Letters of Credit and How to Use Them

Introduction

The Commercial Letter of Credit

Banker's Acceptances

Revolving Letters of Credit

Partial Shipments and Installment Letters of Credit

Back-to-Back Letters of Credit

Bill of Exchange and Trade Acceptances

Standby Letters of Credit

Elements Common to All Letters of Credit

Sources of Law

Risk and the Issuer's Duty to Honor the Credit

Introduction


The letter of credit, as we know the term today, existed
in England by the time of the 17th century when the bill
of exchange had matured into an instrument similar to the
drafts used today. While the letter of credit was
developed to facilitate international commercial
transactions involving the sale of goods, there is nothing
about letters of credit which limits their application to
international trade. They are used widely in domestic
sales transactions, and as a means to secure performance
of contracts and obligations other than the sale of goods.

Letters of credit are versatile instruments. They are
commonly used in the sale of goods (usually referred to as
a commercial credit), or as a type of guarantee (usually
referred to as a standby credit). Though the functions of
both varieties may differ, the basic elements and parties
in each letter of credit transaction are largely the same.


The Commercial Letter of Credit

In a common transaction involving a letter of credit and
the sale of goods, a buyer of goods (the ACCOUNT PARTY, or
in the case of a credit issued by a bank, the bank's
CUSTOMER) will cause a bank (the ISSUER) to issue a letter
of credit payable to the seller of the goods (the
BENEFICIARY). The letter of credit will state that upon
presentation to the issuing bank of the letter of credit
and accompanying documents specified in the letter, the
issuing bank will pay the beneficiary the sum of money set
forth in the letter of credit. The documents which must
accompany the letter of credit are often invoices, bills
of lading and insurance policies.

The issuing bank is usually located in the place where the
buyer does business. The seller often will want a local
bank available to which it can present the documents for
payment. An ADVISING BANK is one that gives notification
to the beneficiary-seller of the issuance of a letter of
credit by another bank. The advising bank agrees that the
beneficiary will present the letter of credit to it for
payment, but it does not assume any obligation to pay the
letter of credit. A confirming bank is a bank which
promises that it will honor a letter of credit issued by
another bank, and becomes directly obligated to the
beneficiary, as though it had issued the letter of credit
itself. The issuing bank remains obligated as well.

In the transaction discussed above, the letter of credit
provides benefits for both the buyer and seller of goods.
The buyer is assured that the seller will not be paid
until the proper documents evidencing shipment (and
possibly inspection, insurance, etc.) have been presented
to the bank. The risk of payment in advance for goods that
might never be shipped is thus avoided.

The seller's "credit" risk is minimized. The risk of
delivery of goods without payment is minimized. Payment is
obtainable shortly after delivery of goods to the carrier,
unlike the C.O.D. approach. The seller also avoids the
prospects of litigation in a foreign court, with the
accompanying uncertainties and expense.
The commercial letter of credit has become indispensable
in international trade. In any case where a seller does
not know the buyer well enough to ship on open account,
the commercial credit can provide protection in the
transaction. Since international trade is largely centered
in several major cities, the banks in those cities have
dominated the letter of credit industry. Commercial
letters of credit are also used in domestic sales, but
their use in domestic trade is far less pervasive. The
smaller banks in the country will often have little volume
in commercial credit, but significant business in the area
of standby credits.


Banker's Acceptances

Banker's acceptances are created when, instead of "sight"
terms, a commercial letter of credit is drafted with time
payment terms. For example, a commercial letter of credit
may state that payment is due on "90 days sight." This
means that payment is not made to the beneficiary until 90
days after conforming documents are presented. With a
banker's acceptance (time terms), a different series of
events take place. First, documents are presented by the
beneficiary. Assuming the documents conform, the bank
stamps "accepted" on the face of the draft. Once accepted,
the bank is obligated to pay the face amount of the draft
to its holder (usually the beneficiary) at maturity. The
maturity date of the accepted draft (now a "banker's
acceptance") will conform to the payment terms specified
in the original letter of credit. For example, if the
letter of credit payment terms were "90 days sight," the
maturity of the draft will be 90 days after the documents
are presented and accepted. Following acceptance of the
draft, the documents (and therefore title to the goods)
are released to the bank's customer. However, the customer
is not obligated to pay the bank for the goods until one
day prior to the maturity of the draft.

