1.

2.
3.
4.
5.

Principle of Autonomy
Doctrine of Strict Complaince
Kinds
Merits & Demerits of LOC
Case Laws

Chapter 1
Letters of credit: An introduction
Letters of Credit have been a cornerstone of international trade dating back to the early1900s.
They continue to play a critical role in world trade today. For any company entering the
international market, Letters of Credit are an important payment mechanism which helps
eliminate certain risks.
Letters of credit also called documentary credits or bankers commercial credits are the most
common method of payment for goods in the export trade and have been described by
English judges as the life blood of international commerce.1
There are various types of letter of credit. The most important distinctions are made between
revocable and irrevocable credits and between confirmed and unconfirmed credits.
The feature common to all is that in accordance with the agreement between the seller and the
buyer in the contract of sale (the underlying contract), the buyer arranges for payment of
the price to be made by the bank, normally at the sellers place, on presentation of specified
documents (usually including the transport documents) and on the performance of other
conditions stated in the credit and advised by the bank to the seller. On presentation of
documents the bank pays the purchase price, according to the terms of the credit, by sight
payment, deferred payment, or by acceptance or negotiation of a bill of exchange drawn by
the seller.
The essence of the letter of credit transaction lies in its documentary character, i.e. where the
goods are represented by a bill of lading, this document of title is used as a means of
financing the transaction.
1 Export trade: law and practice of international trade- Carole Murray& David Holloway
1

Lord Wright2 describes the function of the letter of credit as follows:

The general course of international commerce involves the practice of raising money on the
documents so as to bridge the period between the shipment and the time of obtaining
payment against documents.
The documentary character of this type of bankers credit, as used in international trade,
cannot be over-emphasised. The paying bank is prepared to pay the exporter because it holds
the documents as collateral security and, if necessary, can have recourse to the issuing bank,
which in turn can have recourse to the buyer as instructing customer. Where the transport
documents consist of bills of lading, the bank invariably asks for the delivery of a full set of
original bills; otherwise a fraudulent shipper would be able to obtain payment under the letter
of credit on one of them and advances from other bankers on the security of other originals
constituting the set.

Parties to letter of credit:

Exporter/Beneficiary/Seller: The party that has contracted to sell goods.
Importer/Applicant/Buyer: The party that has contracted to buy goods.
Issuing Bank: The bank issuing the Letter of Credit on behalf of the Importer (Buyer).
Advising Bank: The bank to which the Issuing Bank forwards the Letter of Credit with
instructions to notify the Exporter (Beneficiary).
Confirming Bank: The bank which, at the request of the Issuing Bank, adds its confirmation
to the Letter of Credit. In doing so, the Confirming Bank undertakes to make payment to the
Exporter upon presentation of documents under the Letter of Credit.

Uniform customs and practices for Documentary credits:

2 In TD Bailey, Son & co v Ross T Smyth &Co Ltd (1940)56 T.L.R.825 at 828.
2

Banking practice relating to letters of credit is standardised by the Uniform Customs and
Practice for Documentary Credits, which are a set of rules issued by the International
Chamber of Commerce.
These are commonly referred to as the UCP. In this area of law attempts at unification have
been highly successful and after more than 70 yrs of effort and periodic revision, the UCP
600, which took effect on July 1, 2007.
It is anticipated that although in the commercial world the period of transition from the use of
UCP 500 to UCP 600 is likely to be brief, disputes arising from the construction of UCP 500
may continue to be heard by the English courts for some time to come. In the text which
follows therefore, although reference is made principally to the provisions of UCP 600,
reference will also be made to the text of UCP 500 where relevant.
In English law the UCP do not have the force of law or the status of a trade custom and in
accordance with Art 1, apply only if the parties have incorporated them into their contract.
Even where the UCP are adopted specifically or generally, the parties are at liberty to contract
out of them, or to exclude the operation of specific parts, as is clearly expressed in Article 1.
The ICC has attempted to standardise documentation relating to letters of credit, and has
published the ICC Standard Documentary Credit Forms, as well as guide to the 1993
revision.
The ICC has also issued the International standard Banking Practices (ISBP) in order to
supplement the UCP and to provide guidance on examining documents presented under
letters of credit.
UCP 600 contains fewer articles than its predecessor, the number being reduced from 49 to
38. Amongst its changes are the introduction of separate articles covering definitions and
interpretations, with the object of making UCP easier to understand and use, as well as the
elimination of phrases such as reasonable time and on its face.
A Definition of Letter of Credit may be found in at Art.2, which provides that, for the
purposes of the rules : A credit means any arrangement , however named or described, that is
irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a
complying presentation.

