Letter of credit

After a contract is concluded between a buyer and a seller, the buyer's bank supplies a letter of credit to the seller.
Seller consigns the goods to a carrier in exchange for a bill of lading.
Seller provides the bill of lading to bank in exchange for payment. Seller's bank then provides the bill to buyer's bank, who provides the bill to buyer.
Buyer provides the bill of lading to carrier and takes delivery of the goods.

A letter of credit is a document, typically from a bank (Issuing Bank), assuring that a seller (Beneficiary) will receive payment up to the amount of the letter of credit, as long as certain documentary delivery conditions have been met. In the event that the buyer (Applicant) is unable to make payment on the purchase, the Beneficiary may make a demand for payment on the bank. The bank will examine the Beneficiary's demand and if it complies with the terms of the letter of credit, will honor the demand.

The letter of credit states what documents the Beneficiary must present, what information they must contain, and the place and date it expires. Beneficiaries who sell goods and utilize a letter of credit as the method of payment have the assurance of the issuing bank that if they present the documents stated in the letter of credit, the issuing bank will honor their demand for payment.

They are often used in international transactions to ensure that payment will be received where the buyer and seller may not know each other and are operating in different countries. In this case the seller is exposed to a number of risks such as credit risk, and legal risk caused by the distance, differing laws and difficulty in knowing each party personally. A letter of credit provides the seller with a guarantee that they will get paid as long as certain documentary delivery conditions have been met. For this reason the use of letters of credit has become a very important aspect of international trade.

The bank that writes the letter of credit will act on behalf of the buyer and make sure that all documentary conditions have been met before making the payment to the seller. Most letters of credit are governed by rules promulgated by the International Chamber of Commerce known as Uniform Customs and Practice for Documentary Credits. The current version, UCP600, became effective July 1, 2007. Letters of credit are typically used by importing and exporting companies particularly for large purchases and will often negate the need by the buyer to pay a deposit before delivery is made.

They are also used in land development to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are the supplier, usually called the "beneficiary", "the issuing bank", of whom the buyer is a client, and sometimes an advising bank, of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without mutual consent of all parties.

Terminology

Origin

The name "letter of credit" derives from the French word "accréditation", a power to do something, which derives from the Latin "accreditivus", meaning trust.

Related terms

the terms and conditions of the credit
the applicable provisions of UCP
international standard banking practice
Making payment at sight for sight LC.
Incurring a deferred payment undertaking and paying at maturity for deferred payment LC.
Accepting a draft drawn by the beneficiary and paying at maturity for deferred acceptance LC.

Documents that can be presented for payment

To receive payment, an exporter or shipper must present the documents required by the LC. Typically, the payee presents a document proving the goods were sent instead of showing the actual goods. The original bill of lading (BOL) is normally the document accepted by banks as proof that goods have been shipped. However, the list and form of documents is open to negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin or place. Typical types of documents in such contracts include:

Legal principles governing documentary credits

One of the primary peculiarities of the documentary credit is that the payment obligation is independent from the underlying contract of sale or any other contract in the transaction. Thus the bank’s obligation is defined by the terms of the LC alone, and the sale contract is irrelevant. The defenses available to the buyer arising out of the sale contract do not concern the bank and in no way affect its liability.[1] Article 4(a) of the UCP600 states this principle clearly.

Fundamental to all letters of credit is the principle that letters of credit deal with documents, not with goods. Article 5 of the UCP600 explicitly 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, are in order, then in general the bank is obliged to pay without further qualifications. Therefore the buyer bears the risk that a dishonest seller may present documents which comply with the letter of credit and receive payment, only to later discover the documents are fraudulent.

The policies behind adopting the abstraction principle are purely commercial and reflect a party’s expectations.

First, if the responsibility for the validity of documents was thrown onto banks, they would be burdened with investigating the underlying facts of each transaction, and less inclined to issue documentary credits because of the risk and inconvenience.

Second, documents required under the LC could in certain circumstances be different from those required under the sale transaction. This would place banks in a dilemma in deciding which terms to follow if required to look behind the credit agreement.

