Letter of credit

The letter of credit has been used in Europe since ancient times. Letters of credit were traditionally governed by internationally recognized rules and procedures rather than by national law. The International Chamber of Commerce oversaw the preparation of the first Uniform Customs and Practice for Documentary Credits (UCP) in 1933, creating a voluntary framework for commercial banks to apply to transactions worldwide. In the late 19th century and early 20th century, travelers commonly carried a circular letter of credit issued by a relationship bank, which allowed the beneficiary to withdraw cash from other banks along their journey. This type of letter of credit was eventually replaced by traveler's checks, credit cards and automated teller machines. Although letters of credit first existed only as paper documents, they were regularly issued by telegraph in the late 19th century, and by telex in the latter half of the 20th century. Beginning in 1973 with the creation of SWIFT, banks began to migrate to electronic data interchange as a means of controlling costs, and in 1983 the UCP was amended to allow "teletransmission" of letters of credit. By the 21st century, the vast majority of LCs were issued in electronic form and entirely "paperless". LCs were becoming more common. ==Terminology==

UCP 600 (2007 Revision) regulates common market practice within the letter of credit market. It defines a number of terms related to letters of credit which categorise the various factors within any given transaction. These are crucial to understanding the role financial institutions play. These include: • The applicant is the person or company who has requested the letter of credit to be issued; this will normally be the buyer. • The beneficiary is the person or company who will be paid under the letter of credit; this will normally be the seller (UCP600 Article 2 defines the beneficiary as "the party in whose favour a credit is issued"). • The issuing bank is the bank that issues the credit, usually following a request from an applicant. • The nominated bank is a bank mentioned within the letter of credit at which the credit is available (in this respect, UCP600 Article 2 reads: "Nominated bank means the bank with which the credit is available or any bank in the case of a credit available with any bank"). • The advising bank is the bank that will inform the beneficiary or their nominated bank of the credit, send the original credit to the beneficiary or their nominated bank, and provide the beneficiary or their nominated bank with any amendments to the letter of credit. • Confirmation is an undertaking from a bank other than the issuing bank to pay the beneficiary for a complying presentation, allowing the beneficiary to further reduce payment risk, although confirmation is usually at an extra cost. • A confirming bank is a bank other than the issuing bank that adds its confirmation to credit upon the issuing bank's authorization or request thus providing more security to the beneficiary. • A complying presentation is a set of documents that meet with the requirements of the letter of credit and all of the rules relating to letters of credit. ==Function==

