- Is Your Letter of Credit "Letter Perfect?"
- April 30, 2003 | Author: Charles V. McPhillips
- Law Firm: Kaufman & Canoles A Professional Corporation - Norfolk Office
Our clients continue to express interest in letter-of-credit transactions. Exporters who have been burned selling to overseas customers on open account often seek to protect themselves from further financial injury by requiring their new customers from abroad to open letters of credit for the seller's benefit. Importers confront demands from their foreign suppliers that they furnish a letter of credit, which may entail fees to the importer's bank (the issuing bank) of 25 or 50 basis points as well as tying up the importer's working capital: i.e., the issuing bank needs available cash from which to reimburse itself for payments made on the letter of credit.
With sellers carefully managing their accounts receivable to minimize risk of non-collection from foreign customers, the documentary letter of credit will continue (and perhaps expand) its role as the preferred means of settling payments on the international sale of products.
A letter of credit supplements the buyer's credit with an independent obligation incurred by a bank to pay the seller upon the presentation of stipulated documents. The three fundamental features of a letter of credit are as follows:
Independent Obligation. Regardless of the underlying sales agreement between the seller and the buyer, the issuing bank (and occasionally a "confirming" bank) accepts an independent contractual obligation to the seller, as beneficiary under the letter of credit. The bank obligates itself to pay the beneficiary as long as the documentary criteria established in the letter of credit itself are satisfied: whether the seller has in fact complied with its contractual obligations to the buyer is technically irrelevant.
Document-Only Transaction. The paying bank has no obligation (or right) to look behind the documents presented by the seller. Indeed, the bank will disregard any non-documentary requirements mentioned in the credit: e.g., a provision that the seller advise the buyer when shipping or insurance arrangements have been made. The bottom line is that the bank must honor a seller's demand for payment under a letter of credit whenever the documents presented comply with the requirements of the letter of credit, regardless of whether the products delivered to the buyer conform to the underlying sales contract.
Strict Construction. The seller's responsibility is to present documents that appear on their face to satisfy the terms and conditions of the letter of credit. Likewise, the bank is duty-bound to refuse payment on the letter of credit if there are discrepancies between the documents presented by the seller and the requirements stated in the letter of credit.
The seller should not relax simply because a bank in the buyer's home country has issued a letter of credit. Several years ago, many Russian banks routinely defaulted on their letter of credit obligations. With the current financial crises in Argentina, a U.S. exporter might want to do his homework on the creditworthiness of an issuing bank located in that financially strapped nation. With a reported 60% of loans classified as "non-performing" in China, one wonders how strong letters of credit issued by some Chinese banks may turn out to be. And even in affluent countries such as Japan, we have seen the failure of some well-known banks in recent years, undermining confidence, just a tad, even in Japanese letters of credit. Consequently, perhaps the most important task for a seller is a credit analysis of the bank issuing the letter of credit.
Confirmed vs. Advised. Sometimes for fear of a foreign bank's creditworthiness, and sometimes out of a simple lack of familiarity with the issuing bank, a seller will desire a "confirmed" letter of credit, meaning that a bank in the exporter's home country engages to honor the credit issued by the buyer's bank. Directly liable for payment to the seller/beneficiary, the confirming bank relies upon payment or reimbursement from the issuing bank. The downside of a confirmed letter of credit is that confirmation adds an additional layer of bank charges to the transaction, but a U.S. exporter company receiving a letter of credit confirmed by a strong U.S. bank should feel much more secure of payment.
However, many sellers seem ready to accept letters of credit that are merely "advised" by a U.S. bank. An advising bank does not obligate itself to pay under the letter of credit if the issuing bank in the buyer's home country fails to do so. An advising bank merely notifies the seller that the letter of credit has been opened and generally undertakes to receive the seller's documents and to forward them to the issuing bank for payment.
