INTERNATIONAL TRADE LAW

Tutorial
Topic- “ International Trade and Letters of Credit”

Submitted to
DR. AZMAT ALI

ASSISTANT PROFESSOR, AMUMC

Submitted by
KUNJALI SINGH

GK7931, 18BALLB34
 Department of law 03
Introduction
Introduction 03

Understanding letter of Credit 04

Features and Characteristics of Letter of 04

Credit

The Advantages of Letter of Credit 06

Principles Governing Letter of Credit 08

The Letter of Credit Process 08

Format of Letter of Credit 10

Parties of Letter of Credit 12

Types of Letter of Credit 13

Difference between Bank Guarantee and 13

letter of credit

Conclusion 14
 INTRODUCTION

One of the most important considerations when it comes to international trade is how you are
going to get paid for your exports. While relying on cash up front may eliminate the risk of non-
payment, it limits your universe of potential customers as it can cause cash flow and other
problems for buyers.There are five primary methods of payment in international trade that range
from most to least secure: cash in advance, letter of credit, documentary collection or draft, open
account and consignment. This Tutorial focuses on letter of Credit.

A letter of credit, also referred to as a documentary credit, is a contractual agreement whereby the
issuing bank (importer's bank), acting on behalf of the customer (the importer or buyer), promises
to make payment to the beneficiary or exporter against the receipt of complying stipulated
documents. The issuing bank will typically use intermediary banks to facilitate the transaction and
make payment to the exporter.

UNDERSTANDING A LETTER OF CREDIT

The LC is a separate contract from the sales contract on which it is based; therefore, banks are not
concerned with the quality of the underlying goods or whether each party fulfills the terms of the
sales contract.

The bank's obligation to pay is solely conditioned upon the seller's compliance with the terms and
conditions of the LC. In LC transactions, banks deal in documents only, not goods.

LCs can be arranged easily for one-time transactions between the exporter and importer, or used
for an ongoing series of transactions.

A letter of credit may be irrevocable, which means that it cannot change unless both parties agree;
or, it can be revocable, in which case either party may unilaterally make changes. Unless the
conditions of the LC state otherwise, it is always irrevocable, which means the document may not
be changed or canceled unless the importer, banks and exporter agree. A revocable LC is
inadvisable, as it carries many risks for the exporter.
 FFEATURES AND CHARACTERSTICS OF LETTER OF
CREDIT

Negotiability

A letter of credit is a transactional deal, under which the terms can be modified/changed at the
parties assent. In order to be negotiable, a letter of credit should include an unconditional promise
of payment upon demand or at a particular point in time.

Revocability

A letter of credit can be revocable or irrevocable. Since a revocable letter of credit cannot be
confirmed, the duty to pay can be revoked at any point of time. In an irrevocable letter of credit,
all the parties hold power, it cannot be changed/modified without the agreed consent of all the
people.

Transfer and Assignment

A letter of credit can be transferred, also the beneficiary has the right to transfer/assign the LC.
The LC will remain effective no matter how many times the beneficiary assigns/transfers the LC.

Sight & Time Drafts

The beneficiary will only receive the payment upon maturity of letter of credit from the issuing
bank when he presents all the drafts & the necessary documents.

THE ADVANTAGES OF LETTER OF CREDIT

LCs are one of the most versatile and secure instruments available to international traders. Since
LCs are credit instruments, the importer’s credit with their bank is used to obtain an LC. The
importer pays the bank a fee to render this service. An LC is useful when reliable credit information
about a foreign buyer is difficult to obtain or if the foreign buyer’s credit is unacceptable, but the
exporter is satisfied with the creditworthiness of the importer’s bank.

This method also protects the importer because the documents required to trigger payment provide
evidence that goods have been shipped as agreed. However, because LCs open up the potential for
discrepancies, which may negate payment to the exporter, documents should be prepared by
trained professionals.

