Letter of credit 1

Letter of credit
A standard, commercial letter of credit is a document issued mostly
by a financial institution, used primarily in trade finance, which usually
provides an irrevocable payment undertaking.
The letter of credit can also be source of payment for a transaction,
meaning that redeeming the letter of credit will pay an exporter. Letters
of credit are used primarily in international trade transactions of
significant value, for deals between a supplier in one country and a
customer in another. They are also used in the land development
process to ensure that approved public facilities (streets, sidewalks,
storm water ponds, etc.) will be built. The parties to a letter of credit
are usually a beneficiary who is to receive the money, the issuing
After a contract is concluded between buyer and
bank of whom the applicant is a client, and the advising bank of seller, buyer's bank supplies a letter of credit to
whom the beneficiary is a client. Almost all letters of credit are seller.
irrevocable, i.e., cannot be amended or canceled without prior
agreement of the beneficiary, the issuing bank and the confirming
bank, if any. In executing a transaction, letters of credit incorporate
functions common to giros and Traveler's cheques. Typically, the
documents a beneficiary has to present in order to receive payment
include a commercial invoice, bill of lading, and documents proving
the shipment was insured against loss or damage in transit. However,
the list and form of documents is open to imagination and 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.

Seller consigns the goods to a carrier in exchange

Terminology for a bill of lading.

The English name “letter of credit” derives from the French word
“accreditation”, a power to do something, which in turn is derivative of
the Latin word “accreditivus”, meaning trust. This applies to any
defense relating to the underlying contract of sale. This is as long as
the seller performs their duties to an extent that meets the requirements
contained in the letter of credit.

How it works
A business called the InCosmetika from time to time imports goods
from a business called ACME, which banks with the ABC Bank.
InCosmetika holds an account at the Commonwealth Bank.
InCosmetika wants to buy $500,000 worth of merchandise from Seller p bill of lading for payment from buyer's
ACME, who agrees to sell the goods and give InCosmetika 60 days to bank. Buyer's bank exchanges bill of lading for
payment from the buyer.
pay for them, on the condition that they are provided with a 90-day
letter of credit for the full amount. The steps to get the letter of credit
would be as follows:
Letter of credit 2

• InCosmetika goes to The Commonwealth Bank and requests a

$500,000 letter of credit, with ACME as the beneficiary.
• The Commonwealth Bank can issue a letter of credit either on
approval of a standard loan underwriting process or by InCosmetika
funding it directly with a deposit of $500,000 plus fees which are
typically between 1% and 8% of the face value of the letter of
credit.
• The Commonwealth Bank sends a copy of the letter of credit to the
ABC Bank, which notifies ACME that payment is available and
they can ship the merchandise InCosmetika has ordered with the full
assurance of payment to them.
Buyer provides bill of lading to carrier and takes
• On presentation of the stipulated documents in the letter of credit
delivery of goods.
and compliance with the terms and conditions of the letter of credit,
the Commonwealth Bank transfers the $500,000 to the ABC Bank, which then credits the account of ACME for
that amount.
• Note that banks deal only with documents required in the letter of credit and not the underlying transaction.
• Many exporters have mistakenly assumed that the payment is guaranteed after receiving the letter of credit. The
issuing bank is obligated to pay under the letter of credit only when the stipulated documents are presented and
the terms and conditions of the letter of credit have been met.

Availability
A letter of credit being an irrevocable undertaking of the issuing bank makes available the Proceeds, to the
Beneficiary of the Credit provided, stipulated documents strictly complying with the provisions of the letter of credit,
UCP 600 and other international standard banking practices, are presented to the issuing bank, then:
• i.if the Credit provides for sight payment – by payment at sight against compliant presentation
• ii.if the Credit provides for deferred payment – by payment on the maturity date(s) determinable in accordance
with the stipulations of the Credit; and of course undertaking to pay on due date and confirming maturity date at
the time of compliant presentation
• iii.a.if the Credit provides for acceptance by the Issuing Bank – by acceptance of Draft(s) drawn by the
Beneficiary on the Issuing Bank and payment at maturity of such tenor draft, or
• iii.b. if the Credit provides for acceptance by another drawee bank – by acceptance and payment at maturity
Draft(s)drawn by the Beneficiary on the Issuing Bank in the event the drawee bank stipulated in the Credit does
not accept Draft(s) drawn on it,
or by payment of Draft(s) accepted but not paid by such drawee bank at maturity;
• iv. if the Credit provides for negotiation by another bank – by payment without recourse to drawers and/or bona
fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit, (and so negotiated
by the nominated bank )
• Negotiation means the giving of value for Draft(s) and/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.
Letter of credit 3

