Letterofcredit

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Aletterofcreditisadocument,typicallyfromabank(Issuing
Bank),assuringthataseller(Beneficiary)willreceivepaymentup
totheamountoftheletterofcredit,aslongascertaindocumentary
deliveryconditionshavebeenmet.Intheeventthatthebuyer
(Applicant)isunabletomakepaymentonthepurchase,the
Beneficiarymaymakeademandforpaymentonthebank.Thebank
willexaminetheBeneficiary'sdemandandifitcomplieswiththe
termsoftheletterofcredit,willhonorthedemand.
TheletterofcreditstateswhatdocumentstheBeneficiarymust
present,whatinformationtheymustcontain,andtheplaceanddate
itexpires.Beneficiarieswhosellgoodsandutilizealetterofcredit
asthemethodofpaymenthavetheassuranceoftheissuingbank
thatiftheypresentthedocumentsstatedintheletterofcredit,the
issuingbankwillhonortheirdemandforpayment.

Afteracontractisconcludedbetween
abuyerandaseller,thebuyer'sbank
suppliesaletterofcredittotheseller.

Theyareoftenusedininternationaltransactionstoensurethat
paymentwillbereceivedwherethebuyerandsellermaynotknow
eachotherandareoperatingindifferentcountries.Inthiscasethe
sellerisexposedtoanumberofriskssuchascreditrisk,andlegal
riskcausedbythedistance,differinglawsanddifficultyinknowing
eachpartypersonally.Aletterofcreditprovidesthesellerwitha
guaranteethattheywillgetpaidaslongascertaindocumentary
deliveryconditionshavebeenmet.Forthisreasontheuseofletters
ofcredithasbecomeaveryimportantaspectofinternationaltrade.
Thebankthatwritestheletterofcreditwillactonbehalfofthe
buyerandmakesurethatalldocumentaryconditionshavebeenmet
beforemakingthepaymenttotheseller.Mostlettersofcreditare
Sellerconsignsthegoodstoacarrier
governedbyrulespromulgatedbytheInternationalChamberof
inexchangeforabilloflading.
CommerceknownasUniformCustomsandPracticefor
DocumentaryCredits.Thecurrentversion,UCP600,became
effectiveJuly1,2007.Lettersofcreditaretypicallyusedbyimportingandexportingcompanies
particularlyforlargepurchasesandwilloftennegatetheneedbythebuyertopayadepositbeforedelivery
ismade.
Theyarealsousedinlanddevelopmenttoensurethatapprovedpublicfacilities(streets,sidewalks,storm
waterponds,etc.)willbebuilt.Thepartiestoaletterofcreditarethesupplier,usuallycalledthe
"beneficiary","theissuingbank",ofwhomthebuyerisaclient,andsometimesanadvisingbank,ofwhom
thebeneficiaryisaclient.Almostalllettersofcreditareirrevocable,i.e.,cannotbeamendedorcanceled
withoutmutualconsentofallparties.

Contents

1 Terminology
1.1 Origin
1.2 Relatedterms
2 Documentsthatcanbepresentedforpayment
3 Legalprinciplesgoverningdocumentarycredits
4 Types
5 Pricing
6 Legalbasis
7 InternationalTradePaymentmethods

Sellerprovidesthebillofladingto
bankinexchangeforpayment.
Seller'sbankthenprovidesthebillto
buyer'sbank,whoprovidesthebillto
buyer.

8 Risksituations
9 Seealso
10 References
11 Externallinks

Terminology
Origin
Thename"letterofcredit"derivesfromtheFrenchword
"accrditation",apowertodosomething,whichderivesfromthe
Latin"accreditivus",meaningtrust.

Buyerprovidesthebillofladingto
carrierandtakesdeliveryofthe
goods.