The primary benefit to both the bank's customer (account
party) and the beneficiary in a banker's acceptance
transaction is the delayed payment feature. The customer
is able to wait until after the goods have arrived (and,
perhaps, sold) before paying for them. The beneficiary is
able to offer terms (and perhaps make goods more
attractive to customers) without any credit risk, since
the bank guarantees payment.


Revolving Letters of Credit

Revolving letters of credit are similar to a revolving
line of credit. If a bank's customer (account party) plans
to make multiple purchases from one beneficiary, a
revolving letter of credit may be used. The bank sets a
specific maximum amount covered under the revolving letter
of credit. The beneficiary can then make multiple
shipments up to the limit of the revolving letter of
credit. As shipments are received and paid for by the
customer, new availability is created for the beneficiary
to ship against. Revolving letters of credit are generally
used in established , ongoing relationships to reduce the
paperwork associated with multiple orders.


Partial Shipments and Installment Letters of Credit

Only the beneficiary benefits from the unrestricted
privilege of making partial shipments. The beneficiary of
a letter of credit that does not prohibit or limit partial
shipments may ship goods as they become ready and may
obtain payment for whatever portion is shipped.

Installment letters of credit offer the bank's customer
firm control over the number and size of partial
shipments. Specified installments of goods to be shipped
are detailed in this type of letter of credit. If a
beneficiary misses the deadline for one shipment, the
remaining installments are canceled.


Back-to-Back Letters of Credit

Letters of credit are not only used as a means of ensuring
payment; frequently, letters of credit are used as a
financing device. A bank's customer may have a letter of
credit established in his or her favor, that is, he or she
would be the beneficiary of this letter of credit. This
customer may then approach his or her bank as an applicant
(account party) for another letter of credit (or loan)
using the first letter of credit to assure the bank of
payment under the new letter of credit or loan. This
situation is commonly referred to as a back-to-back
credit. Because the customer's payment of the second
letter of credit (where he or she is the applicant)
depends on the performance of the terms on the first
letter of credit (where he or she is the beneficiary), the
risks are compounded. Instead of this scenario, often a
transferable or assignable letter of credit will be issued
on the beneficiary's behalf, who in turn, assigns or
transfers it to a third party for payment of goods
shipped. When it is assigned, the original account party
will know who the third party is, when it is transferred,
this will normally not occur.


Bill of Exchange and Trade Acceptances

Another method of financing trade is through bills of
exchange and trade acceptances. Bills of exchange are
similar to sight drafts drawn under commercial letters of
credit, with two exceptions: 1) there is no letter of
credit (the bank does not guarantee payment), and the
draft represents an obligation of the importer only.
Extended terms can also be arranged through bills of
exchange that convert to trade acceptances when accepted
by the importer (again, there is no guarantee of payment
by the bank). In these cases, the bill of exchange is
drawn under time terms, just as banker's acceptances are.
Instead of the bank accepting the documents and
guaranteeing payment, however, the trade acceptance
represents an obligation of the importer only.

Trade acceptance financing is much cheaper than banker's
acceptance financing and may be acceptable financing to
the seller (exporter), provided the seller has a great
deal of confidence in the buyer (importer). The bank may
obtain fees for processing documents in this situation,
referred to as foreign collections.


Standby Letters of Credit

The standby credit performs some of the functions of
guaranty. The standby credit secures an account party's
legal obligation to the beneficiary. Under the standby
credit, the beneficiary may draw upon the credit by
submitting the default notice, demand for payment or draft
required by the credit. In a case where a unilateral
demand or simple draft will suffice, the expression
"suicide credit" has been applied.

Standby credits account for the bulk of the growth in the
use of letters of credit in the past few years. Standby
credits are cheap, efficient and often are used in lieu of
suretyship contracts in arrangements which fall for some
guarantee of performance or payment. Banks generally
charge a fee of 1 to 2 percent per annum of the face
amount of the credit to issue a standby letter of credit.


