The Basics of Letters of Credit
There are two types of letter of credit: commercial
(or trade) letters of credit and stand-by (or guarantee)
letters of credit. A commercial letters of credit
(technical term is documentary credit) is simply a
method of payment for the goods in an international
transaction, e.g., cash verses a letter of credit.
An exporter who does not want the burden of evaluating
the foreign buyer’s ability to pay for the ordered
goods would require the buyer to substitute bank’s
credit with buyer’s credit. A letter of credit (“LC”
or “LoC”) is a preferred method of payment because
even cash against delivery poses significant risk
since international shipping can be expensive. No
exporter wants to ship the goods overseas only to
find out that buyer cannot pay and to incur additional
expense of a return shipment.
To substitute bank’s credit with buyer’s credit, a
buyer/importer (applicant of a letter of credit) applies
for a line of credit with a bank in his own country.
When a bank issues a letter of credit, it lists required
documents that the seller (beneficiary of a letter
of credit) must present in order to collect amount
owed by the buyer because nothing more is required.
Once the seller presents the required documents to
the issuing bank, a bank will not pay unless a seller
submits proper documents that comply with the terms
of a letter of credit such as commercial invoice,
a bill of lading, insurance documents, etc. Because
bank’s commitment to make a payment under letter of
credit is independent of beneficiary’s performance
under the contract, the bank is obligated to pay if
the beneficiary/seller/exporter presents required
documents even if the seller ships wrong goods or
inferior goods so long there is no fraud. A court
may enjoin if a document is forged or fraudulent or
there is a fraud in the transaction.
Although there are two primary sources of law governing
letters of credit the Uniform Commercial Code (“U.C.C.”)
and the ICC Uniform Customs and Practice for Documentary
Credits (“UCP”), parties generally select and specify
the governing law. If parties do not select a governing
law, the governing law will be U.C.C. only if the
state has adopted U.C.C. The key here is to understand
that UCP in itself is not a body of law and has no
binding effect without an implementing contractual
provision. Lastly, it is important to understand the
effect to UCP because even though UCP provisions are
similar to the corresponding UCC provisions, there
three major differences. Those three differences are
definition of reasonable time; effect of failure to
discover discrepancies and notify the parties; and
number of times a letter of credit can be transferred.
