What Is the Letter of Credit and Why Is It Significantly Important for International Commerce Transactions and International Commercial Law

A. Introduction

While businesses are making a transaction, both of the seller and the purchaser complete their debt with reliable processes. Especially in international commerce, the letter of credit method is tremendously important for reliable payment. On the contrary, the side of the contractual relationship might not have access to their demands that might have given rise to the relevant transaction. Because we will consider this process and mention the importance of those transactions. In this essay, the stage of this paramount transaction will be explained initially. After that, create a connection between the transaction and the importance of the relevant transaction. Let’s consider to letter of credit.

B. What is a Letter of Credit and how companies can be done this Transaction

Initially, an explanation of the letter of credit method is so important. A letter of credit is a contractual commitment by the foreign buyer’s bank to make a payment initially. The exporter ships the goods and presents the required documentation to the exporter’s bank as proof. [1]Due to the nature of international commercial transactions, a letter of credit payment method is one of the payment methods that is fundamental and necessary. If a letter of credit document’s quality needs to be explained, it is exactly a negotiable instrument. Moreover, the function of a letter of credit should be debated. Two fundamental doctrines are accepted by the international commerce doctrines. The first one is implementing a letter of credit as independent and autonomous from the underlying contract, which is called the “doctrine of autonomy”.[2]Another doctrine that is accepted to explain the function of a letter of credit is “the doctrine of documents and strict conformity”. According to this doctrine, the transaction of a letter of credit is that the bank deals with documents and does not get involved with the performance in terms of the underlying contract. [3] If we consider the reason for making the payment with this method, the reasons are logical. For instance, distance, different legal systems, legal regulations in each country, etc., factors are getting decrease to the level of confusion. Due to the fact that the usage of that method is a significantly important aspect of providing bilateral confusion. The relevant transaction started with a satisfying offer from the importer’s bank to the exporter and the exporter’s bank. Importer and exporter make a sales contract. After that, the importer’s bank drafts the letter of credit, which is sent to the exporter’s bank. The bank must consider those documents. The exporter’s bank examines the letter of credit and sends it to the exporter after approval. In the third stage, the exporter ships the goods as the letter of credit describes. Mandatory documents are submitted to the exporter’s bank, and they review the documents to ensure that the letter of credit terms and conditions were met. If it is approved, the exporter’s bank resends relevant documents to the importer’s bank. And finally, the importer’s bank sends payment to the exporter’s bank. At the end of those stages, the importer sends the goods which are the topic of the sales contract. [4]

C. What Are the Types of Letters of Credit

The letter of credit can be categorized into “revocable”, “irrevocable credit”, “irrevocable confirmed” , and “irrevocable unconfirmed” credit. If the revocable credit is considered, this type of letter of credit is recognized as UCP 500. According to UCP 500, revocable credit is explained with this sentence: ”… may be amended or canceled by the issuing bank at any moment and without prior notice to the beneficiary[5]”. In the implementation, banks give information to the beneficiary of the withdrawal of credit. Desirable from banks, they are not legally obliged to give exclusive notice to the seller[6]. 

Secondly, if the consideration of “irrevocable unconfirmed credit payment method”, UCP articles have to be reviewed. According to UCP 500 Article 2 and 7(a), the issuing bank takes the legal responsibility of paying credit to the beneficiary, and the beneficiary ought to present relevant documents related to the credit. Initially, credit has been communicated with the seller, and any banks that are in the relationship of the letter of credit transaction do not make an amendment or cancellation to the relevant contract following Article 10(a) of UCP.[7]Payment is normally arranged in the vendor’s(buyer’s) country as an advising bank. The advising bank acts as an agent of the issuing bank and does not give an independent undertaking to make a payment for the seller, and finally, this undertaking access to the issuing bank. [8]The risk of this type of transaction is the beneficiary has a better position since the loan cannot be withdrawn or canceled as the extent of revocable credit. Another disadvantage of this payment method is that if the issuing bank rejects the documents, the place of litigation has international quality and jurisdiction, being governed by a foreign country’s codes, which have an extent of the relevant dispute. 

