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Letters of Credit Essay

The use of the letter of credit in international trade has for a long time been an easy way of carrying out business operations without really having to use the credit of the applicant’s bank. Letters of credit usually take the place of a bank’s credit and enhances the speed of transactions when used properly.[1] Usually, the letter of credit serves to give an importer of goods as well as the exporter a chance to go a head with their business transactions even when there is no real liquid money available to either party.

Letters of credit, however, present very many challenges to both the exporter and the issuing bank because they are usually documents that cannot be revoked under certain circumstances and so exposes some players to a lot of risk. A key concern has been the nature of the conditions that ought to be met before such documents can be honored by the exporter’s bank which usually has to rely on information from the importer’s bank.[2]

It is on the basis of the intricate issues that surround the letter of credit and its use that this paper seeks to critically discuss it especially when used in the context of international trade. Of particular interest, though, is a discussion of the undue exposure to losses and other risks on the issuer of the letter of credit, particularly in instances when the applicant or beneficiary of the letter of credit does not duly perform one’s obligations or wrongfully obtains payment.

The Working of a Letter of Credit

From a business point of view, it is usually very important for an importer of goods and who holds an account with a local bank to seek for the financing of the bank for goods that are to be sourced from another country.[3]

The reasons this is appropriate range from an ability to facilitate the business transactions and ensure a faster and timely transfer of the goods from the exporter’s location to that of the importer, and to reduce the costs that could be incurred in having to use other means of payment to pay for goods in another country – means of which are not always available. Therefore, from the business point of view, a letter of credit serves to enhance the general business transactions involving international trade.

Where the challenge comes in is that point when it is never drawn or requested unless there is some form of credit that needs to be transferred. Actually, the letter of credit is used as an exchange of the credit of the bank and that of the buyer. Here, issues of compliance with the terms and conditions of the letter of credit poses many challenges and risks to the issuing bank as well as the advising bank which literally transfers the credit to the exporter’s account. This results because of the manner in which the transactions are conducted.

First, an importer in the United Kingdom orders for coffee beans from a farmer in Brazil. The farmer insists that the coffee beans can only be exported or ferried on condition that the payment for them is paid within forty days from the time the transaction is entered into.

The UK importer cannot get to Brazil to make the payments but there is a way that the exporter’s bank can communicate with the importer so that the credit can be transferred. However, the buyer does not want any undue risks so he does not offer cash to his bank but asks for a letter of credit to be drafted with the Brazilian coffee exporter as the beneficiary. The UK bank makes an arrangement with this importer and because he satisfies the conditions required, the bank drafts a letter of credits and transfers it to the beneficiary’s bank in Brazil. That advising bank then verifies the details of and terms of the letter of credit and duly pays the exporter.

Once this is done, it is all to the exporter to ship the coffee beans to the UK. Only then can the advising bank (the exporter’s bank) be able to seek for the payment for the goods in accordance with the terms and conditions of the letter of credit. As can be clearly seen, there are so many processes involved and it all boils down to four main players who are bound to lose or benefit. There are the bank of the exporter, the bank of the importer, the exporter and the importer.

Commercial Letter of Credit and Standby Letter of Credit

It is always important to draw a distinction between two types of letters of credit commonly used in international trade and to ascertain the roles each plays towards enhancing payments for imports by a customer.[4] The commercial letter of credit is the most widely used and its use is restricted to the actual exchange of credit on behalf of the customer of a bank. It is the commercial letter of credit that will be needed by the advising bank or the exporter’s bank in order to effect payments.

However, owing to the risks to the issuing bank regarding defaulting on the part of the importer who is also its customer, the issuing bank usually drafts and issues another letter of credit for the purposes of proving the credit worthiness of the importer. This particular letter of credit, therefore, serves the function of guaranteeing the advising bank and the exporter that the importer will actually pay for the goods. This reduces the risks inherent in international trade.[5]

Based on this fact, it can be fairly argued that an issuer of the commercial letter of credit will be protected significantly in the event of failure by the beneficiary to adhere to the terms and conditions of the letter of credit. To a significant level, having the standby letter of credit protects the issuer because it cannot be allowed to pursue the property of the importer and recover the money; or it can fail to pass the money to the advising bank. In accordance to the UCP provisions, the banks are protected only mildly when it comes to failure by trader to honor their part of the contract regarding payments to be submitted. For instance, the UCP never really form part of the official international trade rules and are only applicable when the parties to the trade deal believe it is right for them.

The absence of a clear law, therefore, that emphatically seeks to help issuers of letters of credit means that they are exposed to many risks. The law in this country regarding international trade in general and letters of credit in particular tend to offer protection to consumers more than the issuer of the letters of credit. It is almost always believed that banks have the right and the capacity to set up their own terms and conditions which they believe are sufficient enough to protect them from any acts of fraud by traders; and as such not a lot of protection is offered them under the law.

International trade law will also protect the local bank and not the foreign bank, meaning that in the event the local bank, which is the issuer of the letter of credit, has already passed on the money to the advising bank, then there is little that can be done to recover the money especially in cases where the trader fails to honor the obligations to pay the bank due to bankruptcy or any other reason.

This is because the law on bankruptcy protects the importer from the actions of banks that can lead to further legal battles. If such an importer files for bankruptcy during the period when the goods are yet to be delivered to him, then there is nothing the bank can do to recover its money.[6] A person declared bankrupt is protected from his debtors until at such a time when the bankruptcy can be lifted. This clearly renders the issuer of the letter of credit to such a trader incapable of recovering its owed monies.

[1] Campbell, Dennis. REMEDIES FOR INTERNATIONAL SELLERS OF GOODS [2008] Volume II. Lulu.com, 2008
[2] Edwards, George. Foreign Commercial Credits; A Study in the Financing of Foreign Trade. General Books LLC, 2009
[3] Great Britain. Law Commission. Company security interests: a consultative report. Routledge, 2005
[4] Credit research Foundation. “Understanding and Using Letters of Credit, Part I” (1999). Retrieved 08/16/2010 from: http://www.crfonline.org/orc/cro/cro-9-1.html
[5] Warner, Susan. The Letter of Credit. Kessinger Publishing, 2007
[6] LLL. “U.C.C. – ARTICLE 5 – LETTERS OF CREDIT .” (2005). http://www.law.cornell.edu/ucc/5/article5.htm

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