Letters of credit (L/C)

Why choose documentary collection? Documentary collection is useful if the parties fail to agree on payment in the country of the seller, but the buyer needs the documents to clear customs or prove ownership of the goods in its own country (or vis-à-vis its own customers). In most cross-border transactions, the goods must be transported, transport should often be insured, and frequently the goods have to be exported and imported (i.e. cleared for customs). The related actions are reflected or evidenced in various documents.[1] Possessing those documents (e.g. a negotiable bill of lading) implies a great level of control over the corresponding goods.

Risks involved. The seller usually ships the goods before receiving payment and therefore bears the risk that the buyer will not accept the goods, will not take delivery, or will refuse to pay. Moreover, if the goods are defined as delivered at the premises of the buyer, as is often the case in air, truck and rail shipment, the buyer simply obtains possession of the goods. Finally, the seller also bears the risk of the buyer’s insolvency. In an opposite scenario with a ‘strong seller’, the buyer must pay a demand draft or accept a draft before the goods are delivered (or are even available for inspection). The buyer may examine the documents before the payment, but nevertheless bears the risk of delivery of damaged or non-conforming goods. This risk can be diminished if the seller also provides inspection and insurance certificates. Involving banks to interchange documents against payment facilitates the transaction. Especially if the seller is generally reliable (e.g. the seller has a good reputation and standing) and if the seller is not particularly concerned about the buyer’s failure to take delivery (e.g. the goods may alternatively be sold to a third party), documentary collection is an appropriate payment arrangement.

Types of collection. The most common types of documentary collection are:

• documents against payment (D/P), also called cash against documents (C/D)) – a type of documentary collection whereby the presenting bank will deliver the documents only upon receipt of the agreed price; and
• documents against acceptance (D/A) – a type of documentary collection whereby the presenting bank will deliver the documents only upon acceptance of the bill of exchange by the buyer.

Terminology. If the parties have stipulated documents against acceptance, the presenting bank demands payment by presenting a “bill of exchange” (also called a “draft”). The bill of exchange, often a cheque, is a written demand for payment of a specified amount addressed to the “drawee”. Payment may be demanded upon presentation (i.e. “at sight”) or on a certain specified maturity date such as a number of days after sight (e.g. “30 days after sight”), or a number of days after another date (e.g. “30 days after the bill of lading date”). Such deferred payment is in fact a credit from the seller to the buyer. Typically, a bill of exchange specifies a party to be paid (the “payee”). Nevertheless, most bills of exchange are also “negotiable”. This means that the payee’s right to payment may be transferred to another party.

Regulatory framework: URC 522. The most authoritative legal framework for documentary collection is the Uniform Rules for Collections published by the International Chamber of Commerce (URC 522).[2] URC 522 applies only if this is stated in the collection instruction. Also, the parties must stipulate in the sales agreement that “the payment by documentary collection is subject to the Uniform Rules for Collections”.[3]

Collection Instruction. In connection with the documents sent for collection, the seller must provide a “collection instruction”. The collection instruction must indicate that the collection is subject to URC 522 and give complete and precise instructions. Collecting banks will only act according to the collection instruction. A bank will not look elsewhere for instructions and is not obliged to examine documents for instructions. Therefore, a seller (or a remitting bank, i.e. the seller’s own bank responsible for communications with the presenting bank) must ensure that all necessary information and instructions are provided in the collection instruction. Usually, a bank would ask its customer to use a specific form.

The collection instruction should:[4]

• state the amount and currency to be collected;
• enclose the list of accompanying documents;
• state the terms and conditions upon which the payment or acceptance is to be obtained;
• specify the terms of the delivery of the documents (D/P, D/A or other terms or conditions);
• stipulate the method of payment and instructions in case of non-payment, non-acceptance or non-compliance with other instructions.

The collection instruction may specify aspects of protest (or objection rights) in the event of non-payment or non-acceptance.[5] If it does not, the bank will have no obligation to allow the buyer to refuse payment or acceptance. Finally, the parties may consider including instructions in the collection instruction in the event that the documents are not taken by the buyer. Do the goods then need to be transported to a warehouse and insured?

[1]           See the ITC Model Contract for the international commercial sale of goods (standard version) Article 4.3, requiring a specification of the documents-to-be-presented in Article 5 (Documents). See also the ITC Model Contract for the international commercial sale of goods (short version) Articles 4 and 5, the ITC Model Contract for the international long-term supply of goods Article 4.3 (option 2), and the ITC Model Contract for international distribution of goods Article 5.3 (option 2).
[2]           ICC Publication No. 522.
[3]           URC 522 Article 4(a)(i).
[4]           URC 522 Article 4(b).
[5]           URC 522 Article 24.

