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Essentials of Letters of Credit

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By Scott Blakeley Esq.
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

Inexpensive means of payment in domestic and international trade

Letters of credit (L/C) have long served as a convenient, inexpensive means of payment in domestic and international trade. L/Cs may serve as guaranties, securing performance obligations with a bank,s commitment to pay upon presentation of a draft, default notice or other documents specified by the L/C. L/Cs have long been governed by Article 5 of the Uniform Commercial Code. The L/C is intended to assure the vendor of payment before the goods leave its warehouse.

What is a Letter of Credit?

An L/C may be broadly defined as an undertaking by an issuer, the bank, to pay a third party, the vendor who is the beneficiary for the account of the bank,s customer, the debtor, when the vendor submits documents specified by the L/C. If the vendor submits proper documents before the credit expires, the bank will pay the L/C , and the debtor must reimburse the bank. An L/C may be either revocable or irrevocable. An irrevocable L/C can be modified only with the consent of the vendor. A revocable L/C can be modified by the bank without the vendor,s consent. L/C s come in two varieties: commercial L/Cs, commonly used to pay for goods, and "standby L/Cs, which secure performance by assuring payment after default. Under either type, the credit of the bank is substituted for the credit of the debtor in favor of the vendor.

Essential Principles Governing Law

Within the United States, Article 5 of the Uniform Commercial Code (UCC) governs L/Cs. Article 5 is founded on two principles: (1) the L/C,s independence from the underlying business transaction, and (2) strict compliance with documentary requirements.

The Independence Doctrine

L/Cs are purely documentary transactions, separate and independent from the underlying contract between the debtor and the vendor. The bank honoring the L/C is concerned only to see that the documents conform with the requirements in the L/C. If the documents conform, the bank will pay, and obtain reimbursement from the debtor. The bank need not look past the documents to examine the underlying sale of merchandise. The letter of credit is independent from the underlying transaction and, except in rare cases of fraud or forgery, the issuing bank must honor conforming documents. Thus, vendors are given protections that the issuing bank must honor its demand for payment (which complies with the terms of the L/C) regardless of whether the goods conform with the underlying sale contract.

Strict Compliance

The bank may insist upon strict compliance with the requirements of the L/C. In the absence of conformity with the L/C, the vendor cannot force payment and the bank pays at its peril. The question remains, how strict compliance? Some courts insist upon literal compliance, so that a misspelled name or typographical error dooms the vendors demand for payment. Other courts require payment upon substantial compliance with documentary requirements. Careful vendors should remember that the bank may insist upon strict compliance with all documentary requirements. If the documents do not conform, the bank should give the vendor prompt, detailed notice, specifying all deficiencies.

Forms of Letters of Credit
Commercial Letters of Credit

This form of L/C is commonly used when the contract involves sale of goods. Many exporters require payment by letter of credit. Typically, the buyer applies to his bank, which opens a letter of credit in favor of the exporter, payable upon presentation of the seller,s draft, bill of lading and other shipping documents specified in the credit. When the goods are shipped, the seller delivers those documents to the bank and collects full payment. The bank holds the documents and usually takes a security interest, pending reimbursement by its customer, the buyer. The transaction involves three relationships: (1) the letter of credit, which obligates the bank to pay the beneficiary upon presentation of the documents; (2) the reimbursement agreement between the bank and its customer, which obligates the beneficiary to reimburse the bank and pay a fee; and (3) the underlying contract for the sale of goods.

Standby Letters of Credit

A standby L/C is customarily used in non-sales transactions. This form of L/C assures payment in case of nonperformance. Under the commercial L/C, the vendor,s right to payment is conditioned upon submitting certain documents; with standby L/Cs, a vendor draws down on the L/C only when the vendor establishes that the debtor has defaulted. For the commercial L/C, payment is expected; for the standby L/C, payment should be the exception.

The Parties, Rights and Obligations
Issuing Bank

When an issuer receives a draft and demand for payment, it must decide to honor or dishonor within three banking days under the UCC. The bank must examine the documents with reasonable care. If the documents conform, the bank must pay, and be reimbursed by its customer, the debtor. Failure to honor within three banking days constitutes dishonor. If the documents do not conform, the bank should give the beneficiary prompt, detailed notice, specifying all deficiencies.


The vendor is entitled to payment upon submission of proper documents. By presenting its draft and demand for payment, the vendor represents that all conditions of the L/C have been complied with.


The debtor must reimburse the bank when the bank honors conforming drafts and demands, i.e. the debtor unconditionally agrees to reimburse the bank.

Reprinted by permission from Trade Vendor Quarterly
Blakeley & Blakeley LLP Fall 2001

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