International sales transactions between sellers and buyers
require an agreement as to the form of payment for the goods.
Various methods of payment settlement include but are not
limited to open account, foreign collection, cash in advance and
documentary credit. One of the most common forms of payment
is documentary credit, which is also known as a Letter of Credit.
What is a Letter of Credit?
A Letter of Credit is literally a "letter" pertaining to a sales
transaction between a buyer and seller. The "letter" is initiated
by the buyer and is directed to the seller or beneficiary, in most
cases. In some cases, the beneficiary may not necessarily be
the Seller but would be the party possessing the right to receive
payment for the goods or services. (Please refer to the
webpage dealing with transferable letters of credit for additional
A Letter of Credit is the traditional worldwide risk management
tool for international transactions. Issued by a foreign bank
(representing the buyer) and confirmed by a corresponding
bank usually in the country of the seller, a Letter of Credit is the
overseas bank's commitment to pay the seller's drafts. A Letter
of Credit is opened by an issuing or opening bank. The buyer
chooses the opening bank.
Revocable vs. Irrevocable Letters of Credit
A Letter of Credit may be revocable or irrevocable. In a
revocable Letter of Credit, the issuing bank (representing the
buyer) has the right to cancel or alter its obligation at any time
before payment of a sight draft or acceptance of a time draft.
That situation exists even if goods were shipped in reliance on
the expectation of payment.
An irrevocable Letter of Credit that is accepted by the seller,
however, cannot be altered or canceled without the consent of
the seller. Any change to an irrevocable Letter of Credit requires
the consent of all parties. Consent would include any parties
beyond the buyer and seller. For example the confirming banks
would be affected parties.
Confirmed vs. Unconfirmed
An irrevocable Letter of Credit can be either confirmed or
In a confirmed Letter of Credit, the issuing bank (representing
the buyer) agrees independently to the buyer's commitments to
pay the seller the agreed-up amount of money, as long as all the
requirements of the Letter of Credit are fulfilled.
A confirmed irrevocable Letter of Credit can become very
elaborate. A second bank (often specified as a prime bank) may
confirm or otherwise guarantee payment of the foreign bank that
initially opened the Letter of Credit. This requirement originates
from the seller and usually takes places only if the bank of the
buyer is not internationally established.
Other types of Letters of Credit
Other types of Letters of Credit may include straight or
negotiation credits. These types of Letters of Credit inform the
seller whether any bank, or only certain banks, can process the
documents of the seller to receive payment. All of the various
types of Letters of Credit can be combined in various ways with
extended rights and/or obligations, depending upon the exact
type of Letter of Credit issued. A Seller should be aware of
rights under a Letter of Credit before proceeding with a sale.
Letter of Credit rules- International Chamber of Commerse
A Standard Documentary Credit Application Form has been
developed by the International Chamber of Commerce (ICC), in
Paris, France. The ICC has also published a guide to
Documentary Credit Operations. Banks throughout the world
adhere to the rules developed by the ICC.
The rights and obligations of buyers, sellers and participating
banks in international Letters of Credit transactions are
presented in careful detail in publications made available by the
ICC. Under the Uniform Customs and Practices for Document
Credits (UCP), the International Chamber of Commerce has
made available in a publication called the UCP 600. The
publication is almost always referred to in international Letter of
Credit forms and is a part of the Letter of Credit contract. The
ICC also has available ICC Publication No. 511, which takes the
reader through UCP 600 on an article-by-article and
clause-by-clause basis. The ICC Publication No. 511 also
explains the reasoning that led the ICC Working Group to
develop a thoroughly revised sets of Rules for Documentary
Credits under UCP 600.
Benefits of using a Letter of Credit
By conducting export sales transactions under an irrevocable
Letters of Credit, the seller does not have to determine the
credit standing of the foreign buyer. Letters of Credit are issued
in many different forms from foreign banks and financial
institutions. The variations are due to differences in customs
and regulations of trade and finance in the country of origin of
the issuing bank or financial institution. If, for any reason, a
seller cannot comply with one or more conditions of a Letter of
Credit, it is absolutely imperative for the seller to contact the
buyer to arrange for one or more amendments to the original
Letter of Credit Discrepancies
If there is a disagreement between a sale contract's shipping
and documentation requirements and those in a Letter of Credit,
the seller must take immediate action before shipping to arrange
for an amendment to the Letter of Credit. If the seller does not
arrange for such an amendment, the seller may experience
payment problems. Full compliance with all conditions for
payment are interpreted by banks rigidly. Any disagreement,
however small, represents grounds to reject the payment of the
On a worldwide basis, approximately 60% of document
presentations on Letters of Credit are presented with
discrepancies. Banks charge for EACH discrepancy. Therefore,
it is extremely important to ensure document presentations are
accurate and complete to avoid additional costs and delays in
Payment on a Letter of Credit
The documents listed in a Letter of Credit are presented to the
negotiating/paying Bank with a draft, which is sometimes
referred to as a "bill of exchange". A draft resembles a check. In
a Letter of Credit sale, the drawee on the draft is the bank that
issued the Letter of Credit. The seller is the drawer of the draft.
Drafts are classified as either sight or time. A sight draft requires
a drawee to pay the amount shown in full upon proper
presentation of documentation. On a time draft, a payment date
later than the date of presentation would be stipulated (such as
60 days after sight or 90 days after sight).
When properly presented, a time draft is accepted by the
drawee. This means the drawee indicates an acknowledgement
that the necessary conditions to its payment were met and the
drawee is obligated to pay on the appointed date.
Paying a sight draft or accepting a time draft when documents or
goods have been presented is known as honoring the draft.
If the Letter of Credit states "payment at sight", the seller should
receive payment within a reasonable time (usually not exceeding
seven days) after documents are presented within the validity
period of the Letter of Credit and accepted by the negotiating
Usual Letter of Credit conditions
The usual conditions included in a Letter of Credit include
delivery dates, product specifications and receipt by the bank of
specific documents (such as negotiable bills of lading, inspection
certificates, commercial invoices and packing lists). Any required
documents must be presented to the bank within a specific
period of time. There may also be other terms and conditions as
negotiated between the buyer and seller.
Letter of Credit terms and conditions (and all required
documents) should be agreed upon between the buyer and
seller, in advance of opening of a Letter of Credit. Letter of
Credit issuance instructions should then conform to the terms of
such an agreement.
Exporters in the United States should request the overseas
buyer to open an Irrevocable Commercial Letter of Credit,
payable 100% at sight, freely negotiable or confirmed by a bank.
If the Letter of Credit is to be confirmed, the seller should also
request the buyer to instruct the issuing bank to obtain the
Letter of Credit confirmed by a bank in the United States.
International Letter of Credit