A standard, commercial
letter of credit (LC) is a document issued mostly by a
financial institutionIn financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries...
, used primarily in
trade financeTrade finance is related to international trade.While a seller can require the purchaser to prepay for goods shipped, the purchaser may wish to reduce risk by requiring the seller to document the goods that have been shipped. Banks may assist by providing various forms of support...
, which usually provides an irrevocable payment undertaking.
The letter of credit can also be payment for a transaction, meaning that redeeming the letter of credit pays an exporter. Letters of credit are used primarily in
international tradeInternational trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product...
transactions of significant value, for deals between a supplier in one country and a customer in another. In such cases, the International Chamber of Commerce
Uniform Customs and Practice for Documentary CreditsThe Uniform Customs and Practice for Documentary Credits is a set of rules on the issuance and use of letters of credit. The UCP is utilized by bankers and commercial parties in more than 175 countries in trade finance...
applies (UCP 600 being the latest version). 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 bank of whom the applicant is a client, and the
advising bankAn advising bank advises a beneficiary that a letter of credit opened by an issuing bank for an applicant is available. Advising Bank's responsibility is to authenticate the letter of credit issued by the issuer to avoid fraud...
of whom the beneficiary is a client. Almost all letters of credit are 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
giroA Giro or giro transfer is a payment transfer from one bank account to another bank account and instigated by the payer, not the payee...
s and
Traveler's chequeA traveler's cheque is a preprinted, fixed-amount cheque designed to allow the person signing it to make an unconditional payment to someone else as a result of having paid the issuer for that privilege.- Usage :As traveler's cheques can usually be replaced if lost or stolen A traveler's cheque...
s. Typically, the documents a beneficiary has to present in order to receive payment include a
commercial invoiceA commercial invoice is a document used in foreign trade. It is used as a customs declaration provided by the person or corporation that is exporting an item across international borders...
,
bill of ladingA bill of lading is a document issued by a carrier to a shipper, acknowledging that specified goods have been received on board as cargo for conveyance to a named place for delivery to the consignee who is usually identified...
, and documents proving the shipment was insured against loss or damage in transit.
Origin of the term
The English name “letter of credit” derives from the French word “accreditation,” a power to do something, which in turn derives from the Latin “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.
Types and related terms
Letters of credit (LC) deal in documents, not goods. An LC can be
irrevocable or
revocable. An irrevocable LC cannot be changed unless both buyer and seller agree. With a revocable LC, changes can be made without the consent of the beneficiary.
A
sight LC means that payment is made immediately to the beneficiary/seller/exporter 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) 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.
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 (OBL) is normally the document accepted by banks as proof that goods have been shipped. 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 or place. Typical types of documents in such contracts might include:
- Bill of Exchange
A negotiable instrument is a document guaranteeing the payment of a specific amount of money, either on demand, or at a set time. According to the Section 13 of the Negotiable Instruments Act, 1881 in India, a negotiable instrument means a promissory note, bill of exchange or cheque payable either...
, Co-accepted Draft
- Invoice
An invoice or bill is a commercial document issued by a seller to the buyer, indicating the products, quantities, and agreed prices for products or services the seller has provided the buyer. An invoice indicates the buyer must pay the seller, according to the payment terms...
, Packing list
- Transport Document
A bill of lading is a document issued by a carrier to a shipper, acknowledging that specified goods have been received on board as cargo for conveyance to a named place for delivery to the consignee who is usually identified...
, Insurance Certificate, Commercial, Official or Legal Documents
- License, Embassy legalization, Origin Certificate, Inspection Certificate, Phytosanitary certificate
The Agreement on the Application of Sanitary and Phytosanitary Measures - also known as the SPS Agreement is an international treaty of the World Trade Organization...
- Bill of Lading
A bill of lading is a document issued by a carrier to a shipper, acknowledging that specified goods have been received on board as cargo for conveyance to a named place for delivery to the consignee who is usually identified...
(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 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. 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.
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 would thus be less inclined to issue documentary credits as the transaction would involve great risk and inconvenience. Second, documents required under the 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 honour their obligation notwithstanding allegations of misfeasance by the buyer. 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. The general legal maxim
de minimis non curat lexDe minimis is a Latin expression meaning about minimal things, normally in the locutions de minimis non curat praetor or de minimis non curat lex .In risk assessment it refers to a level of risk that is too small to be concerned with...
has no place in the field of documentary credits.
Letter of credit also refers to FIATA documents. More strictly, in practice freight forwarders usual present FIATA documents and the question is does FIATA documents can use like a document for activating letter of credit. In theory, the question is not very clear, because of the weakness in UCP 600.
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.
A standard, commercial letter of credit (LC[1]) 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 payment for a transaction, meaning that redeeming the letter of credit pays 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. In such cases, the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies (UCP 600 being the latest version).[2] 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 bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are 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.
Legal basis
Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any
considerationConsideration is the central concept in the common law of contracts and is required, in most cases, for a contract to be enforceable. Consideration is the price one pays for another's promise. It can take a number of forms: money, property, a promise, the doing of an act, or even refraining from...
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,
assignmentAn assignment is a term used with similar meanings in the law of contracts and in the law of real estate. In both instances, it encompasses the transfer of rights held by one party—the assignor—to another party—the assignee...
theory, the
novationIn contract law and business law, novation is the act of either replacing an obligation to perform with a new obligation, or replacing a party to an agreement with a new party...
theory, reliance theory,
agencyThe law of agency is an area of commercial law dealing with a contractual or quasi-contractual, or non-contractual set of relationships when a person, called the agent, is authorized to act on behalf of another to create a legal relationship with a third party...
theories,
estoppelEstoppel in its broadest sense is a legal term referring to a series of legal and equitable doctrines that preclude "a person from denying or asserting anything to the contrary of that which has, in contemplation of law, been established as the truth, either by the acts of judicial or legislative...
s and
trustIn common law legal systems, a trust is a relationship whereby property is held by one party for the benefit of another...
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 generisSui generis is a Latin expression, literally meaning of its own kind/genus or unique in its characteristics. The expression is often used in analytic philosophy to indicate an idea, an entity, or a reality which cannot be included in a wider concept....
.
A few countries including the United States (see Article 5 of the
Uniform Commercial CodeThe Uniform Commercial Code , first published in 1952, is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America.The goal of harmonizing state law is...
) 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. For more information on legal issues surrounding letters of credit, the
Journal of International Commercial Law at George Mason University's
School of Law published
Volume 1, Issue 1 exclusively on the topic.
.
International Trade Payment methods
International Trade Payment method can be done in the following ways.
- 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 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 (more secure for buyer and to a certain extent to seller)
Also called "Cash Against Documents". Subject to ICC's URC 525, sight and
usanceUsance refers to the utilization of economic goods to satisfy needs. In manufacturing, "usance" means "inputs." It is used in "usance bills." This terminology is used in banks in India, when dealing with forex....
, 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 (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 MajeureForce majeure or vis major "superior force", also known as cas fortuit or casus fortuitus "chance occurrence, unavoidable accident", is a common clause in contracts that essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of...
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
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
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty 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
Force majeure or vis major "superior force", also known as cas fortuit or casus fortuitus "chance occurrence, unavoidable accident", is a common clause in contracts that essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of...
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.
External links