1. Principle of Autonomy

2. Doctrine of Strict Complaince

3. Kinds

4. Merits & Demerits of LOC

5. Case Laws

Chapter 1

Letters of credit: An introduction

Letters of Credit have been a cornerstone of international trade dating back to the early1900s.

They continue to play a critical role in world trade today. For any company entering the

international market, Letters of Credit are an important payment mechanism which helps

eliminate certain risks.

Letters of credit also called documentary credits or banker’s commercial credits are the most

common method of payment for goods in the export trade and have been described by

English judges as “the life blood of international commerce”.1

There are various types of letter of credit. The most important distinctions are made between

revocable and irrevocable credits and between confirmed and unconfirmed credits.

The feature common to all is that in accordance with the agreement between the seller and the

buyer in the contract of sale (“the underlying contract”), the buyer arranges for payment of

the price to be made by the bank, normally at the seller’s place, on presentation of specified

documents (usually including the transport documents) and on the performance of other

conditions stated in the credit and advised by the bank to the seller. On presentation of

documents the bank pays the purchase price, according to the terms of the credit, by sight

payment, deferred payment, or by acceptance or negotiation of a bill of exchange drawn by

the seller.

1 Export trade: law and practice of international trade- Carole Murray& David Holloway

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The essence of the letter of credit transaction lies in its documentary character, i.e. where the

goods are represented by a bill of lading, this document of title is used as a means of

financing the transaction.

Lord Wright2 describes the function of the letter of credit as follows:

“The general course of international commerce involves the practice of raising money on the

documents so as to bridge the period between the shipment and the time of obtaining

payment against documents.”

The documentary character of this type of banker’s credit, as used in international trade,

cannot be over-emphasised. The paying bank is prepared to pay the exporter because it holds

the documents as collateral security and, if necessary, can have recourse to the issuing bank,

which in turn can have recourse to the buyer as instructing customer. Where the transport

documents consist of bills of lading, the bank invariably asks for the delivery of a full set of

original bills; otherwise a fraudulent shipper would be able to obtain payment under the letter

of credit on one of them and advances from other bankers on the security of other originals

constituting the set.

Parties to letter of credit:

Exporter/Beneficiary/Seller: The party that has contracted to sell goods.

Importer/Applicant/Buyer: The party that has contracted to buy goods.

Issuing Bank: The bank issuing the Letter of Credit on behalf of the Importer (Buyer).

Advising Bank: The bank to which the Issuing Bank forwards the Letter of Credit with

instructions to notify the Exporter (Beneficiary).

Confirming Bank: The bank which, at the request of the Issuing Bank, adds its confirmation

to the Letter of Credit. In doing so, the Confirming Bank undertakes to make payment to the

Exporter upon presentation of documents under the Letter of Credit.

Uniform customs and practices for Documentary credits:2 In TD Bailey, Son & co v Ross T Smyth &Co Ltd (1940)56 T.L.R.825 at 828.

2

Banking practice relating to letters of credit is standardised by the Uniform Customs and

Practice for Documentary Credits, which are a set of rules issued by the International

Chamber of Commerce.

These are commonly referred to as the UCP. In this area of law attempts at unification have

been highly successful and after more than 70 yrs of effort and periodic revision, the UCP

600, which took effect on July 1, 2007.

It is anticipated that although in the commercial world the period of transition from the use of

UCP 500 to UCP 600 is likely to be brief, disputes arising from the construction of UCP 500

may continue to be heard by the English courts for some time to come. In the text which

follows therefore, although reference is made principally to the provisions of UCP 600,

reference will also be made to the text of UCP 500 where relevant.

In English law the UCP do not have the force of law or the status of a trade custom and in

accordance with Art 1, apply only if the parties have incorporated them into their contract.

Even where the UCP are adopted specifically or generally, the parties are at liberty to

contract out of them, or to exclude the operation of specific parts, as is clearly expressed in

Article 1.

The ICC has attempted to standardise documentation relating to letters of credit, and has

published the ICC Standard Documentary Credit Forms, as well as guide to the 1993

revision.