Some of the Documents Called for under a Letter of Credit

• 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 (ocean or multi-modal or Charter party), 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 abstract and 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 credit alone, and the sale contract is irrelevant. The defences of the buyer arising out of the sale
contract do not concern the bank and in no way affect its liability.[1] 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 (facts).
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.
The policies behind adopting the abstraction principle are purely commercial and reflect a party’s expectations:
firstly, 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 would thus be less inclined to issue documentary credits as
the transaction would involve great risk and inconvenience. Secondly, documents required under the credit could in
certain circumstances be different from those required under the sale transaction; banks would then be placed in a
dilemma in deciding which terms to follow if required to look behind the credit agreement. Thirdly, the fact that the
basic function of the credit is to provide the seller with the certainty of receiving payment, as long as he performs his
documentary duties, suggests that banks should honour their obligation notwithstanding allegations of misfeasance
by the buyer. [2] Finally, courts have emphasised 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.[3] The general legal maxim de
minimis non curat lex has no place in the field of documentary credits.
Letter of credit 4

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 for Letters of Credit

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. In addition, the performance of an existing duty under a contract cannot be a valid
consideration for a new promise made by the bank: the delivery of the goods is consideration for enforcing the
underlying contract of sale and cannot be used, as it were, a second time to establish the enforceability of the
bank-beneficiary relation.
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. [4] 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.
A few countries including the US (see Article 5 of the Uniform Commercial Code) 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[5] . 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

• Advance payment (most secure for seller)
Where the buyer parts with money first and waits for the seller to forward the goods
• Documentary Credit (more secure for seller as well as buyer)
Subject to ICC's UCP 600, where the bank gives an undertaking (on behalf of buyer and at the request of applicant )
to pay the shipper ( beneficiary ) the value of the goods shipped if certain documents are submitted and if the
stipulated terms and conditions are strictly complied.
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 (more secure for buyer and to a certain extent to seller)
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
Letter of credit 5

to the [collecting bank] buyer's bank by seller's bank [remitting bank], for delivering documents against collection of
payment/acceptance
• Direct payment (most secure for buyer)
Where the supplier ships the goods and waits for the buyer to remit the bill proceeds, 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 forged.
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
• Credit Issued by Party other than Bank
Risks to the Advising Bank
• The Advising Bank’s only obligation – if it accepts the Issuing Bank’s instructions – is to check the apparent
authenticity of the Credit and advising it to the Beneficiary
Risks to the Nominated Bank
• Nominated Bank has made a payment to the Beneficiary against documents that comply with the terms and
conditions of the Credit and is unable to obtain reimbursement from the Issuing Bank
Letter of credit 6

Risks to the Confirming Bank

• If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may not be able to obtain
reimbursement from the Issuing Bank because of insolvency of the Issuing Bank or refusal of the Issuing Bank to
reimburse because of a dispute as to whether or not payment should have been made under the Credit
Other Risks in International Trade
• A Credit risk risk from change in the credit of an opposing business.
• An Exchange risk is a risk from a change in the foreign exchange rate.
• A Force majeure risk is 1. a risk in trade incapability caused by a change in a country's policy, and 2. a risk caused
by a natural disaster.
• Other risks are mainly risks caused by a difference in law, language or culture. In these cases, the cargo might be
found late because of a dispute in import and export dealings.

See also
• Uniform Customs and Practice for Documentary Credits
• Buyer's Credit

References
[1] See Ficom S.A. v. Sociedad Cadex [1980] 2 Lloyd’s Rep. 118.
[2] United City Merchants (Investments) Ltd v Royal Bank of Canada (The American Accord) [1983] 1.A.C.168 at 183
[3] J. H. Rayner & Co., Ltd., and the Oilseeds Trading Company, Ltd. v.Hambros Bank Limited [1942] 73 Ll. L. Rep. 32
[4] For extensive analysis See Finkelstein, H. Legal Aspects of Commercial Letters of Credit, pp. 275-295
[5] Dominique Doise,“The 2007 Revision of the Uniform Customs and Practice for Documentary Credits (UCP 600)” (http:/ / www.
alerionavocats. com/ fr/ expertise/ publications/
la-revision-2007-des-regles-et-usances-uniformes-relatives-aux-credits-documentaires-ruu-600/ )
Article Sources and Contributors 7

Article Sources and Contributors

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