Chapter 2
The stages of letter of credit transaction:
Where payment under a letter of credit is arranged, four stages can normally be distinguished:
(a) The exporter and the overseas buyer agree in the contract of sale that payment shall be
made under a letter of credit.
(b) The overseas buyer ( acting as applicant for the credit) instructs a bank at his place
of business (known as issuing bank) to open a letter of credit for the exporter( known
as the beneficiary) on the terms specified by the buyer in his instructions to the
issuing bank.
(c) The issuing bank arranges with the bank at the locality of the exporter (known as the
advising bank) to negotiate, accept, or pay the exporters draft upon delivery of the
transport documents by the seller.
(d) The advising bank informs the exporter that it will negotiate, accept or pay his draft
upon delivery of the transport documents.

Two points emerge from this structure. First, stages (a) and (d) are of great importance to the
exporter, viz. The arrangement, in his contract of sale of the most appropriate type of credit ;
and the corresponding notification from the advising bank.
Second, provided the correct documents are tendered and this is done before the expiry of the
credit, there is a binding undertaking of the issuing

bank, if the credit is irrevocable, and

also of the confirming bank, if it is confirmed, to the beneficiary to pay the purchase price.
These undertakings are contractual in nature. A bank which has given such an undertaking
will refuse to accept instructions from the buyer not to pay a seller who has performed the
conditions of the credit, and will not accept a revocation of the credit.

9 Steps in the Letter of Credit Process:3

3 http://www.tradev.net/Downloads/Tools/guide2lc.pdf
4

Buyer and seller agree to terms including means of transport, period of credit offered

(if any), and latest date of shipment acceptable.

Buyer applies to bank for issue of letter of credit. Bank will evaluate buyer's credit

standing, and may require cash cover and/or reduction of other lending limits.
Issuing bank issues LC, sending it to the Advising bank by airmail or electronic

means such as telex or SWIFT.

Advising bank establishes authenticity of the letter of credit using signature books or

test codes, then informs seller (beneficiary).

Seller should now check that LC matches commercial agreement and that all its terms

and conditions can be satisfied.

Seller ships the goods, then assembles the documents called for in the LC (invoice,

transport document, etc.).

The Advising bank checks the documents against the LC. If the documents are

compliant, the bank pays the seller and forwards the documents to the Issuing bank.
The Issuing bank now checks the documents itself. If they are in order, it reimburses

the seller's bank immediately.

The Issuing bank debits the buyer and releases the documents (including transport
document), so the buyer can claim the goods from the carrier.

The two fundamental principles:4

The law relating to letters of credit is founded on two principles:
(a) The autonomy of credit; and
(b) The doctrine of strict compliance.
The autonomy of the letter of credit
According to this principle, the credit is separate from and independent of the underlying
contract of sale or other transaction. A bank which operates a credit is concerned only with
whether the documents tendered by the seller correspond to those specified in the
instructions. The letter of credit transaction is thus a paper transaction. It is irrelevant to the
bank whether the underlying contract concerns the purchase of timber, oil, machinery or
whether it concerns another transaction. The only case in which bank should refuse to pay
under the credit occurs if it is proved to its satisfaction that the documents, though apparently
4 Export trade: law and practice of international trade- Carole Murray & David Holloway