Relatedterms
AsightLCcausespaymenttobemadeimmediatelytothebeneficiary/seller/exporterupon
presentationofthecorrectdocuments.AtimeordateLCspecifieswhenpaymentistobemadeata
futuredateanduponpresentationoftherequireddocuments.
Negotiationmeansthegivingofvaluefordraft(s)ordocument(s)bythebankauthorizedto
negotiate,withthenominatedbank.Mereexaminationofthedocumentsandforwardingthesameto
theLCissuingbankforreimbursement,withoutgivingofvalue/agreedtogive,doesnotconstitutea
negotiation.
AdvisingBankadvisesthebeneficiaryattherequestoftheissuingbank.

Applicantthepartyonwhoserequesttheissuingbankissuesacredit.
BankingdayThedayonwhichabankisregularlyopenattheplaceatwhichanacttobe
performed.
Beneficiarythepartywhoistoreceivethebenefit(payment)oftheLC.TheconsigneeofanLC
andthebeneficiarymaynotbethesame.Thecreditisissuedinthebeneficiary'sfavor.
PresentationeitherdeliveryofdocumentsagainstanLCorthedocumentitself.
Complyingpresentationwhenthepresentationofdocumentsisinaccordancewith:
thetermsandconditionsofthecredit
theapplicableprovisionsofUCP
internationalstandardbankingpractice
Confirmationadefiniteundertakingfromtheconfirmingbanktohonorornegotiateacomplying
presentationinadditiontothatoftheissuingbank.
ConfirmingbankaddsconfirmationtoanLC.Itdoessoattherequestoftheissuingbankand
takingauthorizationfromtheissuingbank.
Letterofcredit/creditanirrevocablecommitmentoftheissuingbanktohonoracomplying
presentation.
HonourtoactaccordingtocommitmentoftheLC.Presentationsarehonoredindifferentways
dependingonthetypeofcredit:
MakingpaymentatsightforsightLC.
IncurringadeferredpaymentundertakingandpayingatmaturityfordeferredpaymentLC.
AcceptingadraftdrawnbythebeneficiaryandpayingatmaturityfordeferredacceptanceLC.
IssuingbankissuestheLC.
NominatedBankthebankwithwhichcreditisavailable.Ifnobankismentionedinthecreditas
nominatedbank,allbanksare"nominated".
NegotiationAnominatedbankissaidtonegotiateadocumentifitpurchasesadraftordocuments
underacomplyingpresentationeitherbymakinganadvanceoragreeingtoadvancefundstothe
beneficiaryonorbeforethedateonwhichreimbursementisduetothenominatedbank.Adraft
drawnonanominatedbankcannotbepurchasedseparately.

Documentsthatcanbepresentedforpayment
Toreceivepayment,anexporterorshippermustpresentthedocumentsrequiredbytheLC.Typically,the
payeepresentsadocumentprovingthegoodsweresentinsteadofshowingtheactualgoods.Theoriginal
billoflading(BOL)isnormallythedocumentacceptedbybanksasproofthatgoodshavebeenshipped.
However,thelistandformofdocumentsisopentonegotiationandmightcontainrequirementstopresent
documentsissuedbyaneutralthirdpartyevidencingthequalityofthegoodsshipped,ortheirplaceof
originorplace.Typicaltypesofdocumentsinsuchcontractsinclude:

Financialdocumentsbillofexchange,coaccepteddraft
Commercialdocumentsinvoice,packinglist
Shippingdocumentstransportdocument,insurancecertificate,commercial,officialorlegal
documents
OfficialdocumentsLicense,embassylegalization,origincertificate,inspectioncertificate,
phytosanitarycertificate
Transportdocumentsbilloflading(oceanormultimodalorcharterparty),airwaybill,lorry/truck
receipt,railwayreceipt,CMCotherthanmatereceipt,forwardercargoreceipt
InsurancedocumentsInsurancepolicyorcertificate,butnotacovernote.
IfimportMachinery/devicethenrequired"TestCertificate"