The ICC has also issued the International standard Banking Practices (ISBP) in order to

supplement the UCP and to provide guidance on examining documents presented under

letters of credit.

UCP 600 contains fewer articles than its predecessor, the number being reduced from 49 to

38. Amongst its changes are the introduction of separate articles covering definitions and

interpretations, with the object of making UCP easier to understand and use, as well as the

elimination of phrases such as “reasonable time” and “on its face”.

A Definition of Letter of Credit may be found in at Art.2, which provides that, for the

purposes of the rules : A “credit means any arrangement , however named or described, that

is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a

complying presentation.”

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Chapter 2

The stages of letter of credit transaction:

Where payment under a letter of credit is arranged, four stages can normally be distinguished:

(a) The exporter and the overseas buyer agree in the contract of sale that payment shall be

made under a letter of credit.

(b) The overseas buyer ( “acting as applicant for the credit”) instructs a bank at his place

of business (known as issuing bank) to open a letter of credit for the exporter( known

as the “beneficiary”) on the terms specified by the buyer in his instructions to the

issuing bank.

(c) The issuing bank arranges with the bank at the locality of the exporter (known as the

“advising bank”) to negotiate, accept, or pay the exporter’s draft upon delivery of the

transport documents by the seller.

(d) The advising bank informs the exporter that it will negotiate, accept or pay his draft

upon delivery of the transport documents.

Two points emerge from this structure. First, stages (a) and (d) are of great importance to the

exporter, viz. The arrangement, in his contract of sale of the most appropriate type of credit ;

and the corresponding notification from the advising bank.

Second, provided the correct documents are tendered and this is done before the expiry of the

credit, there is a binding undertaking of the issuing bank, if the credit is irrevocable, and

also of the confirming bank, if it is confirmed, to the beneficiary to pay the purchase price.

These undertakings are contractual in nature. A bank which has given such an undertaking

will refuse to accept instructions from the buyer not to pay a seller who has performed the

conditions of the credit, and will not accept a revocation of the credit.

9 Steps in the Letter of Credit Process:3

3 http://www.tradev.net/Downloads/Tools/guide2lc.pdf

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Buyer and seller agree to terms including means of transport, period of credit offered

(if any), and latest date of shipment acceptable.

Buyer applies to bank for issue of letter of credit. Bank will evaluate buyer's credit

standing, and may require cash cover and/or reduction of other lending limits.

Issuing bank issues LC, sending it to the Advising bank by airmail or electronic

means such as telex or SWIFT.

Advising bank establishes authenticity of the letter of credit using signature books or

test codes, then informs seller (beneficiary).

Seller should now check that LC matches commercial agreement and that all its terms

and conditions can be satisfied.

Seller ships the goods, then assembles the documents called for in the LC (invoice,

transport document, etc.).

The Advising bank checks the documents against the LC. If the documents are

compliant, the bank pays the seller and forwards the documents to the Issuing bank.

The Issuing bank now checks the documents itself. If they are in order, it reimburses

the seller's bank immediately.

The Issuing bank debits the buyer and releases the documents (including transport

document), so the buyer can claim the goods from the carrier.

The two fundamental principles:4

The law relating to letters of credit is founded on two principles:

(a) The autonomy of credit; and

(b) The doctrine of strict compliance.

The autonomy of the letter of credit

According to this principle, the credit is separate from and independent of the underlying

contract of sale or other transaction. A bank which operates a credit is concerned only with

whether the documents tendered by the seller correspond to those specified in the

instructions. The letter of credit transaction is thus a paper transaction. It is irrelevant to the

bank whether the underlying contract concerns the purchase of timber, oil, machinery or 4 Export trade: law and practice of international trade- Carole Murray & David Holloway

5

whether it concerns another transaction. The only case in which bank should refuse to pay

under the credit occurs if it is proved to its satisfaction that the documents, though apparently

in order on their face are fraudulent and that the beneficiary(seller) was involved in the fraud.

This is usually referred to as “fraud exception.”

The principle of autonomy is stated in Arts 4 and 5 of the UCP 600.