Discrepant documents—literally not having an “I dotted and t crossed”—may negate the bank’s
payment obligation. That’s why many export companies use export documentation and
compliance software to ensure their export paperwork is accurate and complete.

For the seller:

Bank has an obligation to pay for the shipped goods, this provides the seller with sufficient
assurance to carry forward its work.This same obligation reduces the risk of production in various
cases, for example, if the buyer changes the order, even then the seller has no production risk.It
also provides the seller with the opportunity of finance in the interim period (this involves the
period between the shipment of goods and payment receipt).Since everything is mentioned in the
letter of credit, it becomes easier for the seller to strategise its production, since the date for
shipment of goods is given.Even on the complaint of goods, the buyer cannot refuse the payment
to the seller, this is yet another plus point of letter of credit.

Letter of credit does not only benefit the seller but also the buyer in various aspects. The benefits
incurred by the buyer has been discussed further.

For the buyer:

The bank can only pay the seller when after proper documentation and scrutiny of whether the
documents submitted are in line with the terms mentioned in the letter of credit, this proves
beneficial for the buyer.The buyer can control the various terms of the contractual relationship,
for example, the buyer can decide regarding the period required for the shipment of goods and
mention the same in the letter of credit.Letter of credits explicitly exhibits the solvency and
willingness of the buyer.Letter of credit reduces the risk of repayment, and in cases of issuing a
letter of credit for delayed payments, the seller credits the buyer.

PRINCIPLES GOVERNING LETTER OF CREDIT

One of the fundamental principles governing the LC operation is the principle of strict
compliance. The principle requires the seller to present the necessary documents in accordance
with LC requirements; in order to claim payment for the goods sold. The principle of strict
compliance is defined as the legal principle that entitles the bank to reject documents which did
not strictly comply with the terms of LC The issue of strict compliance comes into the picture
during the process of checking documents in LC transactions. The principle of strict compliance
aims to protect the buyer who has neither the opportunity to examine the physical goods nor to
supervise the process of loading the goods in the seller’s country due to geographical distance.
Therefore, the documents are the only security for the buyer. The documents prove that the goods
have been properly delivered in accordance with the description in the sale contract.

The principle of autonomy stands fundamental among the laws pertaining to the Letters of Credit.
This principle is also known as the independence principle’. This determines the separation and
independence of the letters of credit from the underlying contract for the credit in respect of which
the letter of credit is issued. This means that those claims made or defense taken under the contract
cannot specifically affect the payment undertaking of the banks. The doctrine of autonomy is
considered lying at the heart of the documentary credits.

The Autonomy Principle has an exception known as the “Fraud Exception. The exception entitles
huyers either to restrain sellers from drawing the credit or to restrain banks from making payments
to sellers. After a while, other common law countries approved the reasoning of the court in that
case and the application of the Fraud Exception became a widespread phenomenon.
 THE LETTER OF CREDIT PROCESS

The entire process under LC consists of four primary steps:

Step 1 - Issuance of LC

After the parties to the trade agree on the contract and the use of LC, the importer applies to the
issuing bank to issue an LC in favor of the exporter. The LC is sent by the issuing bank to the
advising bank. The latter is generally based in the exporter’s country and may even be the
exporter’s bank. The advising bank (confirming bank) verifies the authenticity of the LC and
forwards it to the exporter.

Step 2 - Shipping of goods

After receipt of the LC, the exporter is expected to verify the same to their satisfaction and initiate
the goods shipping process.

Step 3 - Providing Documents to the confirming bank

After the goods are shipped, the exporter (either on their own or through the freight forwarders)
presents the documents to the advising/confirming bank.

Step 4 - Settlement of payment from importer and possession of goods

The bank, in turn, sends them to the issuing bank and the amount is paid, accepted, or negotiated,
as the case may be. The issuing bank verifies the documents and obtains payment from the
importer. It sends the documents to the importer, who uses them to get possession of the shipped
goods.

Letter of Credit with Example

Suppose Mr A (an Indian Exporter) has a contract with Mr B (an importer from the US) for sending
a shipment of goods. Both parties being unknown to each other decide to go for an LC
arrangement.

