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Letter Of Credit
Letters of Credit in General
Osman Mohammed Seid

Introduction
Letter of credit transactions have been developed since the middle Ages in connection with the
trade of goods at the international level. Individuals and companies have found themselves dealing
with partners of whom they know little, who are located in distant countries with often insecure
political and economic situations. Furthermore, the dynamism of the actual economy creates a need
for financing that requires a guarantee of payment at a time and for an amount that must be certain.
Diversity in geographical nature, weather, climate, production system and globalization in culture
and fashion has made the countries dependent on each other for the daily necessities. Similarly, one
continent is, largely, dependent on the products of other continents. In addition, diversity in human
appetite and attitude, unequal development of technology, desire for luxury, and the development of
communication system and tale-communication, revolutionarily, increase the necessity of
transnational, transcontinental business activities.
As far as the payment issue is concerned, market reality, distance, geographical barriers, uncertainty
and lack of confidence among the business actors discourage the global commercial venture. In
market reality, the buyer, always, wants to pay the seller only after selling the imported products in
the internal market. On the other hand, the seller wants payment as soon as possible if possible,
even before shipment. Moreover, in transnational business transaction, where the goods and the
payment are not exchanged simultaneously there is a risk that parties to an exchange may not fulfill
their obligations. In such a case the seller may take the payment and not give the good or the buyer
take the good and not give the payment. Furthermore, trade transactions between different countries
involve different payment systems, conflict of laws, barrier of languages, lack of understanding and
reliability among the business partners and other barriers.1

LLB. Currently, he is an appellate court judge. I am grateful to Associated professor tecle Hagos (Mekelle University) for
commenting and teaching me many things about LC. All errors and opinions remain that of the author. He can be reached at Email
uosmanmohammed@gmail.com.
1 By Liton Chandra BIswas, Letter of Credit A theory of The Legal Basis of The Payment Obligation of Issuing Bank. Stamford
University Bangladesh, P-1.

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Letter Of Credit
Fortunately, letter of credit (LC) or documentary credit or bankers commercial credit has
Brought a revolutionary solution to all this problems and has ensured sufficient

securities and

certainty in payment transaction.

As the payment instrument, letter of credit has become widely used in international trade and has
been described by English judges as the life-blood of international commerce Letter of credit
takes care of the interests of both the exporter and importer, so it is considered to be the most
effective and safest method to secure the payment in an international trade transaction.
The letter of credit as a device plays a dominant role in the execution of a great number of
transactions at the international level; the work has been to focus on the bank's position in dealing
with documents. Two parties agree on a deal, they know the terms of their agreement and, for
different purposes, they decide to involve a third party, a bank, to help them in the execution of the
respective obligations. 3
The principal and most important task of letters of credit transactions is to provide security to the
parties with respect to the fulfillment of the reciprocal financial obligations. The involvement of the
bank as a credit institution through the issuance of letters of credit offers an opportunity to finance
the import and export of goods. The broad credit transaction consists of three separate relationships.
The first a relationship between the beneficiary (exporter/ seller) and the issuing bank; the second a
relationship between the beneficiary and the applicant (importer/ buyer); and the third is between
the buyer and the issuing bank. The first relationship is the Letter of Credit engagement; whereas
the second and the third are, respectively called as underlying contract and application agreement or
cover relationship.
Under this arrangement the buyer apply for opening a Letter of Credit which is to be issued in favor
of the seller. The issuing bank approving the payment obligation opens a Letter of Credit in favor of
the seller. This is the basic mechanism of Letter of Credit. However, oftentimes, the seller cannot
rely on the buyers bank (issuing bank) which is situated in the Buyers jurisdiction. In such a case,
the issuing bank requests a bank at or near the sellers business place to advise or notify the credit.
The second bank is called advising bank. Here the relationship between the issuing bank and

2 It would not be wise to say that LC ensures the absolute security and certainty. In reality, it is impossible to ensure absolute
security and certainty in business; an entire absence of risk would mean an absence of business. See AG Davis, The Law Relating to
Commercial Letters of Credit (3rd edition, Isaac Pitman & Sons Ltd 1 963) P-19.

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Letter Of Credit
3

By paolo S. Grassi, Pace International Law Review, Letter of credit transactions; the Banks Position in determining

Documentary Compliance A Comparative Evaluation Under US, Swiss and Germany Law. Volume 7, (1995). P-83.