in order on their face are fraudulent and that the beneficiary(seller) was involved in the fraud.
This is usually referred to as fraud exception.
The principle of autonomy is stated in Arts 4 and 5 of the UCP 600.
By virtue of its autonomous character, the letter of credit is approximated, to some extent, to
the bill of exchange. This development was noted by Lord Denning M.R. in Power Curber
International Ltd v National Bank of Kuwait 5, when he said: It is vital that every bank
which issues a letter of credit should honour its obligations. The bank is in no way concerned
with any dispute that the buyer may have with the seller. The buyer may say that the goods
are not up to contract. Nevertheless the bank must honour its obligations. The buyer may say
that he has a cross claim in a large amount. Still the bank must honour its obligations. A letter
of credit is like a bill of exchange given for the price of the goods. It ranks as cash and must
be honoured. No set off or counter claim is allowed to detract from it. Whereas a bill of
exchange is given by buyer to seller, a letter of credit is given by a bank to the seller with the
very intention of avoiding anything in the nature of set off or counterclaim.
The doctrine of strict complianceThe legal principle that the bank is entitled to reject documents which do not strictly conform
to the terms of letter of credit is conveniently referred to as the doctrine of strict compliance.
The reason underlying this rule- which is not always appreciated by exporters is that the
advising bank is a special agent of the issuing bank and latter is the special agent of the buyer.
If an agent with limited authority acts outside that authority (in banking terminology: his
mandate) the principal is entitled to disown the act of the agent, who cannot recover from him
and has to bear the commercial risk of the transaction. In a falling market buyer is easily
tempted to reject the documents which the bank accepted, on the ground that they do not
strictly confirm with the terms of credit. Moreover the bank deals in finance, not in goods; it
normally has no expert knowledge of the usages and practices of a particular trade. If the
documents tendered are not strictly in conformity with the terms of the credit and the bank
refuses to accept them, the exporter should at once contact his overseas buyer and request
him to instruct the bank to accept the documents as tendered. The refusal of the bank to
depart in even a small and apparently insignificant matter not sanctioned by the instructions
or the UCP, where applicable, from its instructions will, in the overwhelming majority of
5 [1981] 1 W.L.R at 1241
6

cases, be upheld by the courts if litigation ensues. Lord Sumner expressed the doctrine of
strict compliance in the following classic passage there is no room for documents which are
almost the same, or which will do just as well.

Chapter 3
The documents tendered to the bank
The bank must determine on the basis of the documents alone whether or not they comply
with the mandate. According to the doctrine of strict compliance the bank is within its rights
when refusing documents tendered by the seller which do not contain all the particulars
specified in the credit. Beyond this bank is not obliged to go and should not go. In particular,
it need not concern itself with the legal significance and value of the documents which it is
instructed to demand. An illustration is the requirement of a credit that the bill of lading shall
contain a specific description of the goods; the value of such description is nugatory in view
of the- usual- clause in the bill that weight, measure, marks, numbers, quality, contents and
value if mentioned in the bill of lading are to be considered unknown; nevertheless, the bank
must insist that the bill contains the specified description but, unless instructed otherwise,
need not reject such bill on the ground that the weight, etc., unknown clause is not deleted.
All they have to do is to satisfy themselves that the correct documents are presented to them,
and that the bills of lading bear no indorsement or clausing by the ship owners or shippers
which could reasonably mean that there was, or might be, some defect in the goods or their
packing.

Time for examinationUCP 400 did not provide clear guidance as to what was reasonable time for the examination
of documents. UCP 500 Art 13(b) differed significantly from its predecessor in this regard
and stated as follows:
the issuing bank, the confirming bank, if any, or a nominated bank acting on their behalf,
shall each have a reasonable time, not to exceed seven banking days following the day of
receipt of the documents, to examine the documents and determine whether to take up or to
refuse the documents and to inform the party from which it received the documents
accordingly.
The question of what amounted to reasonable time was considered by the court of appeal in
Bankers Trust co v state bank of India 6. In light of this case, amendments were made to
6 [1991]2 Lloyds Rep.443,CA
8

UCP 500 resulting in the seven day time limit set out in Art 13(b). However the issue as to
how many days upto seven actually constituted a reasonable time for the purposes of
compliance with this rule led to a number of differing interpretations and resulted in deletion
of these words and UCP 600 now provides instead, at Art 14(b), that the bank shall have a
fixed maximum number of days- five banking days following the day of presentation- in
which to examine the documents and to determine whether or not the presentation is
complying.

