Introduction to

Letters of Credit

Presented By
Nishant Tigga

1
 What is a letter of credit? Why is
it used?
Seller in country A – Buyer in country B -
Malaysia USA
 Seller sells palm oil to  Buyer buys palm oil
the buyer shipped for delivery at
from Malaysia to Rotterdam
Rotterdam  Risk to buyer if it
 Risk to seller if it pays for goods
parts with before shipment
possession and title  Plus immediate tying
and ships goods on up of buyer’s
basis of buyer’s capital
promise to pay
alone
2
 What is a letter of credit? Why is
it used?
 “A letter of credit is a commercial
instrument used as a means of
financing international business
transactions”


 “A letter of credit is a contract under

which a bank agrees to pay the seller in
connection with the export of specific
goods against the presentation of
specified documents relating to those
goods … Thecred it is issued at the
request of the buyer (the applicant) in 3
favour of the seller (the beneficiary)”
 What is a letter of credit? Why is
it used?
 A banker’s assurance of  Sales contract does not
payment against provide security for
specified documents either party. Object of
 Most frequent method of credit is two-fold: to (1)
payment in international furnish security and
trade (2) raise credit
 Used for over [ ] years  Risk to seller if it parts
with possession of and
 Adaptable – e.g. trade title to the goods and
finance, provision of ships them on basis of
services not just goods, buyer’s promise to pay;
and as guarantee and,
instruments in the form
of standby letters of  Risk to buyer if it pays
credit for goods before
shipment
 Raising credit without
having to tie up capital
whilst goods are on
board ship 4
 How does a letter of credit
operate?
 To fully understand the operation of the letter
of credit, we need to look at the following:


(1) The parties involved and their

respective roles
(2) The contracts involved

(3) The mechanisms of the transaction

(4) Fundamental concepts

(5) The UCP

5
 Four parties and the contracts
involved
Four parties
 The buyer (the applicant)
 The issuing bank
 The advising bank (may also be the
correspondent, nominated, confirming bank)
 The seller (the beneficiary)
Four bilateral contracts between

 The buyer and the issuing bank

 The issuing bank and the
advising/nominated/confirming bank
 The issuing bank and the seller
 The confirming bank and the seller 6
 Role of the banks
Issuing bank


 The issuing bank is buyer’s bank

 In buyer’s own country

 The seller will be wary of receiving a credit

from a bank in a different country


Advising bank


 The advising bank advises the credit

 Also known as the “correspondent” bank

 Can be a nominated bank and/or a confirming

bank 7
 Role of the banks
Nominated bank


 Normally the advising bank

 Nominated by issuing bank to be bank where the
seller presents documents
 and obtains payment


Confirming bank


 Nominated bank may be authorised to pay in

accordance with the terms of the credit
 BUT it will only be liable to the seller if it adds its
own undertaking to the credit (= a confirmed
letter of credit)
 Nominated bank becomes a confirming bank
8
How does a letter of credit
operate?

9
 How the letter of credit operates:
the four stages
Stage 1 - Sales contract


 Starting point = the sales contract

 Provision for payment by letter of credit

 Precise terms of the letter of credit

 Mirror: sales contract requirements and the

letter of credit opened
 No indication in the sales contract as to the
type of credit required?
 Contract no.1: the sales contract
between the buyer and the seller
10
 How the letter of credit operates:
the four stages
Stage 2 – Instruction to the issuing bank


 Buyer requests issuing bank to open credit in

favour of the seller
 Involves completing bank’s standard application
form
 Buyer will add his instructions: documents to be
tendered; description of goods; type of credit to
be opened
 Issuing bank acts on the buyer’s instructions alone

 Once the application is made, the bank notifies the

buyer in writing of its agreement to open the
credit
11
 Contract no.2: application form = basis of
contract between buyer and issuing bank
 How the letter of credit operates:
the four stages
Stage 3 – Opening of the credit


 The issuing bank notifies the seller of the opening of

the credit in his favour; or,
 It arranges for the advising bank to do so; usually,
its correspondent bank in the seller’s own country
 Advising the credit is usually done in electronic form;
e.g. SWIFT
 Notification by the advising bank constitutes the letter
of credit
 The issuing bank will become bound to the seller
immediately as the seller receives the letter of credit
 Contract no.3: between the issuing bank and the
advising bank
 Contract no.4: between the issuing bank and the
seller 12
 How the letter of credit operates:
the four stages
Stage 3 – Opening of the credit – other parties


 • Nominated bank: Unless the credit is only

available with the issuing bank, it must
nominate the bank authorised to pay (or issue a
deferred payment undertaking, accept drafts or
negotiate the credit)
 Unless the nominated bank is also the confirming bank,
neither the nomination by the issuing bank nor the
nominated bank’s receipt, examination or forwarding
of documents commits the nominated bank
 The advising bank does not incur any liability to the
seller merely by advising the opening of the letter of
credit
 Confirming bank: if a confirmed credit, the
correspondent/advising bank must add its
“confirmation” to the credit; i.e. undertake to seller to
honour the credit on presentation of the documents
13
 Contract no.5: contract between
correspondent/confirming bank and the seller
 How the letter of credit operates:
the four stages
Stage 4 – Operation of the credit by the beneficiary


 The seller/beneficiary has shipped the goods

 And has presented documents to operate the credit
 The bank will check that the documents comply and are
presented in accordance with the credit
 IF the documents are in order, the bank will pay the
seller/beneficiary (or it will comply with whatever
undertaking the credit provides for)
 IF the documents are not in order, the bank must refuse
them
 Before refusal becomes final, at seller’s request the
bank may take instructions from the issuing bank or
the applicant itself (the buyer) to see whether the
applicant is prepared to accept non-conforming
documents
 COMMON for buyers to waive discrepancies because
they want the goods 14
How does a letter of credit
operate?