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. 1. 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 bank 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.

Standby v. L/C: A standby differs from the ordinary L/C: the L/C is a payment instrument, which normally obliges the beneficiary to provide transport documents; the standby is intended to protect the beneficiary in the event of non-performance by its counterparty in the underlying contract. The standby obligation may be triggered by a document of any description (such as a mere statement that the counterparty is in default), not necessarily the presentation of any ‘official’ documents referred to in the previous section.) Standby practice originated in the United States to circumvent rules that prevent a bank from giving guarantees.

Practical use. Standbys are commonly named descriptively. For example a:

• Performance standby supports an obligation to perform other than to pay money, including for the purpose of covering losses arising from partial or non-performance of the applicant in the underlying contract;
• Advance payment standby supports an obligation to make an advance payment;
• Bid bond or tender bond standby supports an obligation to negotiate and enter into a contract if the applicant is awarded a bid;
• Financial standby supports an obligation to pay money (or repay under a loan);
• Counter standby supports the issuance of a separate standby by the beneficiary of the countered standby;
• Direct pay standby supports payment when due of an underlying payment obligation;
• Insurance standby supports an insurance or reinsurance obligation of the applicant;
• Commercial standby supports the obligations of an applicant to pay for goods or services in the event of non-payment by ordinary payment methods.

Regulatory framework: ISP98. Standby practice triggers many questions. ISP 98 (International Standby Practices)[1] provides a clear and authoritative framework for addressing them. ISP 98 has become the industry standard for the use of standbys in international transactions. For it to apply, however, the contract must express that the standby is subject to the ICC’s International Standby Practices (or, in short, ISP98).

ISP98 vs. UCP600. UCP600 reinforced the independence and documentary character of the standby. It provides standards for examination and ‘notice of dishonour’ and an authoritative basis to resist pressures to issue a standby without expiration date. In many cases, however, UCP600 is not appropriate for standbys. Even simple standbys may pose problems not addressed by UCP600. More complex standbys – those involving longer terms or automatic extensions, transfer on demand, requests that the beneficiary issue its own undertaking to another, and the like – require more specialized rules of practice. ISP98 fills these needs.

ISP98 receives acceptance not only from bankers and merchants (as does UCP600), but also from a broader range of businesses (e.g. project managers, corporate treasurers, rating agencies, government agencies). Because standbys are often intended to be available in the event of disputes or applicant insolvency, their texts are subject to a degree of scrutiny not encountered in the context of (the typical UCP600-governed) L/C’s. There are basic similarities between ISP98 and UCP600 because standby and commercial practices are fundamentally the same. Nevertheless, ISP98 is more precise, expressly stating the intent implied in the UCP600 rule. Like UCP600 (and demand guarantees), ISP98 will apply to any independent undertaking issued subject to it.

U.N. Convention. ISP98 has been developed as a complement to the United Nations Convention on Independent Guarantees and Standby Letters of Credit[2] The Convention facilitates the use of independent guarantees and standby letters of credit and reflects their basic principles.

[1]           Initially developed by the Institute of International Banking Law and Practice and adopted by the ICC (ICC Publication No. 590, 1998 Edition). ISP 98 came into effect on 1 January 1999.
[2]           General Assembly 11 December 1995, entered into force on 1 January 2000. Eight countries have ratified the Convention: Belarus, Ecuador, El Salvador, Gabon, Kuwait, Liberia, Panama and Tunisia. The text of the Convention is available at: http://www.uncitral.org/uncitral/en/uncitral_texts/payments/1995Convention_guarantees_credit.html.

URDG: demand guarantees (aka bank guarantees)

General. An adequate alternative to a ‘confirmed L/C’ is a bank guarantee.[1] A guarantee provides a higher level of certainty as regards the other party’s performance. It can be procured by both parties. If a buyer procures the bank guarantee, its aim is to secure the payment of the contract price (that would normally be paid by the buyer itself). If a supplier procures the bank guarantee, its aim is to secure repayment of any paid contract price, or of any damages caused by non-conformity or delayed performance.

Usage. Guarantees are used in various types of risky, often complex transactions. Such transactions include:

• in a sale of goods transaction, payment upon a seller’s default (e.g. non-conformity or delayed delivery);
• in a service contract or construction contract, security for due performance; or
• in joint venture agreements, underwriting the liability of the partners by their respective parent companies.

