A letter of credit is a document issued by a financial institution, or a similar party,
assuring payment to a seller of goods or services provided certain documents have been presented
to the bank.
"Letters of Credit" are documents that prove the seller has performed the duties under
an underlying contract and the goods have been supplied as agreed.
In return for these documents, the beneficiary receives payment from the financial institution
that issued the letter of credit.
The letter of credit serves as a guarantee to the seller that it will be paid regardless
of whether the buyer ultimately fails to pay.
In this way, the risk that the buyer will fail to pay is transferred from the seller
to the letter of credit's issuer.
The letter of credit can also be used to ensure that all the agreed upon standards and quality
of goods are met by the supplier, provided that these requirements are reflected in the
documents described in the letter of credit.
Letters of credit are used primarily in international trade for transactions between a supplier
in one country and a customer in another.
Most letters of credit are governed by rules promulgated by the International Chamber of
Commerce known as Uniform Customs and Practice for Documentary Credits.
They are also used in the land development process to ensure that approved public facilities
will be built.
The parties to a letter of credit are the supplier, usually called the beneficiary,
the issuing bank, of whom the buyer is a client, and sometimes an advising bank, of whom the
beneficiary is a client.
Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without
the consent of the beneficiary, issuing bank, and confirming bank, if any.
In executing a transaction, letters of credit incorporate functions common to giros and
travelers' cheques.
Terminology Origin of the term
The name "letter of credit" derives from the French word "accréditation", a power to do
something, which derives from the Latin "accreditivus", meaning trust.
Related terms A sight LC means that payment is made immediately
to the beneficiaryexporter upon presentation of the correct documents in the required time
frame.
A time or date LC will specify when payment will be made at a future date and upon presentation
of the required documents.
Negotiation means the giving of value for draft(s) or document(s) by the bank authorized
to negotiate, viz the nominated bank.
Mere examination of the documents and forwarding the same to the letter of credit issuing bank
for reimbursement, without giving of value / agreed to give, does not constitute a negotiation.
Documents that can be presented for payment To receive payment, an exporter or shipper
must present the documents required by the letter of credit.
Typically, the payee presents a document proving the goods were sent instead of showing the
actual goods.
The Original Bill of Lading is normally the document accepted by banks as proof that goods
have been shipped.
However, the list and form of documents is open to negotiation and might contain requirements
to present documents issued by a neutral third party evidencing the quality of the goods
shipped, or their place of origin or place.
Typical types of documents in such contracts might include:
Financial Documents Bill of Exchange, Co-accepted Draft
Commercial Documents Invoice, Packing list
Shipping Documents Transport Document, Insurance Certificate,
Commercial, Official or Legal Documents Official Documents
License, Embassy legalization, Origin Certificate, Inspection Certificate, Phytosanitary certificate
Transport Documents Bill of lading, Airway bill, Lorry/truck receipt,
railway receipt, CMC Other than Mate Receipt, Forwarder Cargo Receipt, Deliver Challan...etc
Insurance documents Insurance policy, or Certificate but not a
cover note.
Legal principles governing documentary credits One of the primary peculiarities of the documentary
credit is that the payment obligation is independent from the underlying contract of sale or any
other contract in the transaction.
Thus the bank’s obligation is defined by the terms of the letter of credit alone, and
the sale contract is irrelevant.
The defenses available to the buyer arising out of the sale contract do not concern the
bank and in no way affect its liability.
Article 4(a) UCP states this principle clearly.
Article 5 the UCP further states that banks deal with documents only, they are not concerned
with the goods.
Accordingly, if the documents tendered by the beneficiary, or his or her agent, appear
to be in order, then in general the bank is obliged to pay without further qualifications.
Policies behind adopting the abstraction principle are purely commercial, and reflect a party’s
expectations: first, if the responsibility for the validity of documents was thrown onto
banks, they would be burdened with investigating the underlying facts of each transaction,
and less inclined to issue documentary credits as the transaction would involve great risk
and inconvenience.
Second, documents required under the letter of credit could in certain circumstances be
different from those required under the sale transaction.
This would place banks in a dilemma in deciding which terms to follow if required to look
behind the credit agreement.
