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Letter of credit
From Wikipedia, the free encyclopedia
Contents
1 Terminology
1.1 Origin
1.2 Related terms
2 Documents that can be presented for payment
3 Legal principles governing documentary credits
4 Types
5 Pricing
6 Legal basis
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Terminology
Origin
Seller provides bill of lading to bank
in exchange for payment. Seller's
The name "letter of credit" derives from the French word
bank the buyer.
"accréditation", a power to do something, which derives from the
Latin "accreditivus", meaning trust.
Related terms
Advising Bank — advises the beneficiary at the request of the issuing bank.
Applicant — 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 — 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 the beneficiary's favor.
Confirming bank — adds confirmation to an LC. It does so at the request of the issuing bank and
taking authorization from the issuing bank.
Honour — to act according to commitment of the LC. Presentations are honored in different ways
depending on the type of credit:
Nominated Bank — the bank with which credit is available. If no bank is mentioned in the credit
as nominated bank, all banks are "nominated".
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
Insurance documents — Insurance policy or certificate, but not a cover note.
The 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 less inclined to issue
documentary credits because of the risk and inconvenience. Second, documents required under the LC
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 buyer misfeasance.[3] 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 a bank had to
investigate every breach of contract.
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.[4] The general legal maxim de minimis non curat lex has no place in the field.
Types
Import/export — The same credit can be termed an import or export LC[5] depending on whose
perspective is considered. For the importer it is termed an Import LC and for the exporter of
goods, an Export LC.
Revocable — The buyer and the bank that established the LC are able to manipulate the LC or
make corrections without informing or getting permissions from the seller. According to UCP
600, all LCs are irrevocable, hence this type of LC is obsolete.
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Confirmed — An LC is said to be confirmed when a second bank adds its confirmation (or
guarantee) to honor a complying presentation at the request or authorization of the issuing bank.
Unconfirmed — This type does not acquire the other bank's confirmation.
Transferrable — 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, but procures goods from suppliers and arranges 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 supplier's and acquire the
difference as profit.
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 alternate beneficiary as long as it
allows partial shipments.
The terms and conditions of the original credit must be replicated exactly in the transferred credit.
However, to keep the workability of the transferable letter of credit, some figures can be reduced
or curtailed.
Amount
Unit price of the merchandise (if stated)
Expiry date
Presentation period
Latest shipment date or given period for shipment.
The first beneficiary may demand from the transferring bank to substitute for the applicant.
However, if a document other than the invoice must be issued in a way to show the applicant's
name, in such a case that requirement must indicate that in the transferred credit it will be free.
Transferred credit cannot be transferred again to a third beneficiary at the request of the second
beneficiary.
Untransferable — A credit that the seller cannot assign all or part of to another party. In
international commerce, all credits are untransferable.
Deferred / Usance — A credit that is not paid/assigned immediately after presentation, but after an
indicated period that is accepted by both buyer and seller. Typically, seller allows buyer to pay the
required money after taking the related goods and selling them.
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At Sight — A credit that the announcer bank immediately pays after inspecting the carriage
documents from the seller.
Red Clause — Before sending the products, seller can take the pre-paid part of the money from
the bank. The first part of the credit is to attract the attention of the accepting bank. The first time
the credit is established by the assigner bank, is to gain the attention of the offered bank. The
terms and conditions were typically written in red ink, thus the name.
Back to Back — A pair of LCs in which one is to the benefit of a seller who is not able to provide
the corresponding goods for unspecified reasons. In that event, a second credit is opened for
another seller to provide the desired goods. Back-to-back is issued to facilitate intermediary trade.
Intermediate companies such as trading houses are sometimes required to open LCs for a supplier
and receive Export LCs from buyer.
Pricing
Issuance charges, covering negotiation, reimbursements and other charges are paid by the applicant or as
per the terms and conditions of the LC. If the LC does not specify charges, they are paid by the
Applicant. Charge-related terms are indicated in field 71B.
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]
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. However, the performance of an existing duty
under a contract may be a valid consideration for a new promise made by the bank, provided that there is
some practical benefit to the bank[7] A promise to perform owed to a third party may also constitute a
valid consideration.[8]
Another theory asserts that it is feasible to typify letter of credit as a collateral contract for a third-party
beneficiary because three different entities participate in the 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 LC is to release the buyer of his obligation to pay directly to the seller.
Therefore, a LC 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 participates 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 an LC 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 buyers and the seller receives no money in gratuity mode. Thus is possible
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that a “letter of credit” was one of those contracts that needed to be masked to disguise the
“consideration or Privity requirement”. As a result this kind of arrangement, would make letter of credit
to be enforceable under the action assumpsit because of its promissory connotation.[9]
A few countries, including the United States (Article 5 of the Uniform Commercial Code) have created
statutes in relation to letters of credit. These statutes are designed to work with the rules of practice
including UCP and 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.[10] Since the UCP are
not laws, parties have to include them into their arrangements as normal contractual provisions.
Advance payment (most secure for seller) — 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, the
bank gives an undertaking (on behalf of buyer and at the request of applicant) to pay the
beneficiary the value of the goods shipped if acceptable documents are submitted and if the
stipulated terms and conditions are strictly complied with. 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 buyer's bank by seller's bank, for delivering documents against
collection of payment/acceptance
Direct payment (most secure for buyer) — The supplier ships the goods and waits for the buyer to
remit the bill, on open account terms.
Risk situations
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.
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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.
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
Issuing Bank
Reimbursing Bank
no obligation to reimburse the claiming bank unless it has issued a reimbursement undertaking.
Beneficiary
See also
Bank Payments Obligation
Buyer's Credit
Documentary collection
Uniform Customs and Practice for Documentary Credits
References
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External links
Letter of Credit Information, Procedure and Videos. (http://www.bwtradefinance.com/letter-of-
credit-lc/)
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/newsdetail/tci-fall-2007-
fe-letters-of-credit)
(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)
Categories: Contract law Basic financial concepts Legal documents Letters (message)
International trade International finance Payment systems
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