A letter of credit is an important payment method in international trade and used worldwide. It is particularly useful where the buyer and seller may not know each other personally and are separated by distance, differing laws in each country, and different trading customs. It is a primary method in international trade to mitigate the risk a seller of goods takes when providing those goods to a buyer. It does this by ensuring that the seller is paid for presenting the documents which are specified in the contract for sale between the buyer and the seller. That is to say, a letter of credit is a payment method used to discharge the legal obligations for payment from the buyer to the seller, by having a bank pay the seller directly. Thus, the seller relies on the credit risk of the bank, rather than the buyer, to receive payment. As will be seen, and is observed in Image 2, the bank will pay the seller the value of the goods when the seller provides negotiable instruments, documents which themselves represent the goods. Upon presentation of the documents, the goods will traditionally be in the control of the issuing bank, which provides them security against the risk that the buyer (who had instructed the bank to pay the seller) will repay the bank for making such a payment. In the event that the buyer is unable to make payment on the purchase, the seller may make a demand for payment on the bank. The bank will examine the beneficiary's demand and if it complies with the terms of the letter of credit, will honor the demand. Most letters of credit are governed by rules promulgated by the International Chamber of Commerce known as Uniform Customs and Practice for Documentary Credits. The current version, UCP 600, became effective July 1, 2007. Banks will typically require collateral from the purchaser for issuing a letter of credit and will charge a fee which is often a percentage of the amount covered by the letter of credit. Types Several categories of LCs exist which seek to operate in different markets and solve different issues. Examples of these include: • Import vs export (commercial): The same credit can be termed an import or export letter of credit 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 vs irrevocable: Whether an LC is revocable or irrevocable determines whether the buyer and the issuing bank 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 in practice the revocable type of LC is increasingly obsolete. Any changes (amendment) or cancellation of the LC (except when expired) is done by the applicant (buyer) through the issuing bank. It must be authenticated and approved by the beneficiary (seller). • Confirmed vs unconfirmed: 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. • Restricted vs unrestricted: Either the one advising bank can purchase a bill of exchange from the seller in the case of a restricted LC, or the confirmation bank is not specified, which means that the exporter can show the bill of exchange to any bank and receive a payment on an unrestricted LC. • Deferred vs usance: A credit that is not paid or 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. Additionally, a letter of credit may also have specific terms relating to the payment conditions which relate to the underlying reference documents. Some of these include • 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 unable 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 suppliers and receive export LCs from buyers. • Standby letter of credit (SBLC): Operates like a commercial letter of credit, except that typically it is retained as a standby instead of being the intended payment mechanism. In other words, this is an LC which is intended to provide a source of payment in the event of non-performance of contract. This is a security against an obligation which is not performed. If the bank is presented with demands of non-payment it is not a guarantee; the trigger is not non-payment but documentation. UCP600 Article 1 provides that the UCP applies to standby LCs; ISP98 applies specifically to standby letters of credit; and the United Nations Convention on Independent Guarantees and Standby Letters of Credit applies to a small number of countries that have ratified the convention. Transferability 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", who does not supply the documents himself, but procures either goods or documents from other suppliers and arranges for them to be sent to the issuing bank. 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. It can further 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, including: • 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. In some cases, the middleman does not want the buyer and supplier to know each other. The middleman is entitled to substitute his own invoice for the supplier's and acquire the difference as profit. Documents that may be requested To receive payment, an exporter or shipper must present the documents required by the LC. Typically the letter of credit will request an original bill of lading as the use of a title document such as this is critical to the functioning of the letter of credit. 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: Some of the other risks inherent in international trade include: Fraud The payment will be obtained for nonexistent or worthless merchandise against presentation by the beneficiary of forged or falsified documents. Legal risks There is the 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 or performance may be prevented by government action outside the control of the parties. Alternatively, performance of a contract – including an obligation under a documentary credit relationship – could also be prevented by external factors such as natural disasters or armed conflicts. These risks, however, are often seen as secondary to the risk of non-payment. Applicant Several risks could relate to the parties of the applicant themselves. These may include situations where there is a non-delivery of Goods, Short shipment, the goods are of inferior quality, are damaged, or are late. The applicant is also exposed to the failure of the bank to make payment. Issuing bank The issuing bank is also exposed to risks which it may seek to mitigate through various techniques. It will be exposed to the insolvency risk of the applicant, that is, the risk the applicant runs insolvent before it is able to repay the letter of credit. Secondly, the bank will be exposed to a risk of fraud by the seller, who may provide incorrect or falsified documents to receive payment. If the bank ought to have known that the documents were a fraud, then the bank will be exposed to a fraud. Beneficiary The beneficiary will be exposed to the risk of its own failure to comply with credit conditions or failure of, or delays in payment from, the issuing bank. These risks are considered remote. Crucially, the beneficiary is not exposed to the risks of set-off by the applicant where the goods are damaged or are of inferior quality. While he may be sued by the applicant at a later point, the issuing bank cannot reduce the payment owed to correspond with the damage occurred. This is crucial in mitigating the risk to insolvency. Crucial to a letter of credit is the beneficiary's (the seller) attempt to isolate itself from the credit risk of the buyer. That is to say, it is concerned primarily with the ability of the buyer to pay for the goods. 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 principles==