By virtue of its autonomous character, the letter of credit is approximated, to some extent, to

the bill of exchange. This development was noted by Lord Denning M.R. in Power Curber

International Ltd v National Bank of Kuwait5, when he said: “It is vital that every bank

which issues a letter of credit should honour its obligations. The bank is in no way concerned

with any dispute that the buyer may have with the seller. The buyer may say that the goods

are not up to contract. Nevertheless the bank must honour its obligations. The buyer may say

that he has a cross claim in a large amount. Still the bank must honour its obligations. A letter

of credit is like a bill of exchange given for the price of the goods. It ranks as cash and must

be honoured. No set off or counter claim is allowed to detract from it. Whereas a bill of

exchange is given by buyer to seller, a letter of credit is given by a bank to the seller with the

very intention of avoiding anything in the nature of set off or counterclaim.

The doctrine of strict compliance-

The legal principle that the bank is entitled to reject documents which do not strictly conform

to the terms of letter of credit is conveniently referred to as the doctrine of strict compliance.

The reason underlying this rule- which is not always appreciated by exporters is that the

advising bank is a special agent of the issuing bank and latter is the special agent of the

buyer. If an agent with limited authority acts outside that authority (in banking terminology:

his mandate) the principal is entitled to disown the act of the agent, who cannot recover from

him and has to bear the commercial risk of the transaction. In a falling market buyer is easily

tempted to reject the documents which the bank accepted, on the ground that they do not

strictly confirm with the terms of credit. Moreover the bank deals in finance, not in goods; it

normally has no expert knowledge of the usages and practices of a particular trade. If the

documents tendered are not strictly in conformity with the terms of the credit and the bank

refuses to accept them, the exporter should at once contact his overseas buyer and request

him to instruct the bank to accept the documents as tendered. The refusal of the bank to

depart in even a small and apparently insignificant matter not sanctioned by the instructions 5 [1981] 1 W.L.R at 1241

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or the UCP, where applicable, from its instructions will, in the overwhelming majority of

cases, be upheld by the courts if litigation ensues. Lord Sumner expressed the doctrine of

strict compliance in the following classic passage” there is no room for documents which are

almost the same, or which will do just as well’.

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Chapter 3

The documents tendered to the bank

The bank must determine on the basis of the documents alone whether or not they comply

with the mandate. According to the doctrine of strict compliance the bank is within its rights

when refusing documents tendered by the seller which do not contain all the particulars

specified in the credit. Beyond this bank is not obliged to go and should not go. In particular,

it need not concern itself with the legal significance and value of the documents which it is

instructed to demand. An illustration is the requirement of a credit that the bill of lading shall

contain a specific description of the goods; the value of such description is nugatory in view

of the- usual- clause in the bill that “ weight, measure, marks, numbers, quality, contents and

value if mentioned in the bill of lading are to be considered unknown”; nevertheless, the bank

must insist that the bill contains the specified description but, unless instructed otherwise,

need not reject such bill on the ground that the “weight, etc., unknown clause is not deleted.

All they have to do is to satisfy themselves that the correct documents are presented to them,

and that the bills of lading bear no indorsement or clausing by the ship owners or shippers

which could reasonably mean that there was, or might be, some defect in the goods or their

packing.

Time for examination-

UCP 400 did not provide clear guidance as to what was reasonable time for the examination

of documents. UCP 500 Art 13(b) differed significantly from its predecessor in this regard

and stated as follows:

“the issuing bank, the confirming bank, if any, or a nominated bank acting on their behalf,

shall each have a reasonable time, not to exceed seven banking days following the day of

receipt of the documents, to examine the documents and determine whether to take up or to

refuse the documents and to inform the party from which it received the documents

accordingly.”

The question of what amounted to reasonable time was considered by the court of appeal in

Banker’s Trust co v state bank of India6. In light of this case, amendments were made to

UCP 500 resulting in the seven day time limit set out in Art 13(b). However the issue as to 6 [1991]2 Lloyd’s Rep.443,CA

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how many days upto seven actually constituted a ‘reasonable time’ for the purposes of

compliance with this rule led to a number of differing interpretations and resulted in deletion

of these words and UCP 600 now provides instead, at Art 14(b), that the bank shall have a

fixed maximum number of days- five banking days following the day of presentation- in

which to examine the documents and to determine whether or not the presentation is

complying.

