Management of Financial Institutions

Letter of Credit and International Trade:Terminology, Risks in International Trade

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Management of Financial Institutions - MGT 604
Lecture # 30
Letter of Credit and International Trade
A letter of credit is a document issued mostly by a financial institution which usually
provides an irrevocable payment undertaking (it can also be revocable, confirmed,
unconfirmed, transferable or others e.g. back to back: revolving but is most commonly
irrevocable/confirmed) to a beneficiary against complying documents as stated in the Letter
of Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a
documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply
as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank
acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any,
within the expiry date of the LC, comprising documents complying with the terms and
conditions of the LC, the applicable UCP and international standard banking practice, the
issuing bank or confirming bank, if any, is obliged to honour irrespective of any instructions
from the applicant to the contrary. In other words, the obligation to honour (usually
payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-
banks can also issue letters of credit however parties must balance potential risks.
The LC can also be the source of payment for a transaction, meaning that an exporter will
get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in
international trade transactions of significant value, for deals between a supplier in one
country and a wholesale customer in another. They are also used in the land development
process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.)
will be built. 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. Since nowadays almost all letters of credit are irrevocable, (i.e.
cannot be amended or cancelled without prior agreement of the beneficiary, the issuing
bank, and the confirming bank, if any). However, the applicant is not a party to the letter of
credit. In executing a transaction, letters of credit incorporate functions common to giros
and Traveler's cheque. Typically, the documents a beneficiary has to present in order to
avail himself of the credit are commercial invoice, bill of lading, insurance documents.
However, the list and form of documents is open to imagination and negotiation and might
contain requirements to present documents issued by a neutral third party evidencing the
quality of the goods shipped.
The 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.This in effect reflects the modern understanding of the instrument. When a seller
agrees to be paid by means of a letter of credit s/he is looking at a reliable bank that has an
obligation to pay them the amount stipulated in the credit notwithstanding any defence
relating to the underlying contract of sale. This is as long as the seller performs their duties
to an extent that meets the credit terms.
How it works
Imagine that a business called the Acme Electronics from time to time imports computers
from a business called Bangalore Computers, which banks with the India Business Bank.
Acme holds an account at the Commonwealth Financials. Acme wants to buy $500,000
worth of merchandise from Bangalore Computers, who agree to sell the goods and give
Management of Financial Institutions - MGT 604
Acme 60 days to pay for them, on the condition that they are provided with a 90-day LC for
the full amount. The steps to get the letter of credit would be as follows:
Acme goes to The Commonwealth Financials and requests a $500,000 letter of
credit, with Bangalore Computers as the beneficiary.
The Commonwealth Financials can issue an LC either on approval of a standard
loan underwriting process or by Acme funding it directly with a deposit of $500,000
plus fees between 1% and 8%.
The Commonwealth Financials sends a copy of the LC to the India Business Bank,
which notifies the Bangalore Computers that payment is ready and they can ship the
merchandise Acme has ordered with the full assurance of payment to them.
On presentation of the stipulated documents in the letter of credit and compliance
with the terms and conditions of the letter of credit, the Commonwealth Financials
transfers the $500,000 to the India Business Bank, which then credits the account to
the Bangalore Computers by that amount.
Note that banks deal only with documents under the letter of credit and not the
underlying transaction.
Many exporters have misunderstood that the payment is guaranteed after receiving
the LC. The issuing bank is obligated to pay under the letter of credit only when the
stipulated documents are presented and the terms and conditions of the letter of
credit have been met accordingly.
Legal principles governing documentary credits
One of the primary peculiarities of the documentary credit is that the payment obligation is
abstract and independent from the underlying contract of sale or any other contract in the
transaction. Thus the bank's obligation is defined by the terms of the credit alone, and the
sale contract is irrelevant. The defences of the buyer arising out of the sale contract do not
concern the bank and in no way affect its liability.Article 3(a) UCP states this principle
clearly. Article 4 the UCP further states that banks deal with documents only, they are not
concerned with the goods (facts). Accordingly, if the documents tendered by the
beneficiary, or his agent, appear to be in order, then in general the bank is both entitled and
obliged to pay without further qualifications.