Third, the fact that the basic function of the credit is to provide a seller with the
certainty of payment for documentary duties suggests that banks should honor their obligation
notwithstanding allegations of misfeasance by the buyer.
Finally, courts have emphasized that buyers always have a remedy for an action upon the
contract of sale, and that it would be a calamity for the business world if, for every breach
of contract between the seller and buyer, a bank were required to investigate said breach.
The “principle of strict compliance” also aims to make the bank’s duty of effecting
payment against documents easy, efficient and quick.
Hence, if the documents tendered under the credit deviate from the language of the credit
the bank is entitled to withhold payment even if the deviation is purely terminological.
The general legal maxim de minimis non curat lex has no place in the field of documentary
credits.
Definitions of related terms The Bank which advises a Letter of Credit
to the Beneficiary at the request of the issuing Bank is known as the Advising Bank
Applicant: Applicant is the party on whose request the issuing bank issues a credit .
Banking day: The day on which a bank is regularly open at the place at which an act to be performed.
Beneficiary: Beneficiary is the party who is to receive the benefit of the LC.
The consignee of an LC and the beneficiary may not be the same.
The credit is issued in his favor.
Presentation: Presentation is either delivery of documents against an LC or the document
itself.Complying presentation : A presentation is said to be complying presentation when
it is in accordance with: i.
the terms and conditions of the credit, ii.
the applicable provisions of UCP and iii.
international standard banking practice.Confirmation: Confirmation is a definite undertaking from
the confirming bank to honor or negotiate a complying presentation in addition to that
of the issuing bank.Confirming bank: The Bank which adds confirmation to an LC is termed
as Confirming Bank.
It does so at the request of the issuing bank and taking authorization from the issuing
bank.Letter of Credit/ Credit: Credit is a definite undertaking of the issuing bank to
honor a complying presentation.
According to UCP all credit must be Irrevocable.Honour: Honour means act according to commitment of
the LC.
Presentations are honored in different ways depending on the type of credit like.
i.
Making payment at sight for sight LC ii.By incurring a deferred payment undertaking and
paying at maturity deferred payment LC.
iii.
by accepting a Draft drawn by the beneficiary and paying at maturity for Deferred Acceptance
LC.
Issuing bank: The bank which issues a credit is known as issuing bank.Nominated Bank: The
bank with which credit is available is termed as Nominated Bank of that credit.
If no bank is mentioned in the credit as nominated bank, all banks are nominated bank.
Negotiation: A bank is said to negotiate a document if it purchases a draft or documents
under a complying presentation either by making advance or agreeing to advance funds to the
beneficiary on or before the date on which reimbursement is due to the nominated bank
. A draft drawn on a nominated bank can not be purchased by itself.
Different types of letters of credit Import/export Letter of Credit
The same credit can be termed as import and export LC depending on whose perspective it
is being looked upon.
For the importer it is termed as Import LC and for the Exporter of goods, Export LC.
Revocable Letter of Credit In this type of credit, buyer and the bank
which has established the LC, are able to manipulate the letter of credits or make any
kinds of corrections without informing the seller and getting permissions from him.
According to UCP 600, all LCs are Irrevocable, hence this type of LC used no more.
Irrevocable LC In this type of LC, Any changes or cancellation
of the LC is done by the Applicant through the issuing Bank.
It must be authenticated by the Beneficiary of the LC.
Whether to accept or reject the changes, depends on the beneficiary.
Confirmed LC An LC is said to be confirmed when another
bank adds its additional confirmation to honor a complying presentation at the request or
authorization of the issuing bank.
Unconfirmed LC This type of letter of credit, does not acquire
the other bank's confirmation.
Transferrable LC A Transferable Credit is the one under which
the exporter has the right to make the credit available to one or more subsequent beneficiaries.
Credits are made transferable when the original beneficiary is a middleman and does not supply
the merchandise himself but procures goods from the suppliers and arrange them to be
sent to the buyer and does not want the buyer and supplier know each other.
The middleman is entitled to substitute his own invoice for the one of the supplier and
acquire the difference as his profit in transferable letter of credit mechanism.
