The function of the letter of credit is to substitute the credit of the bank
for the customers’ credit to facilitate trade. Letters of credit are
either one of two types: documentary or standby. The documentary letter of
credit is the traditional payment method used in an international
transaction, whereas the standby letter of credit is often obtained as a
guaranty of payment.Documentary Letter of Credit
Documentary letters of credit have been used for
centuries to facilitate payment in international trade. These letters of
credit are governed by the International Chamber of Commerce Uniform Customs
and Practice for Documentary Credits. The general provisions and definitions
of the International Chamber of Commerce are binding on all parties.
A documentary letter of credit is a contractual
agreement between banks, known as the issuing bank, on behalf of its
customer, authorizing another bank, known as the advising or confirming
bank, to make payment to the seller (beneficiary). The issuing bank, at the
request of its customer, opens the letter of credit. In doing so, the
issuing bank makes a commitment to honor drawings made against the credit.
The beneficiary is normally the provider of goods and/or services.
Elements of a Letter of Credit
A payment undertaking by a bank (issuing bank)
On behalf of a buyer (bank customer)
To pay a seller (beneficiary) a specified amount of
On presentation of specified documents representing the
supply of goods
Within specified time limits
Documents must conform to terms and conditions set out
in the letter of credit
Documents to be presented at a specified place
The beneficiary is entitled to payment as long as they
can provide the documentation required in the letter of credit. The letter
of credit is a separate transaction from any other written agreements. All
parties to the letter of credit are only concerned with and deal in the
required documents and not in the goods and/or services for which the letter
is provided. The issuing bank is not liable for any performance of the
underlying contract between the buyer and seller. The issuing bank's
obligation to the buyer is to examine all documents to insure that they meet
all the terms and conditions of the letter of credit. Upon requesting demand
for payment the seller warrants that all conditions of the letter of credit
have been complied with. If the seller (beneficiary) conforms to the letter
of credit, they must be paid by the bank.
The issuing bank's liability to pay and to be
reimbursed from its customer becomes absolute upon the completion of the
terms and conditions of the letter of credit. Under the provisions of the
Uniform Customs and Practice for Documentary Credits, the bank is given a
reasonable amount of time after receipt of the documents to honor the draft.
The issuing banks' role is to provide a guarantee to
the seller that if required documents are presented, the bank, upon
examination, will pay the seller the amount due and only pay if these
documents comply with the terms and conditions set out in the letter of
Typically the documents requested will include an
invoice, a bill of lading or airway bill and an insurance document. However,
additional documents may be required.
Advising Bank vs. Confirming Bank
An advising bank, usually a foreign correspondent bank
of the issuing bank will advise the seller. Generally, the seller will use a
local bank to insure the letter of credit is valid. In addition, the
advising bank is responsible for sending the documents to the issuing bank.
The advising bank has no other obligation under the letter of credit. If the
issuing bank does not pay the seller (beneficiary), the advising bank is not
obligated to pay.
A correspondent bank may also confirm the letter of
credit for the seller (beneficiary). At the request of the issuing bank, the
correspondent bank obligates itself to insure payment under the letter of
credit. The confirming bank normally would not confirm the letter of credit
until it evaluated the country and bank where the letter of credit
originates. The confirming bank often is the advising bank.
Letter of Credit Characteristics
Letters of credit are usually negotiable. The issuing
bank is obligated to pay not only the beneficiary, but also any bank
nominated by the beneficiary. Negotiable instruments are passed freely from
one party to another almost in the same way as money. To be negotiable, the
letter of credit must include an unconditional promise to pay on demand or
at a definite time. The nominated bank becomes a holder in due course. As a
holder in due course, the holder takes the letter of credit for value; in
good faith; and without notice of any claims against it. A holder in due
course is treated favorably under the Uniform Commercial Code.
The transaction is considered a straight negotiation if
the issuing bank's payment obligation extends only to the beneficiary of the
credit. If a letter of credit is a straight negotiation it is referenced on
its face by "we engage with you" or "available with
ourselves". Under these conditions the promise does not pass to a
purchaser of the draft as a holder in due course.
Letters of credit may be either revocable or
irrevocable. Whether revocable or irrevocable, it will state on the face of
the document what type of credit is being presented. A revocable letter of
credit may be revoked or modified for any reason, at any time by the issuing
bank without notification. A revocable letter of credit cannot be confirmed.
If a correspondent bank is engaged in a transaction that involves a
revocable letter of credit, it serves only as the advising bank.
Once the documents have been presented and meet the
terms and conditions in the letter of credit, and the draft is honored, the
letter of credit cannot be revoked. The revocable letter of credit is not
commonly used. It is generally used to provide guidelines for shipment.
The most commonly used irrevocable letter of credit may
not be revoked or amended without the agreement of the issuing bank; the
confirming bank; and the seller (beneficiary). An irrevocable letter of
credit from the issuing bank insures the seller that if the required
documents are presented and the terms and conditions are complied with,
payment will be made.
Transfer and Assignment
The seller has the right to transfer or assign the
right to draw, under a letter of credit only when the letter of credit
states that it is transferable or assignable. Letters of credit governed by
the Uniform Commercial Code (Domestic) maybe transferred an unlimited number
of times. Under the Uniform Customs Practice for Documentary Credits
(International) the credit may be transferred only once. However, even if
the credit specifies that it is nontransferable or non-assignable, the
seller may transfer their rights prior to performance.
Sight and Time Drafts
All letters of credit require the seller to present a
draft and specified documents in order to receive payment. A draft is a
written order by which the party creating it, orders another party to pay
money to a third party. A draft is sometimes referred to as a bill of
The two types of drafts used in letters of credit are
sight and time. A sight draft is payable as soon as it is presented for
payment although the issuing bank is allowed a reasonable time to review the
documents before making payment.