The policies behind adopting the abstraction principle are purely commercial and reflect a
party's expectations: firstly, if the responsibility for the validity of documents was thrown
onto banks, they would be burdened with investigating the underlying facts of each
transaction and would thus be less inclined to issue documentary credits as the transaction
would involve great risk and inconvenience. Secondly, documents required under the credit
could in certain circumstances be different from those required under the sale transaction;
banks would then be placed in a dilemma in deciding which terms to follow if required to
look behind the credit agreement. Thirdly, the fact that the basic function of the credit is to
provide the seller with the certainty of receiving payment, as long as he performs his
documentary duties, suggests that banks should honour their obligation notwithstanding
allegations of misfeasance by the buyer. [3] Finally, courts have emphasised that buyers
always have a remedy for an action upon the contract of sale, and that it would be a
calamity for the business world if, for every breach of contract between the seller and buyer,
a bank were required to investigate said breach.
The "principle of strict compliance" also aims to make the bank's duty of effecting payment
against documents easy, efficient and quick. Hence, if the documents tendered under the
credit deviate from the language of the credit the bank is entitled to withhold payment even
Management of Financial Institutions - MGT 604
if the deviation is purely terminological. The general legal maxim de minimis non curat lex
has no place in the field of documentary credits.
The price of LCs
The applicant pays the LC fee to the bank, and may in turn charge this on to the beneficiary.
From the bank's point of view, the LC they have issued can be called upon at any time
(subject to the relevant terms and conditions), and the bank then looks to reclaim this from
the applicant.
Legal Basis for Letters of Credit
Although documentary credits are enforceable once communicated to the beneficiary, it is
difficult to show any consideration given by the beneficiary to the banker prior to the tender
of documents. In such transactions the undertaking by the beneficiary to deliver the goods to
the applicant is not sufficient consideration for the bank's promise because the contract of
sale is made before the issuance of the credit, thus consideration in these circumstances is
past. In addition, the performance of an existing duty under a contract cannot be a valid
consideration for a new promise made by the bank: the delivery of the goods is
consideration for enforcing the underlying contract of sale and cannot be used, as it were, a
second time to establish the enforceability of the bank-beneficiary relation.
Legal writers have analyzed every possible theory from every legal angle and failed to
satisfactorily reconcile the bank's undertaking with any contractual analysis. The theories
include: the implied promise, assignment theory, the novation theory, reliance theory,
agency theories, estoppels and trust theories, anticipatory theory, and the guarantee theory.
Davis, Treitel, Goode, Finkelstein and Ellinger have all accepted the view that documentary
credits should be analyzed outside the legal framework of contractual principles, which
require the presence of consideration. Accordingly, whether the documentary credit is
referred to as a promise, an undertaking, a chose in action, an engagement or a contract, it is
acceptable in English jurisprudence to treat it as contractual in nature, despite the fact that it
possesses distinctive features, which make it sui generis.
Even though a couple of countries and US states (see eg Article 5 of the Uniform
Commercial Code) have tried to create statutes to establish the rights of the parties involved
in letter of credit transactions, most parties subject themselves to the Uniform Customs and
Practices (UCP) issued by the International Chamber of Commerce (ICC) in Paris. The ICC
has no legislative authority, rather, representatives of various industry and trade groups
from various countries get together to discuss how to revise the UCP and adapt them to new
technologies. The UCP are quoted according to the publication number the ICC gives them.
The UCP 600 are ICC publication No. 600 and will take effect July 1, 2007. The previous
revision was called UCP 500 and became effective 1993. Since the UCP are not laws,
parties have to include them into their arrangements as normal contractual provisions. It is
interesting to see that in the area of international trade the parties do not rely on
governmental regulations, but rather prefer the speed and ease of auto-regulation.
Risks in International Trade
A Credit risk is a risk from a change in the credit of an opposing business.
An Exchange risk is a risk from a change in the foreign exchange rate.
A Force majeure risk is
Management of Financial Institutions - MGT 604
1. a risk in trade incapability caused by a change in a country's policy, and
2. a risk caused by a natural disaster.
Other risks are mainly risks caused by a difference in law, language or culture. In
these cases, the cargo might be found late because of a dispute in import and export
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday