Magazine article Business Credit

Letters of Credit: Satisfy the Documentary Requirements or Risk Nonpayment

Magazine article Business Credit

Letters of Credit: Satisfy the Documentary Requirements or Risk Nonpayment

Article excerpt

A letter of credit (L/C) is a common mechanism of payment. The seller requests that the buyer obtain the issuance of an L/C in favor of the seller to insure the seller's receipt of payment. An L/C permits the seller to substitute the payment obligation of a reliable third party, such as a bank, for the obligation of the buyer to pay the seller by presenting documents required by the L/C to the L/C issuing bank. This requires the seller to know in advance whether it is capable of presenting the required documents. If a required document cannot be presented (either because it does not exist or the seller is unable to obtain it), the L/C's utility as a payment device may be lost.

Letters of credit have been used historically in international sales transactions. They have also been used more frequently in domestic transactions. In either case, a seller may be unwilling to ship on open account to a buyer in another country where there is concern about the buyer's ability to pay for the goods. The buyer may be unwilling to pay for the goods on a CBD (cash before delivery) or COD (cash on delivery) basis without knowing whether the goods were shipped timely and/or otherwise conform to the contract. An L/C may address these concerns by providing the seller with a more certain source of payment (the L/C issuing bank). The L/C should also provide the buyer the assurance that the L/C issuing bank will not make payment until the seller presents the documents required under the L/C that, if the buyer has its way, presumably evidence the seller's compliance with the contract.

There are two types of L/Cs. Under a documentary or commercial L/C, the L/C issuing bank is obligated to pay against documents evidencing shipment of the goods or provision of services. These documents include invoices, transport and insurance documents. The seller looks to the L/C issuing bank (rather than the buyer) for payment upon presentation of the documents required under the L/C. A standby L/C contemplates that the buyer will pay for the goods. Upon the buyer's failure to pay for the goods, the seller will look to the L/C issuing bank for payment upon the seller's presentation of documents evidencing such default as required by the L/C.

In a typical L/C transaction, the L/C is one of three distinct relationships between any two of three different parties. The first relationship is the sales contract between seller and buyer. This agreement describes the terms of sale. The second relationship is the agreement between the bank issuing the L/C and the buyer (known as the L/C Applicant) who is requesting that the bank issue an L/C in favor of the seller. This agreement describes the terms of the L/C and the Applicant/buyer's obligation to reimburse the bank when the bank makes payment to the seller on the L/C, the collateral that secures the buyer's reimbursement obligations to the bank, and the bank's charges, commissions and other expenses set forth in the agreement. The third agreement is the L/C itself, issued by the bank in favor of the seller (known as the beneficiary). The L/C is the issuing bank's irrevocable promise to pay the seller/beneficiary upon the seller's presentation of documents, such as a draft, commercial invoices, transport and insurance documents and all other documents specified by the L/C.

The bank's obligation to make payment on the L/C is unconditional once the beneficiary satisfies all of the documentary requirements in the L/C. The bank deals only in documents presented by the seller/beneficiary to determine whether they conform to the L/C. If the seller presents the required documents, the bank must pay under the L/C regardless of any disputes between the seller and buyer arising out of the underlying sale transaction and/or the buyer's ability to reimburse the bank for payments made under the L/C.

What standard does an issuing bank use in determining whether the documents the beneficiary presents on any L/C drawing complies with the terms of the L/C? …

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