4/28/13 Letter of credit - Wikipedia, the free encyclopedia

Letter of credit
From Wikipedia, the free encyclopedia

A letter of credit is a document issued by a financial institution, or a

similar party, assuring payment to a seller of goods and/or services.[1]
The seller then seeks reimbursement from the buyer or from the buyer's
bank. The document serves essentially as a guarantee to the seller that it
will be paid by the issuer of the letter of credit regardless of whether the
buyer ultimately fails to pay. In this way, the risk that the buyer will fail to
pay is transferred from the seller to the letter of credit's issuer. The letter
of credit also insures that all the agreed upon standards and quality of
goods are met by the supplier.

Letters of credit are used primarily in international trade for large

transactions between a supplier in one country and a customer in another.
In such cases, the International Chamber of Commerce Uniform After a contract is concluded between
Customs and Practice for Documentary Credits applies (UCP 600 being buyer and, buyer's bank supplies a
the latest version).[2] They are also used in the land development process letter of credit to seller
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 the consent of the beneficiary, issuing bank, and
confirming bank, if any. In executing a transaction, letters of credit
incorporate functions common to giros and traveler's cheques.

Contents
1 Terminology Seller consigns the goods to a carrier
1.1 Origin of the term in exchange for a bill of lading.
1.2 Related terms
2 Documents that can be presented for payment
3 Legal principles governing documentary credits
4 Definitions of Related Terms
5 Different Types of Letter of Credit
6 The price of letters of credit
7 Legal basis
8 International Trade Payment methods
9 Risk situations in letter-of-credit transactions
10 See also
11 References
12 External links

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Terminology
Origin of the term

The name “letter of credit (http://www.quantity-surveying-

practices.com/2011/06/letter-of-credit-letter-of-credit.html)” derives
from the French word “accréditation,” 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.[citation needed]
Seller provides bill of lading to bank in
Related terms exchange for payment. Seller's bank
exchanges bill of lading for payment
A sight LC means that payment is made immediately to the from buyer's bank. Buyer's bank
beneficiary/seller/exporter upon presentation of the correct documents in exchanges bill of lading for payment
the required time frame. A time or date LC will specify when payment from the buyer.
will be made at a future date and upon presentation of the required
documents.[citation needed]

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.[citation needed]

Documents that can be presented for

payment
To receive payment, an exporter or shipper must present the documents Buyer provides bill of lading to carrier
required by the letter of credit. Typically, the payee presents a document and takes delivery of goods.
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 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:[citation needed]

Financial Documents

Bill of Exchange, Co-accepted Draft

Commercial Documents

Invoice, Packing list

Shipping Documents

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Transport Document, Insurance Certificate, Commercial, Official or Legal Documents

Official Documents

License, Embassy legalization, Origin Certificate, Inspection Certificate, Phytosanitary certificate

Transport Documents

Bill of lading (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 documents

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 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 letter of credit 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.[3] 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 letter of 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 honor their obligation notwithstanding allegations of misfeasance by the buyer.[4] Finally, courts have
emphasize 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.[5] The general legal maxim de
minimis non curat lex 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. -pramod rajbanshi

Definitions of Related Terms

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Advising bank: The Bank which advises a Letter of Credit to the Beneficiary at the request of the issuing Bank is
known as the Advising Bank

Applicant: Applicant is the party on whose request the issuing bank issues a credit .

Banking day: The day on which a bank is regularly open at the place at which an act to be performed.

Beneficiary: Beneficiary is the party who is to receive the benefit (payment) of the LC. The consignee of an LC
and the beneficiary may not be the same. The credit is issued in his favor.

Presentation: Presentation is either delivery of documents against an LC or the document itself.