Another type of letter of credit is “confirmed credit”; these are always irrevocable. According to this payment method, the seller also receives an undertaking from the confirmed bank. Furthermore, the seller must present the stipulated documents. The UCP’s approach for confirming the irrevocable credit is the same as Article 2 and Article 8(a). [9]If the seller is a “middleman” that means “if the seller used to credit into the buyer’s country in the extent of this relationship, this letter of credit’s types are “back to back” credits. Another observation of this credit is “transferable credits”. That is a better alternative than “back-to-back credit method” and this method is recognized by UCP Rules in accordance to Article 38(b). Other methods are called “revolving credits” and “red clause credits and green clause credits (anticipatory credits)”. In “revolving credits” method, the relationship is regular between to the seller and buyer and this credit revolved agreed value and time. Initially, payment has been made against documents, and the value of the credit is naturally restored after this transaction. “Red clause credits” were revealed to wool commerce in Australia, New Zealand, and South Africa. [10]If we sum relevant methods, the seller draws the documentary credit in advance to the shipment. The advances are made against the warehouseman’s receipt even though the beneficiary is able to deal goods. [11] “Green clause credits” were revealed to the coffee trade in Zaire and completed this transaction with the same method of “red clause credits” payment type. Only the difference between the two payment methods is that the goods are stored in the name of the bank. [12]

D. The Pros and Cons of the Letter of Credit Payment Method

If the pros and cons are examined, relevant transactions not only have advantages but also a few disadvantages. If we mentioned the advantages of a letter of credit, we exactly said this transaction provides safe growth for businesses worldwide and is highly customizable. Moreover, the seller gets their payment when terms are met, and it exactly acts as a buyer’s credit certificate. It does not have any credit risk for sellers and rapid execution for parties due to providing good credit. Other features that qualities are advantageous are the assurance of payment in contested transactions timely payments, and enhanced cash flow management.

As we mentioned, this payment method not only has advantages but also has a few disadvantages. If we consider those ones, initially, this transaction is really time-consuming and it has high costs. Not only does it have some features, but it is also exposed to fraud risks. One quality of these risks may be currency; this transaction is constrained by time limits, and it has some risk for the issuing bank. [13] 

E. Conclusion

Even though this transaction is frequently used in international commerce, the nature of this commerce is regulated by international commercial law sources. Many businesses prefer this transaction due to the confusion of this transaction because they know their receiving is confused by the banks. But as we mentioned, it has many stages to complete this transaction, and if you side with this relationship or represent someone for this debt relationship, you must review and examine all stages tidily. In contrast, the result of the mistakes damages the side transaction that you make for your side.

[1] https://www.trade.gov/letter-credit#:~:text=A%20Letter%20of%20Credit%20is,protect%20both%20exporters%20and%20importers.

[2] Schulze, W. W. (2009). The UCP 600: New law applicable to documentary letters of credit. South African Mercantile Law Journal, 21(2), 228-248, p.234

[3] SCHULZE, p.239

[4]https://www.investopedia.com/terms/l/letterofcredit.asp

[5] Carr, India; Stone, Peter, International Trade Law, 4th Edition, Routledge-Cavendish, 2010, p.484

[6] CARR/STONE, p.484

[7] CARR/STONE, p.485

[8] CARR/STONE, p.485

[9] Article 2 mentions the confirmation as “ a definite undertaking of confirming bank, moreover, that of the issuing bank, to honor or negotiate a complying presentation”.

[10] Tukan Timber Ltd v. Barclays Bank plc(1987).

[11] CARR/STONE, p.491

[12] CARR/STONE, p.491

[13]https://www.theknowledgeacademy.com/blog/advantages-and-disadvantages-of-letter-of-credit/