Customary Documents. Whether a letter of credit is advised or confirmed, the seller will typically need to present certain standard documents, including a commercial invoice, a bill of lading and, where the seller is responsible for obtaining transport insurance, an appropriate certificate of insurance. U.S. exporters should refuse to ship under letters of credit that require something called a "certificate of origin" issued by the Chamber of Commerce, which may be a document that a seller can obtain in, say, Turkey, but which is not a document that the Hampton Roads Chamber of Commerce or the Virginia Peninsula Chamber of Commerce has even heard of, much less provides to exporters. Also, customers in some Arab nations participating in the boycott of Israel might insert boycott-related stipulations which violate U.S. law; U.S. exporters should refuse to ship products under such illegal letters of credit.
Sight vs. Time Draft. Another crucial issue negotiated by the seller and buyer is whether the bank will pay against the seller's sight draft or time draft. (A draft is a simple document, much like a check, by which the seller draws payment against the letter of credit.) If the letter of credit provides for payment against the seller's draft "at sight", then the paying bank will disburse the proceeds to the seller/beneficiary promptly after examining the documents and finding them in conformity with the letter of credit. If, however, the letter of credit stipulates that payment will be made by a certain number of days after presentation of the seller's draft (e.g., 30 or 45 days "after draft"), then the seller has effectively given the buyer deferred payment terms.
Irrevocable. Once upon a time, it was crucial for the seller to obtain a letter of credit that was explicitly "irrevocable"; otherwise, the seller confronted the risk that the buyer would revoke the letter of credit at some point prior to the seller receiving payment. Under the newest version of the Uniform Customs and Practices for Documentary Letters of Credit (UCP), published by the International Chamber of Commerce, a letter of credit is irrevocable unless otherwise stated. Almost all letters of credit invoke the consensual rules established in the UCP.
Time Requirements. After evaluating the creditworthiness of the issuing or confirming bank, and determining whether it can provide the documents stipulated under the letter of credit, the seller should make sure that it can meet the various deadlines which apply to the letter-of-credit transaction. For example, each credit stipulates an expiration date by which all required documents must be presented to the bank for acceptance.The credit will also usually state the latest date by which the products may be shipped. Further, unless otherwise permitted in the credit itself, the bank will not accept documents presented more than 21 days after the actual date of shipment.
As a crucial timing matter, the UCP provides that the issuing or confirming bank, as the case may be, must give notice of its refusal to accept the seller's documents -- based on specified discrepancies -- within a reasonable period of time not to exceed seven banking days following the date of presentation. Consequently, it behooves the seller/beneficiary to present the necessary documents well in advance of the expiration date so that any flaws in the documents can be corrected in sufficient time.
Finally, unless the letter of credit states otherwise, if the seller is to supply the products in installments on various dates, the failure to present documents indicating timely shipment on any installment will prevent payment on all subsequent installments as well, whether those are timely or not.
The above comments are offered from the perspective of a seller or exporter. On some issues, the perspective of an importer opening the letter of credit would be dramatically different.
For example, the buyer/importer might want to stipulate that payment will be made against the seller's time draft, effectively saving the buyer an interest expense should its reimbursement of the issuing bank be funded out of the buyer's working capital line of credit. Also, in light of the documentary nature of a letter-of-credit transaction, a buyer concerned about the seller's reliability might require an inspection certificate, to be issued by a trusted third party, as one of the mandatory documents that the seller must present in order to get paid.
As yet another example, an importer might want the letter of credit to stipulate that transshipments are prohibited, since the risk of theft or loss of the products increases when they are handled in an intermediate port, especially in certain places notorious for corruption and similar mischief. Finally, a buyer who is compelled to issue a letter of credit in order to obtain necessary supplies will certainly want the underlying sales agreement with the seller to contain appropriate warranty and dispute-resolution provisions, giving the importer adequate recourse against a seller that delivers defective products. Under a letter of credit, a seller will be paid when its documents are defect-free, even if its products are defect-laden. The importer should at least have effective legal recourse against the seller to redress such an unfair result.