Letter of credit
A letter of credit (LC), also known as a documentary credit or bankers commercial credit, or letter of undertaking (LoU), is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exporter of goods. Letters of credit are used extensively in the financing of international trade, when the reliability of contracting parties cannot be readily and easily determined. Its economic effect is to introduce a bank as an underwriter that assumes the counterparty risk of the buyer paying the seller for goods.[1]
This article is about commercial financial credit instruments. For personal letters of credit, see Circular letter of credit.
Typically, after a sales contract has been negotiated, and the buyer and seller have agreed that a letter of credit will be used as the method of payment, the applicant will contact a bank to ask for a letter of credit to be issued. Once the issuing bank has assessed the buyer's credit risk – i.e. that the applicant will be able to pay for the goods – it will issue the letter of credit, meaning that it will provide a promise to pay the seller upon presentation of certain documents. Once the beneficiary (the seller) receives the letter of credit, it will check the terms to ensure that it matches with the contract and will either arrange for shipment of the goods or ask for an amendment to the letter of credit so that it meets with the terms of the contract. The letter of credit is limited in terms of time, the validity of credit, the last date of shipment, and how late after shipment the documents may be presented to the nominated bank.[2]
Once the goods have been shipped, the beneficiary will present the requested documents to the nominated bank.[3] This bank will check the documents, and if they comply with the terms of the letter of credit, the issuing bank is bound to honor the terms of the letter of credit by paying the beneficiary.
If the documents do not comply with the terms of the letter of credit they are considered discrepant. At this point, the nominated bank will inform the beneficiary of the discrepancy and offer a number of options depending on the circumstances after consent of applicant. However, such a discrepancy must be more than trivial. Refusal cannot depend on anything other than reasonable examination of the documents themselves. The bank then must rely on the fact that there was, in fact, a material mistake.[3] A fact that if true would entitle the buyer to reject the items. A wrong date such as an early delivery date was held by English courts to not be a material mistake.[3] If the discrepancies are minor, it may be possible to present corrected documents to the bank to make the presentation compliant.[3] Failure of the bank to pay is grounds for a chose in action. Documents presented after the time limits mentioned in the credit, however, are considered discrepant.
If the corrected documents cannot be supplied in time, the documents may be forwarded directly to the issuing bank in trust; effectively in the hope that the applicant will accept the documents. Documents forwarded in trust remove the payment security of a letter of credit so this route must only be used as a last resort.
Some banks will offer to "Telex for approval" or similar. This is where the nominated bank holds the documents, but sends a message to the issuing bank asking if discrepancies are acceptable.[3] This is more secure than sending documents in trust.
History[edit]
The letter of credit has been used in Europe since ancient times.[4] Letters of credit were traditionally governed by internationally recognized rules and procedures rather than by national law. The International Chamber of Commerce oversaw the preparation of the first Uniform Customs and Practice for Documentary Credits (UCP) in 1933, creating a voluntary framework for commercial banks to apply to transactions worldwide.[5]
In the late 19th century and early 20th century, travelers commonly carried a circular letter of credit issued by a relationship bank, which allowed the beneficiary to withdraw cash from other banks along their journey. This type of letter of credit was eventually replaced by traveler's checks, credit cards and automated teller machines.[6]
Although letters of credit first existed only as paper documents, they were regularly issued by telegraph in the late 19th century, and by telex in the latter half of the 20th century.[7] Beginning in 1973 with the creation of SWIFT, banks began to migrate to electronic data interchange as a means of controlling costs, and in 1983 the UCP was amended to allow "teletransmission" of letters of credit.[8] By the 21st century, the vast majority of LCs were issued in electronic form and entirely "paperless". LCs were becoming more common.[7] Marcell David Reich (commonly known as Marc Rich) popularised the use of letters of credit in the oil trade.[9]
UCP 600 (2007 Revision) regulates common market practice within the letter of credit market.[10] It defines a number of terms related to letters of credit which categorise the various factors within any given transaction. These are crucial to understanding the role financial institutions play. These include:
National laws[edit]
Germany[edit]
Bürgerliches Gesetzbuch, the German civil code, does not directly address letters of credit. German case law indicates that the relationship between the issuing bank and customer is a contract for execution of a transaction, while the relationship between the issuing bank and the beneficiary is a promise of a debt.[28]
Switzerland[edit]
The Swiss Civil Code of 1911 did not directly address letters of credit, which were still rare in the country at the time. Courts eventually dealt with the device by treating it as a hybrid of a mandate (Auftrag) and authorization-to-pay contract (Anweisung).[28]
United States[edit]
Letters of credit came into general domestic use in the United States during World War I, although they had been used in American foreign trade for some time prior.[4] The state of New York has historically had the most substantial and consistent body of case law in the United States with regard to letters of credit, due to the prominence of New York banks in international trade.[29] The New York Bankers [sic] Commercial Credit Conference of 1920 provided the first set of voluntary LC regulations for major banks in the United States, but these banks transitioned to the international UCP standard by 1938.[5]
Article 5 of the Uniform Commercial Code, drafted in 1952, provided a basis for codifying many UCP principles into state law[5] and created one of the only extensive specific legal regulations of letters of credit worldwide, although the UCC rules do not cover all aspects of letters of credit.[28] New York effectively subjugated the UCC rules to the existing UCP rules, and as a result the UCP rules continued to govern letters of credit under New York law.[29] Article 5 was revised in 1995 to reflect the latest international practices as codified in the UCP.[30]
Use in fraud[edit]
Letters of credit are sometimes used to defraud banks through presentment of false documentation indicating that goods were shipped when they actually were not. Letters of credit are also sometimes used as part of fraudulent investment schemes.[31]
In the international banking system, a letter of undertaking (LOU) is a provisional bank guarantee, under which a bank allows its customer to raise money from another bank's foreign branch in the form of short-term credit. The LOU serves the purpose of a bank guarantee. However, to be able to raise the LOU, the customer is supposed to pay margin money to the bank issuing the LOU and accordingly, he is granted a credit limit. In 2018, PNB suffered from such a breach of documentation protocols.[32]