Introduction

A study of letter of credit deals with studying and understanding the Letter of credit, different

fields of letter of credit and different types of L/C charges namely L/C Advising charges, L/C

Amendment charges and discrepancy charges and calculating saving potential and making

recommendations.

A letter of credit (LC) is a binding document that a buyer can request from his bank in order

to guarantee that the payment for goods will be transferred to the seller. Basically, a letter of

credit gives the seller reassurance that he will receive the payment for the goods.

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Letter of CreditThe English name “letter of credit” derives from the French word “accreditif”, a power to do

something, which in turn is derivative of the Latin word “accreditivus”, meaning trust.

A letter of credit is basically a document issued by a bank guaranteeing a client's ability to

pay for goods or services. A bank or finance company issues a letter of credit on behalf of a

buyer, authorizing the seller to obtain payment within a specified timeframe once the terms

and conditions outlined in the letter of credit are met. The letter of credit acts like an

insurance contract for both the buyer and seller and practically eliminates the credit risk for

both parties, while at the same time reducing payment delays. A letter of credit provides the

seller with the greatest degree of safety when extending credit. It is useful when the buyer is

not well known and when exchange restrictions exist or are possible.

The LC can also be the source of payment for a transaction, meaning that a will get paid by

redeeming the letter of credit. Letters of credit are used primarily in international trade

transactions of significant value, for deals between a supplier in one country and a customer

in another. The parties to a letter of credit are usually a beneficiary who is to receive the

money, the issuing bank of whom the applicant is a client, and the advising bank of whom the

beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or

canceled without prior agreement of the beneficiary, the issuing bank and the confirming

bank, if any. In executing a transaction, letters of credit incorporate functions common

Traveler's cheques.

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The ConceptA letter of credit is a document issued mostly by financial institutions which usually provides

an irrevocable payment undertaking to a beneficiary against complying documents as stated

in the credit.

Once the beneficiary or a presenting bank acting on his behalf, makes a presentation to the

issuing bank or confirming bank, if any, within the expiry date of L/C, comprising documents

complying with the terms and conditions of the L/C, the applicable UCP. And international

standard banking practices. The issuing bank or confirming bank, if any, is obliged to honor

irrespective of any instructions from the applicants to the contrary.

Seller Bank

Carrier

After a contract s concluded between buyer and seller, buyer bank supplies a letter of credit

to the seller

Seller consigns goods to a carrier in exchange for a bill of lading.

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Buyer Bank

Seller Buyer

Seller Bank Buyer Bank

Seller Buyer

Carrier

Seller provide bill of lading to a bank in exchange for payment. Seller’s bank exchanges bill

of lading for payment from a buyer’s bank. Buyer’s bank exchange bill of lading for payment

from buyer.

Seller Bank

Carrier

Buyer provides bill of lading to a carrier and takes delivery of goods

Seller Bank

Carrier

Elements of a Letter of Credit

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Buyer Bank

Seller Buyer

Buyer Bank

Seller Buyer

A payment undertaking given by a bank (issuing bank)

On behalf of a buyer (applicant)

To pay a seller (beneficiary) for a given amount of money

On presentation of specified documents representing the supply of goods

Within specified time limits

Documents must conform to terms and conditions set out in the letter of credit

Documents to be presented at a specified place

PARTIES TO AND ASSOCIATED WITH THE LETTER OF CREDIT

1. Applicant 1

The applicant is the party who requests and instructs the issuing bank to open a letter of

credit in favor of the beneficiary. The applicant usually is the importer or the buyer of goods

and/or services. The applicant can also be another party acting on behalf of the importer, such

as a confirming house. The confirming house is equivalent to a buying office, it acts as an

intermediary between buyer and seller, and it can be located in a third country or in the

seller’s country.

2.Beneficiary

The beneficiary is entitled to payment as long as he can provide the documentary evidence

required by the letter of credit. The letter of credit is a distinct and separate transaction from

the contract on which it is based. All parties deal in documents and not in goods. The issuing

bank is not liable for performance of the underlying contract between the customer and

beneficiary. The issuing bank's obligation to the buyer, is to examine all documents to insure

that they meet all the terms and conditions of the credit. Upon requesting demand for

payment the beneficiary warrants that all conditions of the agreement have been complied

with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the

bank.