Advising bank is that of principal and agent. Alternatively, the seller, who wants commitment of
payment by a bank he or she knows, may arrange another bank in his or her jurisdiction.
The confirming bank (sellers bank) on the assurance of reimbursement by the issuing bank
undertakes to pay, accept or negotiate the sellers draft. The act of confirmation binds the
confirming bank to the beneficiary without reducing the liability of the opening bank (issuing
bank). That means in case of confirmed letter of credit the seller has rights against both the issuing
bank and confirming bank.
There are so many kinds of letter of credit; such as revocable LC, Irrevocable LC, Confirmed LC,
and Unconfirmed LC, Red clause LC, back to back LC, Standby LC, Revolved LC and
Transferable LC. Some Letters of Credit are recognized and accepted by Commercial Code of
Ethiopia.4
1. The Legal principles governing Letter of credits.
Letter of Credit transaction based on certain principles which has made it one of the most successful
commercial instruments. All type of Letter of credit have legal basis and holds the most important
doctrines for using of letter of credit. The two principles are principle of autonomy and strict
compliance.
1.1. Principle of Autonomy.
Principle of autonomy is one of the fundamental principles of letter of credit. The essence of this
principle is that the Letter of Credit transaction (transaction between seller and the issuing bank) is a
separate and independent transaction and it is, no way, connected with any other transactions (for
example, second and third transactions, as mentioned earlier in introduction part). As a result of the
autonomy principle, the banks do not deal with the goods, services or performance regarding the
underlying contract.
The Principle of autonomy has to be mentioned in our commercial law. Sub-Article (2) of Article
959 of Commercial Code said a documentary credit is independent of any contract of sale on which
it may be based and to which a bank is not a party {Emphasized Added}. The payment obligation of
issuing bank to beneficiary (exporter) is separated from the performance of beneficiary based on the
sales contract. As long as beneficiary presents the compliant bill of documents, issuing bank

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Letter Of Credit
4 There are various types of letters of credit in the world. Therefore, it is essential to state that this article focuses on various
commercial letters of credit which are the most common and other special types of letters of credit are included. Each has different
features and some are more secure than others. This article only focuses on the LC issued by banks, hence popularly known as bank
credits.

Should accept even though beneficiary disobeyed the sales contract that made with the applicant
(importer).
The payment obligation of issuing bank is also independent of the underlying the contract between
applicant and bank. For example, applicant goes bankruptcy after the bank issues letter of credit.
Although applicant cannot pay the money, issuing bank still cannot reject the payment obligation.
In general, breach of underlying contract by the seller does not immune the bank from its payment
undertaking. At the same way, the bank is not allowed to refuse the payment just because of the
buyers failure to put it in funds.
Although the principle of autonomy is set up steadily, it is not absolutely. There are some
exceptions in the real practice. Fraud is the main exception for principle of autonomy. The fraud
exception means that banks obey the principle of autonomy in general situation; however, if banks
keep the obvious evidence of the fraud behavior of beneficiary, banks could refuse to pay.
Applicant can require the bank for rejection, or apply the payment injunctive from the court. 5
1.2 The principle of Strict Compliance.
The presented documents must be in accordance with the terms and conditions of the letter of
credit. Based on the contract between applicant (importer) and issuing bank, the bank has the
obligation to observe the borders of the commission given to it and fulfils the request by observing
the principle of strict compliance. Issuing bank keeps the rejection right when it meets the
documents that disobey this principle.
This Principle is incorporated in our legal system; Article 965 and 966 of the Commercial Code said
that the bank shall satisfy itself that the documents conform strictly to the Instructions contained in
the credit. When it refuses documents the bank shall notify the presenter within as short a time as
possible and inform him of the errors found. The bank shall not incur any liability where the
documents are on their Face in conformity with the instructions received. It shall not incur any
obligation in relation to the goods which are the subject of the credit Opened {Emphasized Added}.
Under the term of letter of credit, issuing bank perform the payment obligation no other than the
exporter submits the documents which is strict compliance with the clauses of letter of credit on the
appearance. Thereby strict compliance becomes the fundamental principle, which restricts the right
and obligation between issuing bank and exporter. The investigation in recent years indicates that:

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Letter Of Credit

5 by Yan Hao and Ling Xiao, International Journal of Business and Social Science, Risk Analysis of Letter of Credit Based on
Principle of Autonomy and Strict Compliance. Law School, Sichuan University of Science & Engineering. Sichuan Province, China.
Vol. 4, (2013). P-200-201.

