Letter of Credit Essay Example

Latin. According to www.investorwords.com, this financial instrument ensures secure transfer of the buyer's payment for goods to the seller.

The primary purpose of a letter of credit is to ensure that the seller receives payment for the goods. In order to receive payment, the seller must provide the necessary shipping documents to the bank as proof of delivery within a specific timeframe. This approach is commonly used in international trade to mitigate risks associated with unfamiliarity with foreign countries, customs, or political instability. The subsequent information provides an overview of findings related to letters of credit in global business.

A letter of credit is a document issued by larger banks that guarantees payment to a seller when the buyer receives goods, provided certain conditions stated in the letter of credit are met. It functions as an arrangement where the importer (known as the applicant) requests and instructs either the issuing bank or another bank acting on its behalf. The use of a letter of credit abides by three main principles: 1) Banks solely handle documents; 2) Strict adherence to terms and conditions is crucial; and 3) Independence from other agreements is maintained. When an exporter chooses payment via a letter of credit, they transfer the risk of non-payment to the issuing Bank, alongside any Confirming Bank involved, so long as all necessary documents are presented strictly in accordance with the credit terms, excluding cash paid beforehand.

The exporter considers a letter of credit as the most secure method of payment in international trade, as long as the terms of the credit are satisfied. In a letter of credit transaction, all parties deal with documents instead of goods.

Figure 1 illustrates the parties involved in a letter of credit transaction. Figure 3 depicts the different types of letter of credit processes.

There are several types of letters of credit available in the market:

1. Irrevocable: This type cannot be amended or cancelled without agreement from all parties involved. The issuing bank provides a binding commitment to the beneficiary, as long as all credit terms and conditions are met. According to UCP 600, all letters of credits are considered irrevocable.
2. Unconfirmed: This type does not have an additional confirmation from a second bank.
3. Confirmed: This type includes an additional confirmation from a second bank, adding extra security for the beneficiary.
4. Standby Letter of Credit: This type ensures payment to the beneficiary if the buyer fails to fulfill their obligations.
5. Revolving Letter of Credit: This type allows for multiple shipments and payments within a specified period.
6. Transferable Letter of Credit: This type allows the beneficiary to transfer all or part of their rights to another party.

A Back-to-Back Letter Of Credit entails two distinct letters Of Credits where one acts as collateral for other.

An unconfirmed letter of credit is sent by the Advising bank directly to the exporter without adding its own commitment to payment or responsibility for future payment, but it does confirm its authenticity.

On the other hand, a confirmed letter of credit is when a bank, typically in the Beneficiary's country, adds its own commitment to confirm that payment will be made as long as compliant documents are presented. This commitment remains even if the Issuing bank or the Applicant fails to make payment. Confirmation provides the exporter with additional security, especially if the standing of the Issuing bank is unknown

or if the importer's country is experiencing uncertain political and economic conditions. Confirming a letter of credit incurs an additional charge, with varying costs depending on the country involved. In many high-risk countries, this charge ranges between 2% and 8%.

A standby letter of credit functions as a secondary payment mechanism that provides support when an alternative, less secure payment method has been agreed upon. The involved parties do not anticipate that the letter of credit will ever be utilized. In the United States of America, standby letters of credit are commonly used instead of bank guarantees. They are often employed to guarantee performance or enhance the creditworthiness of a customer. In case the exporter does not receive payment from the importer, he can make a claim under the standby letter of credit.

Certain documents are likely to be required to obtain payment, including:
1. The standby letter of credit itself
2. Sight draft for the amount due
3. Copy of the unpaid invoice
4. Proof of dispatch
5. A signed declaration from the Beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit.
The International Chamber of Commerce rules for operating standby letters of credit are UCP600 and ISP98 International Standby Practices.
Revolving Letter of Credit is used for regular shipments of the same commodity between the same exporter and importer. The credit must state that it is a revolving letter of credit. It may revolve either automatically or subject to certain provisions. This avoids the need for repetitious arrangements for opening or amending letters of credit, which can revolve in relation to time or value. If

the credit is time revolving, once utilized, it is re-instated for further regular shipments until the credit is fully drawn.

If the value of the credit is utilized and paid back, it can be reinstated for further drawings. In a Transferable Letter of Credit, the exporter can request the paying or negotiating bank to make part or all of the credit value available to third parties. This is useful for middlemen who need to finance purchases from third party suppliers. Upon request from the first beneficiary, the credit can be made available in whole or in part to another beneficiary. It is also possible to transfer a credit in part to multiple second beneficiaries. A Back to Back Letter of Credit can be used as an alternative to the transferable letter of credit.

