08 - Asynchronous Recording - Letters of Credit

Letters of Credit in International Commerce

  • Letters of credit are crucial for international commerce, ensuring that neither the buyer nor the seller is at a disadvantage by being without money or goods.
  • When a sale of goods contract is established, both parties agree that payment will be made via a letter of credit, governed by either UCP 500 or UCP 600.
  • UCP 500 remains relevant, particularly for revocable letters of credit, which UCP 600 does not recognize. UCP 600 finds irrevocable letters of credits to be just insane and doesn't even recognize that.
  • The contract specifies payment terms and required documents such as:
    • Commercial invoice
    • Inspection certificate (to ensure goods meet contract requirements)
    • Bill of lading

Parties and Process

  • The buyer, as the applicant, requests their bank to open a letter of credit in favor of the seller.
  • The buyer's bank (located in the buyer's country), upon issuing the letter of credit, becomes the issuing bank.
  • The issuing bank contacts the seller's bank (in the seller's country), asking them to advise the seller about the issued letter of credit. This makes the seller's bank the advising bank.
  • The advising bank informs the seller, who then ships the goods, obtains the bill of lading, and presents it to their bank to get paid.
  • The seller's bank (advising bank) then presents the bill of lading to the buyer's bank (issuing bank) gets paid.
  • Finally, the buyer's bank gives the bill of lading to the buyer.

Benefits of Letters of Credit

  • For the Seller:
    • Ensures payment once goods are shipped and conforming documents are presented.
    • Reduces risk related to buyer insolvency. Risk is reduced because he knows that there is a reputable third party a bank that has promised to pay so long as the documents are presented to it.
  • For the Buyer:
    • Ensures the seller is only paid upon submission of conforming documents, including the bill of lading, verifying the shipped goods.
    • The buyer knows that the seller will not get paid unless he gives conforming documents. Conforming documents will include the bill of lading.
    • The carrier will actually record exactly what weight it is.

Bank's Role: Documents, Not Goods

  • Banks primarily deal with documents, not the physical goods. This is really important because it protects the buyer as well.

Autonomy of Letter of Credit

  • The autonomy principle dictates that a letter of credit is independent of the underlying sales contract.
  • Banks are not responsible for policing the underlying contract or verifying if goods conform to the agreement.
  • Once a letter of credit is issued irrevocably, the buyer cannot prevent payment if conforming documents are presented, regardless of issues with the underlying contract. Because the bank would say I don't care about what's going on with your underlying document.

Doctrine of Strict Compliance

  • The doctrine of strict compliance means that the banks only pay the seller when the documents comply 100% to what it was agreed to begin with. Because banks deal with documents and not with goods.
  • Payment is contingent on strict adherence to documentary requirements specified in the sales contract.
  • Even minor discrepancies, like using "calf leather" instead of "full grain leather" (though they are synonymous), can lead to rejection of payment by the bank.
  • Example:
    • Contract specifies "10 tons of full grain leather".
    • Bill of lading states "10 tons of calf leather".
    • Despite being the same, the bank can refuse payment due to non-compliance.

Types of Letters of Credit

  • Revocable Letter of Credit:
    • Can be revoked anytime before payment, offering minimal protection to the seller.
    • Cheapest option due to low risk for the bank, suitable when there's high trust between parties.
    • UCP 600 does not govern revocable letters of credit.
      • Governed by UCP 500.
  • Irrevocable Unconfirmed Letter of Credit:
    • Cannot be revoked; the issuing bank is the buyer's bank.
    • The advising bank (seller's bank) acts as an agent of the issuing bank, not making an independent promise to pay.
    • If the advising bank refuses payment, the seller can only sue the issuing bank (in the buyer's jurisdiction). Because the advising bank is acting as an agent of the issuing bank.
    • Cheaper than a confirmed letter of credit, as the advising bank assumes no independent risk.
  • Irrevocable Confirmed Letter of Credit:
    • The advising bank provides an independent promise to pay, becoming a confirming bank.
    • The seller can sue the confirming bank in their own jurisdiction if payment is refused.
    • Offers the most security but is more expensive due to the advising bank's added risk.

Bank's Document Inspection

  • Banks have five working days to inspect documents upon presentation.
  • If the bank intends to reject the documents, a notice of rejection must be given to the presenter by the end of the fifth working day, explaining the reasons for non-compliance and rejection.
  • Failure to provide a notice of rejection within the specified timeframe results in automatic acceptance of the documents.