About 50% rejection of payment is resulted from the discrepancies between the documents and
credit, which decrease the effectiveness of letter of credit, and cause the financial effects for the
parties. Banks must examine all documents stipulated in the credit with reasonable care, to ascertain
whether or not they appear, on their face, to be in compliance with the terms and conditions of the
credit.
2. Types of Letter of Credit
Although they utilize the same basic mechanism as the standard letter of credit, the specialized
types have been designed to satisfy specific needs in the business world. Depending on the degree
of trust and confidence, the parties dispose of two different forms of commercial letters of credit,
such as revocable and irrevocable.
2.1 Irrevocable and revocable letters of credit.
Revocable Letter of Credit does not provide the beneficiary with any particular form of security; the
revocable letter of credit can be canceled or amended at any time prior to payment, at will and
without warning or notification. This form does not give any security to the beneficiary and all the
advantages are to the benefit of the buyer, who disposes with absolute flexibility. Therefore, the
beneficiary will accept a revocable letter of credit not only when he has absolute trust in the buyer,
but also when he trusts the issuing bank. Article 962 and 961 of the Commercial Code recognizes
Revocable Credits, which credits do not constitute a binding agreement between the opening bank
and the beneficiary. Hence, it may be modified or cancelled by the opening bank at any time by a
notice communicated to the correspondent bank prior to payment or negotiation, or the acceptance
bills there under by the latter. A documentary credit is presumed to be revocable in the absence of a
provision that clearly specifies that it is irrevocable.
Whereas Irrevocable Letter of Credit may involve the undertaking of a second bank, in addition to
the issuer, and which represents the most secure among the letter of credit types. Under an
irrevocable letter of credit, the issuing bank commits itself irrevocably to honor its obligation under
the letter of credit upon full compliance by the beneficiary with all the credit conditions. Irrevocable
credits are credits which represent a definite undertaking between the opening bank and the
seller/beneficiary or good faith holders of bills of exchange, drawn by the beneficiary. Hence, the
bank is obliged to pay the money specified in the credit (Commercial Code Article 963). Such

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Letter Of Credit
undertakings can neither be modified nor cancelled without the agreement of all persons concerned
(Commercial code Article 964/3/). There is no difference in

the rapidity and convenience of

payment under the revocable or the irrevocable letter of credit: both devices require the documents
to be delivered under the same conditions and examined by the bank with the same level of
scrutiny. There are two forms of irrevocable letters of credit, such as unconfirmed and confirmed
LC.
2.2 Confirmed and unconfirmed letters of credit.
Unconfirmed Letter of Credit offers a commitment to pay only on the part of the issuing bank.
When the irrevocable letter of credit involves a third bank, the advising bank, it is only to act on
behalf of the issuing bank for administrative purposes, such as the notification of the letter of credit
to the beneficiary, the collection and transfer of the documents, and the payment of the money to
the beneficiary when received from the issuing bank.
Whereas Confirmed Letter of Credit represents the most secure device because it offers an
unconditional undertaking by two entities; the issuing and the confirming bank in confirming the
credit, the advising bank enters into a commitment to pay that is independent of, in addition to, the
issuing bank's commitment. The confirming bank undertakes to honor its commitment regardless of
whether the issuing bank is in a position to reimburse it, thus granting the beneficiary an additional
guaranty of payment. Sub-Article (1) of Article 964 The Commercial code said that This type of
letter of credit may also be confirmed by the correspondent bank upon the request of the opening
bank, and where irrevocable letters are confirmed by the correspondent bank / confirming bank/, a
binding relation will be created between the beneficiary of the credit and the correspondent bank
and the latter will be liable on the letter of credit. We can see an increased rapidity of payment
comparing both of them to the confirmed letter of credit because the latter requires transfer of the
documents and wire of the money through an additional entity, the confirming bank.
2.3 The Standby Letter of Credit.
The standby letter of credit which has been developed specifically to overcome the legal obstacle of
the prohibition for banks to issue guaranties, the specialized types of letter of credit is designed to
provide efficiency to certain transactions. Payment is not automatic but is conditional to an event
which is uncertain. the bank may never be called to execute the payment. The standby credit is
often used in sales transactions to provide the buyer with a guarantee of performance by the seller,
thus providing the same service as the performance bond. 6

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Letter Of Credit
In the U.S., where the performance bond is a contract dependent on the underlying transaction, the
standby letter of credit has the advantage that the bank is not concerned with the determination of
the obligor's default. This allows the beneficiary to receive payment upon presentation of a simple
6 By paolo S. Grassi, Pace International Law Review, Letter of credit transactions; the Banks Position in determining Documentary
Compliance A Comparative Evaluation Under US, Swiss and Germany Law. Volume 7, (1995). P-92.