Important Points of Consideration: A letter of credit can be transferred to the
second beneficiary at the request of the first beneficiary only if it expressly states that
the letter of credit is "transferable".
A bank is not obligated to transfer a credit.
A transferable letter of credit can be transferred to more than one second beneficiary as long
as credit allows partial shipments.
The terms and conditions of the original credit must be indicated exactly in the transferred
credit.
However, in order to keep the workability of the transferable letter of credit below
figures can be reduced or curtailed.
• Letter of credit amount • any unit price of the merchandise • the expiry date • the
presentation period or • the latest shipment date or given period for shipment.
The first beneficiary may demand from the transferring bank to substitute his name for
that of the applicant.
However, if a document other than invoice required in the transferable credit must be
issued in a way to show the applicant's name, in such a case that requirement must be indicated
in the transferred credit will be given free.
Transferred credit cannot be transferred once again to any third beneficiary according to
the request of the second beneficiary.
Untransferable LC It is said to the credit that seller cannot
give a part or completely right of assigned credit to somebody or to the persons he wants.
In international commerce, it is required that the credit will be untransferable.
Deferred / Usance LC It is kind of credit that won't be paid and
assigned immediately after checking the valid documents but paying and assigning it requires
an indicated duration which is accepted by both of the buyer and seller.
In reality, seller will give an opportunity to the buyer to pay the required money after
taking the related goods and selling them.
At Sight LC It is a kind of credit that the announcer
bank after observing the carriage documents from the seller and checking all the documents
immediately pays the required money.
Red Clause LC In this kind of credit assignment, the seller
before sending the products, can take the pre-paid or part of the money from the bank.
The first part of the credit is to attract the attention of the acceptor bank.
The reasoning behind this, is the first time this credit is established by the assigner
bank, it is to gain the attention of the offered bank.
The terms and conditions were written by red ink, going forward it became famous with that
name.
Back to Back LC This type of LC consists of two separated
and different types of LC.
First one is established in the benefit of the seller that is not able to provide the
corresponding goods for any reasons.
Because of that reason according to the credit which is opened for him, neither credit will
be opened for another seller to provide the desired goods and sends it.
Back-to-back L/C is a type of L/C issued in case of intermediary trade.
Intermediate companies such as trading houses are sometimes required to open L/Cs by supplier
and receive Export L/Cs from buyer.
SMBC will issue a L/C for the intermediary company which is secured by the Export L/C.
This L/C is called "Back-to-back L/C".
The price of letters of credit All the charges for issuance of letter of
credit, negotiation of documents, reimbursements and other charges like courier are to the
account of applicant or as per the terms and conditions of the letter of credit.
If the Letter of Credit is silent on charges, then they are to the account of the Applicant.
The description of charges and who would be bearing them would be indicated in the field
71B in the letter of credit.
Legal basis Legal writers have failed to satisfactorily
reconcile the bank’s undertaking with any contractual analysis.
The theories include: the implied promise, assignment theory, the novation theory, reliance
theory, agency theories, estoppels and trust theories, anticipatory theory, and the guarantee
theory.
Davis, Treitel, Goode, Finkelstein and Ellinger have all accepted the view that documentary
credits should be analyzed outside the legal framework of contractual principles, which
require the presence of consideration.
Accordingly, whether the documentary credit is referred to as a promise, an undertaking,
a chose in action, an engagement or a contract, it is acceptable in English jurisprudence
to treat it as contractual in nature, despite the fact that it possesses distinctive features,
which make it sui generis.
Although documentary credits are enforceable once communicated to the beneficiary, it is
difficult to show any consideration given by the beneficiary to the banker prior to
the tender of documents.
In such transactions the undertaking by the beneficiary to deliver the goods to the applicant
is not sufficient consideration for the bank’s promise because the contract of sale is made
before the issuance of the credit, thus consideration in these circumstances is past.
However, the performance of an existing duty under a contract may be a valid consideration
for a new promise made by the bank, provided that there is any practical benefit to the
bank Ltd), or a promise to perform owed to a third party may also constitute a valid
consideration.(Scotson v Pegg) A theory sustains that is feasible to typify
letter of credit as a Collateral Contract for a Third-Party Beneficiary because there
are in fact three different entities participating in the letter of credit transaction the seller,
the buyer, and the banker.
