Controlling The Letter of Credit Transaction

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Controlling The Letter of Credit Transaction
By Margaret L. Moses
Of Counsel
Exporters expecting to be paid under a letter of credit (referred to in this article as "LC" or
"Credit") may be sadly disappointed. Although an LC is considered one of the most secure means of
obtaining prompt payment for sale of goods, clients who are exporting should be made to
understand that they can never totally control the payment process. Documents which are required
to be presented under an LC are frequently prepared by other people, and may not meet the strict
compliance standards required by the banking community for payment. Sometimes banks which have
not properly ensured they will be adequately reimbursed by their customer (the buyer), have very
narrowly applied LC principles to deny payment. They have been regularly upheld by courts on
grounds that the seller has not strictly complied with the terms of the LC.

There are steps, however, that a prudent exporter can take to maximize his control of the LC
process, thereby greatly increasing the likelihood of being paid under the LC. This article will first
look at the scope of the problem, then discuss a ways of maintaining control of the LC process, as
well as the legal and economic consequences of losing control.

THE SCOPE OF THE PROBLEM
It is difficult to obtain information from banks on how often letters of credit go wrong. Since banks
are selling a product, it is understandable that there is little interest on their part in letting the
public know how often the product does not work. A report was put together, however, by Britain's
Midland Bank International (MBI) and the Simplification of International Trade Procedures Board
(SITPRO), which found that during three random weeks, one out of two of all documentary
presentations against credits were rejected. It was estimated that total letter of credit business gone
wrong in Britain was five billion pounds annually. ("Euromoney Trade Finance Report", April, 1985.)

In the U.S., the National Council on Trade Documentation showed initial LC failure rates of 77% in
Saint Louis, 75% in San Francisco, and for four banks in New York, 40%, 55%, 70% and 50%.
Major companies, with a rejection rate of 49%, were as unsuccessful in obtaining payment as small
organizations. The worst record was held by companies doing business in the 50 to 100 million
dollar range, with a failure rate of 63.3% on LC's.

KNOWING THE RULES
To maximize the chance for payment under an LC, a seller/beneficiary must know the rules of the
game. The rules are codified in a publication sponsored by the International Chamber of Commerce
("ICC"), known as the Uniform Customs and Practice for Documentary Credits. The latest version
of the rules is ICC Publication No. 500, 1993 Revision(the UCP 500), which is in force as of January
1, 1994. Attorneys who advise clients about LC's should have a good understanding of the UCP
500. (Copies of the UCP 500 are available from ICC Publishing, Inc., 156 Fifth Avenue, Suite 820,
New York, N.Y. 10010, Tel.: (212) 206-1150, Fax.: (212) 633-6025)

The rules in the UCP 500 are drafted by and for the banking community. One of the major
purposes is to protect the banks from liability in LC transactions. The banks are providing a service
- the financing of the transaction - and they expect to be protected from getting involved in
disputes between the parties as to the terms of the contract of sale. For this reason "the
independence principle" is a very important concept in LC transactions. This means that the LC, and
the documents required under the LC for payment, are completely independent from the underlying
transaction between buyer and seller.

The bank is not concerned with whether the contract between buyer and seller is being performed
according to its terms. The bank's only concern is whether the documents presented by the seller
conform to the documents required under the LC, and whether the documents are presented within
the required time periods. The bank employees who examine documents presented under the LC are
essentially clerks. Their job is not to make judgment calls, but simply to see if the documents
presented by the seller/beneficiary comply strictly with the documents required by the LC. It is
therefore very important to assist clients in understanding the rules, because a lack of knowledge
will only work to their detriment.

CONTROLLING THE PROCESS
Choosing the Issuing Bank
An attorney should encourage clients to try to control the payment process from the outset. This
means that when negotiating with the buyer, the seller should try to get the buyer to use a bank
of the seller's choice to issue the LC. The seller should find out from its own bank, preferably a
bank with a substantial international presence, what corresponding bank it uses in the country of
the buyer. If the buyer can have the LC issued by that correspondent bank, the process can proceed
more expeditiously.

At the very least, the seller should insist that the buyer use a bank that is well-known and highly
regarded by the banking community. The seller's own bank can provide information on the financial
status and reputation of the foreign bank. Since a major purpose served by an LC is that the
issuing bank assumes the risk of the buyer's insolvency, if the bank itself is financially weak, the
LC may not serve its purpose.

Confirm‎ing the Letter of Credit
If the seller does not have confidence in the bank of the buyer's choice, or if there is any question
about the political stability of the foreign country where the issuing bank is located, then the LC
should be confirmed by a U.S. bank. When a U.S. bank confirm‎s an LC issued by a foreign bank,
it takes upon itself the payment obligation. Thus, if a U.S. bank confirmed an LC, and subsequently,
for political or economic reasons, the foreign bank could not reimburse the U.S. bank, the U.S. bank
is nonetheless on the hook to pay the beneficiary under the LC.

There is a charge for confirmation, which becomes more expensive in proportion to how big a risk
the U.S. bank believes it is taking in confirm‎ing the LC. There are some situations where the risk
may appear so high that a U.S. bank will not agree to confirm‎ at all. If the bank refuses to confirm‎
because of political instability, advise the client to try to have the LC issued outside the politically
unstable area, in a country such as Switzerland. The question of who pays the U.S. bank's
confirmation charges is negotiable, but if not negotiated in advance, the bank will generally charge
the beneficiary for this service.

