What is a letter of credit?
A letter of credit (L/C) is a payment method in which the buyer's bank undertakes to pay if the seller presents documents that comply with the terms of the credit within the time allowed. The bank examines the documents, not the goods, and its undertaking is independent of the sales contract. In international practice it is used by reference to the UCP 600 rules published by the ICC.
What does a letter of credit give the exporter and the importer?
A letter of credit balances the risk between two parties who do not know each other by putting a bank in between. For the exporter the gain is that payment depends on the bank's undertaking, not on the buyer's intention. For the importer the gain is that money does not leave before the shipment is proved by documents. The price for both is document discipline and extra work: the credit must be set up separately from the sales contract, and the shipping programme and the document conditions must match each other.
How does a letter of credit process work?
The process starts with the sales terms being tied to the proforma invoice. Because the terms in the credit are mostly transferred directly from the proforma, an error in the proforma carries over into the credit and can afterwards be corrected only by an amendment.
- Based on the proforma, the buyer instructs the issuing bank to open the credit
- The credit is advised to the seller through a correspondent bank; if confirmation has been requested, a confirming bank steps in
- The seller ships according to the time and conditions written in the credit
- The set of documents is presented to the bank and compared with the terms of the credit
- If the presentation complies, payment is made or a promise is given to pay on the due date
What is the role of the transport document in a letter of credit?
What makes a letter of credit work is the existence of a document that represents the shipment. An original bill of lading is a document of title and the goods are delivered to its lawful holder; this is why banks ask for an original bill of lading in a credit, because the document controls who can collect the goods. A sea waybill and an air waybill are not documents of title, cannot be transferred by endorsement and cannot be held to block the goods. The CMR consignment note used in road transport is not a document of title either (see CMR). Because the type of transport document is named explicitly in the credit, the transport organisation should be planned while the credit is being set up, not after it has been opened.
What is a discrepancy, and what happens if one arises?
A discrepancy is the case where the presented documents do not match the terms of the credit. Banks examine documents under a strict-compliance approach; the fact that the goods were really shipped does not remove a discrepancy. UCP 600 gives the bank a limited time to examine the presentation and makes the notice of refusal a matter of procedure; for the length of the period one should look at the text of the credit and the rules.
- Common causes: an incomplete set of original documents, late presentation, a goods description that does not match the text of the credit
- A difference in amount or quantity for which no tolerance was written
- The delivery term appearing differently on the invoice and on the transport document
- Order of remedies: correct and re-present within the time allowed, the issuing bank's consent, tolerance written from the start
What is UCP 600, and how are the types of credit distinguished?
UCP 600 is the set of 39 articles published by the International Chamber of Commerce (ICC), and it came into force on 1 July 2007. The rules apply not by themselves but by reference, as with Incoterms. Its basic principle is that banks deal only with documents, not with goods or services.
- Irrevocable: cannot be amended without the agreement of the parties
- Confirmed: a second bank adds its own undertaking to that of the issuing bank
- Sight and deferred: distinguished by when payment is made
- Transferable: the beneficiary can transfer the credit to another beneficiary
How risk is shared across payment methods in foreign trade
| Payment method |
Seller's risk |
Buyer's risk |
Role of the bank |
| Advance payment |
Low |
High: the price is paid, no shipment is made |
Transfer intermediary |
| Letter of credit (L/C) |
Low: the bank's undertaking applies on a complying presentation |
Low: payment depends on presentation of documents |
Undertakes payment subject to the document conditions |
| Documents against payment |
Medium: if the buyer does not take the documents, the goods remain at the destination |
Medium: the documents are taken, the goods have not been inspected |
Hands over the documents against collection |
| Open account |
High: the goods are shipped, the price is not received |
Low |
Transfer intermediary |
Frequently asked questions
Does a letter of credit guarantee payment for certain?
The bank's undertaking is not unconditional; it depends on a complying presentation. If the documents do not match the terms, the obligation to pay does not arise by itself, and the fact that the goods were really shipped does not change this, because the bank looks at the documents, not the goods. The real work is to check, while the credit is being set up, that the terms can actually be met.
If a discrepancy arises, is the money never collected?
Most discrepancies can be resolved. If the document can be corrected, it is corrected and re-presented within the presentation period; if not, the issuing bank is asked to waive the discrepancy. For differences that can be foreseen, the most practical way is to have a tolerance written into the credit when it is opened.
Is a sea waybill accepted in a letter of credit instead of a bill of lading?
What decides is what the text asks for. But a sea waybill is not a document of title and cannot be endorsed; the goods are delivered to the consignee named on it. Because the ability to control the goods by holding the document is lost, an original bill of lading is the common standard in credit-based deals.
Which Incoterms rule should be used with a letter of credit?
For containerised and multimodal shipments, the ICC recommends FCA instead of FOB. If the credit asks for a bill of lading carrying an "on board" notation, the provision added to the FCA rule in Incoterms 2020 allows the parties to agree that this document be issued to the seller.