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Using Documentary Letters of Credit in International Transactions

Fall 1995

Many clients transacting business internationally are unfamiliar with their foreign partners and need the most effective means to ensure receipt of payment. Aside from payment at the "seller’s door," the surest means of payment is to include in a contract for the sale of goods, a provision requiring, before shipment, a documentary letter of credit "issued" or "confirmed" (but not "advised") by a U.S. bank. When a U.S. bank "confirms" a foreign bank letter of credit, the U.S. bank agrees to honor the letter of credit according to its terms. In other words, it is as if the U.S. bank had certified a check written by the foreign bank. The documentary letter of credit is part of an internationally accepted structure established to reduce risks to parties involved in the transnational movement of goods.

Under a typical documentary letter of credit, the buyer (the "bank customer," also called the "account party") requests that its bank (called the "issuing bank") issue a documentary letter of credit in which the bank will undertake to pay the seller ("customer’s vendor," also called the "beneficiary") upon presentation of specified documents. The bank customer completes a letter of credit application and a "reimbursement agreement" to ensure payment to the issuing bank (often one document). In the reimbursement agreement, the bank customer agrees to reimburse the bank for all amounts the bank pays under the letter of credit. In the letter of credit application, the bank customer specifies the terms of the letter of credit under which the customer wants the bank to issue the documentary letter of credit to the customer’s vendor (e.g., the "maturity," also called the "expiry date") and the documents which must be presented before the bank must make payment to the customer’s vendor (the documents specified typically include invoices, packing lists, insurance certificates and/or bills of lading).

The fees charged by foreign banks for letters of credit vary widely. The vendor’s bank typically charges a small fee for processing the letter of credit documents. Often, the letter of credit specifies that such fees are for the account of the vendor, with the result that they are deducted from the letter of credit proceeds. Also, where a vendor requires a foreign bank letter of credit to be confirmed by a U.S. bank, the vendor is forced to absorb part of the confirmation charge. In the United States, banks typically charge about .25% of the letter of credit face amount to issue a documentary letter of credit for a 90-day period, and also charge about .25% when a draw is made under a documentary letter of credit. Although this low charge indicates the very limited risk in these transactions, industry pressures are pushing prices for this service even lower.

The transnational sale of goods involves many separate and independent contracts that comprise the complete transaction (e.g., a contract between the seller and buyer for the sale of goods, a contract for the transport of the goods, and the letter of credit "contract" between the customer’s bank [as well as the "confirming" bank] and the vendor). When a vendor holds a documentary letter of credit, it obtains payment by delivering the required documents to its bank. The vendor’s bank then forwards the required documents to the issuing bank. Upon receipt of the documents conforming with the letter of credit, the issuing bank pays the vendor’s bank. Finally, the vendor’s bank pays the vendor.

Because a documentary letter of credit is an independent agreement between the buyer’s issuing bank and the vendor, if the vendor presents the documents specified in the letter of credit before the letter of credit matures, the bank is required to pay the vendor. Thus, a vendor who has insisted on receiving a letter of credit in the contract for the sale of goods before it will ship the goods is actually relying on the credit and integrity of the bank rather than the customer. In fact, because the "contract" represented by the documentary letter of credit must be completed, and the vendor paid, before the buyer can receive the bill of lading necessary to obtain the goods, the vendor will have already been paid, even if the customer tells the bank that it believes that the vendor has defaulted under the customer’s contract with the vendor (e.g., for delivering damaged goods). Of course, the vendor ultimately may be liable to the customer for such damage under the contract for the sale of goods.

Letters of credit are very technical instruments and are typically written in a language all their own. In the United States, letters of credit are governed by the Uniform Commercial Code. In addition, most letters of credit incorporate by reference the UCP 500 (The Uniform Customs and Practice for Documentary Credits, 1993 Revision, Interna-tional Chamber of Commerce Publication No. 500). Whether you are the buying or selling party, understanding the use, application, and possibility for abuse of documentary letters of credit is an important part of any international transaction for the sale of goods.

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