Introduction to

Letters of Credit
Jenni Lajzerowicz
Senior Associate

Energy Trade & Transport Group

Norton Rose LLP
22 October 2008

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Objectives today
• Describe letters of credit, their object and function

• Show how a letter of credit operates

• Explain the parties, their roles and the different contractual

relationships

• Explain the relevance and status of the Uniform Customs and

Practice

• Provide some understanding of fundamental concepts underlying

letters of credit

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What is a letter of credit? Why is it used?

• Seller in country A – Malaysia • Buyer in country B - USA

• Seller sells palm oil to the buyer • Buyer buys palm oil for delivery at
shipped from Malaysia to Rotterdam
Rotterdam

• Risk to seller if it parts with • Risk to buyer if it pays for goods before
possession and title and ships shipment
goods on basis of buyer’s promise
to pay alone
• Plus immediate tying up of buyer’s
capital
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What is a letter of credit? Why is it used?

“A letter of credit is a commercial instrument used as a means of

financing international business transactions”

“A letter of credit is a contract under which a bank agrees to pay the

seller in connection with the export of specific goods against the
presentation of specified documents relating to those goods … The
credit is issued at the request of the buyer (the applicant) in favour
of the seller (the beneficiary)”

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What is a letter of credit? Why is it used?

• A banker’s assurance of payment • Sales contract does not provide security for
against specified documents either party. Object of credit is two-fold: to
(1) furnish security and (2) raise credit

• Most frequent method of payment in

international trade • Risk to seller if it parts with possession of
and title to the goods and ships them on

• Used for over [ ] years basis of buyer’s promise to pay; and,

• Risk to buyer if it pays for goods before

shipment
• Adaptable – e.g. trade finance,
provision of services not just goods,
and as guarantee instruments in the • Raising credit without having to tie up capital

form of standby letters of credit whilst goods are on board ship

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How does a letter of credit operate?

To fully understand the operation of the letter of credit, we need to look at the
following:

(1) The parties involved and their respective roles

(2) The contracts involved

(3) The mechanisms of the transaction

(4) Fundamental concepts

(5) The UCP

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Four parties and the contracts involved
Four parties
• The buyer (the applicant)
• The issuing bank
• The advising bank (may also be the correspondent, nominated,
confirming bank)
• The seller (the beneficiary)

Four bilateral contracts between

• The buyer and the issuing bank
• The issuing bank and the advising/nominated/confirming bank
• The issuing bank and the seller
• The confirming bank and the seller

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Role of the banks
Issuing bank
• The issuing bank is buyer’s bank
• In buyer’s own country
• The seller will be wary of receiving a credit from a bank in a different
country

Advising bank
• The advising bank advises the credit
• Also known as the “correspondent” bank
• Can be a nominated bank and/or a confirming bank

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Role of the banks
Nominated bank
• Normally the advising bank
• Nominated by issuing bank to be bank where the seller presents
documents
• and obtains payment

Confirming bank
• Nominated bank may be authorised to pay in accordance with the terms
of the credit
• BUT it will only be liable to the seller if it adds its own undertaking to the
credit (= a confirmed letter of credit)
• Nominated bank becomes a confirming bank

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How does a letter of credit operate?

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How the letter of credit operates: the four stages
Stage 1 - Sales contract

• Starting point = the sales contract

• Provision for payment by letter of credit
• Precise terms of the letter of credit

• Mirror: sales contract requirements and the letter of credit opened

• No indication in the sales contract as to the type of credit required?

• Contract no.1: the sales contract between the buyer and the seller

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How the letter of credit operates: the four stages
Stage 2 – Instruction to the issuing bank

• Buyer requests issuing bank to open credit in favour of the seller

• Involves completing bank’s standard application form

• Buyer will add his instructions: documents to be tendered; description of

goods; type of credit to be opened

• Issuing bank acts on the buyer’s instructions alone

• Once the application is made, the bank notifies the buyer in writing of its
agreement to open the credit

• Contract no.2: application form = basis of contract between buyer and

issuing bank
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How the letter of credit operates: the four stages
Stage 3 – Opening of the credit

• The issuing bank notifies the seller of the opening of the credit in his favour; or,

• It arranges for the advising bank to do so; usually, its correspondent bank in
the seller’s own country

• Advising the credit is usually done in electronic form; e.g. SWIFT

• Notification by the advising bank constitutes the letter of credit

• The issuing bank will become bound to the seller immediately as the seller
receives the letter of credit

• Contract no.3: between the issuing bank and the advising bank
• Contract no.4: between the issuing bank and the seller
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 How the letter of credit operates: the four stages
Stage 3 – Opening of the credit – other parties
• Nominated bank: Unless the credit is only available with the issuing bank, it must
nominate the bank authorised to pay (or issue a deferred payment undertaking,
accept drafts or negotiate the credit)

• Unless the nominated bank is also the confirming bank, neither the nomination by the
issuing bank nor the nominated bank’s receipt, examination or forwarding of
documents commits the nominated bank

• The advising bank does not incur any liability to the seller merely by advising the
opening of the letter of credit

• Confirming bank: if a confirmed credit, the correspondent/advising bank must add its
“confirmation” to the credit; i.e. undertake to seller to honour the credit on presentation
of the documents

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Contract no.5: contract between correspondent/confirming bank and the seller
How the letter of credit operates: the four stages
Stage 4 – Operation of the credit by the beneficiary
• The seller/beneficiary has shipped the goods
• And has presented documents to operate the credit

• The bank will check that the documents comply and are presented in accordance
with the credit

• IF the documents are in order, the bank will pay the seller/beneficiary (or it will
comply with whatever undertaking the credit provides for)
• IF the documents are not in order, the bank must refuse them

• Before refusal becomes final, at seller’s request the bank may take instructions
from the issuing bank or the applicant itself (the buyer) to see whether the applicant
is prepared to accept non-conforming documents
• COMMON for buyers to waive discrepancies because they want the goods
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How does a letter of credit operate?

