Letter of credit
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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. The seller then seeks reimbursement from the buyer or from the buyer's bank. The document serves essentially 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 also insures that all the agreed upon standards and quality of goods are met by the supplier.
Letters of credit are used primarily in international trade for large transactions between a supplier in one country and a customer in another. In such cases, the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies (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 transaction, letters of credit incorporate functions common to giros and traveler's cheques.
Origin of the term 
The name “letter of credit” derives from the French word “accréditation,” a power to do something, which in turn derives from the Latin “accreditivus,” meaning trust. This applies to any defense relating to the underlying contract of sale. This is as long as the seller performs their duties to an extent that meets the requirements contained in the letter of credit.
Related terms 
A sight LC means that payment is made immediately to the 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.
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.[clarification needed]
Documents that can be presented for payment 
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 imagination and 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:
- Financial Documents
- Bill of Exchange, Co-accepted Draft
- Commercial Documents
- Shipping Documents
- Transport Document, Insurance Certificate, Commercial, Official or Legal Documents
- 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 bank’s 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. 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 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 would thus be 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. Finally, courts have emphasize 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 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. The general legal maxim de minimis non curat lex has no place in the field of documentary credits.
Letter of credit also refers to FIATA documents. More strictly, in practice freight forwarders usual present FIATA documents and the question is does FIATA documents can use like a document for activating letter of credit. In theory, the question is not very clear, because of the weakness in UCP 600.
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.
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
i. in accordance with 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 
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>
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.
In this type of LC, Any change (amendment) or cancellation of the LC (except it is expired) done by the Applicant through the issuing Bank must be authenticated by the Beneficiary of the LC. Whether to accept or reject the changes depends on the beneficiary.
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.
This type of letter of credit, does not acquire the other bank's confirmation.
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 its own invoice for the one of the supplier and acquire the difference as his profit in transferable letter of credit mechanism.
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.
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.
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.
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.
In this kind of credit assignment seller before sending the products can take the pre-paid and parts of the money from the bank. The first part of the credit is to attract the attention acceptor bank. The reason why it named so, is that the first time this credit is established by the assigner bank, to take the attention of the offered bank, the terms and conditions were written by red ink, from that time it became famous with that name.
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.
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. 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 bank’s 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.
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 buyer’s 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 sellers nor benefactors of the buyers, and the seller doesn’t 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.
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. 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 proceeds, on open account terms.
Risk situations in letter-of-credit transactions 
- The payment will be obtained for nonexistent or worthless merchandise against presentation by the beneficiary of forged or falsified documents.
- Credit itself may be forged.
Sovereign and Regulatory Risks
- Performance of the Documentary Credit may be prevented by government action outside the control of the parties.
- 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 
- Letter of Credit explained What is a letter of credit?. LoanUniverse.com.
- Understanding and Using Letters of Credit, Part I. Credit Research Foundation.
- See Ficom S.A. v. Socialized Cadex  2 Lloyd’s Rep. 118.
- United City Merchants (Investments) Ltd v Royal Bank of Canada (The American Accord)  1.A.C.168 at 183
- J. H. Rayner & Co., Ltd., and the Oilseeds Trading Company, Ltd. v.Ham bros Bank Limited  73 Ll. L. Rep. 32
- For extensive analysis See Finkelstein, H. Legal Aspects of Commercial Letters of Credit, pp. 275-295
- Dominique Doise,“The 2007 Revision of the Uniform Customs and Practice for Documentary Credits (UCP 600)”
- Anatomy of a Letter of Credit, showing an actual negotiated letter of credit
- Letters of Credit and How They Work
- Credit Research Foundation - Understanding & Using Letters of Credit - Part 1
- Credit Research Foundation - Understanding & Using Letters of Credit - Part 2
- (in Persian)
- Letter of Credit, its Relation with Stipulation for the Benefit of a Third Party