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Information > Financial Terms > This page Letter of Credit Instrument
by which a bank substitutes its own credit for that of an individual,
firm, or corporation, to the end that domestic and foreign trade may be
more safely economically, and expeditiously conducted.
In the case American Steel Company v. "A
letter requesting one person to make advances to a third person on the
credit of the writer is a letter of credit.
These letters are general or special.
They are general if directed to the writer's correspondents generally.
They are special if addressed to some particular person." From
a functional standpoint, banks recognize two classes of letters of credit
- commercial and traveler's - and the above definition includes both classes.
Since a TRAVELER'S LETTER OF CREDIT is treated under that subject,
only additional definitions of commercial letters of credit are given
below. A
commercial letter of credit has been defined as follows: "An
instrument by which a banker, for account of a buyer, gives formal evidence
to a seller of its willingness to permit him to draw on certain terms
and stipulates in legal form that all such bills will be honored, is what
has come to be known as a commercial letter of credit" (Board of Governors
of the Federal Reserve System, Federal Reserve Bulletin). The
following is a somewhat more complete definition:
an instrument drawn by a bank, known as the credit-issuing bank
(and eventually the drawee bank), in behalf of one of its customers (or
in behalf of a customer of one of its domestic correspondents), known
as the principal (who guarantees payment to the credit-issuing bank),
authorizing another bank at home or abroad, known as the credit-notifying
or negotiating bank (and usually the payer bank), to make payments or
accept drafts drawn by a fourth party, known as the beneficiary, when
such beneficiary has complied with the stipulations contained in the letter. Interpretive
Ruling 7.7016 of the Comptroller of the Currency provides that a national
bank may issue letters of credit permissible under the Uniform Commercial
Code or the Uniform Customs and Practice for Documentary Credits to or
on behalf of its customers. As
a matter of sound banking practice, the Comptroller of the Currency in
the referenced ruling further states that letters of credit should be
issued in conformity with the following: 1.
Each letter of credit should conspicuously state that it is a letter
of credit or be conspicuously entitled as such. 2.
The bank's undertaking should contain
a specified expiration date or be for a definite term. 3.
The bank's undertaking should
be limited in amount. 4. The bank's obligation to pay should arise only upon the presentation of a draft or other documents as specified in the letter of credit, and the bank must not be called upon to determine questions of fact or law at issue between the account party and the beneficiary. 5.
The bank's customer should
have an unqualified obligation to reimburse the bank for payments made
under the letter of credit. A
common form of commercial letter of credit is appended.
Analyzed
into its component elements it will be seen that a commercial letter of
credit consists of the following parts:
(1) heading, (2) address to the beneficiary, (3) promise to honor
drafts, (4) tenor of drafts, (5) amount, (6) description of requir3ed
documents, (7) nature of shipment, (8) expiration date, (9) privilege
of cancellation, and (10) supplementary details, such as issue date, number,
disposition of letter, and interpretation. Commercial
letters of credit are classified as follows: 1.
Direction of shipment. a. Export. b. Import. c. Domestic. 2. Security. a.
Documentary. b. Clean. 3. Tenor
of drafts drawn there under. a. Sight. b. Time. 4.
Form of letter. a. Straight. b. Revolving. 5.
Form of currency. a. Dollar. b. Sterling. c. Continental
currency. d. Asiatic
currency. 6.
Privilege of cancellation. a. Irrevocable-confirmed. b. Irrevocable-unconfirmed. c. Revocable-Unconfirmed. 7. Payment
of principal. a. Paid. b. Guaranteed. None
of the above classifications is mutually exclusive.
A letter of credit may, for instance, arise out of an import transaction
and be straight, documentary, 60 days' sight, guaranteed, revocable-unconfirmed,
and payable in dollars. An
export letter of credit is one arranged to finance the export of merchandise,
while an import letter of credit finances the import of merchandise. A
documentary letter of credit is supported by a bill of lading and relative
papers, while a clean credit is not. A
sight letter of credit is one in which the draft drawn thereagainst is
payable on presentation, while a time or acceptance credit is one in which
the draft is payable only when the stipulated number of days after date
of acceptance has elapsed. A
straight letter of credit is one issued to finance the shipment of specified
merchandise and thereupon becomes void, while a revolving letter of credit
automatically renews itself for the original stipulated amount each time
a draft is drawn there against and does not exhaust itself until the expiry
date. A
revocable letter of credit is one in which the credit-issuing bank reserves
the right to rescind its obligation to honor drafts drawn by the beneficiary
by the phrase "good till cancelled" or other similar expression.