Legalprinciplesgoverningdocumentarycredits
Oneoftheprimarypeculiaritiesofthedocumentarycreditisthatthepaymentobligationisindependent
fromtheunderlyingcontractofsaleoranyothercontractinthetransaction.Thusthebanksobligationis
definedbythetermsoftheLCalone,andthesalecontractisirrelevant.Thedefensesavailabletothebuyer
arisingoutofthesalecontractdonotconcernthebankandinnowayaffectitsliability.[1]Article4(a)of
theUCP600statesthisprincipleclearly.
Fundamentaltoalllettersofcreditistheprinciplethatlettersofcreditdealwithdocuments,notwithgoods.
Article5oftheUCP600explicitlystatesthatbanksdealwithdocumentsonly,theyarenotconcernedwith
thegoods(facts).Accordingly,ifthedocumentstenderedbythebeneficiary,orhisorheragent,arein
order,theningeneralthebankisobligedtopaywithoutfurtherqualifications.Thereforethebuyerbears
theriskthatadishonestsellermaypresentdocumentswhichcomplywiththeletterofcreditandreceive
payment,onlytolaterdiscoverthedocumentsarefraudulent.
Thepoliciesbehindadoptingtheabstractionprinciplearepurelycommercialandreflectapartys
expectations.
First,iftheresponsibilityforthevalidityofdocumentswasthrownontobanks,theywouldbeburdened
withinvestigatingtheunderlyingfactsofeachtransaction,andlessinclinedtoissuedocumentarycredits
becauseoftheriskandinconvenience.
Second,documentsrequiredundertheLCcouldincertaincircumstancesbedifferentfromthoserequired
underthesaletransaction.Thiswouldplacebanksinadilemmaindecidingwhichtermstofollowif
requiredtolookbehindthecreditagreement.
Third,thefactthatthebasicfunctionofthecreditistoprovideasellerwiththecertaintyofpaymentfor
documentarydutiessuggeststhatbanksshouldhonortheirobligationnotwithstandingallegationsofbuyer
misfeasance.[2]Courtshaveemphasizedthatbuyersalwayshavearemedyforanactionuponthecontract
ofsaleandthatitwouldbeacalamityforthebusinessworldifabankhadtoinvestigateeverybreachof
contract.
Theprincipleofstrictcompliancealsoaimstomakethebanksdutyofeffectingpaymentagainst
documentseasy,efficientandquick.Hence,ifthedocumentstenderedunderthecreditdeviatefromthe
languageofthecreditthebankisentitledtowithholdpayment,evenifthedeviationispurely
terminological.[3]Thegenerallegalmaximdeminimisnoncuratlexhasnoplaceinthefield

Types
Import/exportThesamecreditcanbetermedanimportorexportLC[4]dependingonwhose
perspectiveisconsidered.FortheimporteritistermedanImportLCandfortheexporterofgoods,
anExportLC.
RevocableThebuyerandthebankthatestablishedtheLCareabletomanipulatetheLCormake
correctionswithoutinformingorgettingpermissionsfromtheseller.AccordingtoUCP600,allLCs
areirrevocable,hencethistypeofLCisobsolete.
IrrevocableAnychanges(amendment)orcancellationoftheLC(exceptitisexpired)isdoneby
theapplicantthroughtheissuingbank.Itmustbeauthenticatedandapprovedbythebeneficiary.
ConfirmedAnLCissaidtobeconfirmedwhenasecondbankaddsitsconfirmation(or
guarantee)tohonoracomplyingpresentationattherequestorauthorizationoftheissuingbank.
UnconfirmedThistypedoesnotacquiretheotherbank'sconfirmation.
RestrictedOnlyoneadvisingbankcanpurchaseabillofexchangefromthesellerinthecaseofa
restrictedLC.
UnrestrictedTheconfirmationbankisnotspecified,whichmeansthattheexportercanshowthe
billofexchangetoanybankandreceiveapaymentonanunrestrictedLC.
TransferrableTheexporterhastherighttomakethecreditavailabletooneormoresubsequent
beneficiaries.Creditsaremadetransferablewhentheoriginalbeneficiaryisamiddlemananddoes
notsupplythemerchandise,butprocuresgoodsfromsuppliersandarrangesthemtobesenttothe
buyeranddoesnotwantthebuyerandsupplierknoweachother.[5]
Themiddlemanisentitledtosubstitutehisowninvoiceforthesupplier'sandacquirethedifference
asprofit.
Aletterofcreditcanbetransferredtothesecondbeneficiaryattherequestofthefirstbeneficiary
onlyifitexpresslystatesthattheletterofcreditis"transferable".Abankisnotobligatedtotransfera
credit.
Atransferableletterofcreditcanbetransferredtomorethanonealternatebeneficiaryaslongasit
allowspartialshipments.
Thetermsandconditionsoftheoriginalcreditmustbereplicatedexactlyinthetransferredcredit.
However,tokeeptheworkabilityofthetransferableletterofcredit,somefigurescanbereducedor
curtailed.
Amount
Unitpriceofthemerchandise(ifstated)
Expirydate
Presentationperiod
Latestshipmentdateorgivenperiodforshipment.
Thefirstbeneficiarymaydemandfromthetransferringbanktosubstitutefortheapplicant.However,
ifadocumentotherthantheinvoicemustbeissuedinawaytoshowtheapplicant'sname,insucha

