The role of letters of credit in payment transactions.

• Author: Mann, Ronald J.

Common justifications for the use of the letter of credit fail to explain its widespread use. The classic explanation claims that the letter of credit provides an effective assurance of payment from a financially responsible third party. In that story, the seller -- a Taiwanese clothing manufacturer, for example -- fears that the overseas buyer -- Wal-Mart -- will refuse to pay once the goods have been shipped. Cross-border transactions magnify the concern, because the difficulties of litigating in a distant forum will hinder the manufacturer's efforts to force the distant buyer to pay.(1) The manufacturer-seller solves that problem by obtaining a letter of credit from a reputable bank. A reputable bank is unlikely to default on its obligation to pay the seller, and the seller knows that it has an absolute right to payment once it ships the goods -- conditioned only on the seller's presentation to the bank of the specified documents (typically the invoice, a packing list, an insurance certificate, and a transport document such as a bill of lading). Thus, the story goes, the seller that obtains a letter of credit can rest assured that it will be paid even if the buyer would not pay voluntarily.(2)

The payment-assurance story is logical and plausible. But it rests on a line of reasoning that is largely untrue at one important and critical point: the seller's possession of an absolute right to payment. When I spoke anecdotally to bankers and lawyers familiar with the industry, they uniformly claimed that sellers ordinarily do not present documents that conform to the requirements of the letter of credit. Among other things, documents might be missing, late, or fail to precisely match the details about the shipment provided in the letter of credit.(3)

Under the standard payment-assurance account, the whole transaction hinges on the seller having a reliable right to payment by the bank that issues the letter of credit. But if the seller often does not submit documents that conform to the letter of credit, then the seller has no right to payment at all, just a request for a payment that will be honored only if the buyer waives the defects in the seller's presentation.(4) And if the seller's ability to collect rests on the buyer's unconstrained choice to waive defects in the seller's presentation, then why buy the letter of credit instead of the simpler (and presumably cheaper) course of shipping the goods and simply waiting for payment from the buyer?(5) That parties to a sale transaction would ignore formal documentation requirements is not surprising, but their systematic purchase of a product conditioned on their compliance with requirements they commonly ignore does not appear rational.

Intrigued by that question, I explored the topic in detail in the summer of 1999. I gathered data in two ways. First, I visited five separate banks on-site to collect data on their letter-of-credit transactions. Although all of the banks are located in the United States, I selected institutions of sufficient variety to get a representative picture of the industry as a whole. I visited the following banks: (a) a large U.S. regional bank headquartered in the Midwest with significant letter-of-credit volume; (b) a mid-sized U.S. regional bank headquartered in the Northeast with significant letter-of-credit volume; (c) a major U.S. domestic bank headquartered in the West with worldwide letter-of-credit operations; (d) a major foreign bank, with more than one U.S. location and with worldwide letter-of-credit operations; and (e) a major U.S. bank headquartered in the Northeast with worldwide letter-of-credit operations.(6) At each bank, I personally collected information on 100 transactions (fifty "import" transactions, in which the bank's client was the buyer, and fifty "export" transactions, in which the bank's client was the seller).(7) For each transaction, I recorded twenty-five data points.(8) Among other things, I determined whether the presentation conformed to the letter of credit and, if it did not, what the discrepancies were, and the parties' response to them? As a matter of practicality, I relied entirely on the banks' internal documentation of those issues. The banks, of course, could have erred in their assessment of discrepancies, but given the point of my study -- understanding how parties react to discrepancies -- data regarding their perception of discrepancies is directly relevant.(10)

To supplement the raw data, I also interviewed ten bankers who engage in letter-of-credit transactions.(11) I interviewed five of the bank officers who supervise the sites that I visited, and five officers at other banks with substantial letter-of-credit portfolios (two other large American banks, and three Tokyo-based Japanese banks).(12) Those interviews explored the significance of discrepancies in letter-of-credit transactions.