A second letter of credit is established by using a letter of credit as security, issued by the Advising Bank in favor of the exporter's merchandise supplier. Instead of transferring the original letter of credit to the supplier, this method is employed. However, many banks are hesitant to issue back to back letters of credit due to the associated risk. On the other hand, a transferable credit does not expose them to a higher risk than that present under the original credit. All documents required by the letter of credit must adhere to its terms and be coherent with each other. These documents encompass financial claims, transport documents, and other miscellaneous documents. Typically, a letter of credit obtained from a bank specifies that the transaction is governed by both sets of rules.

The rule of independence is codified in both the Uniform Commercial Code

(UCC) and Uniform Customs and Practice for Documentary Credits (UCP). The UCC, also known as the Code, is a uniform act that aims to harmonize sales and other commercial transactions across all 50 states in the US. This is crucial due to the prevalence of transactions that span multiple states, involving manufacturing, warehousing, selling, and delivery. The UCC focuses on personal property transactions rather than real property. (Wikipedia)

The Uniform Customs and Practice for Documentary Credits (UCP) is a set of rules on the issuance and use of letters of credit. The UCP, published by the International Chamber of Commerce (ICC) in 1933, standardizes the techniques and methods for handling letters of credit in international trade finance. The UCP has been regularly revised by the ICC, with the current version being the UCP500. Considered the most successful international attempt at unifying rules, the UCP has had a substantial universal effect.

The Banking Commission of the ICC approved the latest revision at its meeting in Paris on 25 October 2006, which officially started on 1 July 2007 with the name UCP600. The ICC is responsible for preparing and promoting its uniform rules of practice, aiming to codify international practice by selecting the best practices after thorough debate and consideration. These rules, designed by bankers and merchants rather than legislatures with political and local influences, reflect the needs, customs, and practices of business.

The flexibility and stability of the rules, which are voluntarily incorporated into contracts, allow for international review and judicial scrutiny. This allows for easy revision and integration of evolving commercial practices. The goal of the ICC, established in 1919, was to facilitate international trade in the face

of rising nationalism and protectionism. In line with this objective, the UCP was introduced to address confusion caused by individual countries promoting their own rules on letter of credit practice. The UCP aimed to establish uniformity in practice and reduce the need to navigate conflicting national regulations. The widespread acceptance of the UCP by practitioners across diverse economic and judicial systems is evidence of its success.

The International Chamber of Commerce (ICC) accepts a variety of members, such as corporations, companies, associations, federations, law firms and consultancies, chambers of commerce, and individuals involved in international business. A rule governs the autonomy of a letter of credit, mandating that the paying bank must make payment without conditions if the beneficiary fulfills the specified payment requirements outlined in the letter. This means that any terms and conditions stated in the sales and purchase contract between the buyer and seller will not impact the bank's payment under the letter of credit. For instance, if the letter requires a documentary check and the seller meets all document requirements as outlined in it, then the bank must make payment to them without exceptions unless there is non-compliance or fraud related to those documents. A notable international case in New York (O'Meara (Maurice) Co v National Park Bank 146 NE 636 (1925)) served as an illustration of this principle involving a paper trade. It was emphasized that there was no obligation for the bank to personally examine or use other means to verify whether or not the paper conformed to the contract between buyer and seller; their only concern was with regards to drafts and their accompanying documents.If the bank received

the correct documents along with the drafts, they were obligated to make the payment under the letter of credit, regardless of their knowledge or belief about whether the paper met the contracted tensile strength.

The bank's responsibility to fulfill payment as outlined in the letter of credit remains the same, regardless of any breaches by the seller in the sales contract. This is due to the autonomy principle, which treats the letter of credit as separate from the agreement between buyer and seller. The independence of the letter of credit benefits international sales by ensuring successful delivery and payment for goods. The seller must provide delivery documents according to the terms specified in the letter of credit, and upon receiving payment, it is expected that the buyer will reimburse the bank. It is mandatory for the bank to strictly adhere to its obligations stated in the agreement between the applicant and issuing bank.

The concept of strict compliance applies to all contracts in a letter of credit transaction, including the buyer-banker contract, banker-seller contract, and issuing-correspondent banks contract. The doctrine defines that there is no tolerance for documents that are almost identical or could serve as substitutes. It emphasizes that if the bank adheres precisely to instructions, it operates securely; however, any deviation from the specified conditions is done at its own risk. This clear definition of strict compliance was established by an English court in 1927.