Discrepancy of the documents-

The law on the subject is summed up by sir John Donaldson M.R.7 in the following passage,

where he observed that the basis was:

“ that the banker is not concerned with why the buyer has called for particular documents,8

that there is no room for documents which are almost the same, or which will do just as well,

as those specified, that whilst the bank is entitled to put a reasonable construction upon any

ambiguity in its mandate, if the mandate is clear there must be strict compliance with that

mandate, that the documents have to be taken up or rejected promptly and without

opportunity for prolonged inquiry,9 and that the tender of documents which properly read and

understood calls for further inquiry or is such as to invite litigation is a bad tender.”

Two situations have thus to be distinguished. There may be an ambiguity in the credit

instructions (mandate), or there may be an ambiguity with respect to the tendered documents.

If the credit instructions are ambiguous, the best course for the bank is to ask for clarification.

If this is not possible the bank is protected if it has acted reasonably.

If the tendered documents are ambiguous, the tender is in principle a bad tender. However the

bank, when examining the tendered documents, should not insist on the rigid and meticulous

fulfilment of the precise wording in all cases.10 If properly read and understood, the words in

the instructions and in the tendered documents have the same meaning, if they correspond

though not being identical, the bank should not reject the documents. It has been said in an

opinion of the Banking commission of the ICC that “ banks could not act like robots, but had

to check each case individually and use their judgement”.

7 Banque de l’indochine et de suez SA v JH Rayner (mincing lane) ltd[ 1983] Q.B 711,729-7308 Commercial Banking Co of Sydney ltd v Jalsard Pty Ltd[1973] A.C. 279.9 Hansson v Hamel and Horley Ltd[1922] 2 A.C.3610 Hing Yip Hing Fat Co Ltd v Daiwa Bank Ltd [1991] 2 H.K.L.R.35

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However, the margin allowed to the bank in interpreting the documents is very narrow and

the bank will be at risk if it does not insist on strict compliance.

Provisions relating to documents in the UCP-

When a question of sufficiency of documents under letter of credit issued under the UCP

arises and this question cannot be resolved by reference to the instructions to the bank, it is

necessary to turn to the UCP, which sets out in considerable detail the documents normally

acceptable to the bank. UCP 500 expanded the provisions relating to documents and in

particular those which concerned transport documentation. UCP 600 similarly contains

detailed guidance in relation to specific categories of documentation used in export

transactions and generally follows the pattern of UCP 500.

The transport documents- it is common for buyers to require presentation of an invoice, an

insurance document and a bill of lading or other transport document under the credit. Taking

account of the increased use of certain types of transport documentation, UCP 500 introduced

individual Articles which distinguished between various types of transport document and

which set out the circumstances under which banks may accept them.

The most commonly required transport document is a bill of lading or a combined transport

document. UCP 600 has eliminated the reference to transport documents issued by the freight

forwarders found in UCP 500. In addition, UCP 600 contains individual Articles referring to:

(a). Transport documents covering at least two different modes of transport.(Art 19);

(b). Bills of lading (Art 20);

(c). Non- negotiable sea way bills (Art 21);

(d). Charter party bills of lading (Art 22)

(e). Air transport documents (Art 23);

(f). Road, rail and inland waterway transport documents (Art24);

(g). Courier and post receipts, certificates of posting (Art 25)

(h). The invoice (Art 18)

10

(i). Insurance documents (Art 28)

Several documents to be read together:-

The bank is usually instructed to make finance available on tender of several documents in a

set, and as stated these would normally be the transport documents, eg. A bill of lading, the

invoice and the insurance policy or certificate. In that case, in the absence of instructions to

the contrary, it is sufficient if all the documents in the set, taken together, contain the

particulars required by the bank’s mandate and it is not necessary that every document in the

set should contain them. The goods must be fully described in the invoice in accordance with

the credit instructions, but in the other documents they may be described in general terms.

This rule is now contained in Art14 (e)11 of the UCP which mitigates, to some extent, the

effect of the doctrine of strict compliance.