3. Issuing Bank 2

The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute

upon the completion of the terms and conditions of the letter of credit. Under the provisions

1 A. Mugasha, The Law of Letters of Credit and Bank Guarantees (2003)], 20 BANKING & FIN. L. REV. (Osgoode Hall Law School) 177 (2004).2 A. Mugasha, The Law of Letters of Credit and Bank Guarantees (2003)], 20 BANKING & FIN. L. REV. (Osgoode Hall Law School) 177 (2004).

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of the Uniform Customs and Practice for Documentary Credits, the bank is given a

reasonable amount of time after receipt of the documents to honor the draft.The issuing

banks' role is to provide a guarantee to the seller that if compliant documents are presented,

the bank will pay the seller the amount due and to examine the documents, and only pay if

these documents comply with the terms and conditions set out in the letter of credit. Typically

the documents requested will include a commercial invoice, a transport document such as a

bill of lading or airway bill and an insurance document; but there are many others. Letters of

credit deal in documents, not goods.

4. Advising Bank 3

An advising bank, usually a foreign correspondent bank of the issuing bank will advise the

beneficiary. Generally, the beneficiary would want to use a local bank to insure that the letter

of credit is valid. In addition, the advising bank would be responsible for sending the

documents to the issuing bank. The advising bank has no other obligation under the letter of

credit. If the issuing bank does not pay the beneficiary, the advising bank is not obligated to

pay.

5. Confirming Bank 4

The correspondent bank may confirm the letter of credit for the beneficiary. At the request of

the issuing bank, the correspondent obligates itself to insure payment under the letter of

credit. The confirming bank would not confirm the credit until it evaluated the country and

bank where the letter of credit originates. The confirming bank is usually the advising bank.

TYPES OF LETTER OF CREDIT

3 A. Mugasha, The Law of Letters of Credit and Bank Guarantees (2003)], 20 BANKING & FIN. L. REV. (Osgoode Hall Law School) 177 (2004).4 A. Mugasha, The Law of Letters of Credit and Bank Guarantees (2003)], 20 BANKING & FIN. L. REV. (Osgoode Hall Law School) 177 (2004)

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1.)Commercial and stand by L/C 5 : Commercial letters of credit are used primarily to

facilitate foreign trade. The commercial letter of credit is the primary payment mechanism for

a transaction. It is a contractual agreement between banks, known as the issuing bank, on

behalf of one of its customers, authorizing another bank, known as the advising or confirming

bank, to make payment to the beneficiary. The issuing bank, on the request of its customer,

opens the letter of credit. The issuing bank makes a commitment to honor drawings made

under the credit. The beneficiary is normally the provider of goods and/or services.

Essentially, the issuing bank replaces the bank's customer as the payee. The standby letter of

credit serves a different function. The standby letter of credit serves as a secondary payment

mechanism. The bank will issue the credit on behalf of a customer to provide assurances of

his ability to perform under the terms of a contract. A bank will issue a standby letter of

credit on behalf of a customer to provide assurances of his ability to perform under the terms

of a contract between the beneficiaries. The parties involved with the transaction do not

expect that the letter of credit will ever be drawn upon. The standby letter of credit assures

the beneficiary of the performance of the customer's obligation. The beneficiary is able to

draw under the credit by presenting a draft, copies of invoices, with evidence that the

customer has not performed its obligation. The bank is obligated to make payment if the

documents presented comply with the terms of the letter of credit.

They are issued by banks to stand behind monetary obligations, to insure the refund of

advance payment, to support performance and bid obligations, and to insure the completion

of a sales contract. The credit has an expiration date. The standby letter of credit is often used

to guarantee performance or to strengthen the credit worthiness of a customer. In the above

example, the letter of credit is issued by the bank and held by the supplier. The customer is

provided open account terms. If payments are made in accordance with the suppliers' terms,

the letter of credit would not be drawn on. The seller pursues the customer for payment

directly. If the customer is unable to pay, the seller presents a draft and copies of invoices to

the bank for payment.

