This article is written by Prateek Mudgal, from Faculty of Law, Aligarh Muslim University. The article deals with the letter of credit and regulatory framework of the letter of credit.
With globalisation, the one thing that has increased along with many others(like pollution and greed), is international trading. International trading has opened new gates to the buyers and sellers, with significantly diverse choices to choose from. With growing international trading, various methods have been employed to facilitate the overseas transaction and supplies. Such methods have very efficiently increased the efficiency of international trading. Without these methods, oversea trade would have been a very tedious job. Apart from this, it is well evident that many from our society have not yet accepted online shopping methods, due to the lack of transparency and buyer-seller trust. Such risks are more probable in international trading. This article deals with the intricacies of the letter of credit, which is a very beneficial tool in the field of international trading.
Understanding the letter of credit
Before we delve into the intricacies involved in this, we must make sure that we have at least some understanding of the letter of credit. Letter of credit is an obligation that has to be fulfilled by the bank. The obligation of the letter of credit is usually irrevocable. The letter of credit is issued on behalf of the customer of the bank, to pay a certain sum of amount to the beneficiary after fulfilment of certain conditions or after a certain event. The letter of credit is usually used for long distance-trading or international transactions (commercial).
Whenever a customer of a bank applies for the letter of credit of the bank, he becomes the account party in the arrangement. The bank which issues the letter of credit becomes the issuer or issuing bank. The firm/person in whose favour the letter of credit is addressed becomes the beneficiary in the arrangement. To understand this, let’s take an example. For instance, if there is a buyer who wants to buy goods from a seller. Then here the buyer will apply for a letter of the credit, and therefore will become the account party. Similarly, the bank will issue the letter of credit on behalf of its customer and will become the issuer. The beneficiary will be the seller since the letter of credit will be issued for the benefit of the seller.
Types of letter of credit
It is an obligation that is fulfilled by the issuer or issuing bank by paying the required amount to the beneficiary. The amount to the beneficiary is paid on behalf of the account party, upon the receipt of the specified documents.
Standby is not the primary obligation but a secondary obligation that arises due to the non-performance of the obligation. Also, Standby operates like a demand guarantee, and it is not necessary that it would be issued by the bank. Here, the issuer fulfils the obligation on the application of the account party and presentation of conforming documents by the beneficiary.
Revocable and irrevocable
In a revocable letter of credit, the bank takes no solid undertaking for the payment of the amount, on the presentation of documents by the beneficiary. Apart from this, a revocable letter of credit can be cancelled by the issuer (the bank) at any point of time and for any reason. Whereas, the irrevocable letter of credit is more secure. An irrevocable letter of credit cannot be changed or altered just like that. To bring any change in the irrevocable letter of credit all parties must agree, without agreement no change can be brought. In an irrevocable letter of credit, the bank has the obligation of payment of the agreed sum and has to accept all the terms mentioned in the letter of credit. Therefore in an irrevocable letter of credit, the bank fulfils the obligation if the beneficiary complies with the terms of the credit.
This is a special type of letter of credit that allows the issuing bank to transfer the amount payable according to the letter of credit. The amount mentioned in the letter of credit can be transferred to another party on the request and application of the original beneficiary.
Back to back
This type of letter of credit is very useful when one needs to have a surreptitious trade. Back to back letter of credit uses two letters of credit, one credit is issued by the buyer’s bank to the bank of the intermediary. Then, the intermediary’s bank issues a letter of credit to the seller. This type of letter of credit, therefore, helps in keeping the identity of the ultimate seller hidden from the ultimate buyer.
Confirmed and silent confirmed letter of credit
Confirmation is usually requested in the cases where the credibility of the issuing bank is questionable according to the seller or beneficiary or there is buyer’s country risk. Therefore at the request of the issuing bank, the advising bank adds confirmation to the letter of credit. After this, the advising bank becomes the issuing bank and pays the agreed amount if the seller complies with the terms of the letter of credit. Silent confirmation happens when the confirmation is requested, by the seller himself, and not the issuing bank. Silent confirmation is not disclosed, therefore, parties other than the beneficiary don’t know about it.
This letter of credit works like the scheduled payment feature of the various banking apps. In this type of letter of credit, the amount in the letter of credit can be renewed for several shipments. The amount can be renewed as per the requirement or the time availability. It is very useful for the purpose of regular shipments from the same seller.
Advantages of using a letter of credit
Letter of credit proves beneficial to both the seller and the buyer. It reduces the risk of no-payment for the delivered goods on the part of the seller and shifts the risk of the buyer to the bank. Developing trust in the process of international trade is not easy, and a letter of credit provides a way through the risks that one may face. Since the letter of credit is beneficial to both the seller and the buyer, it is important to discuss the benefits incurred by both the parties.
For the seller
- Bank has an obligation to pay for the shipped goods, this provides the seller with sufficient assurance to carry forward its work.
- This same obligation reduces the risk of production in various cases, for example, if the buyer changes the order, even then the seller has no production risk.
