Different Types of Bank Guarantees – Letter of Credit
Cross-border trade in goods and services (foreign trade), which is significant in the context of globalization and the world economy, is in practice associated with certain risks for the parties involved. As a result, the exporter typically tends to minimize the payment risk of their business partner as much as possible and to secure their payment claims in advance. In this context, the parties frequently agree to secure existing claims by means of a bank guarantee, such as the Letter of Credit.
I. General Information on the Letter of Credit
“Letter of Credit” is a synonym common in international trade for a Documentary Credit, which represents a special form of payment used particularly in cross-border transactions of a documentary nature. The Letter of Credit is an abstract promise of payment by the importer’s bank (Issuing Bank), in which it undertakes to make payment to the exporter upon presentation of documents compliant with the credit terms (by the exporter).
A. Processing of a (Documentary) Letter of Credit
The following documents are typically required for the processing of a Letter of Credit:
- Commercial Invoice
- Freight Invoice
- Packing List
- Certificate of Origin (if available)
- Transport Documents (Bill of Lading, etc.)
- Insurance Certificates regarding any transport insurance
- Quality Certificates
- Declarations of Conformity, etc.
Essentially, the basic procedure of a Letter of Credit is as follows:
- Conclusion of a sales contract for a delivery of goods between the importer and exporter with the payment condition of a Documentary Letter of Credit.
- Examination of the order by the opening bank and opening of an irrevocable Letter of Credit in favor of the beneficiary (given sufficient credit line of the applicant).
- The bank informs a correspondent bank in the respective country of the beneficiary (Advising Bank) about the Letter of Credit and undertakes to make payment to the beneficiary subject to the condition of the proper presentation of the required documents.
- Examination of the Letter of Credit by the beneficiary’s bank for compliance with the sales contract (Advising).
- Shipment of the goods by the exporter. Receipt of the documents compliant with the credit terms.
- Submission of the documents listed in the Letter of Credit to the Advising Bank (Correspondent Bank).
- Forwarding of the documents to the Issuing Bank. The bank is entitled to a reasonable period for examining the documents. (If the paying agent function was transferred to the Advising Bank, it can also effect payment to the beneficiary itself after checking and confirming the conformity of the documents).
- The Issuing Bank checks the regularity of the documents, hands them over to the importer, and effects payment to the exporter. Any objections must be communicated to the presenter of the documents immediately, listing the discrepancies.
Schematic Sequence of a Simple Letter of Credit:
B. UCP 600 – ISBP 681
The processing of Letters of Credit is not subject to binding statutory regulations but to the “Uniform Customs and Practice for Documentary Credits” (UCP) issued by the International Chamber of Commerce in Paris (ICC). These guidelines regulate international Letter of Credit handling in a uniform manner and facilitate processing by, among other things, regulating the business management of the participating banks among themselves and providing guidelines for the examination of documents submitted under the Letter of Credit. They are generally made the basis of the contract when a Letter of Credit is opened, are thus binding for the parties involved, and, meanwhile recognized as autonomous commercial law, represent a generally accepted trade custom.
Currently, the standard condition UCP 600 applies, which came into force in a revised form in July 2007 and replaced UCP 500. As an aid to interpretation for UCP 600, the so-called International Standard Banking Practice, ICC Publ. No. 681 (ISBP) was issued by the ICC. These serve as a practice-oriented guide for the application of the UCP and address individual points not conclusively regulated in UCP 600. Unlike UCP 600, the regulations of the ISBP are not legally binding.
Furthermore, in the event of any interpretation difficulties concerning the application of UCP 600 that are not addressed in the ISBP, the ICC Paris can fundamentally be appealed to directly and an opinion requested. The relevant opinions of the ICC are collected and processed.