2).Revocable or irrevocable letter of credit: Letters of credit may be either revocable or

irrevocable. A revocable letter of credit may be revoked or modified for any reason, at any

time by the issuing bank without notification. A revocable letter of credit cannot be

confirmed. Once the documents have been presented and meet the terms and conditions in the

5 The Law of Letters of Credit: Commercial and Standby Credits (A.S. Pratt & Sons,) 2007 4th edition

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letter of credit, and the draft is honored, the letter of credit cannot be revoked. The revocable

letter of credit is not a commonly used instrument. If a letter of credit is revocable it would be

referenced on its face. The irrevocable letter of credit may not be revoked or amended

without the agreement of the issuing bank, the confirming bank, and the beneficiary. An

irrevocable letter of credit from the issuing bank insures the beneficiary that if the required

documents are presented and the terms and conditions are complied with, payment will be

made. If a letter of credit is irrevocable it is referenced on its face.

Cases

United Commercial Bank …V/s… Bank of India and others6,

The Hon’ble Supreme Court of India:

That, “It is only in exceptional cases that the courts will interfere with the machinery of

irrevocable obligations assumed by banks. They are the life-blood of international commerce.

Such obligations are regarded as collateral to the underlying rights and obligations between

the merchants at either end of the banking chain. Except possibly in clear cases of fraud of

which the banks have notice, the courts will leave the merchants to settle their disputes under

the contracts by litigation or arbitration as available to them or stipulated in the contracts. The

courts are not concerned with their difficulties to enforce such claims; these are risks which

the merchants take … the machinery and commitments of banks are on a different level. They

must be allowed to be honoured, free from interference by the courts. Otherwise trust in

international commerce could be irreparably damaged”.

Svenska Handelsbanken, Appellant v. M/s. Indian Charge Chrome and others,

Respondents7

Under the terms agreed to between the parties, there is no scope of injunction. The High

Court proceeded on the basis that this was not an injunction sought against the bank but

against the appellant. But the net effect of the injunction is to restrain the bank from

performing the bank guarantee. That cannot be done. One cannot do indirectly what one is

not free to do directly. The respondent was not to suffer any injustice which was irretrievable.

6 A.I.R. 1981 SC 14267 A.I.R. 1994 SC 626

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The respondent can sue the appellant for damages. There cannot be any basis in the case for

apprehension that irretrievable damage would be caused, if any.

Unique Alliance Industries, V/s… Anupama Agencies8

The Hon’ble Court observed, “The grant of temporary injunction, as noticed above, is purely

a discretionary exercise of power by the Court. This power has to be exercised by the Court

fairly and suitably. It can refuse temporary injunction against a Bank if the Court feels that

issuing of such injunction will result in gross injustice to the Bank or the public at large. In

certain case public interest assumes much importance at the realms of granting or issuing the

temporary injunction in the case of banking institutions.”

Itek Corporation v. The First National Bank of Boston etc.9

The Hon’ble Supreme Court observed “It will be noticed that this judgment is on peculiar

facts of its own and the situation created after the Iranian Revolution and the American

Government cancelled the export license in relation to Iran as it related to high

technology……. The court was of the view that even if claim for damages is decreed by the

American courts situation in Iran was such that the decree will not be executable in Iran. It

was on these facts that the court felt that it was a case where the plaintiff had demonstrated

that it has no adequate remedy at law and the allegations of irreparable harm are not

speculative but genuine and immediate and the plaintiff would suffer irreparable harm if the

requested relief is not granted.”

3) Sight or usance letter of credit: All letters of credit require the beneficiary to present a

draft and specified documents in order to receive payment. A draft is a written order by

which the party creating it, orders another party to pay money to a third party. A draft is also

called a bill of exchange. There are two types of drafts: sight and time. A sight draft is

payable as soon as it is presented for payment. The bank is allowed a reasonable time to

review the documents before making payment. A time draft is not payable until the lapse of a

particular time period stated on the draft. The bank is required to accept the draft as soon as

the documents comply with credit terms. The issuing bank has a reasonable time to examine

those documents. The issuing bank is obligated to accept drafts and pay them at maturity. A

Letter of credit is known as a Sight letter of credit if it involves payment to the seller against

8 I (1995) BC 127 (DB),9 566 Federal Supplement 1210

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a Sight Draft. On the other hand, if the payment is made against a Usance Draft, then it is

known as Usance letter of credit.

