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Clear out junk files and repair common Windows errorsFree Scan →Scan for outdated or missing drivers - takes under a minuteDriver Scan →A letter of credit (LC), also called a documentary credit, is a bank’s conditional undertaking to pay a seller when the seller presents documents that comply with the credit’s terms. The buyer asks its bank to issue the credit; the bank checks the documents—not the goods. That can make payment more dependable for the seller and give the buyer documentary controls, but it does not guarantee product quality or flawless performance of the sales contract.
Who is involved in a letter of credit?
- Applicant: Usually the buyer or importer, who asks a bank to issue the credit.
- Issuing bank: Issues the credit at the applicant’s request and undertakes to honour a complying presentation.
- Beneficiary: Usually the seller or exporter named in the credit.
- Advising bank: Communicates the credit to the beneficiary and checks its apparent authenticity under UCP 600. Advising alone is not a promise to pay.
- Nominated bank: The bank with which the credit is available. Being nominated does not, by itself, require that bank to pay.
- Confirming bank: Adds its own undertaking, alongside the issuing bank’s, to honour or negotiate a complying presentation.
How does a letter of credit work? An example
Suppose a U.S. importer buys machinery from an overseas exporter. The importer does not want to pay before shipment, while the exporter wants a bank undertaking before sending the machinery. They agree to use an irrevocable documentary credit and settle its required documents, amount, expiry, shipment terms, and payment timing.
- The importer applies. The importer asks its bank to issue a credit in favor of the exporter. The bank assesses the importer and, if it agrees, issues the credit.
- The credit is advised. The issuing bank sends it through an advising bank, which communicates the terms to the exporter. If the exporter is concerned about the issuing bank or country risk, the parties may arrange for a bank to add confirmation.
- The exporter checks the terms and ships. Before shipment, the exporter should confirm it can meet the credit’s requirements. It ships the machinery and obtains the required documents, often including a commercial invoice and transport document.
- The exporter presents the documents. The beneficiary presents them to the nominated bank or issuing bank within the credit’s deadline.
- The bank examines the presentation. It compares the documents on their face with the credit and applicable rules. When UCP 600 is incorporated, the relevant banks have up to five banking days after presentation to decide whether the documents comply.
- Payment follows the credit’s terms. If the presentation complies, the issuing bank must honour. The credit may provide for payment at sight or at a later determinable date. A confirming bank that determines the presentation complies must honour or negotiate. The documents can then allow the importer to claim the goods and clear them.
The exact document list, shipping terms, bank roles, availability, and reimbursement arrangements depend on the credit. Vague or impractical requirements can create problems: the exporter should resolve them before shipment rather than assume a bank will overlook a documentary issue.
What does the bank check—and what does it not check?
Banks examine the documents specified in the credit; they do not inspect the machinery or certify its quality. The undertaking is independent of the sales contract: the bank’s decision concerns the presentation, not whether the parties have performed every commercial obligation. The buyer gains a documentary mechanism for requiring evidence such as shipment documents before payment or release of documents, while the seller relies on the issuing bank’s undertaking rather than only on the buyer’s promise.
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UCP 600 Article 14(a) says the relevant banks determine, “on the basis of the documents alone,” whether the presentation appears to comply. UCP 600 applies only when the credit expressly states that it is subject to those rules.
What happens if documents do not comply?
A bank may refuse to honour or negotiate a presentation it determines is non-complying. Under UCP 600, a refusal notice must identify the discrepancies and be sent no later than the close of the fifth banking day after presentation. The issuing bank may ask the applicant whether to waive discrepancies, but the applicant’s waiver does not automatically require payment or extend the examination period.
Not every difference between documents automatically defeats payment. Under UCP 600, relevant data need not be word-for-word identical when read in context, but they must not conflict. Whether a presentation complies depends on the credit’s wording and the applicable rules and practice.
To reduce avoidable discrepancies, the exporter should coordinate with the buyer, freight forwarder, insurer, and other document issuers. Check that names, dates, quantities, descriptions, and document types match the credit’s requirements, and raise unclear or unworkable terms before shipping.
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Which letter-of-credit terms matter?
- Irrevocable: Under UCP 600, a credit is irrevocable even if it does not say so. It cannot be amended or cancelled without agreement from the issuing bank, any confirming bank, and the beneficiary.
- Confirmed: A confirming bank adds its own definite undertaking to honour or negotiate a complying presentation. Confirmation may address concerns about the issuing bank or country risk, but it does not cure non-complying documents.
- Advised: An advising bank communicates the credit and checks its apparent authenticity under UCP 600; it does not promise payment merely by advising it.
- Sight payment: Payment is due when the required conditions are met.
- Deferred payment: The bank incurs an undertaking to pay at a future maturity date.
- Documentary credit versus standby LC: A commercial documentary credit commonly serves as a primary payment method, while a standby is generally a secondary payment instrument. UCP 600 applies to a standby only to the extent its rules are applicable; the instrument’s wording controls.
What risks and costs remain?
An LC shifts the seller’s payment reliance toward a bank undertaking, but does not eliminate risk. The exporter remains exposed to the issuing bank and, depending on the transaction, political or payment risk in the importing country. A documentary discrepancy can also delay or prevent payment. Confirmation can add another bank’s definite undertaking against certain bank or country risks, but only a complying presentation qualifies.
Letters of credit can involve substantial fees and administration. Whether one makes sense depends on the value the parties place on a bank-mediated undertaking and documentary controls compared with those costs and the work of preparing and checking documents.
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How to decide whether an LC fits a transaction
Compare the arrangement with the parties’ actual payment and financing needs rather than treating an LC as the default for every sale. Useful factors include:
- the issuing bank’s credit risk;
- country or political risk, and whether confirmation is available;
- how complex the documentary requirements are and how likely discrepancies are;
- bank fees and the operational burden of preparing documents; and
- payment timing and whether either party needs financing.
For a specific transaction, the credit’s exact wording matters. UCP 600 is the ICC’s 2007 ruleset and governs only if incorporated into the credit; parties should check the applicable text and the terms of their instrument rather than assume rules apply automatically.
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