Letter of Credit and International Trade:Terminology, Risks in International Trade

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Management of Financial Institutions - MGT 604

Lecture # 30

Letter of Credit and International Trade

A letter of credit is a document issued mostly by a financial institution which usually

provides an irrevocable payment undertaking (it can also be revocable, confirmed,

unconfirmed, transferable or others e.g. back to back: revolving but is most commonly

irrevocable/confirmed) to a beneficiary against complying documents as stated in the Letter

of Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a

documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply

as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank

acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any,

within the expiry date of the LC, comprising documents complying with the terms and

conditions of the LC, the applicable UCP and international standard banking practice, the

issuing bank or confirming bank, if any, is obliged to honour irrespective of any instructions

from the applicant to the contrary. In other words, the obligation to honour (usually

payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-

banks can also issue letters of credit however parties must balance potential risks.

The LC can also be the source of payment for a transaction, meaning that an exporter will

get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in

international trade transactions of significant value, for deals between a supplier in one

country and a wholesale 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 bank of whom the applicant is a client, and the advising bank of whom

the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e.

cannot be amended or cancelled without prior agreement of the beneficiary, the issuing

bank, and the confirming bank, if any). However, the applicant is not a party to the letter of

credit. In executing a transaction, letters of credit incorporate functions common to giros

and Traveler's cheque. Typically, the documents a beneficiary has to present in order to

avail himself of the credit are commercial invoice, bill of lading, insurance documents.

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.

Terminology

The English name "letter of credit" derives from the French word "accreditif", a power to

do something, which in turn is derivative of the Latin word "accreditivus", meaning

trust.This in effect reflects the modern understanding of the instrument. When a seller

agrees to be paid by means of a letter of credit s/he is looking at a reliable bank that has an

obligation to pay them the amount stipulated in the credit notwithstanding any defence

relating to the underlying contract of sale. This is as long as the seller performs their duties

to an extent that meets the credit terms.

How it works

Imagine that a business called the Acme Electronics from time to time imports computers

from a business called Bangalore Computers, which banks with the India Business Bank.

Acme holds an account at the Commonwealth Financials. Acme wants to buy $500,000

worth of merchandise from Bangalore Computers, who agree to sell the goods and give

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Management of Financial Institutions - MGT 604

Acme 60 days to pay for them, on the condition that they are provided with a 90-day LC for

the full amount. The steps to get the letter of credit would be as follows:

Acme goes to The Commonwealth Financials and requests a $500,000 letter of

credit, with Bangalore Computers as the beneficiary.

The Commonwealth Financials can issue an LC either on approval of a standard

loan underwriting process or by Acme funding it directly with a deposit of $500,000

plus fees between 1% and 8%.

The Commonwealth Financials sends a copy of the LC to the India Business Bank,

which notifies the Bangalore Computers that payment is ready and they can ship the

merchandise Acme has ordered with the full assurance of payment to them.

On presentation of the stipulated documents in the letter of credit and compliance

with the terms and conditions of the letter of credit, the Commonwealth Financials

transfers the $500,000 to the India Business Bank, which then credits the account to

the Bangalore Computers by that amount.

Note that banks deal only with documents under the letter of credit and not the

underlying transaction.

Many exporters have misunderstood that the payment is guaranteed after receiving

the LC. 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 accordingly.

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 3(a) UCP states this principle

clearly. Article 4 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 agent, appear to be in order, then in general the bank is both entitled and

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. [3] 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

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if the deviation is purely terminological. The general legal maxim de minimis non curat lex

has no place in the field of documentary credits.

The price of LCs

The applicant pays the LC fee to the bank, and may in turn charge this on to the beneficiary.

From the bank's point of view, the LC they have issued can be called upon at any time

(subject to the relevant terms and conditions), and the bank then looks to reclaim this from

the applicant.

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 analyzed every possible theory from every legal angle and 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.

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.

Even though a couple of countries and US states (see eg Article 5 of the Uniform

Commercial Code) have tried to create statutes to establish the rights of the parties involved

in letter of credit transactions, most parties subject themselves to the Uniform Customs and

Practices (UCP) issued by the International Chamber of Commerce (ICC) in Paris. The ICC

has no legislative authority, rather, representatives of various industry and trade groups

from various countries get together to discuss how to revise the UCP and adapt them to new

technologies. The UCP are quoted according to the publication number the ICC gives them.

The UCP 600 are ICC publication No. 600 and will take effect July 1, 2007. The previous

revision was called UCP 500 and became effective 1993. Since the UCP are not laws,

parties have to include them into their arrangements as normal contractual provisions. It is

interesting to see that in the area of international trade the parties do not rely on

governmental regulations, but rather prefer the speed and ease of auto-regulation.

Risks in International Trade

A Credit risk is a risk from a 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

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Management of Financial Institutions - MGT 604

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.

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