(b) UCP600: letters of credit (L/Cs)

General. In many sales contracts, the buyer is required to arrange for payment of the contract price to be made by a bank (normally at the supplier’s location). The buyer will seek certainty that it will actually receive the contracted goods or services. In international transactions, where physical exchange of price against goods is rare, a high level of certainty can be achieved by requiring a presentation of documents (usually including an invoice, an insurance policy and a bill of lading or other transport document). Letters of credit (usually abbreviated as “L/C”)[1] are a very common and reliable method of payment for goods in cross-border sales transactions.

The parties involved. The parties involved in an L/C are the seller (referred to as the beneficiary) and the issuing bank (usually the buyer’s own bank). In the context of an irrevocable L/C, the issuing bank undertakes to pay the purchase price to the beneficiary, provided that the seller submits the correct documents before the expiry of the credit. In many cases, the beneficiary’s own bank will also be involved (and be referred to as the advising bank).

Overview of a transaction. Visualising the steps of a sales transaction and related payment clarifies how an L/C works:

      1. The buyer and the seller enter into a sales contract.
      2. The buyer (in L/C terminology: applicant) submits a completed L/C-application form to a bank (in L/C-terminology: the issuing bank), usually its own bank in its own country.
      3. The issuing bank approves the application, and sends the L/C to a bank (in L/C-terminology: the advising bank) in the country of the seller (in L/C-terminology: the beneficiary), often the seller’s bank.
      4. The advising bank authenticates the L/C and sends the beneficiary the details. The beneficiary reviews the L/C: (a) to ascertain that L/C-terms match the provisions of the sales contract; and (b) to make sure that all L/C-conditions can be met. If necessary, the seller/beneficiary contacts the buyer/applicant to request an amendment.
      5. The seller insures the goods (if agreed) and ships the goods (for which the carrier, freight forwarder or transporter issues the relevant transportation documents) and (if agreed) clears the goods for export and import (as reflected in customs forms).
      6. The seller submits the agreed documents to the advising bank, which examines the documents against the terms of the L/C.
      7. If the documents are correct (‘compliant’), the advising bank sends the documents to the issuing bank for acceptance.[2]
      8. The issuing bank examines documents received from the advising bank, and if the documents are in order, pays the amount agreed in the L/C, “at sight” or on the date agreed in the L/C.[3] The issuing bank forwards the documents to the buyer (who can now collect the goods), and debits/settles the L/C amount.
      9. The issuing bank pays to the advising bank (or will pay on the date agreed in the L/C).
      10. The advising bank credits the bank account of the seller.

    Advising vs. confirming bank. An advising bank may confirm the L/C opened by the issuing bank. In such cases, if the credit is confirmed, the confirming bank also undertakes to pay the amount of the L/C. The beneficiary will then be entitled to take recourse on either the issuing bank or the confirming bank. This confirmation, as such, is sometimes requested and paid by the beneficiary (seller´s confirmation).[4]

    In this case, the illustrations change slightly, in that the advising bank has become confirming bank, and the confirming bank does not ‘advise’ the L/C but ‘confirms’ it:

    Date of payment. Upon presentation of the documents, the bank pays the purchase price according to the L/C, by “at sight” payment, deferred payment, by acceptance or by negotiation. The L/C states which of the four settlement methods has been chosen. In case of a payment at sight, the advising bank is instructed to pay to the seller on mere presentation of the documents. This is a case of “payment against documents”.

    L/C expiry date. A letter of credit must stipulate an expiry date, on or before which documents must be presented by the seller.

    Documents that the parties commonly agree to have submitted under an L/C are:

    • commercial documents (e.g. invoice, packing list);
    • shipping or transport documents (e.g. bill of lading (ocean or multi-modal or charter party), airway bill, lorry or truck receipt, railway receipt, forwarder cargo receipt);
    • official documents (e.g. customs documents, import permits, export permit, licence, embassy legalization, certificate of origin, certificate of inspection, phytosanitary certificate);
    • financial documents (e.g. bill of exchange, co-accepted draft);
    • insurance documents (e.g. insurance policy or certificate).

    Regulatory framework: UCP600. The common international practice of letters of credit is reflected in the Uniform Customs and Practice for Documentary Credits (UCP600.)[5] The UCP600’s provisions explain the required actions to be taken by each of the parties, their responsibilities and liabilities. UCP600 also elaborates on the verification of the submitted documents. Finally, it contains provisions related to the presentation of documents in electronic (or part-electronic) form (“eUCP”). UCP600 applies only if the parties have expressly referred to it in the sales contract (see UCP600 Article 1).[6]

    Two fundamental principles apply to letters of credit: the principle of autonomy of the L/C and the doctrine of strict compliance.

    Autonomy of the L/C: independent undertaking. The undertakings by the issuing and confirming banks to pay the beneficiary are separate and independent from the buyer’s actual willingness or ability to pay. This characterises a letter of credit. Accordingly, an issuing bank and a confirming bank will refuse to accept instructions from the buyer not to pay a beneficiary that has satisfied the conditions of the L/C. Similarly, an issuing bank will not accept a revocation of the L/C. A bank that operates an L/C is concerned only whether the documents provided by the beneficiary correspond to those specified in the instructions. This principle of the autonomy of the L/C is stated in UCP600, Articles 4 and 5.