15
 How does a letter of credit
operate?
At the request of the buyer, the issuing
bank promises to pay the price of the
goods to the seller against the tender of
relevant documents.
To fully understand the operation of the letter of

credit, we need to look at the following:

(1) The parties involved and their

respective roles
(2) The contracts involved

(3) The mechanisms of the transaction

(4) Fundamental concepts

(5) The UCP

16
 Fundamental concepts
 The autonomy of a letter of credit


 Bank’s concern with documents, not facts



 Non-conforming documents and the doctrine

of strict compliance


 Each bank’s undertaking as principal

17
The autonomy of a letter of credit
 Payment obligation is independent of the
underlying transaction
 Conditions under which the bank will pay are
contained exclusively in the credit without
regard to the terms of the underlying transaction
 A breach by the seller of his obligations will not
entitle the buyer to instruct the bank to withhold
payment under the credit (provided irrevocable
credit)
 The bank must ensure that documents appear on
their face to conform
 If the documents do not comply with the
credit, the bank is entitled to reject non- 18
compliant documents and not pay
 The autonomy of a letter of credit
Non-payment


 There are two main exceptions to the

confirming or issuing bank’s obligation to
pay notwithstanding that the documents
appear to be in good order


 They are:
 – Illegality; and,
 – Fraud

19
 Bank’s concern with documents,
not facts
 Bank’s concern with documents, not facts
 Must check documents conform on their face (in
the absence of strong evidence of fraud or
illegality)
 Bank does not check the veracity of the
statements contained in the documents, nor to
examine the goods
 This runs hand in hand with the principle of
autonomy of the credit
 If the documents appear to be in order, the bank is
entitled and obliged to pay
 Non-compliant documents mean the bank can
withhold payment even if the non-compliance is 20

purely technical and not material

 Non-conforming documents and the
doctrine of
strict compliance
 The doctrine of strict compliance applies to all
contracts involved in the letter of credit
operation
 A minor discrepancy or one which does not
serve any useful purpose is still a
discrepancy
 UCP 600 provisions on examination of
documents should assist slightly to
lessen purely technical discrepancies
 ISBP which should be read with the UCP
should also assist
21
 Each bank’s undertaking as
principal
 Issuing bank’s undertaking to the seller is given as
principal and not as the buyer’s agent
 He is a stranger to the letter of credit contract; i.e.
not even an “undisclosed principal”.
 Therefore, primarily liable to seller to pay out
under credit
 Consequences: the buyer is not entitled to give
instructions to the issuing bank to refuse
payment under the credit, nor to vary the terms
of the credit
 The buyer cannot be sued under the letter of
credit if the issuing bank fails to pay seller
(although the buyer will incur liability for breach 22
of the sales contract)
The Uniform Customs and Practice
(“UCP”)
 Rules for commercial credits


 Current edition: UCP 600 (issued in July 2007)



 Advantages


 International Standard Banking Practice (ISBP)

23
 UCP 600
 How does UCP 600 apply to credits?


 Status of UCP 600



 A note of warning: not a complete code

 – UCP 600 silent on certain crucial
matters
 – Governing law and jurisdiction
 – Reimbursement of the issuing bank by
the buyer
24
 GOVERNING LAW
 “A wholly undesirable multiplicity of potentially
conflicting laws”
 A number of bilateral contracts not a single transaction
 Each potentially subject to a different governing law
 UCP 600 has no provisions to determine governing law
therefore this must be agreed between the parties
and specified in the credit
 Conflict of laws: “closest connection” test under
English law
 – NOT location of central administration of banks,
nor place where contract made
 – Rather place where documents to be tendered
are presented and checked; and,
 – where payment to the seller is to be made
against those documents 25
 UCP 600 VERSUS UCP 500
 Structural “cosmetic” changes and more
fundamental changes
 Objective: to ensure clarity and consistency in
approach
 • Standard for examination of documents: Art 14,
UCP 600 – data in documents must “not
conflict” with other data (versus
“consistent”)
 mirror image no longer required
 Non-documentary conditions are disregarded
 Affects technical discrepancies as opposed to real
ones
26
 Easier for a document to be compliant than under
UCP 500
 UCP 600
Bills of lading


 A bank will only accept a “clean” transport

document (Art 27, UCP 600) whether or not
the credit requires this
 Bears no clause or notation expressly
declaring a defective condition of the goods
or their packing. The word “clean” need not
appear
 A claused bill of lading is not a “clean” bill.
Defective bill? But bank cannot check
underlying sales contract (principle of
autonomy)
 De minimis? Allowance allowed? See credit 27
terms
 What if bill states goods fine on loading BUT
 Types of letters of credit
 Confirmed credits, sight credits, deferred
payment credits and acceptance credits
 Straight (or specially advised) credits
and negotiation credits
 Revocable and irrevocable credits

 Revolving credits

 Red clause and green clause credits

 Transferable credits and back-to-back

credits
 Demand guarantees and standby credits

28
 Conclusion
 Complex area
 Understanding of why a letter of credit is used

 Better understanding of how a letter of credit

operates in practice with reference to the
individual parties, their respective roles and
the multiple contracts in operation
 Brief view of fundamental concepts relevant to
letters of credit and the role and status of
UCP 600

29