An irrevocable letter of credit is one in which the credit-issuing
bank waives the right to revoke the credit prior to the expiry date, unless
the consent of the beneficiary is obtained.
The irrevocable letter of credit may be strengthened by having
the notifying bank in the exporter's country add its own unqualified assurance
that the credit-issuing bank's obligation will be performed, and that
if the latter refused to honour the draft drawn against the credit the
notifying bank will pay or accept in any event.
Such a letter of credit is known as irrevocable-confirmed.
But if the notifying bank merely transmits the issuing bank's obligation
to the beneficiary without confirming the latter's undertaking, thereby
not making the issuing bank's commitment its own, then the letter of credit
is called irrevocable-unconfirmed. A
paid letter of credit is one in which funds are deposited by the principal
(buyer) with the credit-issuing bank at the time of issue, but this is
of rare occurrence. A guaranteed
letter of credit, which is the usual type, is one in which the principal
guarantees payment of the amount of the draft to the credit-issuing bank
at its maturity. See
GUARANTY. In
issuing letters of credit a bank is not called upon to part with cash,
unless it discounts its own acceptances drawn under the terms thereof.
The liability created in the issue of letters of credit is not
restricted, but the national banking laws and the Federal Reserve Act
place definite limitations upon the amount which a member bank may accept
under such credits. Summary. From
a review of decisions on commercial letters of credit the following principles
may be deduced: 1.
A letter of credit is not a negotiable instrument. 2.
It does not create a trust fund in favour of the beneficiary. 3.
An issuer of a letter of credit may not dishonour drafts presented
by a negotiating bank under a clean irrevocable letter of credit if all
the terms of the credit are fulfilled. 4.
An issuer may dishonor bills drawn in violation of the conditions
specified in a documentary letter of credit. 5.
The negotiator is not liable
for the genuineness of either goods or documents. 6.
The issuer is responsible
to the party requesting the credit for the observance of the conditions
by the beneficiary. 7.
The
contract between the issuer and the beneficiary is entirely independent
of the contract of sale between the buyer and seller, and the issuer cannot,
because of the seller's breach of contract of sale, refuse to honour drafts
which comply with the terms of the letter of credit. Standby Letters of Credit. As defined in Interpretive Ruling 7.1160 of the Comptroller of the Currency, the term "standby letter of credit" does not include commercial letters of credit and similar instruments where the issuing bank expects the beneficiary to draw upon the issuer, which do not guarantee payment of a money obligation and which do not provide for payment in the event of default by the account party. Accordingly,
the referenced ruling defines a standby letter of credit as any letter
of credit, or similar arrangement however named or described, which represents
an obligation to the beneficiary on the part of the issuer:
(1) to repay money borrowed by or advanced to or for the account
of the account party, (2) to make payment on account of any indebtedness
undertaken by the account party, or (3) to make payment on account of
any default by the account party in the performance of an obligation. A
standby letter of credit is subject to the limitations of 12 U.S.C. 84
and must be combined with any other non-excepted loans to the account
party by the issuing bank for the purposes of applying the referenced
Section 84. Where the standby
letter of credit is subject to a non-recourse participation agreement
with another bank or banks, this provision shall apply to the issuer and
each participant in the same manner as in the case of a participated loan. Exceptions
to the application of lending limits to standby letters of credit, as
specified by the Interpretive Ruling 7.1160(c), are as follows: 1.
Where prior to or
at the time of issuance, the issuing bank is paid an amount equal to the
bank's maximum liability under the standby letter of credit. 2.
Where prior to or
at the time of issuance, the issuing bank has set aside sufficient funds
in a segregated deposit account, clearly earmarked for that purpose, to
cover the bank's maximum liability under the standby letter of credit. 3.
Where the Comptroller
of the Currency has found that a particular standby letter of credit or
class of standby letters of credit will not expose the issuer to the similar
risk of loss as would a loan to the account party. Standby
letters of credit and ineligible acceptances, as defined in the Comptroller's
Interpretive Ruling 7.1160, constitute extensions of credit within the
meaning of 12 U.S.C. 371c (which refers to loans to affiliates) when they
are issued on behalf of an affiliate. The
amount of outstanding standby letters of credit shall be stated in the
bank's financial statement (12 CFR 11.7(c)(9)vii). For
legal aspects of letters of credit see Article 5, Uniform Commercial Code.
The process for commercial and standby letters of credit is illustrated
in the appended chart. BIBLIOGRAPHY "Catching
Scams." Global Trade,
March, 1989. |