Complying presentation : A presentation is said to be complying presentation when it is
i. in accordance with the terms and conditions of the credit,
ii. the applicable provisions of UCP and
iii. international standard banking practice.
Confirmation: Confirmation is a definite undertaking from the confirming bank to honor or negotiate a complying
presentation in addition to that of the issuing bank.
Confirming bank: The Bank which adds confirmation to an LC is termed as Confirming Bank. It does so at the
request of the issuing bank and taking authorization from the issuing bank.
Letter of Credit/ Credit: Credit is a definite undertaking of the issuing bank to honor a complying presentation.
According to UCP all credit must be Irrevocable.
Honour: Honour means act according to commitment of the LC. Presentations are honored in different ways
depending on the type of credit like. i. Making payment at sight for sight LC ii.By incurring a deferred payment
undertaking and paying at maturity deferred payment LC. iii. by accepting a Draft drawn by the beneficiary and
paying at maturity for Deferred Acceptance LC.

Issuing bank: The Bank which issues a credit is known as issuing bank.
Nominated Bank: The Bank with which credit is available is termed as Nominated Bank of that Credit. If no Bank
is mentioned in the credit as nominated bank, all banks are nominated bank.

Negotiation: A bank (Nominated Bank) is said to negotiate a document if it purchases a draft and/or documents
under a complying presentation either by making advance or agreeing to advance funds to the beneficiary on or
before the date on which reimbursement is due to the nominated bank . A draft drawn on a nominated bank can not
be purchased by itself.

Different Types of Letter of Credit

Import/export Letter of Credit

The same credit can be termed as import and export LC depending on whose perspective it is being looked upon.
For the importer it is termed as Import LC and for the Exporter of goods, Export LC>

Revocable Letter of Credit

In this type of credit buyer and the bank which has established the LC, are able to manipulate the letter of credits or
make any kinds of corrections without informing the seller and getting permissions from him. According to UCP
600, all LCs are Irrevocable, hence this type of LC used no more.

Irrevocable LC
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In this type of LC, Any change (amendment) or cancellation of the LC (except it is expired) done by the Applicant
through the issuing Bank must be authenticated by the Beneficiary of the LC. Whether to accept or reject the
changes depends on the beneficiary.

Confirmed LC

An LC is said to be confirmed when another bank adds its additional confirmation (or guarantee) to honor a
complying presentation at the request or authorization of the issuing bank.

Unconfirmed LC

This type of letter of credit, does not acquire the other bank's confirmation.

Transferrable LC

A Transferable Credit is one under which the exporter has the right to make the credit available to one or more
subsequent beneficiaries. Credits are made transferable when the original beneficiary is a middleman and does not
supply the merchandise himself but but procures goods from the suppliers and arrange them to be sent to the buyer
and does not want the buyer and supplier know each other. The middleman is entitled to substitute its own invoice
for the one of the supplier and acquire the difference as his profit in transferable letter of credit mechanism.

Important Points of Consideration:

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 second beneficiary as long as credit allows partial
shipments.

The terms and conditions of the original credit must be indicated exactly in the transferred credit. However, in order
to keep the workability of the transferable letter of credit below figures can be reduced or curtailed.

• Letter of credit amount • any unit price of the merchandise (if stated) • the expiry date • the presentation period or
• the latest shipment date or given period for shipment.

The first beneficiary may demand from the transferring bank to substitute his name for that of the applicant.
However, if a document other than invoice required in the transferable credit must be issued in a way to show the
applicant's name, in such a case that requirement must be indicated in the transferred credit.

Transferred credit cannot be transferred once again to any third beneficiary according to the request of the second
beneficiary.

Untransferable LC

It is said to the credit that seller cannot give a part or completely right of assigned credit to somebody or to the
persons he wants. In international commerce, it is required that the credit will be untransferable.

Usance LC

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It is kind of credit that won't be paid and assigned immediately after checking the valid documents but paying and
assigning it requires an indicated duration which is accepted by both of the buyer and seller. In reality, seller will
give an opportunity to the buyerto pay the required money after taking the related goods and selling them.

