Letters of Credit: Legal Considerations

If your company carried out international commercial activity, you may have come across the need for letters of credit. These are traditionally used in trade transactions yet are becoming more widely used. Although less common, you could also use letters of credit in your business for domestic transactions.  If you use or are considering using letters of credit when carrying out your commercial activity, it is essential that you fully understand these. This is crucial before you enter into a letter of credit with financial instructions so that you know where you stand. This article will, therefore, explain letters of credit in terms of their legal framework.

What is a Letter of Credit?

A letter of credit is a form of credit that is part of the credit system and a common way to make payments through international trade. A buyer in a commercial transaction will request a letter of credit, meaning they are an applicant for credit. The letter of credit is a contractual document usually provided by a bank or other financial institution to ensure that a buyer of goods or services will honour their promise to pay for them. The seller of the goods is the beneficiary as they receive the payment. A buyer may request a letter of credit where they have a contract with the seller for the commercial transaction. 

The letter of credit will detail the commitment of the financial institution producing it that it will pay for the export of specific goods, providing the documents it details concerning these goods are to be presented for payment to be made. It will also detail when the buyer of the goods must pay the financial institution for the fee they made when the goods were shipped. Therefore, payment occurs upon the shipping of the goods, and the buyer has peace of mind for this payment and near receipt of goods.

Different types of letters of credit may be of use, such as:

• revocable credits;
• irrevocable credit;
• confirmed letter of credit;
• letter of credit at sight; and 
• red clause letter of credit. 

A commercial solicitor will advise you which type of letter of credit suits your position. The commercial agreement should then provide detail as to the kind of letter of credit. 

Why Might I Use a Letter of Credit? 

Credit payments are helpful if you are purchasing goods from another country. They guarantee your seller that you will pay them on time and the correct amount. A letter of credit helps overcome some problems that can occur during international trade. Problems can include differing laws and the distance of the sale.

What is the Legal Framework for Letters of Credit?

Letters of credit are internationally used and are governed by the Uniform Customs and Practice for Documentary Credits (UCP), which the International Chamber of Commerce (ICP) produced. Using the UCP ensures that you do not have to necessarily understand the law of the different jurisdictions involved when using a letter of credit. 

It is helpful to specify which law governs the letter of credit, although many do not do so. 

Despite letters of credit being subject to the UCP and not always having a specific governing law, the contracts they cover should have their governing laws—for example, the agreement between the buyer and the issuing bank. As the UCP does not provide provisions about determining governing law, these contracts should detail this. 

Disputes and Letters of Credit

It is essential to understand that a dispute with the other party on the contract covering your commercial transaction does not affect the financial institution’s role, as detailed in the letter of credit. They will usually honour the letter of credit rather than your commercial contract. This is regardless of whether the transaction has not complied with the contract’s terms and conditions. 

Even if a bank has not made the payment, the seller or beneficiary can demand it does. This means that the former should comply with their obligations. 

However, there are circumstances in which a bank or other financial institution can refuse to make payment for a compliant request relating to a letter of credit. This is where it would be illegal for the bank in their jurisdiction to comply, where documents are fraudulent, and where a standby letter of credit is obtained, where the beneficiary does not honestly believe the latter is valid.

Guide to Resolving UK Business Disputes

This guide outlines how to resolve commercial disputes.

Download Now

Key Takeaways

A letter of credit is helpful for overseas commercial transactions, as it can help overcome issues such as different laws and currencies. A letter of credit is a legal, contractual document which details that a financial institution such as a bank will pay the seller on shipment of goods provided certain documents are provided. It will also contain details of these documents and when the buyer has to pay the bank for the goods. There are different types of letters of credit, such as irrevocable credits and revocable credits. 

The Uniform Customs and Practices for Documentary Credits (UCP) governs the letter of credit. This came into being through the International Chamber of Commerce. (ICP). The UCP is not law in England and Wales but is binding where the parties agree. If you have a dispute concerning the contract the letter of credit covers, this does not usually affect the letter of credit. This means the parties will still typically honour this. Nevertheless, there are instances when a financial institution will not honour a letter of credit, such as when it would be illegal for them to.

If you need help understanding letters of credit, our experienced disputes and litigation solicitors can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.