Chapter 4

Kinds of Letter Of Credit12

11 UCP500 Art.37(c)12 http://www.tradev.net/Downloads/Tools/guide2lc.pdf

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Payment at sight, deferred payment, acceptance and negotiation credits

It is of importance to the seller to know in what manner he will obtain the moneys due to him

under the credit. Four possibilities exist: the credit may be available by sight payment, by

deferred payment, by acceptance or by negotiation. The credit itself should state which of

these four methods has been chosen by the parties and this issue should be settled beforehand

in the contract under which credit is opened.

1. If the parties have arranged a payment at sight credit, the advising bank is instructed to

pay, or arrange for payment, to the seller the moneys due on presentation of the documents;

This is a case of payment against documents.

2 .If the parties have arranged a deferred payment credit, the advising bank is authorised to

pay, or make arrangements for payment, at some future date determinable in accordance with

the terms of the credit.

The deferred payment credit may, for example, provide for payment 180 days from the date

of bill of lading. In this case an acceptance credit providing for a time bill would be

inappropriate because a bill of exchange cannot be made payable at a time which can only be

determined by reference to the uncertain date of the issue of the bill of lading.

If the seller requires cash before the deferred payment credit matures, he can only provide it

by negotiating the letter of credit. The issuing bank sometimes provides in the credit that such

negotiation shall be restricted to a specified bank, "perhaps because this is a bank with which

it has a commercial relationship.

If the credit is an acceptance credit the seller draws the bill of exchange on the advising bank

in the specified manner. The bill will normally be a time draft. By accepting the bill, the bank

signifies its commitment to pay the face value on maturity to the party presenting it. The bill

accepted by the advising bank provides the seller with a considerable degree of security. If he

does not want to hold the bill until it matures, he may turn it into money by negotiating, e.g.

by discounting it or selling it to his own bank. On negotiation, he is unlikely to receive; the

full amount of money stated in the tenor of the bill because the negotiating bank will deduct a

discount or interest and commission.

Revocable and irrevocable credits; confirmed and unconfirmed credits

12

It is essential to distinguish between these types of credit. The quality of the credit as

"revocable" or "irrevocable" refers to the obligation of the issuing bank to the beneficiary (the

seller). The quality of the credit as "confirmed" or "unconfirmed" refers to the obligation of

the advising bank to the beneficiary.

Article 6 of the UCP 500 revision provided that a credit may either be revocable or

irrevocable, and stated that if a credit did not indicate which type it was then the presumption

was that it was irrevocable. In UCP 600 references to revocable credits have been entirely

removed and the type of credit envisaged by the rules is irrevocable. A credit is defined at

Art.2 as:

"any arrangement, however named or described, that is irrevocable. . .and it is stated in Art.3:

"A credit is irrevocable even if there is no indication to that effect.". Parties wishing therefore

to open a revocable credit may choose to do so by either making appropriate modifications to

the provisions of UCP 600 or by incorporating the terms of UCP 500 into the letter of credit..

Of course, no advising or nominated bank would ever confirm a credit unless the issuing

bank has made it irrevocable. The UCP contains detailed provisions entitling the advising

bank, which has taken up the documents in accordance with the instructions, to

reimbursement from the issuing bank.

It is controversial at which moment the irrevocable credit becomes binding on the issuing

bank and the confirmed credit on the advising bank. It is thought that these obligations

become binding on the banks before the tender of the documents, namely when the

beneficiary receives the communication of the bank and accepts it. The relationships between

the banks which undertake these obligations and the beneficiary are, as already observed,

contractual.

From the exporter's perspective, a particularly important feature of the credit is whether it is

irrevocable or irrevocable and confirmed. He has to arrange in the contract of sale (or other

underlying contract) the most appropriate of these two types of credit and all the other details

of it, including the mode of payment. He must later check the notification sent to him by the

bank; this notification should contain the terms of the credit, as arranged in the underlying

contract.

Revocable and unconfirmed credits

13

In practice, revocable credits are not widely used. Irrevocable credits, which may be

confirmed or unconfirmed, are the norm. Revocable credits may be amended or cancelled by

the issuing bank at any moment and without prior notice to the beneficiary.

