Letter of Credit

From Max-EuP 2012

by Ulrich Drobnig

1. Economic function

The letter of credit is a standard instrument of international trade. It has evolved—without international Conventions and almost without any national legislation—‘autonomously’ out of the international business and contract practice in the handling of overseas sales, where it still plays a major role. As in the independent guarantee to which it is functionally related (guarantee, independent), at least three parties are involved in a letter of credit. Between the overseas exporter of goods and the domestic importer stands the issuing bank, which on the instruction of the importer acts for both contracting parties. On the one hand, it promises the overseas exporter the payment of the purchase price agreed upon in the sales contract (sale); thus, in case the buyer becomes unable or unwilling to pay, the buyer’s duty of payment is complemented by the additional promise of payment by the issuing bank and is thereby secured. However, the issuing bank’s promise to pay is subject to the condition that the documents stipulated in the sales contract regarding the quality and quantity of the sold goods as well as their shipment to the importer, including its date, are proven as provided in the contract (hence the term ‘documentary letter of credit’).

Despite its functional link to the sales contract between exporter and importer, the letter of credit is legally autonomous and independent from this underlying transaction; this aspect satisfies the bank’s interests as well as those of the overseas exporter. Article 5 of the Uniform Customs and Practices for Documentary Credits (Revision 2007) (UCP 600) summarizes this guiding concept of letter of credit law in the formula: ‘Banks deal with documents, and not with goods, services or performance to which the documents may relate’. From this standard model of the letter of credit different types and supplements have been evolved which will be examined below (see 3. below).

2. Sources

As a result of its frequent use, and in order to rationalize the issuing banks’ duties of examining the export seller’s documents, the letter of credit has from an early point been rationalized and standardized, to an increasing degree internationally. This rationalization is manifested in a set of rules, the Uniform Customs and Practices for Documentary Credits (Revision 2007) of the International Chamber of Commerce (ICC) in Paris—in short UCP 600. This set of rules, agreed upon for the first time in 1933 and since then revised five times and adjusted as required, is today stipulated as a basic standard by virtually all participating banks in the world and is declared applicable in all letters of credit: a fruit of the autonomous uniform international trade law (commercial law). In a few countries, there also exist national statutory provisions, especially Art 5 of the Uniform Commercial Code (UCC) in the United States, which, however, are not mandatory and in practice are supplemented or replaced by the UCP 600. In the major European trading nations however, there are no statutory rules and this is not regarded as a gap.

3. Types

The standard type letter of credit is often varied and specified by special contract clauses in order to accommodate the wishes and special needs of the parties of the sales contract. Typical supplementary letter of credit clauses concern the following aspects.

The notification to the foreign exporter concerning the issue of the letter of credit is generally carried out by the foreign exporter’s principal bank, the so-called advising bank. Instead of a mere notification, this bank may also expressly confirm the letter of credit; by virtue of such confirmation this bank additionally assumes full liability for honouring the letter of credit as a co-debtor of the issuing bank. It is obvious that such confirmation by a bank in the country of the exporter secures the letter in a significantly stronger way than a simple, unconfirmed letter of credit of the foreign bank in the country of the importer; however, transaction costs are increased as well.

In principle, the letter of credit is irrevocable. In certain circumstances however, eg particularly risky transactions or insecure market situations, the issuing bank may stipulate a right of withdrawal.

The letter of credit becomes due whenever the beneficiary, the foreign exporter, presents the letter of credit documents required by the sales contract—in particular the invoice, inspection certificates and shipping documents—to, as the case may be, the confirming or the issuing bank. The bank must examine the documents, which in most instances are drafted in a foreign language, very thoroughly because the issuing or the confirming bank is only obliged and entitled to honour the letter of credit if the documents comply exactly with the contract terms. At the same time, the claim for remuneration becomes due. If the documents do not satisfy the terms of the letter of credit, the bank must reject the documents and is not allowed to honour the letter of credit. The same duties apply to the foreign correspondent bank if it previously confirmed the letter of credit; in that case, the foreign seller will turn to this bank in its country in order to obtain the purchase price according to the letter of credit.

4. Parallels to the independent guarantee

Despite different purposes and fields of application, several parallels in the implementation of a letter of credit and an independent guarantee (guarantee, independent) can be observed. This applies primarily to the independence and non-accessoriness of the payment instrument from the underlying contractual relationship (see 1. above). However, at the same time this advantage for the bank and the beneficiary contains in itself—as in case of an independent guarantee—a significant potential risk, namely the abuse of a letter of credit. Practice affirms the existence of this risk. However, the rules on letters of credit are silent on this critical point. At a minimum, it is generally agreed that the issuing bank may refuse performance in case of an abuse by the beneficiary. There is certainly an abuse if an underlying relationship is either missing completely or has ceased to exist, or if an aliud has been delivered instead of the contractual performance (eg stones instead of coffee). In addition, the abuse must be presently provable. These criteria largely equal those for an abuse of an independent guarantee.

The affinity between letter of credit and independent guarantee is confirmed by the fact that a slightly adapted special type of letter of credit, the so-called stand-by letter of credit, constitutes an internationally recognized form of an independent guarantee.

5. Future development

Banks throughout the world acting in the letter of credit business have proven in the past that they are able to meet the practical challenges and developments of overseas trade through the continuous adjustment of their universally accepted ‘terms and conditions’ (standard contract terms). Therefore, statutory provisions do not seem necessary on either a national or international level.


Éric A Caprioli, Le crédit documentaire (1992); Raymond Jack, Ali Malek and David Quest, Documentary Credits (3rd edn, 2001); Rafael Marimón Durá, El crédito documentario irrevocable (2001); Roeland Bertrams, Bank Guarantees in International Trade (3rd edn, 2004); International Chamber of Commerce, Commentary on UCP 600, ICC Publication no 680 (2007); Matti S Kurkela, Letters of Credit and Bank Guarantees Under International Trade Law (2nd edn, 2008); Rolf A Schütze, Das Dokumentenakkreditiv im Internationalen Handelsverkehr (6th edn, 2008); Dan Taylor, The Complete UCP. Texts, Rules and History 1920–2007 (2008); Peter Ellinger and Dora Neo, The Law and Practice of Documentary Letters of Credit (2010).

Retrieved from Letter of Credit – Max-EuP 2012 on 18 May 2024.

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