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Applying for a Letter of Credit – In most cases, a person who needs a letter of credit must apply
to a bank with which he has an existing relationship. In all cases, a Letter of Credit Application
must be completed. The application is not an application for credit, but rather a set of instructions
telling the bank what needs to be included in the letter of credit.
If the bank has not already extended a line of credit to the applicant, or if the applicant does not
have sufficient funds on deposit in the bank to cover the face value of the credit, the bank may
refuse to issue the letter.
The Consequences of Not Obtaining a Letter of Credit
When a buyer and seller enter into a contract and the buyer agrees to obtain a letter of credit, the
consequences of failure to do so depend on whether the letter was (1) a condition precedent to the
formation of the contract or (2) a condition for the performance of the contract. In the first case,
there will be no contract and consequently no breach. In the second, because the contract already
exists, the failure to obtain a letter of credit will be a breach that will entitle the injured party to
sue for damages.
Case 12-5: Trans Trust Sprl v. Danubian Trading Co., Ltd.
Facts: Trans Trust (TT) ordered rolled steel sheets from Danubian Trading Co. (DTC). When TT
Issues: (1) Was the requirement to get the letter of credit a condition precedent to the formation of
the contract or a condition of its performance? (2) What is the proper measure of damages?
Holdings: (1) Condition of its performance. (2) Lost profits.
Law: (1) A condition precedent is one that must be fulfilled before there is a contract. A condition
Explanation: (1) The facts showed that TT promised to obtain the letter of credit as a condition
Order: TT must pay DTC its lost profits.
Documentary Formalities – A letter of credit needs to be (1) in writing, (2) signed by the issuer,
and (3) complete and precise. A credit must also clearly indicate if it is irrevocable. Should there
be any doubt, the credit will be interpreted as being revocable. Letters of credit must additionally
indicate clearly when and how they are to be paid. They must name the bank that is authorized to
pay the credit, or to accept bills of exchange drawn in accordance with the letter, or to negotiate
the credit.
Advising and Confirming Letters of Credit – Once a bank issues a letter of credit, it will
commonly deliver the credit to a correspondent bank located in the beneficiary’s county, which
will in turn deliver the credit to the beneficiary. The correspondent, formally known as an
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Financing
advising bank, assumes no liability for paying the letter of credit. Its only obligation is to ensure
that the beneficiary is advised and the credit delivered, and to take “reasonable care to check the
apparent authenticity of the credit.”
An issuing bank may also request another bank to confirm an irrevocable letter of credit. A
confirmation is an independent promise by a confirming bank that it will pay, accept, or negotiate
a credit, as appropriate, when the documents specified in the credit are presented to it and the
other terms and conditions of the credit have been complied with.
A confirming bank is entitled to reimbursement from the issuing bank if the documents it receives
are in order. If they are not, the confirming bank will be left with title to the goods in its own
name, and it will have to assume the risk of liquidating them as best it can. A confirming bank
also assumes the risk that the issuing bank or the account party may be unable to reimburse it.
Again, it would retain title to the goods, so its losses may be partly offset by whatever price it
gets from the sale of the goods.
The Obligations of Banks – An issuing bank, or any bank that pays, accepts, or negotiates a
letter of credit, is obliged to “examine all documents with reasonable care to ascertain that they
appear on their face in accordance with the terms and conditions of the credit.” If a paying,
accepting, or negotiating bank believes the documents are irregular, it is required to pass them
along to the issuing bank for the latter to determine whether it will honor or refuse them. The
issuing bank must do so “on the basis of the documents alone.”
The issuing bank’s obligations only relate to the appearance of the documents. So long as the
documents appear regular on their face, the bank must pay. A bank is not to concern itself with
matters “off the document,” such as the condition of the goods or even their existence.
The Rule of Strict Compliance
In determining whether the documents submitted by the beneficiary are in order, a bank is entitled
to apply the so-called rule of strict compliance. In other words, a bank may reject documents that
do not exactly comply with the terms specified in the letter of credit. Despite all the safeguards,
however, it is still occasionally possible for deceitful persons to create fraudulent documents that
result in big payoffs to the dishonest dealers and sellers.
Amendments
The new UCP 600 rules (2007) issued by the ICC attempt to prevent minor discrepancies from
causing major problems with letters of credit. If there is a major discrepancy or if the seller is
unable to perform as originally agreed, the letter of credit can be amended. Amendments,
however, require the approval of the issuing bank, the confirming bank (if there is one), and the
beneficiary.