casethatrequirementmustindicatethatinthetransferredcredititwillbefree.
Transferredcreditcannotbetransferredagaintoathirdbeneficiaryattherequestofthesecond
beneficiary.
UntransferableAcreditthatthesellercannotassignallorpartoftoanotherparty.Ininternational
commerce,allcreditsareuntransferable.
Deferred/UsanceAcreditthatisnotpaid/assignedimmediatelyafterpresentation,butafteran
indicatedperiodthatisacceptedbybothbuyerandseller.Typically,sellerallowsbuyertopaythe
requiredmoneyaftertakingtherelatedgoodsandsellingthem.
AtSightAcreditthattheannouncerbankimmediatelypaysafterinspectingthecarriage
documentsfromtheseller.
RedClauseBeforesendingtheproducts,sellercantaketheprepaidpartofthemoneyfromthe
bank.Thefirstpartofthecreditistoattracttheattentionoftheacceptingbank.Thefirsttimethe
creditisestablishedbytheassignerbank,istogaintheattentionoftheofferedbank.Thetermsand
conditionsweretypicallywritteninredink,thusthename.
BacktoBackApairofLCsinwhichoneistothebenefitofasellerwhoisnotabletoprovidethe
correspondinggoodsforunspecifiedreasons.Inthatevent,asecondcreditisopenedforanother
sellertoprovidethedesiredgoods.Backtobackisissuedtofacilitateintermediarytrade.
IntermediatecompaniessuchastradinghousesaresometimesrequiredtoopenLCsforasupplierand
receiveExportLCsfrombuyer.
StandbyLetterofCredit:OperateslikeaCommercialLetterofCredit,exceptthattypicallyitis
retainedasa"standby"insteadofbeingtheintendedpaymentmechanism.UCP600article1provides
thattheUCPappliestoStandbysISP98appliesspecificallytoStandbylettersofCreditandthe
UnitedNationsConventiononIndependentGuaranteesandStandbylettersofCreditappliestoa
smallnumberofcountriesthathaveratifiedtheConvention.

Pricing
Issuancecharges,coveringnegotiation,reimbursementsandotherchargesarepaidbytheapplicantoras
perthetermsandconditionsoftheLC.IftheLCdoesnotspecifycharges,theyarepaidbytheApplicant.
Chargerelatedtermsareindicatedinfield71B.