If the credit is revocable its nature is reflected in the advice sent by the advising bank to the

beneficiary (the seller) which also states expressly that the credit is not confirmed. The

following clause in the advice note is typical:

"We have no authority from our clients to confirm this credit. The credit is therefore subject

to cancellation or modification at any time without notice."

From the exporter's point of view, an unconfirmed credit is a very unsatisfactory method of

finance, but unconfirmed credits are sometimes preferred to confirmed credits because they

are cheaper in respect of bank charges than the latter. The precarious nature of an

unconfirmed credit is well illustrated by the facts in Cape Asbestos v Lloyd’s Bank13.

Irrevocable and unconfirmed credits

The obligations of the issuing bank in terms of an irrevocable credit are set out in UCP 600

Art.7. Where this type of credit is used the issuing bank cannot revoke its undertaking to the

beneficiary, but the advising bank does not enter into its own obligation to make payment

under the credit. The advice of an irrevocable and unconfirmed credit would state:

"This credit is irrevocable on the part of the above-mentioned issuing bank but we are not

instructed to confirm it and therefore it does not involve any undertaking on our part."

These credits are sometimes issued by leading banks, particularly American and British

banks, which consider a local confirmation unnecessary.

While unconfirmed credits are somewhat cheaper than confirmed credits, they have the

disadvantage that they do not localise the performance of the contract of sale in the seller's

country. If the advising bank refused to pay on tender of the documents, the beneficiary

might be compelled to institute proceedings overseas—a ) situation which largely defeats the

main purpose of the commercial credit.

Irrevocable and confirmed credits

13 [1921] W.N.274

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This is the type of letter of credit most favourable to the exporter because the advising Bank

stipulates in terms that it will honour the exporter's drafts provided they are drawn and

presented in conformity with the terms of credit.

In the case of a confirmed credit, the engagement of the advising bank to the beneficiary is

expressly stated in the letter of advice which that bank sends him. The following clause in the

advice note is typical:

"We undertake to honour such drafts on presentation provided that they are drawn and

presented in conformity with the terms of this credit." \

The effect of a confirmed credit has been described by Diplock J. as constituting "a direct

undertaking by the banker that the seller, if he presents the documents as required in the

required time will, receive payment." The bank cannot withdraw from its liability to the

exporter even If instructed by the buyer to cancel the credit.

There is this to be remembered, too. A vendor of goods selling against confirmed letter of

credit is selling under the assurance that nothing will prevent him from receiving the price.

That is no mean advantage when goods manufactured in one country are being sold in

another.

Where the credit does not confirm to the terms of the contract of sale, two courses are open to

the seller. He may reject the non- conforming credit; thus, where under the terms of the

contract of sale he is entitled to a confirmed credit but is only advised of the opening of an

unconfirmed credit, he need not ship the goods.14Alternatively, he may accept the non

conforming credit. If he does so without objection, he is treated as having waived irrevocably

his right to a conforming credit.15

Standby letters of credit

In international trade transactions the stand by letter of credit, like the ordinary letter of

credit, is activated by the tender of documents in accordance with the requirements of credit.

The two types of credit differ significantly. The ordinary letter of credit is a payment

instrument which normally obliges the beneficiary to tender, together with other specified

14 Panoutsos v Raymond Hadley Corp[1917] 2 K.B.47315 WJ Alan &Co Ltd v El Nasr Export & Import Co [1972] 2 Q.B.189

15

documents, the transport documents. The standby credit is intended to protect the beneficiary

in case of default of the other party to the underlying contract. In the standby credit the

required documents need not include the transport documents; this type of credit may be

activated by a document of any description, e.g. a demand by the beneficiary or a statement

from him that the other party is in default. The standby letter of credit is thus often

functionally similar in effect to a bank guarantee or performance bond.

The principles relating to ordinary letters of credit likewise apply to standby credits, mutatis

mutandis. In particular, the principles of the autonomy of the credit and the requirement of

strict compliance also apply to this type of credit.