Part I of this Article briefly describes the basic letter-of-credit transaction. Part II describes the discrepancies that appear in those transactions, providing detail from the data I collected. The data generally support the anecdotal information that led me to conduct the study: the documents presented in the 500 transactions I examined conformed to the letter of credit only 27% of the time. The payment transactions rendered the discrepancies irrelevant because the buyer waived the discrepancies in all but one case and provided full payment for the shipment in spite of the discrepant presentation.(13)

Part III uses the data and the interviews described above to assess the possible reasons for the common use of letter of credit. First, I reject the possibility that businesses use letters of credit out of irrational habit or custom because the ready availability and frequent use of alternative payment transactions strongly suggests that businesses rationally use letters of credit. Second, I evaluate the persuasiveness of the classic payment-assurance story and conclude that the payment-assurance story probably still has some plausibility, at least in contexts (such as many exports from the United States) where parties select the letter of credit to compensate for the weakness of relational ties between the buyer and the seller.

Finally, I consider some alternative reasons that might motivate commercial enterprises to use letters of credit. Specifically, I argue that the issuing bank's ability to verify information about the purchaser and the transaction provides the most compelling reason for widespread use of letters of credit. The issuer verifies information about the purchaser and the transaction in two ways. In the first and principal scenario, commonly used in situations where the parties have no significant relationship, the willingness of the bank to issue the letter of credit signals to the potential seller that the purchaser will not withhold payment for illegitimate reasons. In the second scenario, the bank's willingness to issue the letter of credit verifies to the government (or another financial institution) the legitimacy of the transaction, and the letter of credit indirectly assists in the enforcement of currency controls and laws against money laundering.

Those two explanations share a common and obvious thread -- the problem of information asymmetry. In both situations, the parties design a transaction to include a letter of credit to respond to an information imbalance at the time the transaction begins. Thus, to use my own terminology, I argue that the letter of credit generally serves as a verification institution to resolve that information problem.(14)

1. THE BASIC LETTER-OF-CREDIT TRANSACTION

   This study focuses on the basic commercial(15) letter-of-credit transaction. That transaction has two sides: an import side (the buyer) and an export side (the seller). Both sides ordinarily have a bank, which makes a total of four parties to the transaction. The bank on the import, or buyer's, side of the transaction normally issues the letter of credit, which obligates the bank to pay the purchase price upon the receipt of specified documents.(16) Letter-of-credit rules typically describe the importer as the applicant, and the applicant's bank as the issuing bank or the issuer of the letter of credit.(17) The fees differ significantly from market to market, and from customer to customer (with better customers paying much less). As a general matter, however, the total fees for the banks issuing and processing the letter of credit are likely to approximate one-quarter of one percent of the amount of the letter of credit. On a $1,000,000 sale of goods, then, use of a letter of credit would require about $2,500.(18) Figure One illustrates the typical transaction.

   [Figure 1 ILLUSTRATION OMITTED]

   Central to the letter-of-credit system is the concept of independence: the bank's obligation on the letter of credit is completely separate from any of the contractual obligations of the underlying transaction, either the obligation of the buyer to pay the seller under ordinary principles that govern sales transactions, or any obligation that the buyer might have under an agreement or common-law principles to reimburse the bank for payments made on its behalf under the letter of credit.(19) The bank's obligation depends entirely on the beneficiary's presentation of documents that conform to the requirements of the letter of credit.(20) Indeed, the rules governing letters of credit so thoroughly separate the bank's obligation to pay from ordinary context-laden principles of contract law, that it is best thought of, to use Roy Goode's apt term, as an "abstract payment undertaking" -- an enforceable undertaking to make payment wholly abstracted from the underlying transaction.(21)

   The bank on the export, or seller's, side plays a different role. The seller hopes, to receive the funds offered by the letter of credit as payment for the anticipated shipment, and is thus identified as the...