There are three significant differences between standby
and commercial letters of credit, as follows:

1. Commercial letters of credit typically involve payment
under a contract of sale. Payment is made upon
presentation of conforming documents purportedly
evidencing the movement of goods, that is , the
satisfactory performance of the beneficiary. The shipping
documents triggering payment are standardized and enjoy
nearly universal acceptance and use. In contrast, standby
letters of credit become payable to the beneficiary upon
assertion of the account party's nonperformance. The
beneficiary of a standby letter of credit can trigger
payment simply by making an assertion that a breech of
performance has occurred.

2. Commercial letters of credit are expected to be paid by
the issuer. Payment is consistent with normal performance.
In contrast, the bank does not expect to pay a standby
letter of credit. The standby credit provides a means of
securing payment of performance if the bank's customer
defaults on the underlying obligation. Payment demands
under a standby letter of credit usually mean that
something is wrong. Usually, the account party will not
want the standby letter of credit paid.

3. Commercial letters of credit tend to follow a pattern
with the same documents accompanying the draft in case
after case. The standby letter of credit, however, can
arise out of any number of situations, and the documents
are frequently unique. When a standby letter of credit is
issued, for all practicle purposes, the bank is making a
loan. To ensure that the loan is bankable, the bank must
understand the performance called for by the account
party's contract with the beneficiary.

Standby letters of credit can hold more risk for a bank
than a direct loan. In a direct loan, once an event of
default has occurred, the bank can elect to move against
the borrower and its collateral. In contrast, if the
account party of a standby letter of credit begins to
deteriorate financially, the bank may encounter
difficulties in accelerating the obligation and moving
against collateral. The courts may hold that the bank
cannot foreclose against collateral until the standby
letter of credit has been drawn upon by the beneficiary.
The standby credit closely resembles a guaranty, but there
are several important distinctions between the two, beyond
the costs involved. U.S. National banks lack the authority
to act as guarantors for the performance of contracts made
by others. However, it is well established that a letter
of credit is not a guaranty. The three federal government
agencies that regulate banks have recognized that banks
have the authority to issue standby letters of credit.
Careful drafting of a standby letter is necessary to avoid
it being characterized as a guaranty.

An instrument is a standby letter of credit if the issuer
has a primary obligation that is dependent solely upon
presentation of conforming documents (or demands for
payment), and not upon the factual performance or
nonperformance by the parties to the transaction. In this
circumstance, there is no need to determine liability on
the underlying contract since the letter of credit is
purely documentary.

If conditions of compliance are phrased in factual (facts
of nonperformance) rather than documentary terms, the
honoring of the instrument becomes contingent upon some
occurrence or nonoccurrence which can only be determined
by inquiring into the status of the underlying obligation.
Such a transaction would take on the characteristics of a
guaranty, rather than a letter of credit. For example, a
letter from a bank which provides for payment upon default
in a real estate lease is not a letter of credit, if the
bank's obligation is conditioned upon a determination of
default, rather than presentation of a document.

The standby credit can be used in domestic or
international transactions to guarantee the obligations of
a party - while standby credits offer a less costly
alternative in nearly any situation calling for a surety
contract, standby credits are most frequently used in the
following situations:

1. Supporting Debt Instruments. An issuer of commercial
paper or industrial development bonds may not have
sufficient creditworthiness to float its instruments.
Support of the instruments with a letter of credit from a
major bank will make it possible for potential purchasers
of the instruments to evaluate the offering based on the
creditworthiness of the issuer of the letter of credit. It
may also be that the instruments could be floated without
a letter of credit, but at an unacceptably high interest
rate. The use of a letter of credit may result in the sum
of the interest rate payable on the debt instrument backed
by the letter of credit, plus the letter of credit fee,
being less than the interest rate payable on debt
instruments not supported by a letter of credit.

2. Supporting Real Estate Transactions. A mortgage may
call for a standby credit to be issued to back the equity
commitment of a developer. Standby credits have also been
issued to protect lenders in the event the project fails
during construction, to cover working capital for a
completed project, and to cover liquidated damage
provisions in the lending contract.

3. Supporting Stock Transfers. Standby credits have been
used frequently to support stock tranfers, stock purchases
and corporate consolidations. Standby credits have been
used in a number of recent cases to guarantee stock
redemption according to provisions approved by boards and
shareholders.