Terminology. A demand guarantee (when issued by a bank, a “bank guarantee”) is also referred to as a “first demand guarantee”, an “independent guarantee” or an “abstract guarantee”. These are all designations of the same concept, emphasising the essential characteristic of a guarantee: a separate undertaking by the guarantor to answer for the duty of another, should the other default. The trigger for a (demand) guarantee is contractual non-performance (or poor or delayed performance). To what extent the breach of contract must be proven vis-à-vis the guarantor is a matter of negotiation: a less abstract guarantee that requires a more comprehensive inquiry into the validity of the documents submitted by the beneficiary, or into compliance with the underlying contract, is sometimes also called an “accessory guarantee”.

First pay then talk. A bank guarantee ensures that the harmed customer must start court proceedings to recover damages (it cannot withhold payment). The effect of a bank guarantee is “first pay then talk”. If the customer procures the bank guarantee, the effect of calling under the bank guarantee is that the contract price is paid by operation of the bank guarantee. If the supplier procures the bank guarantee, any damages suffered by the customer are compensated by operation of the bank guarantee. When there is discussion whether or not a claim under the bank guarantee is justified, such discussion would take place after payment under the bank guarantee. Accordingly, a bank guarantee diminishes the risks that either party would otherwise assume.

Abstract (or independent) character. Normally, a guarantee is an ‘absolute’ (‘primary and independent’) undertaking by a bank – the guarantor – to pay if the conditions of the guarantee are satisfied. The issuing bank is not concerned as to whether there has been any actual default by the applicant. Obviously, a bank issuing a guarantee will require that the applicant (or a third party, such as an affiliated or parent company) “counter-guarantee” due performance vis-à-vis the bank.

The conditions of a guarantee are stipulated in a separate agreement with the guarantor, which is called “the guarantee”. The applicant should ascertain that the underlying contract and the guarantee match: the underlying contract should not require a guarantee that is hardly obtainable (or excessively expensive); and the guarantee should not require documents or evidence that will never exist in the framework of the underlying contract. If any documents or evidence must be submitted to the guarantor, the guarantor will examine the required documents and evidence “on their face”, i.e. by interpreting the context of the presented document, the guarantee and the applicable rules. If they reasonably appear to meet the requirements, the bank (or guarantor) will pay.

If the guarantee does not require any document or evidence, a mere statement that there is a breach of contract is sufficient for the guaranteeing bank to pay. The guarantee may expressly stipulate that no such statement is required at all.[2]

Bank guarantees vs. L/C’s. In practice, demand guarantees, performance guarantees, performance bonds and standby L/C’s have a similar legal character and resemble documentary credits: they are ‘primary’ (independent or abstract) and typically conditional only upon a written demand for payment, accompanied by any stipulated documents or evidence. The principle of autonomy of the bank´s undertaking and the doctrine of strict compliance apply to bank guarantees just as they do to L/C’s. Moreover, the fraud exception may be invoked in respect of a guarantee.

Regulatory framework: URDG. The international standard practice for use of demand guarantees is reflected in the Uniform Rules for Demand Guarantees published by the ICC (URDG; current version URDG 758).[3] URDG 758 applies to any demand guarantee or counter-guarantee (whatever name is given to it), provided that this is expressly indicated in the provisions of the guarantee (and the counter-guarantee). A guarantee is irrevocable even if it does not state that this is so.

[1]           See the ITC Model Contract for the international commercial sale of goods (standard and short versions), Article 4.3; the ITC Model Contract for the international long-term supply of goods, Article 4.3; and the ITC Model Contract for the international distribution of goods, Article 5.3.
[2]           URDG Article 15(a) and (c).
[3]           URDG 758 is a complete revision of URDG 458, and effective as of 1 July 2010.

Payment in advance and milestone payments

A seller may be able to negotiate that the purchase price of the goods be paid in advance. The reasons for payment in advance are obvious: the seller requires a way of funding its deliverables, or it desires a high level of certainty that it will be paid by the buyer. Conversely, in such cases, the buyer carries the risk of a possible non-conformity or non-delivery of the goods and the risk of the seller’s insolvency.

Contract milestone payments. A common alternative in international trade practice is that the parties agree on milestone payments. This is particularly common in services agreements (e.g. for product development work or for the construction of a building or infrastructure). The amount of each milestone payment may vary, as well. For example, it is appropriate to agree on:

1. a prepayment of forty percent of the contract price after signing the contract, allowing the supplier to purchase raw materials or components and to pay the salaries of its employees;
2. a payment of another forty percent upon delivery (or the delivery of a first batch); and
3. payment of the remaining ten percent after correction of any initial defects and unconditional acceptance.

Combination of arrangements. The payment arrangements mentioned above can of course be combined with any other payment arrangement for the payment of a remaining part of the purchase price, such as documentary credit or documentary collection.