Legalbasis
Legalwritershavefailedtosatisfactorilyreconcilethebanksundertakingwithanycontractualanalysis.
Thetheoriesinclude:theimpliedpromise,assignmenttheory,thenovationtheory,reliancetheory,agency
theories,estoppelsandtrusttheories,anticipatorytheoryandtheguaranteetheory.[6]
Althoughdocumentarycreditsareenforceableoncecommunicatedtothebeneficiary,itisdifficulttoshow
anyconsiderationgivenbythebeneficiarytothebankerpriortothetenderofdocuments.Insuch
transactionstheundertakingbythebeneficiarytodeliverthegoodstotheapplicantisnotsufficient
considerationforthebankspromisebecausethecontractofsaleismadebeforetheissuanceofthecredit,
thusconsiderationinthesecircumstancesispast.However,theperformanceofanexistingdutyundera

contractmaybeavalidconsiderationforanewpromisemadebythebank,providedthatthereissome
practicalbenefittothebank[7]Apromisetoperformowedtoathirdpartymayalsoconstituteavalid
consideration.[8]
Anothertheoryassertsthatitisfeasibletotypifyletterofcreditasacollateralcontractforathirdparty
beneficiarybecausethreedifferententitiesparticipateinthetransaction:theseller,thebuyer,andthe
banker.Becauselettersofcreditarepromptedbythebuyersnecessityandinapplicationofthetheoryof
JeanDomatthecauseofaLCistoreleasethebuyerofhisobligationtopaydirectlytotheseller.
Therefore,aLCtheoreticallyfitsasacollateralcontractacceptedbyconductorinotherwords,animplied
infactcontractundertheframeworkforthirdpartybeneficiarywherethebuyerparticipatesasthethird
partybeneficiarywiththebankactingasthestipulatorandthesellerasthepromisor.Theterm
"beneficiary"isnotusedproperlyintheschemeofanLCbecauseabeneficiary(also,intrustlaw,cestui
queuse)inthebroadestsenseisanaturalpersonorotherlegalentitywhoreceivesmoneyorotherbenefits
fromabenefactor.Notethatundertheschemeoflettersofcredit,banksareneitherbenefactorsofsellers
norbenefactorsofbuyersandthesellerreceivesnomoneyingratuitymode.Thusispossiblethataletter
ofcreditwasoneofthosecontractsthatneededtobemaskedtodisguisetheconsiderationorprivity
requirement.Asaresult,thiskindofarrangement,wouldmakeletterofcredittobeenforceableunderthe
actionassumpsitbecauseofitspromissoryconnotation.[9]
Afewcountrieshavecreatedstatutesinrelationtolettersofcredit.Forexample,mostjurisdictionsinthe
UnitedStates(U.S.)haveadoptedArticle5oftheUniformCommercialCode(UCC).Thesestatutesare
designedtoworkwiththerulesofpracticeincludingUCPandISP98.Theserulesofpracticeare
incorporatedintothetransactionbyagreementoftheparties.ThelatestversionoftheUCPistheUCP600
effectiveJuly1,2007.SincetheUCParenotlaws,partieshavetoincludethemintotheirarrangementsas
normalcontractualprovisions.

InternationalTradePaymentmethods
DocumentaryCredit(moresecureforselleraswellasbuyer)SubjecttoICC'sUCP600,thebank
givesanundertaking(onbehalfofbuyerandattherequestofapplicant)topaythebeneficiarythe
valueofthegoodsshippedifacceptabledocumentsaresubmittedandifthestipulatedtermsand
conditionsarestrictlycompliedwith.Thebuyercanbeconfidentthatthegoodsheisexpectingonly
willbereceivedsinceitwillbeevidencedintheformofcertaindocumentscalledformeetingthe
specifiedtermsandconditionswhilethesuppliercanbeconfidentthatifhemeetsthestipulationshis
paymentfortheshipmentisguaranteedbybank,whoisindependentofthepartiestothecontract.
Documentarycollection(moresecureforbuyerandtoacertainextenttoseller)Alsocalled"Cash
AgainstDocuments".SubjecttoICC'sURC525,sightandusance,fordeliveryofshipping
documentsagainstpaymentoracceptancesofdraft,whereshipmenthappensfirst,thenthetitle
documentsaresenttothebuyer'sbankbyseller'sbank,fordeliveringdocumentsagainstcollectionof
payment/acceptance
Directpayment(mostsecureforbuyer)Thesuppliershipsthegoodsandwaitsforthebuyerto
remitthebill,onopenaccountterms.