Revolving Credits

Where the export sale is not an isolated transaction but the overseas buyer is a regular

customer of the exporter, the buyer will arrange a revolving credit in favour of the latter. The

buyer gives the bank standing instructions to arrange for a credit in favour of the exporter

which at no time shall exceed a fixed maximum. The advantage of this arrangement is that no

renewal is required and clerical labour is saved; a revolving credit is, for instance, a corollary

to a sole distribution agreement.

Packing; red clause credit

The packing credit, sometimes called an anticipatory credit, is intended to assist the exporter

in the production or procurement of the goods sold. The credit is payable at a time prior to the

shipment of the goods and against the document other than the transport document. The bank

is instructed to pay the purchase price, or part of it, on production of, e.g. a warehouse receipt

(evidencing that the goods are in existence) or a forwarder's certificate(FCR) (affirming that

the goods have been received for shipment or have been shipped), or an air dispatch

registered post receipt.

The packing credit is a convenient method of finance for the small exporter who is not

familiar with shipping practice; if, for example, he sells cloth ex London store and arranges

that the purchase price shall be paid under a letter of credit against delivery of a forwarder's

receipt, he is not concerned with the actual shipping arrangements, which will be made by the

forwarder on instructions of the buyer. The buyer, on the other hand, is certain that the goods

sold are no longer in the possession of the seller when receiving the purchase price.

16

In more complicated transactions, which are nearer in nature to letters of credit proper, the

bank, when advising the exporter of the credit, inserts the so-called red clause into the letter

of advice and is prepared to honour the exporter's sight drafts to a certain amount against

production of the stipulated documents, e.g. the warehouse receipts; when the exporter ships

the goods and delivers the transport documents to the bank, he presents a draft for the

purchase price less the amount received by way of advance.

In the case of a packing credit, the arrangement can be construed as an agreement that the

buyer, through the bank, is to make an advance on the purchase price, the advance being

payable on production of the stipulated documents, and the balance of the price being payable

on delivery of the proper transport documents (and/or other specified documents).

.

Chapter 5

Advantages and Disadvantages of letter of credit16

Advantages to the Importer

• Importer is assured that the Exporter will be paid only if all terms and conditions of the

Letter of Credit have been met.

• Importer is able to negotiate more favourable trade terms with the Exporter when payment

by Letter of Credit is offered.

Disadvantages to the Importer

16 http://www.tradev.net/Downloads/Tools/guide2lc.pdf

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• A Letter of Credit does not offer protection to the Importer against the Exporter shipping

inferior quality goods and/or a lesser quantity of goods.

Consequently, it is important that the Importer performs the appropriate due diligence to

assess the reputation of the Exporter. If the Exporter acts fraudulently, the only recourse

available to the Importer is through legal proceedings.

Added protection to the Importer may be provided by requesting additional documentation in

the Letter of Credit, e.g. a Certificate of Inspection.

• It is necessary for the Importer to have a line of credit with a bank before the bank is able to

issue a Letter of Credit. The amount outstanding under each Letter of Credit issued is applied

against this line of credit from the date of issuance until final payment.

Advantages to the Exporter

• The risk of payment relies upon the creditworthiness of the Issuing Bank and the political

risk of the Issuing Bank’s domicile, and not the creditworthiness of the Importer.

• Exporter agrees in advance to all requirements for payment under the Letter of Credit. If the

Letter of Credit is not issued as agreed, the Exporter is not obligated to ship against it.

• Exporter can further reduce foreign political and bank credit risk by requesting confirmation

of the Letter of Credit by a Canadian bank.

Disadvantages to the Exporter

• Documents must be prepared and presented in strict compliance with the requirements

stipulated in the Letter of Credit.

• Some Importers may not be able to open Letters of Credit due to the lack of credit facilities

with their bank which consequently inhibits export growth.

Fraud affecting letters of credit

It has been seen earlier that one of the maxims on which the letter of credit system is

founded is the autonomy of the institution. This means that the banks engaged in a letter of

credit transaction are, in principle, not involved in any dispute arising between the parties to

the underlying contract of sale or other contract. Only one exception is admitted to this rule;

the fraud exception, which permits a court to consider evidence other than the actual terms

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and conditions of the credit and is founded on the maxim ex turpi causa non oritur actio.

