There are three general principles governing
the use of letters of credit:
- The banks' responsibility to deal in documents only;
- the rule of strict construction, which dictates that the
terms and conditions of the letter of credit are to strictly
adhered to; and
- the rule of independence, which mandates that the letter
of credit is to be considered independent from the sales contract
or any other agreement between the parties.
Put simply, the Issuing bank has two main
- To give a binding undertaking to the seller that if compliant
documents are presented, the bank will pay the seller the
amount due. This offers security to the seller
- To examine the documents, and only pay if these comply
with the terms and conditions set out in the letter of credit.
This protects the buyer's interests
Note that the letter of credit refers to documents
representing the goods - not the goods themselves! Banks are not
in the business of examining goods on behalf of their customers.
Typically the documents requested will include a commercial invoice,
a transport document such as a bill of lading or airway bill,
an insurance document; but there are many others.
How secure is the L/c payment method ? Although an L/c is considered
one of the most secure means of payment, exporters should understand
that they can never totally control the payment process. Documents
which are required to be presented under an L/c are frequently
prepared by other people, and may not meet the strict compliance
standards required by the banking community for payment. Sometimes
banks which have not properly ensured their own reimbursement
by customer (the buyer), apply very narrowly L/c principles to
deny payment. Such denials have regularly been upheld by courts
on grounds that the seller has not strictly complied with the
terms of the L/c.
How to Secure your Payment ?
Like most other things in life -prudence,
knowledge and certain precautions can greatly reduce your risk.
Following are certain steps that an exporter can take to maximize
his control of the L/c process
Knowledge is Power
The rules governing L/c are codified in a
publication sponsored by the International Chamber of Commerce
("ICC"), known as the Uniform Customs and Practice for Documentary
Credits. Professionals advising exporters should have a good understanding
of the UCP 500. The rules in the UCP 500 are drafted by and for
the banking community. One of the major purposes is to protect
the banks from liability in L/c transactions. The banks are providing
a service - the financing of the transaction - and they expect
to be protected from getting involved in disputes between the
parties as to the terms of the contract of sale. For this reason
"the independence principle" is a very important concept in LC
transactions. This means that the LC, and the documents required
under the LC for payment, are completely independent from the
underlying transaction between buyer and seller.
The bank is not concerned if the contract between buyer and seller
is being performed according to its terms. The bank's only concern
is whether the documents presented by the seller conform to the
documents required under the LC, and whether the documents are
presented within the required time periods. The bank employees
who examine documents presented under the L/c are essentially
clerks. Their job is not to make judgment calls, but simply to
see if the documents presented by the seller/ beneficiary comply
strictly with the documents required by the LC. It is therefore
very important to understand the rules as a lack of knowledge
may invite disaster.
Your choice of Issuing Bank
One way of securing some control on payment
process is to choose a bank you know or familiar with. This implies
that during negotiating seller should try to get the buyer to
use a bank of the seller's choice to issue the L/c. The seller
should find out from his/her own bank, preferably a bank with
a substantial international presence, what corresponding bank
it uses in the country of the buyer. If the buyer can have the
L/c issued by that correspondent bank, the process can proceed
more expeditiously. At the very least, the seller should insist
that the buyer use a bank that is well-known and highly regarded
by the banking community. The seller's own bank can provide information
on the financial status and reputation of the foreign bank. Since
a major purpose served by an L/c is that the issuing bank assumes
the risk of the buyer's insolvency, if the bank itself is financially
weak, the L/c may not serve its purpose.
When in doubt - Get Confirmation
If the seller is not comfortable with the
bank of the buyer's choice, the L/c should be confirmed by a prime
world bank. When a prime bank confirms an L/c issued by a foreign
bank, it takes upon itself the payment obligation. There is a
charge for confirmation, which varies directly on perceived risk
the prime bank believes it is taking in confirming the L/c. The
question of who pays the prime bank's confirmation charges is
negotiable, but if not negotiated in advance the bank may charge
The seller should ensure during negotiation
that as few documents as possible are submitted to bank, that
documents should have simple description and all documents called
for by the L/c can in fact be produced. Seller should avoid dependence
on unknown or unreliable parties (e..g. if bank documents include
a certificate from the government of buyer's country or a signature
from someone under buyer's control - complications may arise).