The fundamental principle of all letters of credit is that letters of credit deal with documents and not with goods. The payment obligation is independent from the underlying contract of sale or any other contract in the transaction. The bank's obligation is defined by the terms of the LC alone, and the contract of sale is not considered. The specified documents are often bills of lading or other 'documentary intangibles' which 'A' and 'B' have previously specified in their original contract. The actions 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) of the UCP600 states this principle clearly. This is confirmed within the market-practice documents stated by Article 5 of UCP600. As is a core tenet of financial law, market practice comprises a substantial portion of how parties behave. Accordingly, if the documents tendered by the beneficiary or their agent are in order, then, in general, the bank is obliged to pay without further qualifications. If this were not the case, financial institutions would be much less inclined to issue documentary credits because of the risk, inconvenience, and expense involved in determining the underlying goods. Financial institutions do not act as 'middlemen' but rather, as paying agents on behalf of the buyer. 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. With the UCP 600 rules the ICC sought to make the rules more flexible, suggesting that data in a document "need not be identical to, but must not conflict with data in that document, any other stipulated document, or the credit", as a way to account for any minor documentary errors. If this were not the case, the bank would be entitled to withhold payment even if the deviation is purely technical or even typographical. However, in practice, many banks still hold to the principle of strict compliance, since it offers concrete guarantees to all parties. The general legal maxim de minimis non curat lex (literally "The law does not concern itself with trifles") has no place in the field. However, whilst the details of the letter of credit can be understood with some flexibility the banks must adhere to the “principle of strict compliance” when determining whether the documents presented are those specified in the letter of credit. This is done to make the banks' duty of effecting payment against documents easy, efficient and quick. Legal basis Legal writers have failed to satisfactorily reconcile the bank's obligation to pay on behalf of the applicant with any contractually-founded, academic analysis. That is to say, they have not examined legal effect of the banks obligation through a conclusive theoretical lens. This has produced several conflicting theories as to the contractual effect of a letter of credit. Some theorists suggest that the obligation to pay arises through the implied promise, assignment, novation, reliance, agency, estoppel and even trust and the guarantees. 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. A promise to perform owed to a third party may also constitute a valid consideration. It might also be feasible to typify letters 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. Jean Domat suggests that because letters of credit are prompted by the buyer's necessity, the cause of an LC is to release the buyer of his obligation to pay directly to the seller. Therefore, an LC theoretically fits as a collateral contract accepted by conduct or in other words, an implied-in-fact contract 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 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. A few countries have created statutes in relation to letters of credit. For example, most jurisdictions in the United States (U.S.) have adopted Article 5 of the Uniform Commercial Code (UCC). These statutes are designed to work with the rules of market 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. Since the UCP are not laws, parties have to include them into their arrangements as normal contractual provisions. However, they still form a substantial part of market practice and crucially underpin financial law. == National laws ==

Germany Bürgerliches Gesetzbuch, the German civil code, does not directly address letters of credit. German case law indicates that the relationship between the issuing bank and customer is a contract for execution of a transaction, while the relationship between the issuing bank and the beneficiary is a promise of a debt. Switzerland The Swiss Civil Code of 1911 did not directly address letters of credit, which were still rare in the country at the time. Courts eventually dealt with the device by treating it as a hybrid of a mandate (Auftrag) and authorization-to-pay contract (Anweisung). The New York Bankers [sic] Commercial Credit Conference of 1920 provided the first set of voluntary LC regulations for major banks in the United States, but these banks transitioned to the international UCP standard by 1938. == Use in fraud ==

Letters of credit are sometimes used to defraud banks through presentment of false documentation indicating that goods were shipped when they actually were not. Letters of credit are also sometimes used as part of fraudulent investment schemes. In the international banking system, a letter of undertaking (LOU) is a provisional bank guarantee, under which a bank allows its customer to raise money from another bank's foreign branch in the form of short-term credit. The LOU serves the purpose of a bank guarantee. However, to be able to raise the LOU, the customer is supposed to pay margin money to the bank issuing the LOU and accordingly, he is granted a credit limit. In 2018, PNB suffered from such a breach of documentation protocols. ==See also==