Different Types of Bank Guarantees – Letter of Credit

In particular, where business partners encounter unfamiliar practices and unknown counterparties in dealings abroad, the need to protect one’s own legal position and claims grows. Exporters generally seek to minimise the payment risk posed by their counterparty and to secure their payment claims as far as possible in advance. In practice, this is frequently achieved through a bank-based security arrangement — such as a letter of credit (documentary credit).

What is a documentary credit?

“Letter of credit” is the term commonly used in international trade as a synonym for a documentary credit. It is a special form of payment used chiefly in cross-border commercial transactions, under which performance is evidenced by documents.

Legally, the documentary credit is a self-standing (that is, a primary obligor’s own), abstract payment undertaking of the buyer’s (importer’s) bank towards the seller (exporter), independent of the underlying transaction and conditional upon the presentation of documents. The bank undertakes to make payment as soon as the exporter presents the documents accompanying the goods specified in the credit — including, among others, the commercial invoice, freight invoice, packing list, certificate of origin, transport documents, insurance certificates, and quality certificates or declarations of conformity.

Important clarification: a documentary credit is not, legally speaking, a guarantee or suretyship in the strict sense. Unlike a suretyship (which depends on the existence of the underlying debt), the credit establishes an independent payment obligation of the bank that is detached from the underlying transaction. In practice, it is nonetheless frequently presented — as here — alongside other bank-based security instruments (guarantees, suretyships), because it fulfils an economically comparable security function.

How is a documentary credit typically processed?

• Contract of sale: the importer and exporter conclude a contract of sale for the delivery of goods and agree on a documentary credit as the payment term.
• Instruction to open the credit: the importer (the applicant) instructs its own bank (the issuing bank) to open a credit in favour of the exporter (the beneficiary). Note: banks charge commissions for opening the credit and for examining the documents.
• Examination and issuance: the issuing bank examines the instruction and, provided the applicant has sufficient credit facilities, opens an irrevocable credit in favour of the beneficiary. The credit sets out precise particulars of the type, quantity, and packaging of the goods, the shipment deadlines, and a list of the documents to be presented, including, among others: the commercial invoice; the freight invoice; the packing list; the certificate of origin (where applicable); the transport documents (e.g. a bill of lading); insurance certificates for any transport insurance; and quality certificates and declarations of conformity.
• Advising: the issuing bank informs a correspondent bank in the beneficiary’s country (the advising bank) of the credit. The advising bank checks the credit for conformity with the contract of sale and advises it to the beneficiary.
• Shipment of the goods: the exporter ships the goods and obtains the documents required to conform with the credit.
• Presentation of documents: the exporter presents the documents required under the credit to the advising bank.
• Forwarding and examination: the advising bank forwards the documents to the issuing bank, which is allowed a reasonable time to examine them. Where the paying-agent function has been delegated to the advising bank, it may itself make payment upon examining and confirming conformity.
• Payment: the issuing bank examines the documents for conformity, hands them over to the importer, and makes payment to the exporter. Any discrepancies must be notified to the presenter without delay, listing the defects found.

What rules govern documentary credits (UCP 600 and ISBP)?

The handling of documentary credits is not subject to binding statutory rules, but to the “Uniform Customs and Practice for Documentary Credits” (UCP) published by the International Chamber of Commerce in Paris (ICC). These rules standardise international documentary credit practice, govern the relationship between the banks involved, and set standards for the examination of documents. They are regularly incorporated by reference when a credit is opened, are then binding on the parties involved, and are now recognised as an established international trade usage.

• UCP 600 has been in force since July 2007 and remains, to this day, the current version — a successor (“UCP 700”) has been discussed by the ICC for years but has not so far been adopted.
• The International Standard Banking Practice (ISBP) of the ICC serves as a practice-oriented interpretive aid to the UCP 600. The original version (ICC Publication 681, 2007) was first superseded by ISBP 745 (2013) and most recently by ISBP 821 (2023), which incorporates the ICC opinions issued since then.
• Unlike the UCP 600, the ISBP is not legally binding, but is a recognised aid to interpretation and practice.
• On interpretive questions not conclusively resolved by either the UCP 600 or the ISBP, an opinion may generally be sought from the ICC Banking Commission; these opinions are collected and published by the ICC.