Discrepancy of the documentsThe law on the subject is summed up by sir John Donaldson M.R. 7 in the following passage,
where he observed that the basis was:
that the banker is not concerned with why the buyer has called for particular documents, 8
that there is no room for documents which are almost the same, or which will do just as well,
as those specified, that whilst the bank is entitled to put a reasonable construction upon any
ambiguity in its mandate, if the mandate is clear there must be strict compliance with that
mandate, that the documents have to be taken up or rejected promptly and without
opportunity for prolonged inquiry,9 and that the tender of documents which properly read and
understood calls for further inquiry or is such as to invite litigation is a bad tender.
Two situations have thus to be distinguished. There may be an ambiguity in the credit
instructions (mandate), or there may be an ambiguity with respect to the tendered documents.
If the credit instructions are ambiguous, the best course for the bank is to ask for clarification.
If this is not possible the bank is protected if it has acted reasonably.
If the tendered documents are ambiguous, the tender is in principle a bad tender. However the
bank, when examining the tendered documents, should not insist on the rigid and meticulous
fulfilment of the precise wording in all cases. 10 If properly read and understood, the words in
the instructions and in the tendered documents have the same meaning, if they correspond
7 Banque de lindochine et de suez SA v JH Rayner (mincing lane) ltd[ 1983] Q.B
711,729-730
8 Commercial Banking Co of Sydney ltd v Jalsard Pty Ltd[1973] A.C. 279.
9 Hansson v Hamel and Horley Ltd[1922] 2 A.C.36
9

though not being identical, the bank should not reject the documents. It has been said in an
opinion of the Banking commission of the ICC that banks could not act like robots, but had
to check each case individually and use their judgement.
However, the margin allowed to the bank in interpreting the documents is very narrow and
the bank will be at risk if it does not insist on strict compliance.

Provisions relating to documents in the UCPWhen a question of sufficiency of documents

under letter of credit issued under the UCP

arises and this question cannot be resolved by reference to the instructions to the bank, it is
necessary to turn to the UCP, which sets out in considerable detail the documents normally
acceptable to the bank. UCP 500 expanded the provisions relating to documents and in
particular those which concerned transport documentation. UCP 600 similarly contains
detailed guidance in relation to specific categories of documentation used in export
transactions and generally follows the pattern of UCP 500.
The transport documents- it is common for buyers to require presentation of an invoice, an
insurance document and a bill of lading or other transport document under the credit. Taking
account of the increased use of certain types of transport documentation, UCP 500 introduced
individual Articles which distinguished between various types of transport document and
which set out the circumstances under which banks may accept them.
The most commonly required transport document is a bill of lading or a combined transport
document. UCP 600 has eliminated the reference to transport documents issued by the freight
forwarders found in UCP 500. In addition, UCP 600 contains individual Articles referring to:
(a). Transport documents covering at least two different modes of transport.(Art 19);
(b). Bills of lading (Art 20);
(c). Non- negotiable sea way bills (Art 21);
(d). Charter party bills of lading (Art 22)
(e). Air transport documents (Art 23);
10 Hing Yip Hing Fat Co Ltd v Daiwa Bank Ltd [1991] 2 H.K.L.R.35
10

(f). Road, rail and inland waterway transport documents (Art24);

(g). Courier and post receipts, certificates of posting (Art 25)
(h). The invoice (Art 18)
(i). Insurance documents (Art 28)

Several documents to be read together:The bank is usually instructed to make finance available on tender of several documents in a
set, and as stated these would normally be the transport documents, eg. A bill of lading, the
invoice and the insurance policy or certificate. In that case, in the absence of instructions to
the contrary, it is sufficient if all the documents in the set, taken together, contain the
particulars required by the banks mandate and it is not necessary that every document in the
set should contain them. The goods must be fully described in the invoice in accordance with
the credit instructions, but in the other documents they may be described in general terms.
This rule is now contained in Art14 (e)11 of the UCP which mitigates, to some extent, the
effect of the doctrine of strict compliance.