Because letters of credit are prompted by the buyer’s necessity and in application
of the theory of Jean Domat the cause of a Letter of Credit is to release the buyer of
his obligation to pay directly to the seller with legal tender.
Therefore, Letter of Credit theoretically fits as a collateral contract accepted by
conduct or in other words, an Implied-in-fact contract under the framework for third party
beneficiary where the buyer participate as the third party beneficiary with the bank
acting as the stipulator and the seller as the promisor.
The term "beneficiary" is not used properly in the scheme of a letter of credit because
a beneficiary in the broadest sense is a natural person or other legal entity who receives
money or other benefits from a benefactor.
Note that under the scheme of letters of credit, banks are neither benefactors of sellers nor
benefactors of the buyers, and the seller doesn’t receive money in gratuity mode.
Thus is possible that “letter of credit” was one of those contracts that needed to
be masked to disguise the “consideration or Privity requirment”, as a result this
kind of arrangement, would make letter of credit to be enforceable under the action
assumpsit because of its promissory connotation.
A few countries including the United States have created statutes in relation to the operation
of letters of credit.
These statutes are designed to work with the rules of practice including the UCP and the
ISP98.
These rules of practice are incorporated into the transaction by agreement of the parties.
The latest version of the UCP is the UCP600 effective July 1, 2007.
The previous revision was the UCP500 and became effective on 1 January 1994.
Since the UCP are not laws, parties have to include them into their arrangements as normal
contractual provisions.
. International Trade Payment methods
International Trade Payment method can be done in the following ways.
Advance payment Where the buyer parts with money first and
waits for the seller to forward the goods Documentary Credit
Subject to ICC's UCP 600, where the bank gives an undertaking to pay the shipper the value
of the goods shipped if certain documents are submitted and if the stipulated terms
and conditions are strictly complied with.
Here the buyer can be confident that the goods he is expecting only will be received since
it will be evidenced in the form of certain documents called for meeting the specified
terms and conditions while the supplier can be confident that if he meets the stipulations
his payment for the shipment is guaranteed by bank, who is independent of the parties
to the contract.
Documentary collection Also called "Cash Against Documents".
Subject to ICC's URC 525, sight and usance, for delivery of shipping documents against
payment or acceptances of draft, where shipment happens first, then the title documents are
sent to the [collecting bank] buyer's bank by seller's bank [remitting bank], for delivering
documents against collection of payment/acceptance Direct payment
Where the supplier ships the goods and waits for the buyer to remit the bill, on open account
terms.
Risk situations in letter-of-credit transactions Fraud Risks
The payment will be obtained for nonexistent or worthless merchandise against presentation
by the beneficiary of forged or falsified documents.
Credit itself may be funded.
Sovereign and Regulatory Risks Performance of the Documentary Credit may
be prevented by government action outside the control of the parties.
Legal Risks Possibility that performance of a Documentary
Credit may be disturbed by legal action relating directly to the parties and their rights and
obligations under the Documentary Credit Force Majeure and Frustration of Contract
Performance of a contract – including an obligation under a Documentary Credit relationship
– is prevented by external factors such as natural disasters or armed conflicts
Risks to the Applicant Non-delivery of Goods
Short shipment Inferior Quality
Early /Late Shipment Damaged in transit
Foreign exchange Failure of Bank viz Issuing bank / Collecting
Bank Risks to the Issuing Bank
Insolvency of the Applicant Fraud Risk, Sovereign and Regulatory Risk
and Legal Risks Risks to the Reimbursing Bank
no obligation to reimburse the Claiming Bank unless it has issued a reimbursement undertaking.
Risks to the Beneficiary Failure to Comply with Credit Conditions
Failure of, or Delays in Payment from, the Issuing Bank
See also Bank Payments Obligation
Buyer's Credit Documentary collection
Uniform Customs and Practice for Documentary Credits
References
External links Letter of Credit Information, Procedure and
Videos.
Anatomy of a Letter of Credit, showing an actual negotiated letter of credit
Letters of Credit and How They Work (in Persian)
Letter of Credit, its Relation with Stipulation for the Benefit of a Third Party