Introduction to Letter of Credit

The letter of credit is the most commonly used method of payment for goods in international trade. This thesis highlights the imbalance of the rights and duties of the parties in a letter of credit transaction by emphasising deficiencies in the letters of credit system. In addition, on those areas where there is lack of justice and equity and which make the system of the letters of credit vulnerable for fraudulent activities. After briefly discussing the structure of the letter of credit system, it discusses the rights and duties of parties to such transactions and how the risk of the innocent buyer has increased under UCP and very often the buyer is paying for the goods he had not contracted for. It further discusses the independence principle and the doctrine of documentary compliance, that overprotection of the independence principle, and the lack of reasonable care on the part of banks provide opportunities of fraud to the sellers to obtain payment without actually performing their duties to banks and buyers. It will also argues about the fraud exception to the independence principle, particularly the position of the fraud exception in England and the history of some decisions of English Courts. In the end it gives some suggestions to balance the rights and duties amongst parties in a letter of credit transaction.

Structure of a Letter of Credit Transaction

Commercial letters of credit have been used for the centuries as a most common method of payment, in international trade. Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits (UCP). A commercial letter of credit is a contractual agreement between a bank (issuing bank), on behalf of one of its customers (buyer), authorizing another bank (advising or confirming bank), to make payment to the beneficiary (seller). The issuing bank, on the application of its customer (buyer), opens the letter of credit, and makes a commitment with the buyer to honour the credit on the presentation of the documents, conforming to the terms and conditions of the credit, by the beneficiary. Thus, the issuing bank replaces the bank's customer as the payee.

Elements of a Letter of Credit

A payment undertaking given by a bank (issuing bank) On behalf of a buyer (applicant) To pay a seller (beneficiary) for a given amount of money On presentation of specified documents representing the supply of goods Within specified time limits Documents must conform to terms and conditions set out in the letter of credit

Documents to be presented at a specified place Beneficiary Beneficiary is normally the provider of the goods or services and is entitled to payment as long as he can provide the conforming documents required by the letter of credit. The letter of credit is a distinct and separate transaction from the underlying contract (contract between seller and buyer). All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the buyer and seller. The issuing bank's obligation to the buyer-applicant is to examine all documents to insure that they are in compliance with the terms and conditions of the credit. To get the payment it is for the beneficiary to provide all the required documents. If the sellerbeneficiary conforms to the letter of credit, the seller must be paid by the bank.

Issuing Bank
The issuing bank's duty to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is entitled to have a reasonable time after receipt of the documents to honour the draft. The issuing bank's duty is to provide a guarantee to the seller that if complying documents are presented by the seller, then the bank will make the payment to the seller, and will only pay if these documents comply with the terms and conditions set out in the letter of credit. Typically the documents requested include a commercial invoice, bill of lading or airway bill and an insurance document; but there are many others. Letters of credit only concerns with the documents, not with the goods.

Advising Bank
An advising bank is usually a foreign correspondent bank of the issuing bank which advises the seller-beneficiary. Generally, the beneficiary wants to use a local bank to insure that the letter of credit is valid. In addition, the advising bank is responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. Therefore, if the issuing bank does not pay the beneficiary, the advising bank is not obligated to pay.

Confirming Bank
At the request of the issuing bank, the correspondent bank may confirm the letter of credit for the seller-beneficiary and obligates itself to insure payment under the letter of credit. The confirming bank is usually the advising bank. Letters of credit may be either revocable or irrevocable.

Revocable Letter of Credit

A revocable letter of credit may be revoked or modified by the issuing bank, for any reason at any time, without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction involving a revocable letter of credit, it serves as the advising bank. A letter of credit can not be revoked, once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honoured. The revocable letter of credit is not a commonly used instrument.

Irrevocable Letter of Credit

This is the most common form of credit used in international trade. The irrevocable letter of credit may not be revoked or amended without the consent of the issuing bank, the confirming bank, and the beneficiary. The buyer's issuing bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the letter of credit. Changes in the credit must be approved by both the buyer and the seller. If the documentary letter of credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable. There are two forms of irrevocable credits:

Unconfirmed credit
In an unconfirmed credit, the buyer's bank issuing the credit is the only party responsible for payment to the seller. The seller's advising bank pays only after receiving payment from the issuing bank. The seller's advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk.

Confirmed credit
In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer's issuing bank. Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the seller. The advising bank will then look to the issuing bank for payment. Confirmed Irrevocable letters of credit are used when trading in a highrisk area where war or social, political, or financial instability are real threats. Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order. A confirmed credit is more expensive because the bank has added liability.

Sight and Time Drafts

All letters of credit require the beneficiary to present a draft and required documents in order to receive payment. A draft is a written order by which the party creating it, orders another party to pay money to a third party. A draft is also called a bill of exchange. There are two types of drafts: sight and time. A sight draft is payable as soon as it is presented for payment. The bank is allowed a reasonable time to review the documents before making payment.

A time draft is not payable until the lapse of a particular time period stated on the draft. The bank is required to accept the draft as soon as the documents comply with credit terms. The issuing bank has a reasonable time to examine those documents. The issuing bank is obligated to accept drafts and pay them at maturity.

Step-by-step process

Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment. Buyer applies to his bank for a letter of credit in favour of the seller. Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming). The correspondent bank is usually located in the same geographical location as the seller (beneficiary). Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary). Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a particular company. Seller presents the required documents to the advising or confirming bank to be processed for payment. Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit. If the documents are correct, the advising or confirming bank will claim the funds by: Debiting the account of the issuing bank. Waiting until the issuing bank remits, after receiving the documents. Reimburse on another bank as required in the credit. Advising or confirming bank will forward the documents to the issuing bank. Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer's account. Issuing bank then forwards the documents to the buyer. The most common documents include:

Commercial Invoice

It includes a description of merchandise, price, FOB origin, and name and address of buyer and seller. The buyer and seller information must correspond exactly to the description in the letter of credit.

Bill of Lading
It is a document which shows the receipt of goods for shipment by a freight carrier. It is an evidence of the control of the goods and also acts as an evidence of the carrier's obligation to transport the goods to their proper destination.

Warranty of Title
A warranty given by a seller to a buyer of goods that states that the title being conveyed is good. It is generally issued to the purchaser.

Letter of Indemnity
It is a letter specifically indemnifies the purchaser against a certain stated circumstance. Indemnification is generally used to guarantee that shipping documents will be provided in good order when available.