11 UCP500 Art.37(c)
11

Chapter 4
Kinds of Letter Of Credit12
Payment at sight, deferred payment, acceptance and negotiation credits
It is of importance to the seller to know in what manner he will obtain the moneys due to him
under the credit. Four possibilities exist: the credit may be available by sight payment, by
deferred payment, by acceptance or by negotiation. The credit itself should state which of
these four methods has been chosen by the parties and this issue should be settled beforehand
in the contract under which credit is opened.
1. If the parties have arranged a payment at sight credit, the advising bank is instructed to pay,
or arrange for payment, to the seller the moneys due on presentation of the documents; This is
a case of payment against documents.
2 .If the parties have arranged a deferred payment credit, the advising bank is authorised to
pay, or make arrangements for payment, at some future date determinable in accordance with
the terms of the credit.
The deferred payment credit may, for example, provide for payment 180 days from the date
of bill of lading. In this case an acceptance credit providing for a time bill would be
inappropriate because a bill of exchange cannot be made payable at a time which can only be
determined by reference to the uncertain date of the issue of the bill of lading.
If the seller requires cash before the deferred payment credit matures, he can only provide it
by negotiating the letter of credit. The issuing bank sometimes provides in the credit that such
negotiation shall be restricted to a specified bank, "perhaps because this is a bank with which
it has a commercial relationship.
If the credit is an acceptance credit the seller draws the bill of exchange on the advising bank
in the specified manner. The bill will normally be a time draft. By accepting the bill, the bank
signifies its commitment to pay the face value on maturity to the party presenting it. The bill
accepted by the advising bank provides the seller with a considerable degree of security. If he
12 http://www.tradev.net/Downloads/Tools/guide2lc.pdf

12

does not want to hold the bill until it matures, he may turn it into money by negotiating, e.g.
by discounting it or selling it to his own bank. On negotiation, he is unlikely to receive; the
full amount of money stated in the tenor of the bill because the negotiating bank will deduct a
discount or interest and commission.

Revocable and irrevocable credits; confirmed and unconfirmed

credits^/J
It is essential to distinguish between these types of credit. The quality of the credit as
"revocable" or "irrevocable" refers to the obligation of the issuing bank to the beneficiary (the
seller). The quality of the credit as "confirmed" or "unconfirmed" refers to the obligation of
the advising bank to the beneficiary.
^^
Article 6 of the UCP 500 revision provided that a credit may either be revocable or
irrevocable, and stated that if a credit did not indicate which type it was then the presumption
was that it was irrevocable. In UCP 600 references to revocable credits have been entirely
removed and the type of credit envisaged by the rules is irrevocable. A credit is defined at
Art.2 as:
"any arrangement, however named or described, that is irrevocable. . .and it is stated in Art.3:
"A credit is irrevocable even if there is no indication to that effect.". Parties wishing therefore
to open a revocable credit may choose to do so by either making appropriate modifications to
the provisions of UCP 600 or by incorporating the terms of UCP 500 into the letter of credit..
Of course, no advising or nominated bank would ever confirm a credit unless the issuing
bank has made it irrevocable. The UCP contains detailed provisions entitling the advising
bank, which has taken up the documents in accordance with the instructions, to
reimbursement from the issuing bank.
It is controversial at which moment the irrevocable credit becomes binding on the issuing
bank and the confirmed credit on the advising bank. It is thought that these obligations
become binding on the banks before the tender of the documents, namely when the
beneficiary receives the communication of the bank and accepts it. The relationships between
the banks which undertake these obligations and the beneficiary are, as already observed,
contractual.