The letter of credit assures Mr A that he will receive the payment from the buyer and Mr B that he
will have a systematic and documented process along with the evidence of goods having been
shipped.

From this point on, this is how a letter of credit transaction would unveil between Mr A & Mr B:-

• Mr B (buyer) goes to his bank that is the issuing bank (also called an opening bank) and
issues a Letter of Credit.
• The issuing bank further processes the LC to the advising bank (Mr A's bank).
• The advising bank checks the authenticity of the LC and sends it to Mr A.
• Now that Mr A has received the confirmation he will ship the goods and while doing so he
will receive a Bill of Lading along with other necessary documents.
• Further, he will send these documents to the negotiating bank.
• The negotiating bank will make sure that all necessary requirements are fulfilled and
accordingly make the payment to Mr A (the seller).
• Additionally, the negotiating bank will send all the necessary documents to the issuing
bank.
• Which again the issuing bank will send to Mr B (Buyer) to confirm the authenticity.
• Once Mr B has confirmed he will make the payment to the issuing bank.
• And the issuing bank will pass on the funds to the negotiating bank.

FORMAT OF LETTER OF CREDIT

 PARTIES TO LETTER OF CREDIT
Whenever a customer of a bank applies for the letter of credit of the bank, he becomes the account
party in the arrangement. The bank which issues the letter of credit becomes the issuer or issuing
bank. The firm/person in whose favour the letter of credit is addressed becomes the beneficiary in
the arrangement. To understand this, let’s take an example. For instance, if there is a buyer who
wants to buy goods from a seller. Then here the buyer will apply for a letter of the credit, and
therefore will become the account party. Similarly, the bank will issue the letter of credit on behalf
of its customer and will become the issuer. The beneficiary will be the seller since the letter of
credit will be issued for the benefit of the seller.

TYPES OF LETTER OF CREDIT

The following are the commonly used types of LC:

1. Revocable Letter of Credit

Revocable LC can be modified or revoked independently by the issuing bank or the buyer
without any notice. This type of LC works entirely in favour of the buyer. It is rarely practiced
in modern-day international trade as it does not provide any protection to the beneficiary or
the seller.

2. Irrevocable Letter of Credit

Irrevocable LC is more commonly used as compared to a revocable LC. Irrevocable LC cannot

be revoked or modified without the consent of the issuing bank, the beneficiary, and the
confirming bank. It is a safer option for the seller or exporter as it assures that the amount
mentioned in the LC will be paid if the submitted papers fulfill the terms and conditions of the
agreement. Irrevocable LC further has 2 types - Confirmed and Unconfirmed LC.

3. Confirmed Letter of Credit

Confirmed LC is an arrangement where another bank or financial institution adds its guarantee
to the LC. It is used when the seller does not trust the buyer’s bank or the issuing bank. It gives
added assurance to the seller, but the cost of the LC also escalates.

4. Unconfirmed Letter of Credit

Here, there is no added guarantee from another bank or financial institution. An unconfirmed
letter of credit only involves the buyer, the seller and the issuing bank or buyer’s bank. Mostly
all letters of credit that are commonly used are unconfirmed letters of credit.

5. LC at Sight

Sight Credit LC requires the advising bank or seller’s bank to make the payment at sight, on-
demand, or upon presentation of documents. The seller submits documents as per terms and
conditions of the sight LC. Upon verification, the advising bank immediately releases the due
payment to the supplier.

6. Usance Letter of Credit or Deferred Payment LC

Usance LC or Deferred Payment LC is where the draft is drawn on the issuing or corresponding
bank at the end of the agreed usance period. The bank may receive the documents early upon
completion of shipment of goods, but the payment is processed only after the usance period is
over. This gives a grace period to the buyer who can make the payment after a certain period
of time from when he receives the goods.

7. Back to Back LC

Back-to-back Letter of Credit is where a second LC is opened with another LC as security.