Waiver
The new UCP 600 rules provide that if the bank fails to act in a timely fashion or if it fails to
return the documents to the person who presented them, “it is precluded from claiming that the
documents are not in accordance with the terms and conditions of the credit.” In other words,
failure to act is tantamount to an implied waiver.
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Financing
Fraud
If the seller delivered mislabeled goods to a carrier to obtain the documents it needed to collect
against a letter of credit, the issuing bank may nevertheless pay the seller even if it knows of this.
If the underlying transaction was fraudulent and the credit is revocable, the issuing bank may
refuse to pay the seller. If the underlying transaction was fraudulent and the credit is irrevocable,
the issuing bank probably has to pay the seller. There is no firm rule in the UCP.
Case 12-6: Sztejn v. J. Henry Schroeder Banking Corp.
Facts: Transea Traders (TT) contracted to sell hog bristles to Sztejn (S). S then arranged with the
Issue: May a bank be enjoined from paying a letter of credit when one of the required documents,
while regular on its face, was procured by fraud?
Holding: Yes.
Law: “When the issuer of a letter of credit knows that a document, although correct in form, is, in
Explanation: Here the letter of credit required that the bill of lading be made to the order of the
Order: The Bank’s motion to dismiss was denied.
Fraud in the Collection Process
In addition to the buyer, a collecting bank may also perpetrate fraud. If a collecting bank,
knowing that a letter of credit has been altered, attempts to collect from the issuing bank, the
issuing bank does not have to pay.
Rights and Responsibilities of the Account Party – The account party’s rights and obligations
are based on two contracts: the underlying contract with the beneficiary and the contract with the
issuing bank relating to the letter of credit. Ordinary contract law determines the account party’s
rights under the first contract. International practice limits the account party’s rights under the
second contract. The main limitation on an account party’s rights under the contract with the
issuing bank is the doctrine of privity.
Rights and Responsibilities of Beneficiaries – UCP, Article 6, states that: “A beneficiary can in
no case avail himself of the contractual relationships existing between the banks or between the
applicant for credit and the issuing bank.” Before a beneficiary is entitled to collect on a letter of
credit, he must comply with the terms and conditions of the credit and present to the issuer the
documents designated in the credit, which commonly include:
a certificate of origin—to comply with customs requirements;
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Financing
an export license and/or a health inspection certificate—to show that the goods are approved
for export;
a certificate of inspection—to show that all of the goods have been shipped;
a commercial invoice—to identify the shipment;
a bill of lading—to show title to the goods; and
a marine insurance policy.
As soon as a letter of credit is delivered to a beneficiary for advisement, he needs to examine it
carefully to make sure that it reflects the underlying agreement he has with the account party.
Changes can be made by amendment, but they need to be made promptly.
Standby Letters of Credit
To ensure that a seller will perform, a buyer can insist that the seller procure a standby letter of
credit. Standby credits are most commonly used in situations where the seller is delivering a
product that the buyer needs time to evaluate, such as a stand-alone factory or a computer
installation.
Financing Foreign Operations
Multinational enterprises cannot always generate internally all of the funds they need for capital
investment and operating expenses. To expand, to avoid cash flow problems, and for a variety of
other reasons, they have to turn to the world’s capital markets, and to governmental and
intergovernmental investment and development programs.
Private Sources of Capital – Equity funding is generally available from stock exchanges,
although it is not uncommon, especially for smaller firms, to raise funds privately. Debt funding
is available in the multinational enterprise’s home country, in its host countries, and now, more
commonly, in a large number of so-called capital-exporting countries.
Governmental Sources of Capital – Both host and home governments provide capital for
foreign investors.
Host Country Development Banks and Government Agencies
Virtually every country has an established bureaucracy that promotes local investment. Many
have development banks that provide low-interest-rate, long-term loans to foreign investors.
Information about investment opportunities in host countries is available from their embassies
and consulates.
Home Country Import and Export Financing Agencies
Virtually every developed country has a variety of agencies that finance imports and exports. In
the United States, the U.S. Agency for International Development (AID) lends money directly to
foreign governments to finance purchases from American exporters. The U.S. Overseas Private
Investment Corporation (OPIC) provides loans, loan guarantees, and insurance to American firms
to underwrite activities in developing countries. The U.S. Export–Import Bank promotes
international trade by making loans to both American importers and foreign exporters. The U.S.
Commercial Service is the trade promotion arm of the U.S. Department of Commerce’s
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Financing
International Trade Administration. And the U.S. Small Business Administration provides loans to
American Exporters.