13

From the exporter's perspective, a particularly important feature of the credit is whether it is
irrevocable or irrevocable and confirmed. He has to arrange in the contract of sale (or other
underlying contract) the most appropriate of these two types of credit and all the other details
of it, including the mode of payment. He must later check the notification sent to him by the
bank; this notification should contain the terms of the credit, as arranged in the underlying
contract.

Revocable and unconfirmed credits

In practice, revocable credits are not widely used. Irrevocable credits, which may be
confirmed or unconfirmed, are the norm. Revocable credits may be amended or cancelled by
the issuing bank at any moment and without prior notice to the beneficiary.
If the credit is revocable its nature is reflected in the advice sent by the advising bank to the
beneficiary (the seller) which also states expressly that the credit is not confirmed. The
following clause in the advice note is typical:
"We have no authority from our clients to confirm this credit. The credit is therefore subject
to cancellation or modification at any time without notice."
From the exporter's point of view, an unconfirmed credit is a very unsatisfactory method of
finance, but unconfirmed credits are sometimes preferred to confirmed credits because they
are cheaper in respect of bank charges than the latter. The precarious nature of an
unconfirmed credit is well illustrated by the facts in Cape Asbestos v Lloyds Bank13.

Irrevocable and unconfirmed credits

The obligations of the issuing bank in terms of an irrevocable credit are set out in UCP 600
Art.7. Where this type of credit is used the issuing bank cannot revoke its undertaking to the
beneficiary, but the advising bank does not enter into its own obligation to make payment
under the credit. The advice of an irrevocable and unconfirmed credit would state:
"This credit is irrevocable on the part of the above-mentioned issuing bank but we are not
instructed to confirm it and therefore it does not involve any undertaking on our part."

13 [1921] W.N.274
14

These credits are sometimes issued by leading banks, particularly American and British
banks, which consider a local confirmation unnecessary.
While unconfirmed credits are somewhat cheaper than confirmed credits, they have the
disadvantage that they do not localise the performance of the contract of sale in the seller's
country. If the advising bank refused to pay on tender of the documents, the beneficiary might
be compelled to institute proceedings overseasa ) situation which largely defeats the main
purpose of the commercial credit.

Irrevocable and confirmed credits

This is the type of letter of credit most favourable to the exporter because the advising Bank
stipulates in terms that it will honour the exporter's drafts provided they are drawn and
presented in conformity with the terms of credit.
In the case of a confirmed credit, the engagement of the advising bank to the beneficiary is
expressly stated in the letter of advice which that bank sends him. The following clause in the
advice note is typical:
"We undertake to honour such drafts on presentation provided that they are drawn and
presented in conformity with the terms of this credit."

The effect of a confirmed credit has been described by Diplock J. as constituting "a direct
undertaking by the banker that the seller, if he presents the documents as required in the
required time will, receive payment." The bank cannot withdraw from its liability to the
exporter even If instructed by the buyer to cancel the credit.
There is this to be remembered, too. A vendor of goods selling against confirmed letter of
credit is selling under the assurance that nothing will prevent him from receiving the price.
That is no mean advantage when goods manufactured in one country are being sold in
another.
Where the credit does not confirm to the terms of the contract of sale, two courses are open to
the seller. He may reject the non- conforming credit; thus, where under the terms of the
contract of sale he is entitled to a confirmed credit but is only advised of the opening of an
unconfirmed credit, he need not ship the goods.14Alternatively, he may accept the non
14 Panoutsos v Raymond Hadley Corp[1917] 2 K.B.473
15

conforming credit. If he does so without objection, he is treated as having waived irrevocably

his right to a conforming credit.15

Standby letters of credit

In international trade transactions the stand by letter of credit, like the ordinary letter of
credit, is activated by the tender of documents in accordance with the requirements of credit.
The two types of credit differ significantly. The ordinary letter of credit is a payment
instrument which normally obliges the beneficiary to tender, together with other specified
documents, the transport documents. The standby credit is intended to protect the beneficiary
in case of default of the other party to the underlying contract. In the standby credit the
required documents need not include the transport documents; this type of credit may be
activated by a document of any description, e.g. a demand by the beneficiary or a statement
from him that the other party is in default. The standby letter of credit is thus often
functionally similar in effect to a bank guarantee or performance bond.
The principles relating to ordinary letters of credit likewise apply to standby credits, mutatis
mutandis. In particular, the principles of the autonomy of the credit and the requirement of
strict compliance also apply to this type of credit.