This second LC finances both sides of a transaction through credit and counter-credit. A
middleman buying from one party and selling to another is a typical case of back-to-back LC.

8. Transferable Letter of Credit

Transferable LC is used when there is a middleman involved or where a company sells the
product of another company/producer. The first beneficiary requests the bank to transfer the
entire payment or part thereof to the second beneficiary. In this arrangement, the first
beneficiary is generally the middlemen or a company who sells another’s products.

9. Un-transferable Letter of Credit

An un-transferable letter of credit cannot be transferred to another beneficiary. The beneficiary

as per the original letter of credit is the sole beneficiary and the document cannot be further
used to pay any other party.

10. Standby Letter of Credit

Standby Letter of credit also known as SBLC is similar to a bank guarantee and is more
popular in the US. The seller can obtain payment from the bank even in the case of the buyer’s
failure to perform as per the agreement.

11. Freely Negotiable Letter of Credit

Freely Negotiable LC allows any bank to become a nominated bank as long as it is willing to
pay, accept, incur deferred payment undertaking, or negotiate the LC. The LC has to indicate
that it is not restricted to any bank for negotiation or that it can be negotiated in any bank.

12. Revolving Letter of Credit

Revolving LC is one where the amount mentioned gets reinstated after payment, reducing the
need to create a new LC. It is used in case of shipments with a diverse set of goods or a repeated
set of the same goods, which are traded within a specific period.

13. Red Clause LC

In a Red Clause LC the seller or beneficiary is partly paid or is paid an advance before the
goods are shipped and after receipt of documents and a written confirmation from the seller to
the bank. This type of LC acts as an aid to the seller for his working capital requirements for
purchase of raw materials, packaging and processing of goods.

14. Green Clause LC

Green Clause LC is another type of Red Clause LC with some additional features. In a green
clause LC the seller receives advance payment not only for purchasing raw material, packaging
 and processing of goods but also for the cost incurred for pre-shipment warehousing and
insurance.

DIFFERENCE BETWEEN BANK GUARANTEE AND LETTER

OF CREDIT

A bank guarantee and a letter of credit are similar in many ways but they're two different things.
Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the
loss if the transaction doesn't go as planned. A letter of credit is an obligation taken on by a bank
to make a payment once certain criteria are met. Once these terms are completed and confirmed,
the bank will transfer the funds. This ensures the payment will be made as long as the services are
performed. A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary.
Unlike a line of credit, the sum is only paid if the opposing party does not fulfill the stipulated
obligations under the contract. This can be used to essentially insure a buyer or seller from loss or
damage due to nonperformance by the other party in a contract.

For example a letter of credit could be used in the delivery of goods or the completion of a service.
The seller may request that the buyer obtain a letter of credit before the transaction occurs. The
buyer would purchase this letter of credit from a bank and forward it to the seller's bank. This letter
would substitute the bank's credit for that of its client, ensuring correct and timely payment. A
bank guarantee might be used when a buyer obtains goods from a seller then runs into cash flow
difficulties and can't pay the seller. The bank guarantee would pay an agreed-upon sum to the
seller. Similarly, if the supplier was unable to provide the goods, the bank would then pay the
purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety measure for the
opposing party in the transaction. These financial instruments are often used in trade financing
when suppliers, or vendors, are purchasing and selling goods to and from overseas customers with
whom they don't have established business relationships. The instruments are designed to reduce
the risk taken by each party.
 CONCLUSION

International trade deals with people of diverse backgrounds. The parties involved in an
international commercial transaction may belong to different countries or even to different
continents. Therefore in international trade, the barriers of language, culture and laws are felt
extensively. Therefore, to improve the conditions a uniform system was needed. In the same light
of bringing uniformity to the system of international trade, the International Chamber of
Commerce and the International Court of Arbitration were formed. They have provided us with
the basic framework which has been accepted by the banks across the globe. Letter of credit is one
of the most important tools that help in facilitating international trade.