Where it can be pleaded successfully, the bank—the issuing bank under an irrevocable credit

and the advising bank if it has added its confirmation—should refuse to honour the

undertaking which it has given the beneficiary, viz. to pay, accept or negotiate according to

the terms of the credit, if the correct documents are tendered before the expiry of the credit.

In circumstances where the documents are discrepant, the defects are apparent on their face.

Here, we are dealing with circumstances in which the documents appear to be in order on

their face, but they or their tender are tainted by fraud. This fraud will usually relate to the

documents themselves. They may be forged or untrue in relation to the goods to which they

refer; however on their face they appear to be correct and good tender under the documentary

credit.

The allegation of fraud is normally raised by the buyer, who will attempt to prevent the bank

from honouring the credit or the seller from drawing on it. The buyer may allege that the

seller shipped rubbish instead of conforming goods or that he shipped no goods at all, or that

the bills of lading were forged or fraudulently false, in that they were antedated to show

shipment within the stipulated shipping time whereas the goods were actually shipped out of

time.

The bank is not obliged actively to ascertain whether the alleged fraud can be proved. It may

adopt a passive attitude and evaluate the evidence placed before it by the buyer. If court

proceedings ensue, the issue of whether a relevant fraud has occurred has to be decided

according to the facts then known to the court and it is irrelevant that an earlier stage the

fraud was unknown to the bank. In ascertaining whether the fraud exception applies, three

sets of circumstances have to be distinguished.

First, where there is only an allegation, communicated by the buyer to the bank, that fraud

has occurred. This allegation may be founded on a suspicion, even a grave one. Or the bank

itself, without instigation by the buyer, may entertain such suspicion. If no more can be

established, the bank should pay Secondly, where it is clearly established to the satisfaction

of the bank that a fraud has occurred. There is unambiguous evidence before it, for instance

that the documents, or some of them, are fraudulent or forged. But there is no evidence before

the bank which shows that the beneficiary (the seller) knew of the fraud. There is the

possibility that the fraud was committed by a third party, e.g. a forwarder or loading broker,

who intended to cover up the fact that the goods were shipped out of time, and that the

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beneficiary himself was unaware of this fraud. One should have thought that even in this case

the rule applies that "fraud unravels all". But that was not the case.

Thirdly where the bank has positive proof that a fraud has been committed and that the

beneficiary knew of this fraud. If both these facts are clearly established to the satisfaction of

the bank , it must not honour its obligation under the credit. E.g. if seller tenders documents

evidencing the transportation of the goods to the buyer but the seller has recalled the goods

from the person carrying out the transport and knows that the goods will not reach the buyer

Risk situations in letter-of-credit transactions

Fraud Risks

The payment will be obtained for nonexistent or worthless merchandise against

presentation by the beneficiary of forged or falsified documents.

Credit itself may be forged.

Sovereign and Regulatory Risks

Performance of the Documentary Credit may be prevented by government action

outside the control of the parties.

Legal Risks

Possibility that performance of a Documentary Credit may be disturbed by legal

action relating directly to the parties and their rights and obligations under the

Documentary Credit.

Force Majeure and Frustration of Contract

Performance of a contract – including an obligation under a Documentary Credit

relationship – is prevented by external factors such as natural disasters or armed

conflicts

Risks to the Applicant

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Non-delivery of Goods

Short Shipment

Inferior Quality

Early /Late Shipment

Damaged in transit

Foreign exchange

Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

Insolvency of the Applicant

Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Beneficiary

Failure to Comply with Credit Conditions

Failure of, or Delays in Payment from, the Issuing Bank

Conclusion:

Letter of credit as mode of making payments in international trade plays an important role

where buyer and seller are situated in different jurisdictions. It serves as an important tool for

both the parties to create a mutual trust which is the touchstone of any trade.

Though, Letters of credit are a useful payment tool, but they should only be used where

necessary as they involve a great deal of administration, risk and cost to be a suitable

payment mechanism for day to day trading situations.

Moreover, there are various letter of credits involved in international trade and all of them

have there own advantages as well as disadvantages. so care must be taken while using this

mode of payment.

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