Revolving Credits
Where the export sale is not an isolated transaction but the overseas buyer is a regular
customer of the exporter, the buyer will arrange a revolving credit in favour of the latter. The
buyer gives the bank standing instructions to arrange for a credit in favour of the exporter
which at no time shall exceed a fixed maximum. The advantage of this arrangement is that no
renewal is required and clerical labour is saved; a revolving credit is, for instance, a corollary
to a sole distribution agreement.

Packing; red clause credit

The packing credit, sometimes called an anticipatory credit, is intended to assist the exporter
in the production or procurement of the goods sold. The credit is payable at a time prior to the
shipment of the goods and against the document other than the transport document. The bank
15 WJ Alan &Co Ltd v El Nasr Export & Import Co [1972] 2 Q.B.189

16

is instructed to pay the purchase price, or part of it, on production of, e.g. a warehouse receipt
(evidencing that the goods are in existence) or a forwarder's certificate(FCR) (affirming that
the goods have been received for shipment or have been shipped), or an air dispatch
registered post receipt.
The packing credit is a convenient method of finance for the small exporter who is not
familiar with shipping practice; if, for example, he sells cloth ex London store and arranges
that the purchase price shall be paid under a letter of credit against delivery of a forwarder's
receipt, he is not concerned with the actual shipping arrangements, which will be made by the
forwarder on instructions of the buyer. The buyer, on the other hand, is certain that the goods
sold are no longer in the possession of the seller when receiving the purchase price.
In more complicated transactions, which are nearer in nature to letters of credit proper, the
bank, when advising the exporter of the credit, inserts the so-called red clause into the letter
of advice and is prepared to honour the exporter's sight drafts to a certain amount against
production of the stipulated documents, e.g. the warehouse receipts; when the exporter ships
the goods and delivers the transport documents to the bank, he presents a draft for the
purchase price less the amount received by way of advance.
In the case of a packing credit, the arrangement can be construed as an agreement that the
buyer, through the bank, is to make an advance on the purchase price, the advance being
payable on production of the stipulated documents, and the balance of the price being payable
on delivery of the proper transport documents (and/or other specified documents).
.

17

Chapter 5
Advantages and Disadvantages of letter of credit16
Advantages to the Importer
Importer is assured that the Exporter will be paid only if all terms and conditions of the
Letter of Credit have been met.
Importer is able to negotiate more favourable trade terms with the Exporter when payment
by Letter of Credit is offered.
Disadvantages to the Importer
A Letter of Credit does not offer protection to the Importer against the Exporter shipping
inferior quality goods and/or a lesser quantity of goods.
Consequently, it is important that the Importer performs the appropriate due diligence to
assess the reputation of the Exporter. If the Exporter acts fraudulently, the only recourse
available to the Importer is through legal proceedings.
Added protection to the Importer may be provided by requesting additional documentation in
the Letter of Credit, e.g. a Certificate of Inspection.
It is necessary for the Importer to have a line of credit with a bank before the bank is able to
issue a Letter of Credit. The amount outstanding under each Letter of Credit issued is applied
against this line of credit from the date of issuance until final payment.
Advantages to the Exporter
The risk of payment relies upon the creditworthiness of the Issuing Bank and the political
risk of the Issuing Banks domicile, and not the creditworthiness of the Importer.
Exporter agrees in advance to all requirements for payment under the Letter of Credit. If the
Letter of Credit is not issued as agreed, the Exporter is not obligated to ship against it.
Exporter can further reduce foreign political and bank credit risk by requesting confirmation
of the Letter of Credit by a Canadian bank.
16 http://www.tradev.net/Downloads/Tools/guide2lc.pdf
18

Disadvantages to the Exporter

Documents must be prepared and presented in strict compliance with the requirements
stipulated in the Letter of Credit.
Some Importers may not be able to open Letters of Credit due to the lack of credit facilities
with their bank which consequently inhibits export growth.