4. Supporting Limited Partnership Investment. Limited
partnerships will often offer investors limited
partnership units, requiring some percentage in cash with
the balance evidenced by a note, supported by a letter of
credit from the investor's bank. The letters of credit
then serve as collateral for the limited partnership when
it seeks financing from other financial institutions.

5. Supporting the Sale of Goods. Standby credits are used
in the sale of goods (bringing the standby credit close to
the function of a commercial credit), where the seller
bills the buyer directly and draws upon the credit only if
the buyer fails to honor the invoice.

6. Miscellaneous Uses. Standby credits have been used in
any number of cases where parties are concerned about 
performance or collection. Standby credits have been
used to secure liquidated damage clauses in contracts 
involving rock concerts, and to guarantee lease
payments for the rental of a stadium by a professional
football team.

7. Substituting for Performance Bonds. Sometimes a
standby letter of credit can replace a performance bond,
but there are distinct differences between the two. With a
performance bond, there is no duty to indemnify the
beneficiary until the beneficiary establishes the fact of
the account party's nonperformance. This action may take
litigation, and the beneficiary bears the cost of the
delay. With a stanby letter of credit, however, the
beneficiary simply must state in writing that an event of
default has occurred, and he or she is paid. If a stanby
letter of credit is issued instead of a performance bond,
the amount should always be a fraction of the amount of
the project covered rather than the full amount. This will
keep the account party and the beneficiary in a more
balanced position in relation to each other. If the
standby is, say 10% of the size of the project, it should
be sufficient to protect the beneficiary against the cost
of delays or shoddy workmanship. If the standby was
written for the full amount of the project, the
beneficiary could draw up to 100% of the value of the
entire job to cure a problem that is most likely much
smaller. This development would be disastrous for the
account party who would not only have funds invested in
the project but would also be liable to the issuing bank
for the standby letter of credit.


Elements Common to All Letters of Credit

All letters of credit, whether commercial or standby,
involve three relationships:

1. The underlying contract between the account party
(buyer of the goods) and the beneficiary of the letter of
credit (seller of the goods);

2. The arrangement between.the account party and the
issuing bank; and

3. The obligation of the issuing bank to pay the
beneficiary upon presentation of the documents specified
in the letter of credit.

These three relationships in a letter of credit
transaction are separate and distinct. The most notable
feature of the letter of credit is the independence of the
obligation of the issuer from the underlying contract
between the bank's customer (buyer of the goods) and the
beneficiary (seller of the goods). The obligation of the
bank is not conditioned upon performance or nonperformance
(perhaps shipment of nonconforming goods) of the
underlying contract. The obligation of the bank is limited
to the determination of whether the drafts or demands for
payment made by the beneficiary comply with the conditions
specified in the letter of credit. This independence
principle is the feature which makes letters of credit a
quick and inexpensive mechanism for payment and
performance in contracts. A letter of credit is not
exactly a contract, third party beneficiary contract, an
assignment, agency relationship nor a negotiable
instrument. While many courts refer to the three
relationships in a letter of credit as "three contracts,"
there is usually no direct contractual relationship
between the issuer and the beneficiary. Offer, acceptance
and consideration are lacking in the relationship between
the issuing bank and the beneficiary, who may be totally
unknown to each other prior to the issuance of the credit.
Furthermore, letters of credit are independent of
contracts directly related to them, are transferable in
limited circumstances, and generally do not lend
themselves to contract rules regarding performance.

The several leading treatises dealing with letters of
credit do not use the contract label, at least in
describing the relationship between the issuer and the
beneficiary, but recognize that contract law supplements
the law of credits to the extent that contract principles
do not interfere with the unique nature of credits.


Sources of Law

Other than state and federal banking statutes, two bodies
of law govern most of the issues which arise in a letter
of credit transaction: Article 5 of the Uniform Commercial
Code (the UCC) nd the International Chamber of Commerce's
Uniform Customs and Practice for Documentary Credits (the
UCP). The UCC and the UCP are generally, but not
completely consistent. Each covers areas not covered by
the other. Both stress the first principle of letter of
credit law, which is that the credit engagement is
independent of the underlying contract.

Since the early 1930's, the International Chamber of
Commerce has promulgated a set of rules, applicable to
both domestic and international letters of credit, for the
purpose of creating uniformity in the treatment of
documentary credits and facilitating trade. American banks
played a major part in promoting these international rules
for commercial credits.