Risksituations
FraudRisks

Thepaymentwillbeobtainedfornonexistentorworthlessmerchandiseagainstpresentationbythe
beneficiaryofforgedorfalsifieddocuments.
Credititselfmaybefunded.
SovereignandRegulatoryRisks
PerformanceoftheDocumentaryCreditmaybepreventedbygovernmentactionoutsidethecontrol
oftheparties.
LegalRisks
Possibilitythatperformanceofadocumentarycreditmaybedisturbedbylegalactionrelating
directlytothepartiesandtheirrightsandobligationsunderthedocumentarycredit.
ForceMajeureandFrustrationofContract
Performanceofacontractincludinganobligationunderadocumentarycreditrelationshipis
preventedbyexternalfactorssuchasnaturaldisastersorarmedconflicts.
Applicant
NondeliveryofGoods
Shortshipment
Inferiorquality
Early/lateshipment
Damagedintransit
Foreignexchange
Failureofbankvizissuingbank/collectingbank
IssuingBank
Insolvencyoftheapplicant
Fraudrisk,sovereignandregulatoryriskandlegalrisks
ReimbursingBank
noobligationtoreimbursetheclaimingbankunlessithasissuedareimbursementundertaking.
Beneficiary
Failuretocomplywithcreditconditions
Failureof,ordelaysinpaymentfrom,theissuingbank

Seealso
BankPaymentObligation
Buyer'sCredit
Documentarycollection
UniformCustomsandPracticeforDocumentaryCredits

References

1.FicomS.A.v.SocializedCadex[1980]2LloydsRep.118.
2.UnitedCityMerchants(Investments)LtdvRoyalBankofCanada(TheAmericanAccord)[1983]1.A.C.168at
183
3.J.H.Rayner&Co.,Ltd.,andtheOilseedsTradingCompany,Ltd.v.HambrosBankLimited[1942]73Ll.L.
Rep.32
4.[1](http://www.bwtradefinance.com/letterofcreditlc)
5.Sinclair,James."WhatarethedifferenttypesofLetterofCredit?".TradeFinanceGlobal.TradeFinanceGlobal.
Retrieved12December2014.
6.Finkelstein,HermanNorman(1930).LegalAspectsofCommercialLettersofCredit.
7.WilliamvRoffeyBrothers&Nicholls(contractors)Ltd
8.ScotsonvPegg
9.Menendez,Andres."LetterofCredit,itsRelationwithStipulationfortheBenefitofaThirdParty".Retrieved
1June2013.

Externallinks
TextofUCP600,document,hostedatFacultyofLaw,UniversidadeNovadeLisboa,Portugal
(http://www.fd.unl.pt/docentes_docs/ma/mhb_MA_24705.pdf)
LetterofCreditInformation,ProcedureandVideos.(http://www.bwtradefinance.com/letterofcredit
lc/)
LetterofCreditinChina.(https://www.examinechina.com/importfromchinaletterofcredit)
AnatomyofaLetterofCredit,showinganactualnegotiatedletterofcredit
(http://www.vulcanhammer.info/china/letterofcredit.php)
LettersofCreditandHowTheyWork(http://www.lancasterpollard.com/newsdetail/tcifall2007fe
lettersofcredit)
(inPersian)(http://banki.ir/danestaniha/214general/2468lc)
LetterofCredit,itsRelationwithStipulationfortheBenefitofaThirdParty
(http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2019474)
AplonTrade:AfreesampletoolforexportingLettersofCreditbyusingSWIFTmessages
(http://aplontrade.com/index.html#everyone)
AsampleLetterofCredit(https://www.key.com/pdf/sampleloc.pdf)
AGuidetoLettersofCredit,differenttypesandhowtheywork
(https://www.tradefinanceglobal.com/lettersofcredit)
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