At Sight LC

It is a kind of credit that the announcer bank after observing the carriage documents from the seller and checking all
the documents immediately pays the required money.

Red Clause LC

In this kind of credit assignment seller before sending the products can take the pre-paid and parts of the money
from the bank. The first part of the credit is to attract the attention acceptor bank. The reason why it named so, is
that the first time this credit is established by the assigner bank, to take the attention of the offered bank, the terms
and conditions were written by red ink, from that time it became famous with that name.

Back to Back LC

In this type of LC consisted of two separated and different types of LC. First one is established in the benefit of the
seller that is not able to provide the corresponding goods for any reasons. Because of that reason according to the
credit which is opened for him, neither credit will be opened for another seller to provide the desired goods and
sends it.

Back-to-back L/C is a type of L/C issued in case of intermediary trade. Intermediate companies such as trading
houses are sometimes required to open L/Cs by supplier and receive Export L/Cs from buyer. SMBC will issue a
L/C for the intermediary company which is secured by the Export L/C (Master L/C). This L/C is called "Back-to-
back L/C".

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.[citation needed]

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] 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.

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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.[citation needed]

A theory sustains that is feasible to typify letter of credit as a Collateral Contract for a Third-Party Beneficiary
because there are in fact three different entities participating in the letter of credit 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 Letter of Credit is to release the buyer of his obligation to pay directly to the seller with
legal tender. Therefore, Letter of Credit 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 participate 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 a letter of credit 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 the buyers, and the seller doesn’t receive money in gratuity mode. Thus is possible that “letter of credit” was one
of those contracts that needed to be masked to disguise the “consideration or Privity requirment”, as a result this
kind of arrangement, would make letter of credit to be enforceable under the action assumpsit because of its
promissory connotation.

A few countries including the United States (see Article 5 of the Uniform Commercial Code) 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.[7] 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. .

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
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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 usance, 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 Majeure 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

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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

See also
Uniform Customs and Practice for Documentary Credits
Buyer's Credit
Documentary collection

References

1. ^ Letter of Credit explained What is a letter of credit? (http://www.loanuniverse.com/letters.html).

LoanUniverse.com.
2. ^ Understanding and Using Letters of Credit, Part I (http://www.crfonline.org/orc/cro/cro-9-1.html). Credit
Research Foundation.
3. ^ See Ficom S.A. v. Socialized Cadex [1980] 2 Lloyd’s Rep. 118.
4. ^ United City Merchants (Investments) Ltd v Royal Bank of Canada (The American Accord) [1983] 1.A.C.168 at
183
5. ^ J. H. Rayner & Co., Ltd., and the Oilseeds Trading Company, Ltd. v.Ham bros Bank Limited [1942] 73 Ll. L.
Rep. 32
6. ^ For extensive analysis See Finkelstein, H. Legal Aspects of Commercial Letters of Credit, pp. 275-295
7. ^ Dominique Doise,“The 2007 Revision of the Uniform Customs and Practice for Documentary Credits (UCP
600)”[1] (http://www.alerionavocats.com/fr/expertise/publications/la-revision-2007-des-regles-et-usances-
uniformes-relatives-aux-credits-documentaires-ruu-600/)

External links
Anatomy of a Letter of Credit, showing an actual negotiated letter of credit
(http://www.vulcanhammer.info/china/letter-of-credit.php)
Letters of Credit and How They Work (http://www.lancasterpollard.com/news/tci-fall-2007-fe-letters-of-
credit)
Credit Research Foundation - Understanding & Using Letters of Credit - Part 1
(http://www.crfonline.org/orc/cro/cro-9-1.html)
Credit Research Foundation - Understanding & Using Letters of Credit - Part 2
(http://www.crfonline.org/orc/cro/cro-9-2.html)
(in Persian) (http://banki.ir/danestaniha/214-general/2468-lc)
Letter of Credit, its Relation with Stipulation for the Benefit of a Third Party
(http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2019474)
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