Letters of Credit

Overview

Letters of credit, often called bankers’ commercial credits are a common method of payment for goods in export sales. The buyer arranges for payment through a bank, usually in the seller’s country, on the presentation of specific documents usually the bill of lading and other transport documents and on the performance of any other conditions specified and advised to the bank.

On presentation of the documents, the bank pays or provides for the relevant sum, which is the purchase price plus or net of additional costs, according to the terms of the credit. The payment / settlement of the price may be immediate or deferred. It is commonly effected by immediate payment, acceptance or negotiation of a bill of exchange drawn by the seller.

In effect, a letter of credit carries a bank guarantee. It also uses the buyer’s bank’s links with its correspondent bank in the exporter / seller’s country to effect collection. The documents effectively act as security. The paying bank, in the exporter’s home country, has recourse to the importer’s / buyer’s bank which in turn has recourse to the buyer.

The credit refers to the obligation of the issuing bank to the seller. A credit can be revocable or irrevocable. It is presumed to be irrevocable. Irrevocable credits are now the norm. A confirmed credit refers to confirmation by the advising bank typically in the exporter’s country.

Uniform Rules on Documentary Credits

Banking practice on Letters of Credit has been standardised by the Uniform Custom and Practice for Documentary Credits issued by the International Chamber of Commerce. The current version is UCP600. The eUCP is a supplement which provides for the use of an electronic format, either alone or with paper documents.

The UCP Rules do not have the force of law in themselves. Parties to an international sale transaction may refer to the UCP rules and incorporate them into their contract. There are highly developed both in their terms and the applicable procedure. They provide harmonised procedures and certainty in international trade.

Typical Procedure

The following procedures typically apply when the sale contract provides that payment should be made under a letter of credit. The overseas buyer requests its bank (the issuing bank) to open a letter of credit for the exporter on the terms specified by the buyer’s instructions.

The issuing bank requests the bank in the exporter’s country (the advising bank) to negotiate, accept or pay the exporter’s draft upon delivery of the transport documents. The advising bank informs the exporter that it will do so.

The advising bank may confirm the letter of credit, which makes it liable on the letter. The issuing bank effectively guarantees payment to the advising bank. This is a confirmed letter of credit and gives extra comfort and security because it is a confirmation of liability by a bank in the seller / exporter’s home country.

Provided that the required documents are tendered before the expiry of the credit, there is a binding undertaking by the issuing bank and (if applicable) by the confirming bank to pay the relevant sum (representing the purchase price). These are contractual undertakings with a level of security equivalent to bank a guarantee.

Documents for Payment

The payment is completely separate from the underlying sale contract. The bank is only concerned to see that the documents tendered correspond with those specified in the instructions. The bank will only refuse to pay if the documents do not appear to be in order. The bank is not concerned with the sold goods themselves.

The terms of the credit must be strictly complied with. The bank must give notice if it proposes to reject the documents. It must give notice of the discrepancy based on which it refuses to accept the documents. Outside of this, the bank may refuse payment, only if there are circumstances of fraud.

The key documents that are required by the buyer are usually an invoice, a bill of lading (or other transport document) and the insurance documents. Documents relevant to the particular goods and their exportation may also be required, e.g. certificates of origin, health certificates etc. This will depend on the particular legal requirements for imports of the goods concerned.

Transport Documents

The transport documents can be a bill of lading, seaway bill, air transport documents, road rail or water transport documents, courier’s receipts or certificates of posting.

The bill of lading is a negotiable document of title. It represents the title of the goods concerned and can be transferred by endorsement and delivery. It is also the contract for the carriage of the goods. It will set out the name of the carrier, the relevant ship, and confirm that the goods are on board the vessel at a port of loading.

A seaway bill is not a negotiable document of title. It provides evidence of receipt of the goods and of a contract of carriage to a nominated consignee.  A charter party bill is similar to a bill of lading. It must be signed by the master or charterer of the ship concerned.

In the case of air transport, an airway bill may be required. The carrier or named agent signs the document to show that the goods have been accepted for carriage. It should show the aircraft departure and destination, dates and other information.

Similar principles apply in respect of road, rail and inland waterway transport documents.

Other Documents

The UCP sets out the requirements for a commercial invoice. It must show that the goods have been issued by the beneficiary of the letter of credit, should describe the goods or the service, comply with the credit and set out the amount due and the currency of payment.

The insurance documentation is stipulated in credit. They are completed by the insurance company or the underwriter. The goods are usually insured for at least their value plus 10%. The credit should stipulate the type of insurance required and the risks to be covered.

Payment

Payment on sight means that the advising bank is instructed to pay the seller, the monies due on presentation of the documents. A deferred payment credit authorises the advising bank to make arrangements for payment at some future date. If the seller requires cash, he may negotiate the letter of credit itself. Such negotiation may be restricted.

If the credit is an acceptance credit, the seller draws a bill of exchange on the advising bank which the bank accepts. It is an agreement to pay the face value on the bill. This provides the seller /exporter with very considerable security. He may sell the accepted bill at a discount or pledge it, by way of security.