Keeping Documents Simple
The seller should negotiate with the buyer prior to the issuance of the LC exactly what documents
must be presented to the bank for payment under the LC. The most important thing from the
seller's point of view is to have as few documents as possible, to have as simple a description as
possible, and to be sure that all documents called for by the LC can in fact be produced. Cases
have occurred where one of the documents is a certificate supposed to be issued by the foreign
government, which was simply never produced. Another problem can by created if the LC requires
a document to be signed by someone under the control of the buyer. The document may not be
signed by the right person, or may not be signed at all.

Almost all LC's require production of a commercial invoice and a transport bill of lading. With
respect to the commercial invoice, the LC will typically state the description of the goods which
must be found in the invoice. If the goods are not described in exactly the same way, the seller
may not be paid. In one case where payment was denied, the LC required for the commercial
invoice to describe the goods as "100% Acrylic Yarn". When the invoices were presented to the
bank, they described the goods as "Imported Acrylic Yarn." Even though the packing list attached
to the invoice described the goods as 100% Acrylic Yarn, the court upheld the bank's refusal to pay
under the LC because the documents did not strictly comply with the requirements of the LC.
Courtaulds North America, Inc. v. North Carolina National Bank, 528 F.2d 802 (4th Cir. 1975).

In many cases, even if the documents do not comply exactly, the buyer will agree to waive any
discrepancies in the documents, and, if the bank agrees, the payment will occur. In the Acrylic Yarn
case above, however, the buyer had gone into bankruptcy, and the trustee in bankruptcy would not
agree to waive discrepancies. In another case, buyer and seller sought to amend the LC to correct a
discrepancy. The bank, however, having never checked the financial status of its customer, the
buyer, prior to issuing the LC, and having learned in the meantime that its customer might not be
able to reimburse the bank if it paid the LC, refused to amend the LC. The court held that the
issuer bank had no duty to amend a letter of credit upon the request of a customer and a
beneficiary. AMF Head Sports Wear v. Ray Scott's All-Am. Sports Club, 448 F. Supp. 222 (1978).
For a more recent case upholding bank's right not to amend LC, see Leaseamerica Corp. v.
Northwest Bank Duluth, N.A., 940 F.2d 345 (8th Cir. 1991).

These cases teach three important lessons. First, documents must be accurate. Second, if there is a
mistake or a problem with the documents which the LC requires to be presented, the
seller/beneficiary should not ship goods until the LC has been amended. The UCP 500 makes clear
that no amendment can take place unless the issuing bank, the confirm‎ing bank, if any, and the
seller, agree to it. UCP 500, Article 9(d). Unless the seller has written confirmation from the bank
that the amendment to the LC has been issued, and the confirm‎ing bank has accepted the
amendment, he bears the risk that the LC will not be paid.

Third, a prudent seller will not let the buyer take possession of the goods until he has been paid
under the LC. The reason should be obvious. If there are discrepancies in the documents preventing
payment of the LC, a buyer in possession of the goods has much less incentive to waive
discrepancies so the seller can be paid. If the seller is not paid by the bank, the buyer still has a
contractual obligation to pay for goods, but the difficulty of collection can make the price drop
substantially, even assuming the buyer is solvent and can pay something. Particularly when the
goods have been shipped to a foreign country, the attempt to collect payment can be quite costly.
The buyer, knowing this, will undoubtedly attempt to negotiate a lower price, if he pays at all.

To keep goods out of the buyer's possession, the seller should be sure to have the marine bill of
lading consigned to order of the bank. Since the marine bill of lading is a title document, a
consignment to order of the bank gives the bank title to the goods until they have been paid for by
the buyer. Assuming proper payment, the bank transfers title to the buyer, who can then take the
bill of lading and go pick up the goods. If payment is not made, the bank has an obligation to hold
the documents for the seller, or return them to the seller if instructed to do so by the seller. The
buyer should not be able to get the goods without the title document.

A buyer may ask the seller to have the bill of lading made out to order and blank endorsed, and to
send one or more sets to the buyer within a few days of shipping the goods. This is like writing a
blank check. It enables the buyer to pick up the goods, and thereby provides him with a
disincentive to waive any discrepancies in documents the seller presents to the bank. Given the high
failure rate of initial presentations of documents under an LC, a seller needs to know he will have
the buyer's cooperation in correcting discrepancies or in waiving them. The buyer's cooperation will
be more forthcoming if he cannot get possession of the goods until any problems with discrepancies
have been resolved.

Meeting the deadlines
Every LC has three important dates: the date by which goods must be shipped, the date by which
documents must be presented, and the expiry date for the LC. A seller should make sure that each
of these dates can be met, and should allow a large margin for error. After the LC has been issued,
if the seller learns that the date for shipping goods cannot be met, he should not ship any goods
until he obtains an amendment to the LC permitting later shipment.

If an LC which calls for transport documents does not contain a date by which documents must be
presented, does this mean the seller can wait until the expiry date to present his documents? Not if
he wants to be paid. Article 43 of the UCP 500 provides that if no time period after shipment is
given in the Credit for presentation of documents, banks will not accept documents presented to
them later than 21 days after shipment. An exporter unfamiliar with the 21 day rule of the UCP
500 could easily miss this deadline.

The exporter should make sure that the expiry date of the LC permits sufficient time to permit
correction, if possible, of any mistakes in the documents. Under the UCP 500, once the documents
are presented, the bank has a maximum of seven days to let the beneficiary know if there are any
discrepancies. If discrepancies can be corrected, they must be corrected and the documents
resubmitted before the expiry date of the LC. Thus the exporter should make sure that the expiry
date allows enough time for errors to be rectified.

CONCLUSION
Clients should understand that in working with LC's, it is most important to get good advice from
the outset, to learn the rules of the game, and to proceed with great care. Once mistakes have been
made, too often they are irreparable and costly.

Reprinted with permission of the
International Section of the
New Jersey State Bar Association.