Introduction
In the international trade, a Letter of Credit (LC) plays an important role as a financial instrument in order to ensure the payment between importers and exporters, considering the complexity of cross-border transactions due to fraud, and legal, political, and commercial risks. The Bank Letter of Credit has provided a structured, reliable alternative. In this article, a critical examination will be carried out regarding the letter of credit process, its legal underpinnings, types, and limitations, along with making a comparison with alternative instruments like Bank Guarantee.
What is a letter of credit?
A letter of credit, specifically a documentary credit letter of credit, is basically a written undertaking by a bank (issuing bank) on behalf of a buyer in which a guarantee for the payment is provided to a seller when he will present specific documents in compliance to the terms of the LC. A letter of credit is regulated by the Uniform Customs and Practices for Documentary Credit, (UCP) 600, that is issued by the International Chamber of Commerce (ICC), under which a letter of credit has provided a structured rule-based mechanism to ensure the payment in international transactions. According to the Article 2 of UCP 600, “an LC is a definite undertaking to honour a complying presentation”. In this way, it is differentiated from open account or cash in advance system, where an important role is played by the trust as compared to the legal enforcement.
Kinds of letter of credit
- Revocable vs. Irrevocable: The irrevocable letter of credit is the norm under UCP 600, meaning it cannot be modified or canceled without all parties’ consent.
- Confirmed vs. Unconfirmed: A confirmed LC adds the assurance of a second bank, often in the exporter’s country.
- Sight vs. Usance LC: Payment is immediate upon presentation in a sight LC, while usance allows deferred payment.
- Standby Letter of Credit (SBLC): Functions like a guarantee and is used when the applicant defaults. It is often used in the U.S. and regulated under ISP98 (International Standby Practices).
- Transferable and Back-to-Back LCs: Useful in intermediary trading or re-exporting situations.
Each of these play different roles based on transaction structure, counterparty trust, and political/economic risk exposure.
Legal framework and case law
The UCP 600 is not a law, but it is evidences that it is widely incorporated into contracts, and also the courts have recognized it all over the globe. Jurisdictions such as UK and US have also respected the autonomy principle, which means that LC is separate from the underlying sales contract. A relevant precedent that can be referred here is United City Merchants (Investments) Ltd. V. Royal Bank of Canada. (1982) 2 W.L.R. 1039, in which the focus of the court was on the autonomy principle, and the bank was made liable to pay upon compliant documents, irrespective of the disputes in the underlying contract. By this protection, the courts are secured from buyers in an insolvency or political interference. However, there are also exceptions. In Themehelp Ltd v West and Other [1996] Q.B. 84, it was adjudicated by the English court that fraud is a valid exception, due to which the banks are allowed to refuse payment when the documents were knowingly falsified.
The letter of credit process
The typical letter of credit process involves:
- Buyer and seller agree on terms with LC as the payment method.
- Buyer requests issuing bank to open LC in favor of seller.
- Advising bank (usually in seller’s country) notifies seller.
- Seller ships goods and presents documents (bill of lading, invoice, inspection certificate, etc.).
- Bank verifies documents and releases payment.
Advantages of letter of credit
- Risk Mitigation: Protects sellers from buyer default and buyers from non-performance.
- Global Acceptability: Recognized and regulated internationally.
- Financing Tool: Enables exporters to obtain pre-shipment or post-shipment finance.
- Autonomy: Legal independence from the underlying contract increases predictability.
Challenges and critical analysis
Despite its advantages, there are a number of limitations of the LC system. First of all, due to the rigid documentary requirements, the delays are observed in the transactions and discrepancies may lead to rejection, even when goods are issued in a correct manner. Secondly, they involve high banking charges, which may not be applicable for small enterprises. Thirdly, the exception of fraud is legally valid, but it is difficult to prove and enforce in the courts. Lastly, there is a confusion between commercial LCs and other related financial instruments like the proof of universa credit letters (related to welfare benefits in the UK), shedding light on the need of a clearer financial literacy. The critics have highlighted that banks focus only on documents, not on goods and services. It may lead to unjust enrichment if the payment is given to the seller despite the delivery of defective or incorrect goods.
Letter of credit versus bank guarantee
LC is a payment mechanism, while Bank Guarantee is basically a risk mitigation tool, where payment is made only in case of the default of a party. The comparison between LCS and Bank Guarantee has revealed that LCS are proactive, which can ensure the payment, while Guarantees are reactive, that can pay in case of the breach. The choice is dependent on the context of transaction, as LCS are preferred in trade, while Guarantees are given preference in construction and service contracts.
Conclusion
In conclusion, Letter of Credit with its efficient framework and global recognition is a cornerstone of the secure international trade. However, the complexity is increasing in global commerce due to the need to modernize and simplify the operations of LC without making any compromise on legal integrity. It is mandatory for stakeholders to create a balance between the reliability of this tool and the associated costs and administrative burden. The future is based on the digitization of the reliability that LC has holistically provided.