C. Special Forms of the Letter of Credit
In business practice, various forms of a Letter of Credit are used, which are tailored to the specific design of the legal transaction depending on the situation and safeguard the special needs of the respective parties as far as possible. Some important special forms are listed below:
1. Revocable and Irrevocable Letters of Credit
Since the introduction of UCP 600, Letters of Credit are fundamentally irrevocable unless explicitly stated otherwise in the credit text. If a revocable Letter of Credit exists, it can be revoked by the importer until documents compliant with the credit terms are submitted (by the exporter). Since the agreement of a revocable Letter of Credit offers insufficient payment security for the exporter, it will hardly be encountered in practice. If a cancellation or amendment is to be made to an irrevocable Letter of Credit, all parties involved must agree to this amendment in the processing order for it to become effective.
2. Confirmed Letter of Credit
If the exporter demands increased payment security, it is possible to agree on the promise of payment of another bank (e.g., the exporter’s bank or a third bank) in addition to the promise of payment of the importer’s opening bank. For this purpose, the importer’s Issuing Bank issues a corresponding confirmation instruction to the requested bank. If the Letter of Credit is confirmed by the requested bank, it is liable to the exporter for the non-fulfillment of the Letter of Credit obligation by the opening bank. Usually, a Letter of Credit is only confirmed if the creditworthiness of the Issuing Bank exists, whereby the confirming bank undertakes the examination of the conformity of the documents itself. A confirmed Letter of Credit thus secures against additional creditworthiness and country risks that may be grounded in the importer’s bank or its state (e.g., payment moratorium due to a lack of foreign exchange).
3. Transferable Letter of Credit
This form of Letter of Credit is frequently used when trade chains exist, e.g., when the importer is not the end customer but an intermediary. The Letter of Credit opened by the end customer is provided with a transfer clause which entitles the first beneficiary (exporter or intermediary) to transfer their claims arising from it to a second beneficiary – subject to any restrictions of the transfer clause (e.g., specific country or supplier). The conditions of the original Letter of Credit are adopted unchanged in accordance with UCP 600, with the exception of the price, the delivery time, and the validity period of the Letter of Credit—points that are generally agreed differently between the first supplier and the intermediary. In this context, the intermediary’s bank assumes the role of the transferring bank, which enters into no independent payment obligation but passes on the existing promise of payment of the opening bank. It remains the paying agent for the Letter of Credit, usually checks the conformity of the submitted documents, and passes the proceeds for the second beneficiary on to their bank’s account. Since the construction of a Letter of Credit transfer is extremely complex, multiple transfers hardly ever occur in practice.
4. Stand-by Letter of Credit
A Stand-by Letter of Credit can embody a guarantee function of the bank in addition to the payment-promising function, or be limited only to such. This form of Letter of Credit is predominantly used in US trade, as abstract bank guarantees cannot be issued by every bank there.
5. Electronic Documentary Credit (eUCP)
The eUCP (Uniform Customs and Practice for Documentary Credits for Electronic Presentation) is an extension of the UCP guidelines for electronic processing, with the purpose of simplifying document presentation and limiting banks to payment transactions in the future.
II. Economic Significance of a Letter of Credit
The Letter of Credit combines a security function with a payment function. It secures the proper fulfillment of the contract and the step-by-step processing of the transaction.
For the buyer and simultaneously importer, the processing of a sales contract via a Documentary Letter of Credit means that they only have to pay for the goods once documentary proof of their timely delivery has been provided and the documents compliant with the credit terms have been submitted.
The seller and exporter, on the other hand, secures their purchase contract claim, provided they submit the proper documents proving the delivery of goods to the advising bank.
In this way, both business partners obtain the certainty that their purchase contract claims are largely secured and will be fulfilled, although some risks remain for the contracting parties. For example, the importer still bears the risk that the delivered goods deviate qualitatively and quantitatively from the condition agreed in the contract and recorded in the Letter of Credit. However, this risk could potentially be remedied by involving quality control before shipment of goods and presentation of corresponding quality confirmation certificates (as Letter of Credit documents).
The exporter, on the other hand, bears the document risk and must fundamentally ensure the proper and complete procurement and handover of the documents compliant with the credit terms. Furthermore, the exporter bears economic and political risks that can negatively influence the creditworthiness of the bank in the importer’s respective country. In this context, as already mentioned above, the agreement of a confirmed Letter of Credit may prove sensible and risk-minimizing.
(Status: May 2010. All information is subject to change and provided without guarantee.)