How Letters of Credit Operate in International Commercial Transactions: an Introduction to the Ucp

• Publication year: 2008
• Pages: 16
• Citation: Vol. 77 No. 3 Pg. 16

How Letters of Credit Operate in International Commercial Transactions: An Introduction to the UCP No. 77 J. Kan. Bar Assn 3, 16 (2008) Kansas Bar Journal March, 2008

By John W. Head

I. Introduction

Most international letters of credit — that is, letters of credit used in commercial transactions involving buyers and sellers in different countries — are not governed by the Uniform Commercial Code (UCC). Instead, they operate under the Uniform Customs and Practice (UCP), a multilateral set of rules that are issued and regularly updated by the International Chamber of Commerce (ICC). If your Kansas client is engaged in a transborder sale-of-goods transaction and wants to maximize the chances of getting paid by the foreign buyer, both you and your client should know the basics about the UCP.

The aim of this article is to provide a nutshell account of international letters of credit, with special emphasis on the UCP. The article focuses on commercial international letters of credit that are used in financing a transborder sale-of-goods transaction of the sort mentioned above. The article does not examine other types of international letters of credit that are commonly confronted in practice, such as standby letters of credit and back-to-back letters of credit.

II. The Setting: International Documentary Sales

Assume that your client, Shera Manufacturing Corp. (Shera), is a Kansas corporation with offices, facilities, and a warehouse in Wichita. Shera produces state-of-the-art geopositioning system (GPS) equipment and has sold that equipment for several years to buyers in the United States — but it recently entered into negotiations with a buyer in the Netherlands named Hugo de Groot Ltd. (Hugo), which wants the GPS equipment shipped to Rotterdam. Shera now seeks your legal advice about how the negotiations, and the transaction itself, should proceed, and particularly about how Shera can be assured of getting paid by Hugo. After all, Hugo is both physically and legally "distant" from Kansas, and Shera does not have total confidence in Hugo.

How might you advise Shera? First, you could point out that, as a general matter, the negotiations and procedure for the transaction can be regarded as falling into four parts: (1) formation of the sales contract, (2) arrangement of financing, (3) shipment of the goods, and (4) payment for the goods. Shera's biggest concern is over the fourth part — getting paid — but addressing that concern requires proper attention to the other steps as well. You might identify those steps as follows:

Part 1: Formation of the sales contract

Step 1.1: Shera and Hugo negotiate the terms of the transaction, including the requirement of a documentary sale, with payment under a confirmed letter of credit with a U.S. confirming bank.

Step 1.2: Shera and Hugo conclude and sign a contract that fully reflects those negotiated terms.

Part 2: Arrangement of financing

Step 2.1: Hugo approaches its bank in the Netherlands, Amster Bank, and asks it to issue a letter of credit in favor of Shera.

Step 2.2: Amster Bank opens a letter of credit in favor of Shera — this makes it the "issuing bank" — and so advises its correspondent bank in Wichita, Prairie Bank. Amster Bank requests Prairie Bank to confirm the credit. Prairie Bank agrees to do this, thus becoming the "confirming bank."

Step 2.3: Prairie Bank, in its capacity as the confirming bank, advises Shera that the issuing bank has opened the letter of credit and that Prairie Bank has "confirmed" it.

Part 3: Shipping of the goods and handling of the documents

Step 3.1: Shera is likely to engage a freight forwarder to make detailed arrangements for handling the goods at the port of shipment. Let us assume the parties have designated Houston for the port of shipment.

Step 3.2: Shera has the goods transported to the port of Houston where the freight forwarder facilitates their delivery to the carrier, the operator of the oceangoing vessel that will transport the goods across the Atlantic.

Step 3.3: The goods might be inspected by an inspection agent of Hugo; if so, that inspection agent issues a Certificate of Inspection.

Step 3.4: When the carrier's vessel arrives in the port of Houston, the goods are loaded onto it, whereupon the carrier issues a negotiable bill of lading.

Step 3.5: Shera arranges for insurance coverage of the goods during their ocean transportation. In this regard, the insurer issues an Insurance Certificate.

Part 4: Payment for the goods and release to buyer

Step 4.1 Shera draws a draft on Amster Bank and presents it and the required documents to Prairie Bank for payment by Prairie Bank to Shera under the confirmed letter of credit. The required documents typically will include:

• Negotiable bill of lading endorsed by Shera;

• The Insurance Certificate;

• A packing list used in putting the GPS equipment into the cartons;

• The Commercial Invoice that Shera prepared for the sale of the goods;

• A Certificate of Origin that Shera would have secured — probably from the Wichita Chamber of Commerce or some similar entity — showing that the GPS equipment comes from the United States; and

• The Certificate of Inspection, if required.

Step 4.2: If Prairie Bank finds that the documents presented by Shera match the documents required in the letter of credit, then Prairie Bank honors the draft and pays Shera.

Step 4.3: Prairie Bank endorses the bill of lading and then forwards it and the other documents listed above to Amster Bank, which pays Prairie Bank, probably by crediting an account that Prairie Bank has with Amster Bank.

Step 4.4: Amster Bank endorses the bill of lading and then transfers it and the other documents to its customer Hugo, typically by charging Hugo's account with Amster Bank or by giving credit to Hugo.

Step 4.5: When the goods arrive by vessel at the port of destination, Hugo presents the negotiable bill of lading, as endorsed by Amster Bank, to the carrier, whereupon the carrier releases the goods to Hugo.

See Illustration A for a stylized diagram summarizing the movement of goods, documents, and money as described in the pertinent steps enumerated above

Illustration A

under a documentary sale with a confirmed letter of credit.

The document that serves as a "lynch-pin" in the transnational documentary sale transaction described above is the letter of credit. If properly used, that letter of credit can make the transaction proceed smoothly, to the benefit of all parties involved: the seller gets paid promptly, the buyer receives the goods as ordered, the issuing and confirming banks earn fees for temporarily accepting risks that they were in a good position to assess and bear, the carrier has been paid for transporting the goods, and the freight forwarder has earned a fee for facilitating the movement of goods and documents at the port of shipment.

However, such transactions sometimes do not proceed smoothly. For example, the documents presented by the seller, in the hypothetical case described above, to the confirming bank might include some discrepancy when compared to the description that the letter of credit gives of the documents that are required thereunder. (As noted below, there are several different types of discrepancies.) In such a case, a question arises for the bank: Should the bank accept those documents and pay the seller, notwithstanding the discrepancy? If it does accept and pay, a similar question would arise when the issuing bank receives the documents (including the discrepancy) from the confirming bank. Another question also might arise: How long does the issuing bank have to make up its mind about accepting or rejecting the documents? And does it have a duty to contact the buyer (its customer) to see if the discrepancy concerns the buyer?

Questions of these types, and of many other types, have arisen countless times in transnational documentary sales involving letters of credit, and, not surprisingly, different answers have been given in different legal systems. Because of the role that London has long played as an international commercial and financial center, English law was for years a dominant source of guidance in handling such questions...