Fraud affecting letters of credit

It has been seen earlier

that one of the maxims on which the letter of credit system is

founded is the autonomy of the institution. This means that the banks engaged in a letter of
credit transaction are, in principle, not involved in any dispute arising between the parties to
the underlying contract of sale or other contract. Only one exception is admitted to this rule;
the fraud exception, which permits a court to consider evidence other than the actual terms
and conditions of the credit and is founded on the maxim ex turpi causa non oritur actio.
Where it can be pleaded successfully, the bankthe issuing bank under an irrevocable credit
and the advising bank if it has added its confirmationshould refuse to honour the
undertaking which it has given the beneficiary, viz. to pay, accept or negotiate according to
the terms of the credit, if the correct documents are tendered before the expiry of the credit.
In circumstances where the documents are discrepant, the defects are apparent on their face.
Here, we are dealing with circumstances in which the documents appear to be in order on
their face, but they or their tender are tainted by fraud. This fraud will usually relate to the
documents themselves. They may be forged or untrue in relation to the goods to which they
refer; however on their face they appear to be correct and good tender under the documentary
credit.
The allegation of fraud is normally raised by the buyer, who will attempt to prevent the bank
from honouring the credit or the seller from drawing on it. The buyer may allege that the
seller shipped rubbish instead of conforming goods or that he shipped no goods at all, or that
the bills of lading were forged or fraudulently false, in that they were antedated to show
shipment within the stipulated shipping time whereas the goods were actually shipped out of
time.
The bank is not obliged actively to ascertain whether the alleged fraud can be proved. It may
adopt a passive attitude and evaluate the evidence placed before it by the buyer. If court
19

proceedings ensue, the issue of whether a relevant fraud has occurred has to be decided
according to the facts then known to the court and it is irrelevant that an earlier stage the
fraud was unknown to the bank. In ascertaining whether the fraud exception applies, three
sets of circumstances have to be distinguished.
First, where there is only an allegation, communicated by the buyer to the bank, that fraud
has occurred. This allegation may be founded on a suspicion, even a grave one. Or the bank
itself, without instigation by the buyer, may entertain such suspicion. If no more can be
established, the bank should pay Secondly, where it is clearly established to the satisfaction
of the bank that a fraud has occurred. There is unambiguous evidence before it, for instance
that the documents, or some of them, are fraudulent or forged. But there is no evidence before
the bank which shows that the beneficiary (the seller) knew of the fraud. There is the
possibility that the fraud was committed by a third party, e.g. a forwarder or loading broker,
who intended to cover up the fact that the goods were shipped out of time, and that the
beneficiary himself was unaware of this fraud. One should have thought that even in this case
the rule applies that "fraud unravels all". But that was not the case.
Thirdly where the bank has positive proof that a fraud has been committed and that the
beneficiary knew of this fraud. If both these facts are clearly established to the satisfaction of
the bank , it must not honour its obligation under the credit. E.g. if seller tenders documents
evidencing the transportation of the goods to the buyer but the seller has recalled the goods
from the person carrying out the transport and knows that the goods will not reach the buyer

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 forged.

Sovereign and Regulatory Risks

20

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

21

Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Beneficiary

Failure to Comply with Credit Conditions

Failure of, or Delays in Payment from, the Issuing Bank

Conclusion:
Letter of credit as mode of making payments in international trade plays an important role
where buyer and seller are situated in different jurisdictions. It serves as an important tool for
both the parties to create a mutual trust which is the touchstone of any trade.
Though, Letters of credit are a useful payment tool, but they should only be used where
necessary as they involve a great deal of administration, risk and cost to be a suitable
payment mechanism for day to day trading situations.
Moreover, there are various letter of credits involved in international trade and all of them
have there own advantages as well as disadvantages. so care must be taken while using this
mode of payment.

22