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How does a letter of credit operate?
At the request of the buyer, the issuing bank promises to pay the price of the
goods to the seller against the tender of relevant documents.

To fully understand the operation of the letter of credit, we need to look at the
following:

(1) The parties involved and their respective roles

(2) The contracts involved

(3) The mechanisms of the transaction

(4) Fundamental concepts

(5) The UCP

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Fundamental concepts

• The autonomy of a letter of credit

• Bank’s concern with documents, not facts

• Non-conforming documents and the doctrine of strict compliance

• Each bank’s undertaking as principal

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The autonomy of a letter of credit

• Payment obligation is independent of the underlying transaction

• Conditions under which the bank will pay are contained exclusively in the
credit without regard to the terms of the underlying transaction

• A breach by the seller of his obligations will not entitle the buyer to instruct
the bank to withhold payment under the credit (provided irrevocable credit)

• The bank must ensure that documents appear on their face to conform

• If the documents do not comply with the credit, the bank is entitled to reject
non-compliant documents and not pay

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The autonomy of a letter of credit
Non-payment

• There are two main exceptions to the confirming or issuing bank’s obligation
to pay notwithstanding that the documents appear to be in good order

• They are:

– Illegality; and,

– Fraud

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Bank’s concern with documents, not facts
• Bank’s concern with documents, not facts

• Must check documents conform on their face (in the absence of strong
evidence of fraud or illegality)

• Bank does not check the veracity of the statements contained in the
documents, nor to examine the goods

• This runs hand in hand with the principle of autonomy of the credit

• If the documents appear to be in order, the bank is entitled and obliged to

pay

• Non-compliant documents mean the bank can withhold payment even if the
non-compliance is purely technical and not material
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Non-conforming documents and the doctrine of
strict compliance

• The doctrine of strict compliance applies to all contracts involved in the

letter of credit operation

• A minor discrepancy or one which does not serve any useful purpose is still
a discrepancy

• UCP 600 provisions on examination of documents should assist slightly to

lessen purely technical discrepancies

• ISBP which should be read with the UCP should also assist

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Each bank’s undertaking as principal
• Issuing bank’s undertaking to the seller is given as principal and not as the
buyer’s agent

• He is a stranger to the letter of credit contract; i.e. not even an “undisclosed

principal”.

• Therefore, primarily liable to seller to pay out under credit

• Consequences: the buyer is not entitled to give instructions to the issuing

bank to refuse payment under the credit, nor to vary the terms of the credit

• The buyer cannot be sued under the letter of credit if the issuing bank fails
to pay seller (although the buyer will incur liability for breach of the sales
contract)

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The Uniform Customs and Practice (“UCP”)

• Rules for commercial credits

• Current edition: UCP 600 (issued in July 2007)

• Advantages

• International Standard Banking Practice (ISBP)

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UCP 600

• How does UCP 600 apply to credits?

• Status of UCP 600

• A note of warning: not a complete code

– UCP 600 silent on certain crucial matters

– Governing law and jurisdiction
– Reimbursement of the issuing bank by the buyer

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GOVERNING LAW
“A wholly undesirable multiplicity of potentially conflicting laws”

• A number of bilateral contracts not a single transaction

• Each potentially subject to a different governing law
• UCP 600 has no provisions to determine governing law therefore this must
be agreed between the parties and specified in the credit

• Conflict of laws: “closest connection” test under English law

– NOT location of central administration of banks, nor place where

contract made
– Rather place where documents to be tendered are presented and
checked; and,
– where payment to the seller is to be made against those documents

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UCP 600 VERSUS UCP 500
• Structural “cosmetic” changes and more fundamental changes

• Objective: to ensure clarity and consistency in approach

• Standard for examination of documents: Art 14, UCP 600 – data in

documents must “not conflict” with other data (versus “consistent”)

• mirror image no longer required

• Non-documentary conditions are disregarded

• Affects technical discrepancies as opposed to real ones

• Easier for a document to be compliant than under UCP 500

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UCP 600
Bills of lading

• A bank will only accept a “clean” transport document (Art 27, UCP 600) whether
or not the credit requires this

• Bears no clause or notation expressly declaring a defective condition of the goods

or their packing. The word “clean” need not appear

• A claused bill of lading is not a “clean” bill. Defective bill? But bank cannot check
underlying sales contract (principle of autonomy)

• De minimis? Allowance allowed? See credit terms

• What if bill states goods fine on loading BUT damaged on board?

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Types of letters of credit
• Confirmed credits, sight credits, deferred payment credits and acceptance
credits

• Straight (or specially advised) credits and negotiation credits

• Revocable and irrevocable credits

• Revolving credits

• Red clause and green clause credits

• Transferable credits and back-to-back credits

• Demand guarantees and standby credits

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Conclusion
• Complex area

• Understanding of why a letter of credit is used

• Better understanding of how a letter of credit operates in practice with

reference to the individual parties, their respective roles and the multiple
contracts in operation

• Brief view of fundamental concepts relevant to letters of credit and the role
and status of UCP 600

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Thank you

Jenni Lajzerowicz
+44 (0)20 7444 2388
+44 (0)7930 354275
jenni.lajzerowicz@nortonrose.com

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comprehensive statement of the law and practice in this area. Readers must take specific legal advice on any particular matter
which concerns them. If you require any advice or information, please speak to your usual contact at Norton Rose Group.

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