credit (the Securities):

the first was with Australia and New Zealand Banking Group
Limited (ANZ Bank) while the second was with Security Bank
Corporation (SBC).
In the course of the construction of the project, Transfield
sought various EOT to complete the Project. LHC denied the
requests, however.
In the arbitration proceedings that followed, the common
issues presented were: [1) whether typhoon Zeb and any of
its associated events constituted force majeure to justify the
extension of time; and [2) whether LHC had the right to
terminate the Turnkey Contract for failure to complete the
Project on target date.
Meanwhile, foreseeing that LHC would call on the Securities,
Transfield advised respondent banks of the pending
arbitration. Asserting that LHC had no right to call on the
Securities until the resolution thereof, Transfield warned the
banks that any transfer, release, or disposition of the
Securities in favor of LHC would constrain it to hold banks
liable for liquidated damages. Despite this, both banks
informed Transfield that they would pay on the Securities if
and when LHC calls on them.
LHC thus declared Transfield in default/delay and demanded
payment of US$75,000.00 for each day of delay. At the same
time, LHC served notice that it would call on the securities
for the payment of liquidated damages for the delay.
Transfield filed a Complaint for Injunction, with prayer for
temporary restraining order and writ of preliminary
injunction seeking to restrain LHC from calling on the
Securities and the banks from transferring, paying on, or in
any manner disposing of the Securities.
RTC: Denied. Employing the principle of independent
contract in letters of credit, it ruled that LHC should be
allowed to draw on the Securities for liquidated damages.
The banks were mere custodians of the funds and as such
they were obligated to transfer the same to the beneficiary
for as long as the latter could submit the required
certification of its claims.
Transfield appealed, contending that LHCs call on the
Securities was premature considering that the issue of its
default had not yet been resolved with finality. It asserted
that until the fact of delay could be established, LHC had no
right to draw on the Securities for liquidated damages.
Ultimately, LHC withdrew from ANZ Bank.

CA: LHC could call on the Securities pursuant to the first

principle in credit law that the credit itself is independent of
the underlying transaction and that as long as the
beneficiary complied with the credit, it was of no moment
that he had not complied with the underlying contract.

WON LHC has the right to call and draw on the securities
before the resolution of petitioners and LHCs disputes.
YES.

Transfield contends that the courts below improperly relied

on the independence principle on letters of credit when
this case falls squarely within the fraud exception rule.
LHC deliberately misrepresented the supposed existence of
delay despite its knowledge that the issue was still pending
arbitration, petitioner continues.
Respondent Banks invoked the independence principle and
argues that it was under no obligation to look into the
validity or accuracy of the certification submitted by LHC or
into the latters capacity or entitlement to so certify.
Moreover, since the Standby Letter of Credit had been fully
drawn, the prayer for preliminary injunction had been
rendered moot and academic.

Applicability of the independence principle and fraud

exception rule in letters of credit
The letter of credit 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.
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.
It reduces the risk of non-payment 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 non-performance. Generally, credits in
the non-sale settings have come to be known as standby
credits.
Commercial
Standby
involve the payment of money under a
involve the performance of a
contract of sale
become payable upon the presentation by
the seller-beneficiary of documents that
payable upon certification o
show he has taken affirmative steps to
performance of the agreeme
comply with the sales agreement
beneficiary of a commercial credit must
beneficiary of the standby c
demonstrate by documents that he has
that his obligor has not perf
performed his contract
contract
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. It is a binding contract between
the issuing and honoring banks without any regard or relation to
the underlying contract or disputes between the parties thereto.
Uniform Customs and Practice (UCP) provides that credits,
by their nature, are separate transactions from the sales or
other contracts on which they may be based and banks are
in no way concerned with or bound by such contracts, even
if any reference whatsoever to such is included in the
credit.
Consequently, the undertaking of a bank to pay under the
credit is not subject to claims or defenses by the applicant
resulting from his relationships with the issuing bank or the
beneficiary.
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.

WON the beneficiary can invoke the independence

principle? YES.
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. 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.
Transfields argument that any dispute must first be
resolved before the beneficiary is entitled to call on the
letter of credit in essence would convert the letter of credit
into a mere guarantee.
Letter of credit vs. guarantee:
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.
Transfield failed to show that it has a clear and unmistakable
right to restrain LHCs call on the Securities. By its own
admission, the right of LHC to call on the Securities was
contractually rooted and subject to the express stipulations
in the Turnkey Contract. It is plain and unequivocal in that it
conferred upon LHC the right to draw upon the Securities in
case of default.

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.
Of course, prudence should have impelled LHC to await
resolution of the pending issues before the arbitral tribunals
prior to taking action to enforce the Securities. But, as
earlier stated, the Turnkey Contract did not require LHC to
do so and, therefore, it was merely enforcing its right.
REMEDY: Transfield could have incorporated in its Contract
with LHC, a proviso that only the final determination by the
arbitral tribunals that default had occurred would justify the
enforcement of the Securities. However, it did not do so;
hence, it would have to live with its inaction.
With respect to the issue of whether the respondent banks
were justified in releasing the amounts due under the
Securities, this Court reiterates that pursuant to the
independence principle the banks were under no obligation
to determine the veracity of LHCs certification that default
has occurred. Neither were they bound by petitioners
declaration that LHCs call thereon was wrongful. To repeat,
respondent banks undertaking was simply to pay once the
required documents are presented by the beneficiary.
At any rate, should petitioner finally prove in the pending
arbitration proceedings that LHCs draws upon the Securities
were wrongful due to the non-existence of the fact of
default, its right to seek indemnification for damages it
suffered would not normally be foreclosed pursuant to
general principles of law.

WHEREFORE, the instant petition is DENIED, with costs

against petitioner.