- It also provides the seller with the opportunity of finance in the interim period (this involves the period between the shipment of goods and payment receipt).
- Since everything is mentioned in the letter of credit, it becomes easier for the seller to strategise its production, since the date for shipment of goods is given.
- Even on the complaint of goods, the buyer cannot refuse the payment to the seller, this is yet another plus point of letter of credit.
Letter of credit does not only benefit the seller but also the buyer in various aspects. The benefits incurred by the buyer has been discussed further:
For the buyer
- The bank can only pay the seller when after proper documentation and scrutiny of whether the documents submitted are in line with the terms mentioned in the letter of credit, this proves beneficial for the buyer.
- The buyer can control the various terms of the contractual relationship, for example, the buyer can decide regarding the period required for the shipment of goods and mention the same in the letter of credit.
- Letter of credits explicitly exhibits the solvency and willingness of the buyer.
- Letter of credit reduces the risk of repayment, and in cases of issuing a letter of credit for delayed payments, the seller credits the buyer.
Regulatory aspects of the letter of credit
Some various laws and rules govern the boundaries and formalities of the letter of credit. I have discussed them hereafter:
Uniform customs and practice for documentary credits
Uniform Customs and Practices (UCP) for documentary credits is codified by the International Chamber of Commerce (ICC). Unified Customs and Practice is voluntarily applied by the banks across the globe. It has to be noted that these regulatory measures are applied voluntarily by the banks, and are not mandatory. This is because the Uniform Customs and Practice for documentary credits is not bound by law but is accepted universally and has become a very important part of almost all the documentation related to the credits. First Uniform Customs and Practice for Documentary Credits was published in 1933 but after the first publication, it has been revised a number of times and the latest publication was dated in July 2007, under publication number UCP 600. Letter of credit issued under the UCP 600 is considered irrevocable unless the language clearly establishes that the letter of credit is revocable.
The Independence principle suggests that the letter of credit is independent of the contractual relationship that arises between the buyer and the seller, it is more like a bank purchasing some documents for the account party (customer).
Rule of strict compliance
This is one of the most beneficial rules. According to the rule of strict compliance, the documents submitted to the issuing bank must strictly comply/conform with the terms mentioned in the letter of credit. Everything includes everything, ranging from invoice to the lading bill to insurance document. The slightest discrepancy in the documents can lead to the rejection of documents. Such a harsh rule is justified because it reduces the risk of misinterpretation of documents by the issuing bank. Misinterpretation of the document can prove to be a loss to the customer. Therefore, such harsh rules prevent any future liability of negatively impacting the customer.
ISBP (International Standard Banking Practice)
This is used and is read in conjunction with UCP 600, it works as complementary to the UCP 600. ISBP 745 helps in defining the terms which are not defined in the UCP 600, like issues related to shipping documents, ports, shipping marks etc. For instance, ISBP 745 clearly states that the name of the port at which lading takes place cannot be different from the mentioned port of lading in the credit. Any such discrepancy, that ensues, is the responsibility of the credit institution. ISBP is a very useful guide having ten main points, which is used in practice along with the UCP 600. It is very useful for checking the discrepancy in the documents presented against the letter of credit.
URDG (Uniform Rules on Demand Guarantees) 758
URDG is also published by the International Chamber of Commerce. Uniform Rules on Demand Guarantees aims at forming universal standards for banking practices, internationally. The Uniform Rules on Demand Guarantees aims at providing rules related to the demand guarantees and counter demand guarantees. Uniform Rules on Demand Guarantees is voluntarily taken by the banks of the world, therefore it lacks the force of law. This proves to be a demerit of such a regulatory body of rules.
ISP (International Standby Practices)
International Standby practices were created by the Institute of International Banking Law & Practice. International Standby Practice has been endorsed by the International Chamber of Commerce (under publication number 590). The Uniform Customs and Practice for documentary credits was specifically for commercial letters of credit, therefore, discrepancies arise when used for Standbys. International Standard Practices remove these discrepancies by providing the practices suitable for Standbys, apart from this the ISP can be used for independent demand guarantees. ISP is not only helpful to bankers but is also of great help to lawyers and corporate users, as well as judges.
International trade deals with people of diverse backgrounds. The parties involved in an international commercial transaction may belong to different countries or even to different continents. Therefore in international trade, the barriers of language, culture and laws are felt extensively. Therefore, to improve the conditions a uniform system was needed. In the same light of bringing uniformity to the system of international trade, the International Chamber of Commerce and the International Court of Arbitration were formed. They have provided us with the basic framework which has been accepted by the banks across the globe. Letter of cred.it is one of the most important tools that help in facilitating international trade.
- Intricacies Involved in an International Transaction by ‘Letter of Credit’, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1583826
- Advantages of Using Letter of Credit in International Transactions, available at https://www.mondaq.com/turkey/international-trade-investment/100456/advantages-of-using-letter-of-credit-in-international-transactions
- Letter of Credit, available at https://www.intelligenteconomist.com/letter-of-credit/
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