Where a seller obtains a negotiation credit, the undertakings of the issuing bank (and the confirming bank if any) are directed to any bank of a description stated in the letter of credit (such a bank is the negotiating bank). The negotiating bank purchases the bill of exchange drawn by the seller on the nominated bank at a discount so that the seller receives payment immediately.

The negotiating bank will obtain from the seller the documents required to be presented under the credit. The negotiating bank can then call on the nominated bank to honour the bill of exchange. The seller is able to obtain payment immediately from any bank which is a negotiating bank, and the negotiating bank has the undertaking given by the letter of credit available to it.

Various Credits

There is a range of common types of letters of credit with different   terms and conditions.

A payment at sight credit provides that the advising bank is to pay or arrange to pay the seller the monies due immediately upon presentation of the documents. In the case of a deferred payment, a bill of exchange may be drawn for payment on a certain period after the presentation. If the period is expressed to be measured from the date of the bill of lading, then a bill of exchange may not be used as the date is insufficiently certain on the face of the bill.

The seller may be able to negotiate a deferred letter of credit to another in order to obtain immediate cash. He may be restricted to a specified bank. The negotiation is generally at a discount, reflecting the time value of money. The authority of the issuing bank should be obtained to avoid the risk of fraud.

In the case of a negotiation credit, the advising bank is authorised to negotiate a bill of exchange drawn by the seller on the buyer or the issuing bank. The advising bank negotiates the bill and deducts discount or commission. The bill may be a sight draft or a time draft depending on the terms of the credit.

Acceptance Credit

If the letter of credit provides for an acceptance credit, the seller draws a bill of exchange on the advising bank. When the bank accepts the bill, it undertakes to pay the face value on the due date to the party who presents it. Such a bill can usually be readily negotiated at an appropriate discount to reflect the implicit negative interest to the payment date.

The acceptance credit may be accepted by the issuing bank or the buyer by and under the terms of the contract. Where the issuing bank issues an irrevocable credit under UCP, it undertakes (effectively guarantees) that the bill will be accepted and paid by the buyer. Where the bank confirms the credit, a similar obligation arises for it.

As with a cheque or bill of exchange generally, an acceptance credit is a conditional payment only. If there is a default, the seller retains a right of recourse for the purchase price.

Atypical Types of Confirmations of Credit

There are various types of confirmation of credit. Confirmation acts as an obligation on the part of a local bank and is accordingly a desirable and common form of assurance of payment for the seller. The seller’s confirmation usually requires that the bank charges are borne by the beneficiary/seller.

A soft confirmation is conditional on the part of the advising bank. It may arise if the advising bank anticipates a complication in obtaining payment from the issuing bank due to regulatory, governmental or political reasons of instability in the country concerned.

A qualification may provide a clause in the confirmation to the effect that the confirmation bank shall only honour it after it has obtained reimbursement (from the issuing bank).

Various other types of Credit

An importer who imports regularly from a particular exporter may organise a revolving letter of credit in his favour. A revolving credit involves standing instructions for credit for the exporter /seller within a certain timeframe up to a certain amount. It need not be set up for each occasion and saves administration and set up costs. There are a number of types of revolving credit.

A packing credit is payable prior to shipment against non-transport documents. They may be payable at an earlier date such as on the proof by a warehouse receipt that the goods exist or a forwarder’s receipt that they have been received for shipment. They assist the regular exporter with earlier stage finance. They provide less assurance to the buyer but do verify that the goods are held for the buyer or have been dispatched.

In some letter of credit cases, proper, the bank may insert a clause into the letter of advice where it is willing to honour the exporter’s sight drafts against the production of stated pre-transport documents such as those above. The exporter may later present the goods and deliver transport documents in the normal course and obtain payment on the basis of the issuing bank’s earlier undertaking to honour the bill. This may allow the exporter to obtain finance earlier.

Back to Back Credits

In case of back-to-back credits, a confirmed letter of credit is opened by the ultimate buyer in favour of the immediate seller to him. It is used as security by that seller to another supplier upwards in the chain. There may be several suppliers in the chain. The original credits are in identical terms and are thereby said to be back-to-back credits.

The credit opened by the ultimate buyer must be in terms that cover the chain of contracts involved. Ideally, the credits should be controlled by the same bank in order to ensure that they are workable.

A similar method of financing is a transferable credit. The UCP allows for credits to be devolved provided that a partial shipment is not prohibited, the credit may be transferable. A back to back arrangement may also be affected by way of transferable credit.

Standby Letter of Credit

Standby letters of credit developed in the United States. They are recognised by the UCP. The principles applicable to ordinary letters of credits apply. A standby letter of credit is fundamentally different to an ordinary letter of credit and is more in the nature of a guarantee of the beneficiary’s performance of the sale contract. It is not focused on the transport documents as such.

A standby letter of credit involves an undertaking by the bank to pay a third-party beneficiary or accept bills drawn on the beneficiary, provided that the conditions of the credit are complied with in a trade transaction. The key condition is usually the tendering up the relevant documents

It usually activated by presenting the trade documents in accordance with the terms of the credit.  In contrast to an ordinary letter of credit which requires its beneficiary to tender the transport and other documents, under the standby letter, the required documents need not include transport documents. The credit may be activated by any document.