4)Transferable: An irrevocable letter of credit may also be transferable. With a transferable

letter of credit, the exporter can transfer all or part of his rights to another party. Transferable

letters of credit are often used when the exporter is the importer's agent or a middleman

between supplier and importer, and not the actual supplier of merchandise. With a

transferable letter of credit, the exporter uses the credit standing of the issuing bank and

avoids having to borrow or use his own funds to buy goods from a supplier. Hence, it is a

viable pre-export financing vehicle. Before transfer can be made, the exporter must contact,

in writing, the bank handling the disbursement of funds - the transferring bank. Transferable

letters of credit can only be transferred based on the terms and conditions specified in the

original credit, with certain exceptions. Therefore, it may be difficult to achieve flexibility

and confidentiality with this finance method.

The transferring bank, whether it has confirmed the letter of credit or not, is only obligated to

affect the transfer to the extent and in the manner expressly specified in the letter of credit.

Transferable letters of credit involve specific risks. When a bank opens a transferable letter of

credit for a buyer, neither party can be certain of who will be the ultimate supplier. Both

parties must rely upon the importer's assessment of the exporter's reputation and ability to

perform. To reduce overall risk and prevent the shipment of substandard goods, an

independent certificate of inspection can be required in the documentation.

For simplicity's sake, many banks prefer single transfer and discourage multiple transfers, but

will do multiple transfers if conditions are right. Partial transfers can also be made to one or

several suppliers if the terms of the original letter of credit allow for partial shipments. The

processing of this type of letter of credit can become complicated and tricky, requiring

logistics coordination and the highest level of precision. Incomplete and/or ambiguous

information on the transferable letter of credit almost always leads to problems. Furthermore,

the beneficiary of the transferable letter of credit must be available throughout the entire

negotiation process to assist the transferring bank.

Benefits of Letter of Credit

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The letter of credit is the safest, most secure and most convenient settlement method for international transactions. There are a number of advantages both for the seller/exporter and the buyer/importer.

Benefits to Sellers Benefits to Buyers

• Assures the security of payment from an international bank once the terms of the letter of credit are met.

• Seller can determine when payment will be satisfied and ship the goods accordingly.

• Bank bears the responsibility of oversight.

• Seller does not have to open an account and grant payment terms to buyer. Credit risk is nearly eliminated. The risk of exchange control created with payment delays is greatly reduced.

• Provides seller easier access to financing once the letter of credit has been issued.

• Once the bank confirms the letter of credit, political and economic risk and questions regarding the buyer's ability to pay are eliminated. The confirming bank is obliged to pay, even if the buyer goes bankrupt, provided the terms of the letter of credit are met.

• Facilitates financing--for example, creating bankers acceptances.

• Buyer can confirm that the merchandise is shipped on or before the required date.

• It is safer to deal with bank than to prepay.

• Buyer may get better terms and prices.

• No cash is tied up in the process. Buyer does not have to pay cash up front to a foreign seller before receiving the documents of title to the goods purchased. This is particularly helpful when the buyer is unfamiliar with local suppliers and laws.

• Protects the buyer since the bank only pays when the supplier complies with the specific terms and conditions and produces the documents required by the buyer.

• The buyer can build safeguards into the letter of credit, including inspection of the goods and quality control, and set production and delivery times.

REVIEWS

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1. Bergami Robert (2007)10 analysis that that international trade transactions carry

inherently more risk than domestic trade transactions, because of differences in culture,

business processes, laws and regulations. It is therefore important for traders to ensure

that payment is received for goods dispatched and that the goods received and paid for

comply with the contract of sale. One effective way of managing these risks has been for

traders to rely on the letter of credit as a payment method. However for exporters in

particular, the letter of credit has presented difficulties in meeting the compliance

requirements necessary for the payment to be triggered. The current rules that govern

letter of credit transactions(UCP 500) have been under review for the past three years and

an updated set of rules (UCP 600) is expected to be introduced on 1July 2007. This paper

focuses on the changes mooted for 2007and compares these main issues with the existing

rules and other associated guidelines and regulations governing this method of payment.