The eUCP (the electronic supplement to the UCP) supplements the UCP 600 with rules for the electronic processing of documentary credits. Since 1 July 2019, eUCP version 2.0 has applied, introduced together with the supplementary eRules (including the eURC), and facilitates the electronic presentation of documents. The ICC is also working on aligning the eRules with the UNCITRAL Model Law on Electronic Transferable Records (MLETR).

What special forms of documentary credit exist?

In practice, various forms of documentary credit are used, tailored to the specific needs of the parties. Since the introduction of the UCP 600, credits are, as a rule, irrevocable, unless expressly agreed otherwise in the credit itself.

A revocable credit can be revoked by the importer at any time until the exporter has presented conforming documents. As this offers the exporter only inadequate payment security, this form is now scarcely used in practice. Where an irrevocable credit is to be amended or cancelled, all parties involved must consent for the amendment to take effect.

Where the exporter requires additional payment security, a further payment undertaking from an additional bank (e.g. the exporter’s own bank or a third bank) may be agreed alongside the issuing bank’s undertaking. The issuing bank gives a confirmation instruction to the requested bank for this purpose. If that bank confirms the credit, it becomes liable to the exporter in its own right in the event that the issuing bank fails to meet its payment obligation. Confirmation is generally given only where the requested bank’s own creditworthiness is sufficient; that bank then also examines the conformity of the documents presented itself. A confirmed credit thus also covers additional credit and country risks — for example, a payment moratorium in the importer’s country due to a shortage of foreign currency.

A transferable credit is frequently used in trading chains, for example where the importer is not the end buyer but an intermediary. The credit opened by the end buyer bears a transfer notation permitting the first beneficiary (the exporter or intermediary) to transfer its rights — subject to any restrictions in the transfer notation (e.g. a particular country or supplier) — to a second beneficiary. Under the UCP 600, the terms of the original credit are generally carried over unchanged, with the exception of the price, delivery time, and validity period of the credit, which may be agreed differently between the original supplier and the intermediary. The intermediary’s bank acts as the transferring bank in this process: it does not assume any payment obligation of its own, but passes on the existing payment undertaking of the issuing bank, remains the paying agent, generally examines the documents, and forwards the proceeds to the second beneficiary. Because a transfer of a credit is legally complex, multiple transfers are rarely seen in practice.

A standby letter of credit can, alongside its payment function, also serve a purely guarantee function for the bank, or be limited to that function alone. This form is used predominantly in US trade, since not every bank there is permitted to issue an abstract bank guarantee.

What are the advantages and risks for the parties?

The documentary credit combines a security function with a payment function: it is intended to ensure proper performance of the contract and a step-by-step, document-based settlement of the transaction.

For the importer, settlement by documentary credit means that payment need only be made once documentary proof of timely delivery of the goods has been provided and the conforming documents have been presented. For the exporter, the purchase-price claim is secured as soon as the conforming documents evidencing delivery of the goods are presented to the advising bank. Both parties thereby gain increased assurance that their claims under the contract of sale will be satisfied — risks are not, however, entirely eliminated:

• The importer continues to bear the risk that the goods delivered differ, in quality or quantity, from what was contractually agreed and specified in the credit. This risk can be mitigated, among other things, through an independent quality inspection before shipment and the presentation of corresponding quality certificates as credit documents.
• The exporter bears what is known as the documentary risk — it must obtain and present the conforming documents completely and correctly. In addition, there are economic and political risks that may affect the creditworthiness of the bank in the importer’s country. As described above, agreeing a confirmed credit can prove effective in minimising this risk.