These rules, set forth in the Uniform Customs and Practice
for Documentary Credits (UCP) were first published in
1933, with revisions being issued in 1951, 1962, 1974 and
1983. The 1962 revision was the first to achieve global
acceptance.

Issuers of credit, primarily banks, commonly specify in
the credit that such credit is subject to the UCP. This
may occur in purely domestic, as well as international
letter of credit transactions.

The 1983 revision of the UCP (adopted fifty years from the
first edition) became effective on October 1, 1984. The
revision is contained in ICC Pub. No. 400. The revision
does not contain any radical changes in credit
transactions. The changes incorporated in the 1983
revision relate primarily to transport documentation,
banking obligations and certain procedures regarding
payment, acceptance and negotiation. No new anti-fraud
provisions were added.


Risk and the Issuer's Duty to Honor the Credit

The letter of credit is an independent arrangement, to be
construed in accordance with its own terms, without
reference to any other contract. An issuing bank which
refuses payment is generally liable for wrongful dishonor
unless it can show that the documents presented do not
comply with the terms of the relevant credit, or that the
case falls within one of the exceptions recognized by the
law. Those exceptions would be a case where the documents
are in fact forged or fraudulent, or there is "fraud in
the transaction." Most of the litigation in letters of
credit deals with cases where customers have attempted to
enjoin payment of a letter of credit, due to what they
consider to be fraud in the transaction. Since neither the
Uniform Commercial Code nor the Uniform Customs provide a
definition of "fraud in the transaction," the case law
takes on special importance in disputes involving letters
of credit.

In one of the leading cases. the documents involved in the
transaction called for the shipment of bristles, but the
goods shipped consisted of cases of cowhair and other
rubbish. At the request of the customer of an issuing
bank, a court enjoined payment of a commercial letter of
credit. The problem with this result is that the action of
the court erodes the long standing independence principle
of letter of credit law, because to launch into an inquiry
of compliance or noncompliance with the underlying
contract threatens the essential nature and utility of a
letter of credit.

It is clear from a reading of the cases that mere breach
of warranty by the beneficiary of the letter of credit
(seller of goods) should not justify dishonor of the
credit. This is true even in cases where the issuer knows
of the breach in advance of payment and the fact is not
disputed. For the most part, the courts have refused to
enjoin payment of a letter of credit absent a clear
showing of intentional fraud, as opposed to a dispute over
performance of a contract.
Pricing

Letters of credit have historically been priced
aggressively (in the bank's view) in relation to their
risk because they were off balance sheet, and the fees
received effectively boosed banks' reported returns on
assets dramatically. New risk-based capital guidelines
will soon require that letters of credit be allocated bank
capital, a process sure to raise the pricing of letters of
credit over time. Current bank guidelines anticipate
dividing letters of credit into three broad categories and
assigning varying degrees of credit risk for each.

In addition, the collateral for a letter of credit may
affect its risk rating.

To determine the allocated credit risk for a transaction,
the type of letter of credit and the collateral offered
are considered, and the two credit risk factors are
multiplied. For example, a standard commercial letter of
credit would have a 20% factor as to type and a 100%
factor as to collateral for a total factor of 20% x 100%
or 20%. Assuming a required capital adequacy ratio of 8%
for the bank, capital in the amount 1.6% (or 8% x 20%) of
the face of the letter of credit must be allocated to the
transaction. The capital allocated to each type of letter
of credit should effect pricing, leading to
differentiation of pricing strategies of the various types
of letters of credits. The minimum returns to a bank for a
letter of credit (prior to charges for servicing,
origination, and expected losses) should be as in the
following equation:

Required return on capital =
(Allocated Base pretax return x Capital) /
(1 - Effective tax rate)

Since a letter of credit represents a contingent
obligation rather than a funded obligation, the equity
required to support it may be invested in risk-free
government securities, so the amount charged for the L/C
can be reduced by: allocated capital x risk-free rate of
return. The following table shows the base annualized
pretax return necessary for each type of letter of credit
a bank may issue. It assumes a tax rate of 35%, risk-free
return of 7%, and required return on capital of 15%. This
shows the potential and future pricing structure for
letters of credit using these assumptions.

Collateral: Cash

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