Accuracy of Wording
Accuracy of wording in respect of all documents
to be submitted in bank is vital. For example, almost all L/c's
require production of a commercial invoice and a transport bill
of lading. The invoice must state the description of goods in
the same way as in L/c. If the goods are not described in exactly
the same way, the seller may not be paid even though Bill of Lading
may have correct wording.
Be sure what you are doing
If seller realizes there is a mistake or a
problem with the documents to be submitted in bank, the goods
should not be shipped until the L/c is amended. The UCP 500 makes
clear that no amendment can take place unless the issuing bank,
the confirming bank, if any, and the seller, agree to it. Unless
the seller has written confirmation from the bank that the amendment
to the L/c has been issued, and the confirming bank has accepted
the amendment, he bears the risk of not being paid.
A stitch in time...
A prudent seller should not let buyer take
possession of goods until he has been paid under the L/c. The
reason is obvious - if there are discrepancies in the documents
preventing payment of the L/c, a buyer in possession of the goods
has much less incentive to waive discrepancies so the seller can
be paid. If the seller is not paid by the bank, the buyer still
has a contractual obligation to pay for goods, but the difficulty
of collection can make the price drop substantially, even assuming
the buyer is solvent and can pay something. Particularly when
the goods have been shipped to a foreign country, the payment
collection can be quite costly. The buyer, knowing this, may attempt
to negotiate a lower price (that is if he pays at all).
To keep goods out of the buyer's possession till payment is settled,
the seller should have the bill of lading consigned to order of
the bank. Since the bill of lading is a title document, a consignment
to order of the bank gives the bank title to the goods until they
have been paid for by the buyer. Assuming proper payment, the
bank transfers title to the buyer, who can then take the bill
of lading and collect the goods. If buyer does not pay, the bank
has an obligation to hold the documents for the seller, or return
them to the seller if instructed to do so by the seller. The buyer
should not be able to get the goods without the title document.
Look Before you Leap...
The buyer may ask seller to have the bill
of lading made out to order and blank endorsed, and to send one
or more sets to the buyer within a few days of shipping the goods.
This is like writing a blank check. It enables the buyer to pick
up the goods, and thereby provides him with a disincentive to
waive any discrepancies in documents the seller presents to the
bank. Given the high failure rate of initial presentations of
documents under an L/c, a seller needs to know he will have the
buyer's cooperation in correcting discrepancies or in waiving
them. The buyer's cooperation will be more forthcoming if he cannot
get possession of the goods until any problems with discrepancies
have been resolved.
Know Your Deadline, for your sake...
Every L/c has three vital dates: the date
by which goods must be shipped, the date by which documents must
be presented, and the expiry date for the L/c. A seller should
make sure that each of these dates can be met, and should allow
a large margin for error. After the L/c has been issued, if the
seller learns that the date for shipping goods cannot be met,
he should not ship any goods until he obtains an amendment to
the L/c permitting later shipment.
If an L/c which calls for transport documents does not contain
a date by which documents must be presented, does this mean the
seller can wait until the expiry date to present his documents?
Not if he wants to be paid. Article 43 of the UCP 500 provides
that if no time period after shipment is given in the Credit for
presentation of documents, banks will not accept documents presented
to them later than 21 days after shipment. An exporter unfamiliar
with the 21 day rule of the UCP 500 could easily miss this deadline.
The exporter should make sure that the expiry date of the L/c
permits sufficient time to permit correction, if possible, of
any mistakes in the documents. Under the UCP 500, once the documents
are presented, the bank has a maximum of seven days to let the
beneficiary know if there are any discrepancies. If discrepancies
can be corrected, they must be corrected and the documents resubmitted
before the expiry date of the L/c. Thus the exporter should make
sure that the expiry date allows enough time for errors to be
Finally - A Quick Checklist
Always make following checks with your L/c:
Did you receive the letter of credit directly
from a bank? If your answer is "No" - do not proceed any further
as the letter of credit has not been authenticated and may
Is the letter of credit irrevocable? If your
answer is "No", do not proceed any further as a revocable
letter of credit can be "revoked" by the buyer without your
Has the latest shipment date passed? If your
answer is yes, the letter of credit must be amended to extend
the latest shipment date.
Is the letter of credit : Confirmed by a U.S.
or prime world bank ? Please see above for correct procedure
Is the amount on the credit correct?
Is the beneficiary's name and address correct?
Is the buyer's name and address correct?
Is the merchandise description correct and consistent with other documents? .
Do any of the documents in the credit need to be legalized?
Which documents are required in the Letter of Credit:
Ocean Bill of Lading