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3/14/2014 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
provided certain documents have been presented to the bank.[1]
These are documents that prove that the seller has performed the
duties under an underlying contract (e.g., sale of goods contract) and
the goods (or services) have been supplied as agreed. In return for
these documents, the beneficiary receives payment from the financial
institution that issued the letter of credit. The letter of credit serves as
a guarantee to the seller that it will be paid 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 can also be used to ensure that all the agreed upon
standards and quality of goods are met by the supplier, provided that After a contract is concluded between
these requirements are reflected in the documents described in the a buyer and a seller, the buyer's bank
letter of credit. supplies a letter of credit to the seller.

Letters of credit are used primarily in international trade for

transactions between a supplier in one country and a customer in
another. Most letters of credit are governed by rules promulgated by
the International Chamber of Commerce known as Uniform Customs
and Practice for Documentary Credits (UCP 600 being the latest
version). 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 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 Seller consigns the goods to a carrier
transaction, letters of credit incorporate functions common to giros in exchange for a bill of lading.
and traveler's cheques.

1 Terminology
1.1 Origin of the term
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 letters 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 1/9
3/14/2014 Letter of credit - Wikipedia, the free encyclopedia

10 See also
11 References
12 External links

Origin of the term

The name "letter of credit" derives from the French word

"accrditation", a power to do something, which derives from the
Latin "accreditivus", meaning trust.[citation needed] Seller provides bill of lading to bank in
exchange for payment. Seller's bank
Related terms exchanges bill of lading for payment
from buyer's bank. Buyer's bank
exchanges bill of lading for payment
A sight LC means that payment is made immediately to the
from the buyer.
beneficiary/seller/exporter upon presentation of the correct documents
in the required time frame. A time or date LC will specify when
payment 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 Buyer provides bill of lading to carrier
and takes delivery of goods.
To receive payment, an exporter or shipper must present the
documents required by the letter of credit. Typically, the payee
presents a document 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 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

Transport Document, Insurance Certificate, Commercial, Official or Legal Documents 2/9
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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 banks 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.[2] 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 partys 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 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.[3] Finally, courts have emphasized 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 banks 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.[4] The general legal
maxim de minimis non curat lex has no place in the field of documentary credits.

Definitions of related terms

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. 3/9
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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 in accordance with:
i. 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 letters 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

In this type of LC, Any changes (amendment) or cancellation of the LC (except it is expired) is done by the
Applicant through the issuing Bank. It 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 4/9
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This type of letter of credit, does not acquire the other bank's confirmation.

Transferrable LC

A Transferable Credit is the 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 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 his
own invoice for the one of the supplier and acquire the difference as his profit in transferable letter of credit

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.

Deferred / Usance LC

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, the seller before sending the products, can take the pre-paid or part of the
money from the bank. The first part of the credit is to attract the attention of the acceptor bank. The reasoning
behind this, is the first time this credit is established by the assigner bank, it is to gain the attention of the offered
bank. The terms and conditions were written by red ink, going forward it became famous with that name. 5/9
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Back to Back LC

This type of LC consists 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 banks 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.[5] 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.

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 banks
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 buyers 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 6/9
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sellers nor benefactors of the buyers, and the seller doesnt 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.[6]

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 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, 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 funded.

Sovereign and Regulatory Risks 7/9
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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

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
Bank Payments Obligation
Buyer's Credit
Documentary collection
Uniform Customs and Practice for Documentary Credits

1. ^ Letter of Credit explained What is a letter of credit? (
2. ^ See Ficom S.A. v. Socialized Cadex [1980] 2 Lloyds Rep. 118.
3. ^ United City Merchants (Investments) Ltd v Royal Bank of Canada (The American Accord) [1983] 1.A.C.168
at 183 8/9
3/14/2014 Letter of credit - Wikipedia, the free encyclopedia

4. ^ J. H. Rayner & Co., Ltd., and the Oilseeds Trading Company, Ltd. v.Ham bros Bank Limited [1942] 73 Ll. L.
Rep. 32
5. ^ For extensive analysis See Finkelstein, H. Legal Aspects of Commercial Letters of Credit, pp. 275-295
6. ^ Menendez, Andres. "Letter of Credit, its Relation with Stipulation for the Benefit of a Third Party"
( Retrieved 1 June 2013.
7. ^ Dominique Doise,The 2007 Revision of the Uniform Customs and Practice for Documentary Credits (UCP
600)[1] (

External links
Letter of Credit Information, Procedure and Videos. (
Anatomy of a Letter of Credit, showing an actual negotiated letter of credit
Letters of Credit and How They Work (
(in Persian) (
Letter of Credit, its Relation with Stipulation for the Benefit of a Third Party

Retrieved from ""

Categories: Contract law Basic financial concepts Legal documents Letters (message)
International trade International finance Payment systems

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