Letters of Credit – Are they really the life blood of international commerce?

In international trade where buyers and sellers are located in different countries, there is little comfort about the credit worthiness and business standing of the parties. To overcome this, remove the risk of insolvency of the buyer and provide a degree of comfort to the parties, Letter of Credit (LC) plays a crucial role. In fact, they have been described as the “lifeblood of international commerce”.1

Our aim in publishing this guide is to provide a basic understanding of Letters of Credit.

A] What is a letter of credit?

In its simplest term, a letter of credit (LC) is a guarantee from a bank that a party to a contract (typically a seller) will receive a payment from the other party (typically a buyer) upon fulfilling certain pre-agreed obligations. To process payment, the bank will require that strict terms are met.

This is most commonly used (but not restricted to) overseas trade as it can give security both to the seller and the buyer. The bank will only issue a letter of credit if it is confident that the buyer will pay, whether by an up-front payment to the bank or through a line of credit with the bank.

It is important to note, the letter of credit is a distinct and separate transaction from the contract on which it is based.

Lord Denning said: ‘It has been long established that when a letter of credit is issued and confirmed by a bank, the bank must pay it if the documents are in order and the terms of the credit are satisfied. Any dispute between buyer and seller must be settled between themselves. The bank must honor the credit”2.

B] Parties commonly involved in a Letter of Credit

1] Applicant:

Applicant is the party who opens the Letter of Credit in favor of the other party to the contract (beneficiary). Normally, the applicant is the party who is buying the goods. The applicant is the one who arrange the opening of letter of credit with his bank as per the terms and conditions agreed between him and the seller.

2] Beneficiary

Beneficiary is the one who gets the benefit and receives amount under letter of credit (eg. the seller). Payment cannot be released until fulfilling certain pre-agreed obligations and submission of a set of pre-defined documents to the issuing bank.

3] Issuing Bank

Issuing bank is the bank that issues a letter of credit at the request of an applicant. The issuing bank is not liable for the performance of the underlying contract between the applicant and beneficiary as, its obligation to the buyer is to examine all documents to insure compliance with the terms and conditions of the LC. In a similar fashion, the issuing banks obligation to the seller is to provide a guarantee that if compliant documents are presented, the bank will pay the amount due.

Reference to compliant documents would typically include commercial invoice, bill of lading, insurance document, etc.

4] Advising Bank

Advising bank is the party responsible for sending the documents to the issuing bank. It is also the bank where the beneficiary must present documents required by the LC in order to be paid. There is no obligation on the advising bank to pay in the event the issuing bank does not pay the beneficiary.

5] Confirming Bank

Confirming bank is the bank who adds his undertaking to the letter of credit thus providing an additional/second guarantee to assure payment. This commonly happens when the issuing bank may have questionable creditworthiness.

Different to the advising bank, the confirming bank is under obligation to pay in the event the issuing bank does not pay the beneficiary. The confirming bank is usually the advising bank and it is noteworthy, only irrevocable letters of credit can be confirmed.

C] Characteristics of Letter of Credit

1] Negotiability

Negotiation is a very important aspect of letter of credit. LCs are usually negotiable where the issuing bank obligation is extended to pay not only the beneficiary, but also any other bank nominated by the beneficiary.

For an LC to be negotiable, it must include an unconditional promise to pay, on demand or at some specific time. The nominated bank takes the letter of credit for value, in good faith, without notice of any claims against it.

2] Revocability

Whilst revocable letter of credits are not commonly used instruments, letters of credit may be either revocable or irrevocable. A revocable letter of credit may be revoked or modified by the issuing bank without notification. On the other hand, irrevocable letter of credit (the commonly used option) may not be revoked or amended without the agreement of the issuing bank, the confirming bank and the beneficiary.

3] Transferable

Under a transferable LC the rights and obligations of the beneficiary are transferred, in whole or in part, to another party, usually a supplier or a manufacturer. This will enable the beneficiary to pay the supplier by letter of credit. Under this process the supplier or manufacture (i.e. the transferee) becomes a substitute beneficiary with the right to submit documents and make draws in its own name. To be transferable, the LC must state that it is transferable.

This shall not be confused with assignment of proceeds where the assignee is not entitled to make a draw directly or to submit documents in its own name.

4] Revolving

For long terms business relationship, revolving LC allows companies to issue a letter of credit that could revolve either in value or in time without the need to reapply for a new LC. In simple terms it is a single letter of credit which can be used several times over a long period of time.

D] Payment against LC:

All letters of credit require the beneficiary to present some specified documents in order to receive payment. In accordance with the rules in place for letters of credit (UCP 600), credit must also state whether it is available by sight payment, deferred payment, acceptance or negotiation.

1] Sight payment

In this scenario, the beneficiary will receive payment immediately upon submission of the required documents. It is important to realize that “immediately” does not literally mean that the payment will be made immediately as the bank is allowed a reasonable time to review the documents before making payment.

2] Deferred payment

In this situation, payment is made at a future date stipulated in the LC (for example 60 days after submission of commercial invoice). This does not mean that the issuing bank will not review the document upon its submission. The bank is still required to review the documents upon submission to ensure they are credit compliant and thereafter pay at maturity.

3] Acceptance

This is similar to the deferred payment method but do require the issuance of bills of exchange. In this situation, the confirming bank would have to accept a bill of exchange (“draft”) drawn by the beneficiary and pay at maturity.

4] Negotiation

The UCP 600 defines negotiation as the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.

This effectively means that the beneficiary is allowed to receive payment by negotiating the sight drafts and documents at a nominated negotiating bank that shall then pay the beneficiary prior to receiving the reimbursement. It is important to note, in the context of UCP 600, only a nominated bank can negotiate and this can only be done under a credit available by negotiation.

E] Main types of Letter of Credit

There are basically two types: commercial and standby. The commercial letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit acts as a secondary payment mechanism.

1] Commercial Letter of Credit

A letter of credit is a contractual relationship between a bank (issuing bank) that on behalf of his customer (the applicant) authorizes another bank (advising/confirming bank) to pay a beneficiary subject to presenting certain documents. The beneficiary is normally the provider of goods and/or services under a separate contract between the applicant and the beneficiary.

2] Standby Letter of Credit

A stand-by Letter of Credit serves a different function than the commercial one. It is simply a bank’s commitment to make payment in the event of default on the part of the Applicant.  This is to typically provide assurance of the applicant ability to perform its obligations (commonly payment obligations) under the terms of a contract between the beneficiary. Under this transaction the parties do not expect that the letter of credit will ever be drawn upon.

Important note:

One thing to remember, Banks deal in documents only. The issuing bank is only replacing its credit worthiness to that of applicant and not undertaking to ensure the quality of the goods. If a dispute arises between the applicant and beneficiary over the quality of the goods, the seller upon presenting complying documents to the Issuing Bank, will be entitled to receive the money and the buyer does not have any authority or remedy to stop the Issuing Bank from making payment. The dispute will then need to be resolved separately.

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1. R-D. Harbottle v. National Westminster Bank, 2 All E.R. 862, 870 (1977) (Kerr, J.)
2. Edward Owen Engineering v Barclays Bank; CA 1978