A time draft is not payable until the lapse of a
particular time period stated on the draft (often 90 days). The issuing bank
is required to accept the draft as soon as the documents comply with the
letter of credit terms. The issuing bank is then obligated to pay the draft
Standby Letter of Credit (Domestic)
The Standby or domestic letters of credit serve a
different function than the documentary letter of credit. The standby letter
of credit serves as a guaranty by the issuing bank rather then a source for
payment. A bank will issue a standby letter of credit on behalf of its’
customer to provide assurances of payment to the seller in the event the
buyer does not or is unable to pay for goods and/or services in accordance
with the sellers’ ordinary terms of sale. The parties involved in the
transaction never intend for the letter of credit to be drawn upon.The
standby letter of credit is issued by the bank and held by the supplier. The
buyer is provided open account terms. If payments are made in accordance
with the suppliers' terms, the letter of credit would not be drawn on. The
seller pursues the customer for payment directly. If the customer is unable
to pay, the seller presents a draft and copies of invoices to the bank for
The domestic standby letter of credit is governed by
Article Five of the Uniform Commercial Code. Under its’ general
provisions, the bank is given until the close of the third banking day after
receipt of the documents to honor the draft. Note however that every state
that has adopted Article Five has the right to amend the language of the
Article including the time period. It is important to verify the time period
of the state whose law governs the letter of credit.It is also possible to
use a standby letter of credit in an international transaction. When doing
so the issuing bank should always reside within the borders of the
The following procedures illustrate the flow of events
that follow the decision to execute a standby letter of credit and are not
as rigorous as a documentary letter of credit. The standby letter of credit
is normally a domestic transaction although it can be implemented in
international transactions. It does not require a correspondent bank
(advising or confirming).
Buyer and seller agree to conduct business. The seller
wants a letter of credit to guarantee payment.
Buyer applies to his bank for a letter of credit in
favor of the seller.
Buyer's bank approves the credit risk of the buyer,
issues and forwards the credit to the seller.
Seller ships the goods and bills the buyer under normal
terms of sale.
Buyer pays invoice at maturity.
If buyer fails to pay and after waiting period
(normally 30 days after maturity) Seller sends past due invoice along with
draft and letter of credit for payment to issuing bank.
Issuing bank pays.
Common Defects in Documentation
About half of all drawings presented contain
discrepancies. A discrepancy is an irregularity in the documents that causes
them to be in non-compliance to the letter of credit. Requirements set forth
in the letter of credit cannot be waived or altered by the issuing bank
without the express consent of the customer. The seller (beneficiary) should
always prepare and examine all documents carefully before presentation to
the issuing bank to avoid any delay in receipt of payment. Commonly found
discrepancies between the letter of credit and supporting documents include:
Letter of Credit has expired prior to presentation of
Bill of Lading evidences delivery prior to or after the
date range stated in the credit.
Stale dated documents.
Changes included in the invoice not authorized in the
letter of credit.
Insurance document contains errors.
Invoice amount not equal to draft amount.
Place of loading and destination are not the same as
specified in the credit.
Description of merchandise is not the same as stated in
letter of credit.
A document required in the letter of credit is not
Documents are inconsistent as to general information
such as volume, quality, etc.
Names of documents are not exact as described in the
letter of credit. (Beneficiary information must be exact.)
Invoice or statement is not signed as stipulated in the
letter of credit.
When a discrepancy is detected by the negotiating bank,
a correction to the document may be allowed if it can be done quickly while
remaining in the control of the bank. If time is not a factor, the seller
should request that the negotiating bank return the documents for
If there is not enough time to make corrections, the
seller should request that the negotiating bank send the documents to the
issuing bank on an “approval basis” or notify the issuing bank by wire,
outline the discrepancies, and request authority to pay. Payment cannot be
made until all parties have agreed to jointly waive the discrepancy.Summary
The use of letters of credit as a tool to reduce risk
has been in use for decades. Letters of credit accomplish their purpose by
substituting the credit of the bank for the customers’. The underlying
purpose of the letter of credit is to facilitate trade both internationally
and domestic.Every credit professional should be familiar with the two types
of letters of credit: documentary and domestic (standby). Documentary
letters of credit are used primarily to facilitate foreign trade. The
documentary letter of credit is the primary source for payment.
The domestic (standby) letter of credit is used as a
guaranty of payment. The bank issues the standby letter of credit on behalf
of its’ customer to provide assurances of the customers’ ability to
perform under the sellers’ normal terms of sale.Upon receipt of any letter
of credit, the credit professional should review all requirements carefully
to insure that what is expected of the seller is fully understood and that
the seller can comply with all the letter of credit terms and conditions.
Whenever compliance is in question, the buyer should be requested to amend
the letter of credit.
There is no requirement that the seller has to accept a
letter of credit. The seller should never accept the letter of credit until
the seller is satisfied with all of the terms and conditions contained in
the letter of credit. Always keep in mind that the letter of credit
substitutes the issuing banks credit for the customers. Therefore, it is
especially important that the banks’ character, capacity and capital be
verified just as we did initially with our customer.If the issuing bank is
unknown to us or we have concerns we should not accept the letter of credit
and request the customer to obtain a letter of credit from a bank we are
comfortable with and have confidence in.
I wish you well.
The information provided above is for
educational purposes only and not provided as legal advice. Legal advice
should be obtained from a licensed attorney in good standing with the Bar
Association and preferably Board Certified in either Creditor Rights or