    Doctrine of strict compliance: document verification. The doctrine of strict compliance means that the bank is entitled to reject the documents if they do not strictly conform to the terms of the L/C. In this respect, the bank examines the documents and determines, on the basis of the documents alone, whether or not the documents appear on their face to constitute a complying presentation (UCP600 Article 14(a)). According to the commentary on UCP600,[7] the concept “on their face” requires a review of data within a document, to determine that a presentation complies with international standard banking practice and UCP600. A bank is not obliged to go beyond “the face” of a document to establish if a document complies with a requirement in the L/C or UCP600.

    Which examination criteria? For the important types of documents commonly submitted in connection with an L/C, UCP600 Articles 18 to 28 identify: (a) the required details and information; (b) the assumptions that a bank will make; (c) which information will be ignored by a bank; and (d) what level of verification it undertakes. If the presented documents do not conform to the L/C, the refusing bank will notify the presenter (UCP600 Article 16).

    Fraud. The bank may only refuse to pay if it is proved that: (a) the documents (even though they are apparently in order ‘on their face’) are fraudulent; and (b) the beneficiary was involved in the fraud. This differs from the case where the documents appear not to be conform to the L/C (since a discrepancy would entitle the bank to refuse payment on the basis of non-compliance). Examples of alleged fraud include cases where the seller/beneficiary shipped worthless junk or no goods at all, or where documents were forged or fraudulent (e.g. antedated bills of lading, reflecting an earlier date of shipment than the actual date of shipment, so as to meet the contractual requirements). The applicable law may in addition require that the seller be aware of the fraud, to entitle a bank to refuse payment. Although this is a matter of the law applicable to the L/C, cases in which fraud was committed by an intermediary (e.g. the carrier or a freight forwarder), for example, should not affect the payment obligation of the bank

    . The logic behind this is that fraud by an intermediary should not affect the obligation of the bank but should be dealt with in the relationship with that intermediary (e.g. the transportation or freight handling agreement). It must be emphasised that the fraud-exception is a matter for the law applicable to the L/C.

    There are various types of letters of credit. The most important distinctions are made between revocable and irrevocable L/Cs and between confirmed and unconfirmed L/Cs.

    Revocable vs. irrevocable L/Cs. L/Cs can be revocable or irrevocable. The distinction refers to the obligation of the issuing bank to the beneficiary. Revocable L/Cs are relatively uncommon. UCP600 addresses irrevocable L/Cs.[8] By definition, under an irrevocable L/C, an issuing bank cannot revoke its undertaking to the beneficiary.

    Confirmed vs. unconfirmed L/Cs. L/Cs can be confirmed or unconfirmed. This distinction refers to the obligation of the advising b

    ank to the beneficiary. UCP600 Article 2 defines confirmation as: “a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying presentation.” Unconfirmed L/Cs are less expensive than confirmed credits, because the advising bank undertakes a separate payment obligation vis-à-vis the beneficiary. However, their disadvantage is that the performance of the sales contract is not entirely located in the seller’s country. This implies that if the advising bank refuses to pay, the beneficiary might need to start payment collection proceedings in the country of the buyer.

    Irrevocable and confirmed credits are most favourable to the seller/beneficiary. The conforming bank cannot withdraw from its liability to the beneficiary even if instructed by the buyer to cancel the credit.

    [1]           L/C’s are also called documentary credits or bankers commercial credits.

    [2]           If the details are not correct, the advising bank informs the beneficiary and waits for corrected documents or the beneficiary instructs the advising bank to forward the documents.

    [3]           If documents are not correct, the issuing bank contacts the buyer for authorization to accept documents. If the buyer accepts, the issuing bank pays when promised; if buyer refuses, the issuing bank notifies the advising bank.

    [4]           See Article 4 (fourth paragraph) of the ITC Model Contract for the international commercial sale of goods (standard version), which contains the seller’s confirmation.

    [5]           International Chamber of Commerce (ICC), Uniform Customs and Practice for Documentary Credits, ICC Publication No. 600, Paris, 2006.

    [6]           See Article 4 of the ITC Model Contract for the international commercial sale of goods (standard version and short version), Article 4.3 (option 2) of the ITC Model Contract for the international long-term supply of goods, and Article 5.3 (option 2) of the ITC Model Contract for the international distribution of goods.

    [7]           Commentary on UCP 600 – Article-by-Article analysis by the UCP600 Drafting Group, ICC Publication No. 680, Paris 2007.

    [8]           See UCP600 Article 2 (definition of Credit) and Article 3 (second sentence). See, accordingly, Article 4 of the ITC Model Contract for the international commercial sale of goods (standard version and short version), Article 4.3 (option 2) of the ITC Model Contract for the international long-term supply of goods, and Article 5.3 (option 2) of the ITC Model Contract for the international distribution of goods.