Third, the fact that the basic function of the credit is to provide a seller with the certainty of payment for documentary duties suggests that banks should honor their obligation notwithstanding allegations of buyer misfeasance.[2] Courts have emphasized that buyers always have a remedy for an action upon the contract of sale and that it would be a calamity for the business world if a bank had to investigate every breach of contract.

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

Types

The middleman is entitled to substitute his own invoice for the supplier's and acquire the difference as profit.
A letter of credit can be transferred to the second beneficiary at the request of the first beneficiary only if it expressly states that the letter of credit is "transferable". A bank is not obligated to transfer a credit.
A transferable letter of credit can be transferred to more than one alternate beneficiary as long as it allows partial shipments.
The terms and conditions of the original credit must be replicated exactly in the transferred credit. However, to keep the workability of the transferable letter of credit, some figures can be reduced or curtailed.
  • Amount
  • Unit price of the merchandise (if stated)
  • Expiry date
  • Presentation period
  • Latest shipment date or given period for shipment.
The first beneficiary may demand from the transferring bank to substitute for the applicant. However, if a document other than the invoice must be issued in a way to show the applicant's name, in such a case that requirement must indicate that in the transferred credit it will be free.
Transferred credit cannot be transferred again to a third beneficiary at the request of the second beneficiary.

Pricing

Issuance charges, covering negotiation, reimbursements and other charges are paid by the applicant or as per the terms and conditions of the LC. If the LC does not specify charges, they are paid by the Applicant. Charge-related terms are indicated in field 71B.

Legal basis

Legal writers have failed to satisfactorily reconcile the bank’s undertaking with any contractual analysis. The theories include: the implied promise, assignment theory, the novation theory, reliance theory, agency theories, estoppels and trust theories, anticipatory theory and the guarantee theory.[6]

Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. However, the performance of an existing duty under a contract may be a valid consideration for a new promise made by the bank, provided that there is some practical benefit to the bank[7] A promise to perform owed to a third party may also constitute a valid consideration.[8]

Another theory asserts that it is feasible to typify letter of credit as a collateral contract for a third-party beneficiary because three different entities participate in the transaction: the seller, the buyer, and the banker. Because letters of credit are prompted by the buyer’s necessity and in application of the theory of Jean Domat the cause of a LC is to release the buyer of his obligation to pay directly to the seller. Therefore, a LC theoretically fits as a collateral contract accepted by conduct or in other words, an implied-in-fact contract under the framework for third party beneficiary where the buyer participates as the third party beneficiary with the bank acting as the stipulator and the seller as the promisor. The term "beneficiary" is not used properly in the scheme of an LC because a beneficiary (also, in trust law, cestui que use) in the broadest sense is a natural person or other legal entity who receives money or other benefits from a benefactor. Note that under the scheme of letters of credit, banks are neither benefactors of sellers nor benefactors of buyers and the seller receives no money in gratuity mode. Thus is possible that a “letter of credit” was one of those contracts that needed to be masked to disguise the “consideration or privity requirement”. As a result, this kind of arrangement, would make letter of credit to be enforceable under the action assumpsit because of its promissory connotation.[9]

A few countries have created statutes in relation to letters of credit. For example, most jurisdictions in the United States (U.S.) have adopted Article 5 of the Uniform Commercial Code (UCC). These statutes are designed to work with the rules of practice including UCP and 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. Since the UCP are not laws, parties have to include them into their arrangements as normal contractual provisions.

International Trade Payment methods

Risk situations

Fraud Risks
Sovereign and Regulatory Risks
Legal Risks
Force Majeure and Frustration of Contract
Applicant
Issuing Bank
Reimbursing Bank
Beneficiary

See also

References

  1. Ficom S.A. v. Socialized 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 Oil seeds Trading Company, Ltd. v.Ham bros Bank Limited [1942] 73 Ll. L. Rep. 32
  4. Sinclair, James. "What are the different types of Letter of Credit?". Trade Finance Global. Trade Finance Global. Retrieved 12 December 2014.
  5. Finkelstein, Herman Norman (1930). Legal Aspects of Commercial Letters of Credit.
  6. William v Roffey Brothers & Nicholls (contractors) Ltd
  7. Scotson v Pegg
  8. Menendez, Andres. "Letter of Credit, its Relation with Stipulation for the Benefit of a Third Party". Retrieved 1 June 2013.

External links

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