A letter of credit ( LC ) is a payment mechanism that is used in international trade to provide a financial guarantee from a reliable bank to the exporters of goods. A letter of credit is issued by a reputable bank to ensure that sellers of goods receive their money, and buyers receive the purchased goods.
In international trade, when the contracting party can’t be easily trusted, letters of credit are generally used.
A letter of credit is especially useful in cases where the buyer and seller don’t know each other personally and geographical distance, different laws of each country and different customs regulations separate them from each other.
A letter of credit (LC) is the main way to reduce risk and danger in international trade, Imagine that you are a seller of goods in China and you want to send goods to an Iranian company in the UAE, how do you make sure that when the goods are exported, the contract amount be paid to you? Now imagine that you are an Iranian buyer and the opposite party is a Chinese exporter, how do you ease your mind about the goods being exported after paying the amount?
In this scenario, letter of credit comes to the aid of both parties.
The Iranian buyer goes to an intermediary bank and requests the issuance of a letter of credit, provides an amount or a guarantee to the bank and asks the bank not to pay the Chinese seller until he has delivered the goods to the ship and until he has provided the shipping documents or insurance documents to the bank.
The bank directly informs the seller that such a request has been registered, the seller, relying on the credit of such a bank, sends the goods, submits the shipping documents and the requested documents to the bank and receives the amount of contract.
A letter of credits can only be transferred to another beneficiary if they are expressly “transferable”. The bank is not obliged to transfer credit. If the letter of credit allows for partial delivery, it can be transferred to more than one alternate beneficiary. The terms and conditions of the original credit must be exactly duplicated in the transferred credit. However, to maintain the efficiency of transferable letters of credit, some figures can be reduced, including:
- Product unit price (if mentioned)
- Expiration date
- Presentation period
- Last date of shipment or specified duration for shipment.
- operational function
Usually after negotiating the sales contract and the agreement between the buyer and the seller regarding the use of a letter of credit as a payment method, the applicant contacts the bank to request the issuance of a letter of credit.
After the issuing bank’s investigations regarding the buyer’s credit risk – that is, the evaluation of the applicant’s ability based on the ability or inability to pay for the goods – the bank issues a letter of credit, which means that if the seller presents certain documents, promise of pyment will be fulfilled.
After receiving the letter of credit, the beneficiary (seller) checks the conditions to ensure that it complies with the contract, and after that, either sends the goods or submits a request to amend the letter of credit to comply with the contract. .
The letter of credit agreement is limited in terms of time, validity of the credit, the date of the last load and how much delay may occur in presenting the documents to the introduced bank after sending.
After sending the goods, the beneficiary submits the requested documents to the nominated bank. The relevant bank also checks the documents and if the terms of the letter of credit valid, it is obliged to meet the terms of the letter of credit by paying the beneficiary.
If the documents do not comply with the terms of the letter of credit, they are considered “Discrepant”. At this stage, the nominated bank informs the beneficiary of this discrepancy and, depending on the conditions, offers options after the applicant’s satisfaction.
If the discrepancies are minor, it may be possible to provide the bank with amended documents to bring the presentation into compliance.
There may also be a possibility that the execution of the letter of credit will be directly distrupted by the legal actions of the two parties, and as a result, the rights and obligations of the parties in the letter of credit and its implementation will be stopped by the government, which is beyond the control of the parties.
On the other hand, the performance of a contract – including the obligations of a letter of credit agreement – can be interrupted by external factors such as natural disasters or armed conflicts, these risks are often considered collateral risks.
Many risks can be faced by the applicant. These cases may include not delivering the goods on time, incomplete shipment or low quality of the products, which may cause damage to the goods and delay in sending them.
In such cases, the applicant should not expect payment from the bank.
The issuing bank may also suffer losses, such as being exposed to the risk of bankruptcy of the applicant, it means that the applicant becomes bankrupt before he can pay the letter of credit.
There is also a possibility that the bank will be at risk of fraud by the seller because it is possible that the seller will provide false or fake documents and receive the credit amount.
The beneficiary may also be at risk of not complying with credit conditions or failure or delay on payment by the issuing bank.
It is very important that the beneficiary is not exposed to the risk of set-off with the applicant in case of damages to or poor quality of the goods.
Because although the applicant may later sue the bank, the issuing bank cannot reduce its payment to the beneficiary (seller) to match the damage, and must pay the full amount in any case.
Issuance, transfer, refund and other costs are paid either by the applicant or according to the terms and conditions of the letter of credit. If the LC doesn’t specify the payer of the fees, the applicant will be the payer.
Uniform Customes and Practice for Documantry Credits
Uniform Regulations for Letters of Credit (UCP 600) is a set of regulations approved by the International Chamber of Commerce for financial institutions issuing letters of credit. These regulations are applied to help companies in creating financial documents related to financing business expenses.
Many banks and lenders are subject to these regulations with the aim of standardizing international trade, reducing the risks of trade in goods and services, and governing trade.
Uniform Letter of Credit Regulations or UCP 600 has been published and issued by the International Chamber of Commerce. These regulations are a set of 39 articles on the issuance and use of letters of credit that apply in 175 countries and cover approximately $1 trillion in trade annually.
What is the purpose of UCP 600?
UCP 600 replaced UCP 500 on July 1, 2007. These regulations were created to standardize a set of rules for the benefit of all parties in commercial financial transactions and relationships.
Is UCP 600 legally binding?
The rules of UCP 600 are voluntarily incorporated into contracts and must be specifically stipulated in financial and commercial contracts to govern the contract.
Along with UCP 600, the International Banking Standardization Procedure for the Examination of Documents Under Documentary Credit (ISBP) has been published by the International Chamber of Commerce.
This procedure helps determine whether a document comport with the terms of a letter of credit.
Credits issued and governed by UCP 600 are interpreted in accordance with the entire set of 39 articles contained in UCP 600.
However, exceptions can be made to these rules by expressly modifying or omitting them.
If you are active in the field of international trade or are facing legal problems related to letters of credit, you can benefit from the legal services of Karimi & Associates Law Firm and its expert consultants through the link to contact us.