The rule "de minimis non curat lex" (rule of insignificance) is not applicable to letter of credit transactions. The bank's duty is limited to checking the documents "on their face", but they must fulfill this obligation strictly in order to provide the

buyer with the protection of the instructed documents. On their face means the bank doesn't need to question if the documents could be false, if the goods were actually shipped, or if the document has lost its value since being issued. The actual situation is not relevant to the bank, except in certain cases. Problems with Doctrine of Strict Compliance arise from different interpretations of strict compliance in courts and various countries. Literal compliance means fulfilling the terms and conditions of the letter of credit exactly as stated. The bank is obligated to act within the given, formal, and precise banking commission because the underlying sale contract is not part of their knowledge or judgment.

When a bank receives documents for payment, it is obligated to pay only if the documents fully comply with the terms of the credit. The strict compliance requirement exists because banks lack expertise in goods and industries, making it difficult for them to judge the quality and terms of goods. This lack of knowledge poses a risk to the beneficiary, as even seemingly insignificant discrepancies can lead to significant damages. A survey conducted in the 1980s revealed that over 60% of document presentations had discrepancies. Although many discrepancies can be easily resolved with the bank's decision and customer agreement, it is still necessary for banks to protect themselves and their customers.

Although article 15 of UCP 500 includes a disclaimer for various risks, banks may still be held responsible for losses and damages. If a bank fails to properly examine the documents, it cannot use the disclaimer as a defense. Another viewpoint argues for a broader interpretation of compliance. If it can

be demonstrated that a supposed discrepancy is due to a clear error, it would be unreasonable to deem the entire transaction invalid based solely on a minor slip or mistake. Treating every typographical error or obvious mistake as a discrepancy would reduce the commercial transaction governed by the letter of credit to a mere proofreading task. Therefore, the type and significance of the mistake are crucial factors, but not the sole determinants for all parties involved.

Despite a discrepancy potentially being insignificant and only of a technical nature, a bank is still obligated to deem the documents acceptable. This is exemplified in the case study UNITED BANK LTD. v. BANQUE NATIONALE DE PARIS ; ORS.

According to Bailhache J in the case of English Scottish and Australian Bank Ltd v. Bank of South Africa [1922] Lloyd Rep 21, it is essential to comply precisely with the terms of a letter of credit when shipping goods based on it. The judge also stated that a bank is neither obligated nor authorized to honor drafts presented under a letter of credit unless those drafts, along with the accompanying documents, align strictly with the credit as initially established. In the case of Moralice (London) Ltd. v. E D ; F Man [1954] 2 Loyd’s Rep 526, the Court determined that the de minimis rule does not apply in transactions involving a letter of credit. This particular case involved a quantity of 500 metric tons of sugar.

The documents revealed a quantity of only 499 metric tons. McNair J ruled that the confirming bank could not be obligated to make a payment based on the letter of credit, and the bank could

not justify deducting that amount from the documents as payment against their principal, the Iraqi buyer. The Court determined this, even though the beneficiary suggested drawing a slightly lower amount relative to the shortfall.

Certain courts strictly require exact adherence, such that any misspelt name or typographical mistake nullifies the demand for payment by the exporter/beneficiary/seller. Conversely, other courts deem the requirement fulfilled if there is substantial compliance with the necessary documents. The bank can demand strict adherence to the L/C requirements. If the Seller fails to conform to the L/C, they cannot compel payment and the bank assumes the responsibility of paying at their own peril.

Sellers should exercise caution and keep in mind that the bank may require strict adherence to all documentary requirements stated in the LC. If the documents fail to meet these requirements, the bank must promptly notify the seller in detail, specifying all discrepancies and shortcomings. In conclusion, Letters Of Credit have emerged as a widely preferred payment mode in trading, surpassing other available alternatives. The seamless nature of Letter of Credit transactions and the attached assurance have significantly contributed to their success.

The flexibility and variety of Letter of Credit make it applicable in both national and international trade practices. Many banks now offer Letter of Credit services to customers, contributing to the facilitation and growth of trade.
Bibliography:
1. http://en.wikipedia.org
2. [Source name or URL]

www.sitpro.org.uk 3.

In 2004, S. Johan from the University of Uppsala published a book titled "International and Comparative Trade Law". Chapter 4 of this book discusses UCP 600. More information can be found at http://www.

iitk.ac.in/ime