Letters of Credit

The Code of Commerce defines a letter of credit as a "letter issued by one merchant to another for the purpose of attending to a commercial transaction." For banking, when a person issues a letter of credit, a bank will request an advance of money to a third person based on the "letter and credit" of the person issuing the letter. This takes place in international transactions in view of unforeseen possibilities that could take place between the time the sale is made and the time the goods are delivered. Any of the parties could change their minds, causing trouble for the deal. The letter of credit's purpose is to make sure the transaction will push through and the seller will get paid when the necessary documents are presented.

A word of caution: the bank is responsible only for handling the documents, not the merchandise. If what was delivered to you isn't what you ordered, you have to go after the seller. Banks only deal with documents, not goods, and have no duty to verify what was indicated in the letter or credit, drafts, etc. with what was actually loaded on board for shipment. This is called the Independence Principle.

The exception to the Independence Principle is fraud or forgery in the underlying transaction or tender of documents.

A letter of credit must be issued to a definite person and not to order (meaning it can't be transferred by negotiation, such as in a negotiable instrument,) and the amounts must be specifically stated in the document. Trust receipts, documents of title and bills of lading also go along with the letter.

Kinds of Letters of Credit

1.) Confirmed letter of credit: the correspondent bank gives the seller the absolute assurance that it will pay the seller for the issuing bank (and becomes the paying bank.) 

2.) Irrevocable letter of credit: can't be revoked by the issuing bank unless the buyer and seller agree. It is a definite obligation for the issuing bank to pay when the papers are presented. An irrevocable letter of credit doesn't mean it's confirmed. The correspondent bank might not confirm it.

3.) Revolving letter or credit: provides for renewed credit  to become available as soon as the opening bank has advised the negotiating or paying bank that the drafts already drawn by the beneficiary were reimbursed to the opening bank by the buyer.

4.) Back-to-back letter of credit: credit with identical documentary requirements and covering the same merchandise as another letter of credit, except for a difference in the price of the merchandise (shown by the invoice and draft.) The second letter of credit can be negotiated only after the first one is negotiated.

5.) Standby letter of credit: security arrangement for the performance of certain obligations. Can be drawn against only if another business transaction isn't performed and may be issued in place of a performance bond. The beneficiary must prove that the obligor failed to perform the secured obligation, unlike an ordinary  letter of credit where the beneficiary can recover if he can show that he performed his obligation (delivered the purchased goods.)

There are three contracts involved in a letter of credit:

1.) The contract between the buyer and seller

2.) The contract between the buyer and the issuing bank

3.) The letter of credit proper where the bank pays the seller according to the stated terms and conditions

The parties to a letter of credit are:

1.) The buyer

2.) The seller -located abroad

3.) The issuing bank -the bank that pays the seller when the letter of credit is delivered. The document of title is issued in its name.

4.) The notifying bank -the bank that notifies the seller that the letter of credit was issued.

5.) The confirming bank -a large and well-known bank (usually) that guarantees the transaction by jointly cooperating with the opening bank under the letter of credit's terms ans conditions (and consequently lending its credibility to the transaction.)

6.) The paying bank -the issuing bank pays the seller through this bank, which is located in the seller's place (can be the notifying bank) or in another place (negotiating bank.) The negotiating bank pays by buying or discounting the draft.

So here's a scenario: a businessman in the Philippines wants to order a set of chemicals for his manufacturing plant. He informs the supplier in China, goes to the bank and applies for a letter of credit. The bank becomes the issuing bank. The issuing bank informs a bank in China which, in turn, informs the supplier. This second bank becomes the notifying bank. If it agrees to pay the supplier when the papers arrive, it becomes the paying bank as well. The issuing bank contacts a big, well-known bank (like HSBC for example) to guarantee the payment. The big bank becomes the confirming bank. When the supplier delivers the goods and gets the letter of credit, he brings the papers to the paying bank and gets paid. The issuing bank reimburses the paying bank and the businessman reimburses the issuing bank.

Another thing to remember: if the papers are fake, the buyer must still reimburse the bank if the seller was paid in good faith (meaning he didn't know the papers were fake) because the issuing bank is not responsible for the genuineness of the papers.