This paper considers the implication to changes of letter of credit transactions and the

sharing of risk. Firstly the paper provides some background to letters of credit, then

comments on existing literature and models, and subsequently an analysis of the most

important changes to the existing rules, before reaching a conclusion. The conclusion is

that the UCP 600 have not paid enough consideration to traders and service providers and

are likely to engender an environment of uncertainty for exporters in particular.

2. Dolan John (2007)11 analysis that The Law of Letters of Credit – Commercial and

Standby Credits is the four the Edition of a traditional treatise on a rather narrow legal

subject. Letters of credit fall into two categories: (1) commercials, which find use in

international sales; and (2) standbys that are a common device in many domestic

transactions. As international trade becomes more and more rationalized, the use of

commercials has diminished; but the use of the standby has enjoyed something of a

boom, for it accomplishes much that security interests, surety ship arrangements, and

other credit enhancing devices accomplish and does it with significantly lower transaction

costs. Regrettably, the parties using letters of credit often are unaware of the credit’s legal

significance. This treatise covers the legal features of the commercial and the standby, all

in a global context. While it is codified to some extent in the Uniform Commercial Code, 10 Bergami Robert, (2007), “Will the UCP 600 Provide Solutions to Letter of Credit Transactions?” International Review of Business Research Papers,Vol.3 No.2, June 2007, Pp. 41 - 53

11 Dolan John, (2007),” THE LAW OF LETTERS OF CREDIT” The Wayne State University Law School Legal Studies Research, Vol 1, April 2007, p149

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the law of letters of credit is largely the law merchant, the is gentium; and the UCC defers

in many respects to international rules. Thus, the treatise deals with those international

rules and cites cases from virtually all of the common-law jurisdictions in an effort to

provide complete coverage of the field.

3. Klien Carter (2005)12 studied that for a relatively small fee and assuming sufficient

collateral or creditworthiness of the tenant or a guarantor, a tenant may be able to apply

for and have its bank issue to its landlord a letter of credit (“L/C”) to secure the tenant’s

obligations under a long-term lease. If the L/C is large enough, the landlord may enter

into a lease with a tenant that the landlord would otherwise refuse due to the tenant’s lack

of creditworthiness. From the tenant’s perspective, an L/C may be preferable to a large

security deposit. An L/C will not necessarily tie up large amounts of the tenant’s cash or

other liquid collateral, as would a security deposit. Instead, the cash can be deployed as

working capital in the tenant’s business. An L/C is an independent obligation of the

issuer. As long as conforming documents specified by the terms of the L/C is presented to

the issuer before the expiration date and no fraud is involved, the issuer must honor. The

credit of the issuer stands behind the obligation of the tenant. If the tenant is insolvent

and/or bankrupt, the issuer still must honor the beneficiary’s conforming draws. Rights

the landlord will lose if the L/C draw is enjoined and the credit expires. This two-part

article provides tips for drafting L/Cs. Part one includes a discussion of using the

International Standby Practices, keeping the draw condition s simple and allowing partial

draws conclusion addresses issues such as providing coverage of the settlement period

after lease termination; shortening pitfalls is eliminated.. The conclusion of this article

will provide six more drafting tips and a discussion of the issuing banks’ concerns.

Conclusion

12 Klien Carter, (2005), “Using Letters of Credit to Secure Lease Obligations”, Law journal Newsletter ,Vol 18, No 4 , September 2005, p. 585

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Letter of credit means when a bank or finance company issues a document on behalf of an

buyer, authorizing the seller to obtain payment within a specified timeframe once the terms

and conditions outlined in the letter of credit are met.

An irrevocable letter of credit has a definite implication. It is a mechanism of great

importance in international trade. The legal frame work that governs the letter of credit has

seen many cases in which fraud of company comes up in the court it is very difficult to prove

the breach lies in part of the parties. It is only in exceptional cases that the courts will

interfere with the machinery of irrevocable obligations assumed by banks. Except possibly in

clear cases of fraud of which the banks have notice, the courts will leave the merchants to

settle their disputes under the contracts by litigation or arbitration as available to them or

stipulated in the contracts.

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