What is a letter of credit?
A letter of credit is perhaps the most common payment method with regard to trade of an international nature. A letter of credit is a written guarantee from a bank or other appropriate financial institution confirming that the buyer in the transaction has the required funds and will make payment to the seller in the transaction. The letter of credit will detail both the amount of money and the time at which the payment has been made. In order to produce such a document, there will be a number of documents that the bank will require in order to ensure that the transaction is legitimate and so that they can ensure that the necessary funds are available and have not been obtained fraudulently or otherwise illegally.
Why are letters of credit used?
Letters of credit are usually used when the two (or more) parties involved in the transaction are in different countries. In such a situation (or otherwise), the buyer may be required to provide a letter in order that the payment is guaranteed. This provides security for the seller as they have reassurance that the buyer has the money and that the payment will be made on the agreed date or as per the agreed payment milestones. The method is generally secure and is often used to ensure that contractual provisions are met. Further, in the event of an issue, the liability is often transferred to the bank or financial institution that has provided the letter of credit, meaning that the seller is less exposed. In addition to this, a letter of credit also provides the buyer with extra security as they have documentation confirming the order and it is more difficult for the seller to withdraw or attempt to amend the terms of the agreement.
It is important to note that there are associated costs in the form of charges for a letter of credit, and this cost must be taken into consideration when looking at the obvious advantages detailed above. They may also lead to delays or other problems with regard to administration, and they are often only used when one party insists on them, where they is a particular requirement under local or national regulation or where there is a particular concern with regard to a parties ability to make payment. Other disadvantages may be associated with the form of letter and the bona fides of the issuing institution, it’s financial strength and the exact terms of the letter, which may mean the guarantee and security offered are not 100% watertight.
Common problems associated with letters of credit :-
- can all terms and conditions be complied with in the prescribed time limits.
- Documentary technicalities – a high proportion of letters of credit are not initially paid by banks because paperwork is not exactly correct. Like insurance companies, banks can be difficult and will insist on and utilise any contractual terms.
- third party problems – some aspects of an international trade transaction are likely to be outside of the direct control of buyer and seller, which can lead to unforeseen problems and contractual issues in a letter of credit
Further good information about possible risks is available here
Types of Letter of Credit
There are a number of different types of letter of credit. From these, there are five that are most commonly used. These are
Irrevocable and revocable letters of credit refer to whether or not the letters can be amended or cancelled either at any time or subject to agreement. A confirmed letter of credit is one that has been checked by a second bank, and a transferable letter of credit is one that allows the beneficial party to be transferred. Other types of letter of credit include revolving, back-to-back and standby, and each type is used for slightly different purposes. It is important to note that certain types can be combined if required.
Regulation and enforceability
Letters of credit are generally regulated by the International Chamber of Commerce (“ICP”), who has produced a standard set of guidelines known as Uniform Customs and Practice for Documentary Credits (“UCP”). These guidelines do not have legal enforceability but are widely adopted voluntarily in transactions involving many countries, so if they are not incorporated into a contract, it is important to enquire and understand why.
Any reason to obtain legal advice ?
Most businesses are reluctant to obtain legal advice except when it’s absolutely necessary, and we can understand this view. Some may take the view that, when dealing with a bank or financial institution, everything is standard and/or non-negotiable. Others may say that, with a letter of credit in place, nothing can go wrong. Unfortunately, this is unlikely to be correct, and lawyers can help by :-
- anticipating potential unforeseen issues based on legal experience of how things can go wrong
- spotting potential contractual clauses which create unnecessary or unacceptable risks or liabilities, and ensuring a client understands all the risks
- assisting in intervening if things do go wrong, by interceding with the bank or institution which issued the letter of credit and which may be refusing to pay.
Get in touch with me if you want to discuss a particular issue or for further general advice on letters of credit or other commercial issue. I have nearly 40 years of experience !
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