Regional and International Development Agencies – The African Development Bank, the
Asian Development Bank, the Central American Bank for Economic Integration, the European
Bank for Reconstruction and Development, the European Investment Bank, and the
Inter-American Development Bank are principle examples of agencies that promote investment
within their regions.
The world’s most important development bank is the International Bank for Reconstruction and
Development (IBRD), commonly called the World Bank. The World Bank and the IDA provide
funds directly to governments. The International Finance Corporation (IFC), on the other hand,
provides funds to private companies.
Countertrade
Not all international trade involves the sale of goods or services for a monetary price. Often what
is exchanged is not money, but goods or services. Such an exchange, when it is made in addition
to, or in place of, a financial settlement is known as a countertrade. Contracting parties agree to
countertrade for a number of reasons. Transactions that fit the definition of a countertrade
include:
Barter: exchange of seller’s goods and services for buyer’s goods and services.
Buyback: buyer uses equipment or technology in order to pay for the equipment or
technology.
Counter purchase: delivery of goods or services to be delivered under one contract in
exchange for a return delivery at a later date of goods or services under a second contract.
Offset: seller of expensive items sold to a government agrees to buy goods from the
government’s country to offset the price.
Production sharing: a buyback arrangement that applies to mining and energy projects, in
which a developer is paid out of a share of a mine or well’s production.
Swap: an exchange of one party’s monetary debt for another party’s non-monetary debt, such
as money owed in exchange for an equity obligation.
Tolling: Supplier employs processor to process raw materials and then supplier sells goods to
a third party to get funds to pay the processor.
A countertrade is agreed to by negotiation and contracting. The United Nations Commission on
International Trade Law’s (UNCITRAL’s) Legal Guide on International Countertrade
Transactions provides detailed guidance for entering into a countertrade contract.
Opponents of countertrade say it is a restraint of free trade that costs jobs in the supplier nation.
II. Chapter Questions
Types of Instruments
1.
a. Certificate of deposit
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Financing
Negotiability Issues
2. Students’ answers may vary. Possible arguments include that this instrument is negotiable since
it meets the promissory requirements of:
3. Students’ answers may vary. This may be carried out in class as an activity where students may
Liability of the Drawer Where the Payee Is Fictitious
4. Students’ answers may vary. The fictitious payee rule says that when the instrument is issued in
Rights of the Holder
5. Students’ answers may vary. A holder in due course is a holder who acquires an instrument (1)
Effect of Alteration of the Instrument
6. The ULB makes a forged endorsement fully effective, and both the person taking an instrument
Fraud in the Execution
7. Students’ answers may vary. A holder in due course is a holder who acquires an instrument (1)
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Financing
Letter-of-Credit Requirements
8. Students’ answers may vary. An issuing bank, or any bank that pays, accepts, or negotiates a
Duty of a Bank Under a Letter of Credit
9. Students’ answers may vary. Since the letter of credit is irrevocable, the bank may not refuse to
10. Students’ answers may vary. Letters of credit are designed to facilitate payment in sales of
11. The UCP states that the obligation to pay on an irrevocable letter of credit “constitutes a
definite undertaking of the issuing bank, provided that the stipulated documents are presented and
III. Key Terms
Account party—The person who requests a bank or some other person to issue a letter of
credit.
Advising bank—A bank engaged by the issuer of a letter of credit to advise the beneficiary
that it has a credit for delivery and to deliver the credit upon verification of the beneficiary’s
signature.
Agency endorsement—An endorsement that requires the endorsee to pay the proceeds from
the negotiation of the instrument to the endorser or a designated third party.
Assignment—The transfer of all or part of an assignor’s contractual rights to an assignee.
Bearer paper—A bill of exchange or promissory note that is payable to the bearer or to cash.
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Financing
Beneficiary—A person who is not a party to a contract who is designated by a party to
receive the benefits of the contract.
Bill of exchange (draft)—A written, dated, and signed three-party instrument containing an
unconditional order by a drawer that directs a drawee to pay a definite sum of money to a
payee on demand or at a specified future date.
Bill of lading—An instrument issued by a warehouseman or carrier to a shipper that serves as
a receipt for goods shipped, as evidence of the contract of carriage, and as a document of title
for the goods.
Bills of Exchange Act (BEA)—English act of 1882 regulating bills of exchange.
Certificate of deposit (CD)—A promissory note on which the maker is a bank.