Declaration of default and without having to go through judicial establishment of the right to be
indemnified (note that the mechanism of the standby letter of credit is the same as the one of the
performance bond as it is known in Germany or in Switzerland). The development of the surety
business by U.S. banks has created a similar structure, though under a different name. Thus, the
standby letter of credit serves many purposes: to provide liquidity, to substitute traditional credit
forms, to reduce credit costs, to shift litigation costs, and to cause prompt payment. A description of
the different options offered by the standby credit and for an illustration of the variety applications.
With the standby letter of credit, the bank provides a guaranty without incurring the risk of having
to pay without being indemnified, as may happen to the traditional surety company. If the customer
becomes insolvent the bank may be compensated from the security or from the customer's account.
The standby letter of credit becomes, in practice, a form of secured loan to the benefit of the
customer.
2.4 The Revolving Letter of Credit.
The Revolving Letter of Credit which allows the rationalization of medium to long term deals,
involving individual payments for multiple shipments. This form of letter of credit is adopted in
cases of transactions involving shipment of goods on a continuing basis and payment of the total
price in multiple installments of similar amounts. The revolving credit is not designed to cover the
full value of goods agreed upon, but the value of the individual shipments to be executed at
different times. Technically the beneficiary receives a letter of credit for the amount of the highest
installment. At the execution of each shipment he may draw the corresponding amount without
causing expiration of the letter of credit. The credit may revolve in relation to time, i.e. up to a
certain amount for a specified number of times during a certain period, or in relation to value, i.e.
for a certain amount to be reinstated each time for a certain period.
2.5 The red clause Letter of Credit.
The red clause Letter of Credit, whose name is derived from originally being written in red ink, the
beneficiary is provided with the right to draw certain amounts of money prior to the execution of his

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Letter Of Credit
obligation. It is a form of financing representing a non collateralized loan to the beneficiary.
Usually it is applied to the benefit of brokers or dealers, who often do not dispose of the amounts
necessary to finance the deal. The red clause credit is also used by manufacturers who need to
dispose of funds prior to the shipping of the goods in order to start production. In consideration of
the high risk involved in this type of credit, it is important that the buyer has extreme trust in the
beneficiary and in his capability to perform the obligations of the underlying contract. There are
different methods that the buyer may use to avoid abuses from the side of the beneficiary; the most
secure is the issuance of a letter of indemnity, but the beneficiary who requests a red clause credit is
probably not in the condition to guarantee a bank for the issuance of such a device. A second
possibility is to request the delivery of documents certifying that the money drawn is used for the
purposes for which the red clause credit has been granted.7
2.6 The Back-to-back Letter Of Credit.
The Back-to-back Letter Of Credit which is used as a basis for the issuance of a second, unrelated,
letter of credit. The back-to-back credit allows the beneficiary to use the letter of credit as a
financing device. In short, the beneficiary who needs to provide guarantees to a third party may
pledge the letter of credit to a bank as collateral for the issuance of a second letter of credit. In this
case, it is the bank, and not the customer, as in the case of the red clause credit, that trusts the
beneficiary of the first letter of credit and believes that he will comply with the obligations of the
first letter of credit. It could happen that the bank is called on to pay the beneficiary of the second
letter of credit, but is not able to recover the amount of the first credit because its customer did not
comply with his obligations. For this reason, banks do not care for this form of credit, and as a
matter of practice tend to refuse to issue second credits.
2.7 The Transferable Letter Of Credit.
To be transferable, the Letter of Credit must be so marked by the issuing bank on the instructions of
the buyer or importer (the account-party). On the instructions of the first beneficiary the advising
bank can transfer it to the second beneficiary but not any further. A Transferable Letter of Credit is
used in cases where there are three parties to a transaction; an Importer (Buyer), Exporter
(Supplier), and an intermediary party, such as a broker, who is responsible for arranging the sale. In
such a transaction, the intermediary party requests a Letter of Credit from the Importer as protection
against non-payment. The Exporter, in turn, wants assurance from the intermediary party that
payment will be made, and will also request a Letter of Credit.

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Letter Of Credit
It may be the case that the intermediary party has little working capital or does not have access to a
line of credit with its bank to issue a separate Letter of Credit to the Exporter. As an alternative, the
intermediary party may provide such assurance to the Exporter by transferring over a portion of the
Letter of Credit it received from the Importer. The Commercial Code of Ethiopia recognizes and
includes Transferable Letter of Credit; Article 967 of commercial Code says that A documentary

7 Ibid, p-93.

Credit is only transferable or divisible where a bank is authorized to pay in whole or in part to one
or more third parties on the Instructions of the first beneficiary. A credit is only transferable on the
Express order of the bank opening the credit. It is so transferable once only, unless otherwise
provided.
This also provides the beneficiary with an indirect financing opportunity. This form of letter of
credit allows the beneficiary to transfer all or part of his rights to a third party. It is a financing
device particularly useful to middlepersons who need to pay their supplier for the goods which are
sold to the buyer in the underlying contract.