Check—Bill of exchange on which the drawee is a bank.
Common law holder—A person who acquires an instrument by negotiation.
Common law holder in due course—A holder who acquires a negotiable instrument for value,
in good faith, and without notice that it is overdue, that it has been dishonored, or that persons
required to pay on it have a valid excuse for not doing so.
Conditional endorsement—An endorsement that conditions payment on the occurrence of
some event.
Confirming bank—A bank that makes an independent promise to pay, accept, or negotiate a
letter of credit issued by another bank when the documents named in the credit are delivered
to it.
Countertrade—Any transaction linking exports and imports of goods or services in addition
to, or in place of, a financial settlement.
Debt funding—Loans to a person or company.
Documents against acceptance—Term in a sales contract that provides for the buyer to
deliver payment to a bank for release to the seller after the seller delivers to the bank a receipt
acknowledging that the buyer has accepted the goods.
Documents against payment—Term in a sales contract that provides for the seller to deliver
shipping documents and title to a bank for release to the buyer after the buyer delivers to the
bank a receipt from the seller verifying that the seller has received payment.
Endorsement—The act of a payee, drawee, accommodation party, or holder of a negotiable
instrument in signing the back of the instrument, with or without qualifying words, to transfer
rights in the instrument to another.
Endorsement for collection—An endorsement that makes the endorsee a collection agent for
the endorser.
Endorsement prohibiting further endorsements—An endorsement that states that the
instrument may be paid only to a particular person.
Equity funding—Investments in the capital of a company.
Fictitious payee rule—A person who solicits and obtains a negotiable instrument drawn or
made to a fictitious person may effectively endorse the fictitious person’s signature on the
instrument.
Forgery—The false making or altering of a writing with the intent to defraud.
Fraud—A knowing misrepresentation made with intent of causing another to rely upon it to
the latter’s detriment.
Geneva Conventions on the Unification of the Law Relating to Bills of Exchange (ULB)—
League of Nations–sponsored conventions signed at Geneva in 1930 that regulate negotiable
instruments.
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Imposter rule—A person who pretends to be another so as to have a negotiable instrument
drawn, made, or endorsed to that person may effectively endorse the pretended person’s
signature on the instrument.
Letter of credit—An instrument issued by a bank or another person at the request of an
account party that obliges the issuer to pay to a beneficiary a sum of money within a certain
period of time upon the beneficiary’s presentation of documents specified by the account
party.
Money—A medium of exchange authorized or adopted by a domestic or foreign government;
it includes a monetary unit of account established by an intergovernmental organization or by
agreement between two or more nations.
Negotiation—The transfer of rights in an instrument, either by endorsement and delivery or
merely by delivery, that entitles the holder to sue in his own name and to take the instrument
free of some of the claims that persons obliged to pay on the instrument have against the
transferor.
Order paper—A bill of exchange or promissory note that is payable to a named payee.
Presentment—A production of an instrument to a party liable to pay on it for that party’s
acceptance (i.e., commitment to pay) or payment.
Promissory note—A written, dated, and signed two-party instrument containing an
unconditional promise by a maker to pay a definite sum of money to a payee on demand or at
a specified future date.
Qualified endorsement—An endorsement in which the endorser does not guarantee that an
instrument will be accepted and paid by the drawer or maker.
Restrictive endorsement—An endorsement that restricts the rights of subsequent holders.
Rule of strict compliance—A bank may reject a document submitted by a beneficiary seeking
to obtain payment on a letter of credit when the document does not exactly comply with the
description stated in the credit.
Sight bill—Bill of exchange that is payable at the time it is presented or at a stated time after
presentment.
Signature—From Latin: signare, “to mark.” The name of a person, written by that person, or
any distinctive mark meant to authenticate a writing.
Standby letter of credit—A letter of credit obtained by a buyer naming the seller as a
beneficiary.
Time bill—Bill of exchange that is payable at a definite future time.
Trade acceptance—Bill of exchange on which the drawer and the payee are the same person.
ULB bad faith—Acquiring an instrument knowing that it was not properly negotiated to you.
ULB gross negligence—Acquiring an instrument in such a careless or reckless manner that
one should have known that it was not properly negotiated.
ULB holder—A person who acquires an instrument by negotiation.
Uniform Commercial Code (UCC)—Model U.S. act. Article 3 regulates negotiable
instruments.
Uniform Customs and Practices for Documentary Credit (UCP)—Model rules issued by the
International Chamber of Commerce for regulating letters of credit.
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