Letters of credit (LCs) are the oldest and most common type of short term trade finance, famously described as the “lifeblood of international commerce,” with some commentators suggesting their use stretches back to 3000 BC. What makes them so successful?
Advantages of LCs
The key advantage, for both seller and buyer, is security. Payment is guaranteed on presentation of conforming documents and is based on an irrevocable undertaking by the issuing bank, separate from the underlying contract of sale. Access to the goods is assured because the seller cannot receive payment without providing the buyer with the conforming documents which will make access possible. In the context of international trade, where the seller will ship the goods before receiving payment and the buyer will have to pay before taking possession of them, the benefit of this arrangement is obvious.
The value of security can be illustrated by considering a seller’s use of a standby LC where it has concerns about the reliability of its counterparty; requiring them to provide a standby LC governed by English law and from a reliable bank offers considerable comfort. The English courts have shown that they are reluctant to depart from the principle that if a compliant demand is made under a standby LC, the issuing bank must pay, with only very limited exceptions. In 2017, two decisions of the English Court of Appeal demonstrated this. In both cases, the Court of Appeal found in favour of the beneficiary. In the first, it held that payment was required even where the beneficiary’s belief that the sums claimed were due and owing had been challenged. In the second, there was a dispute under local law (which governed the underlying contract) as to whether the obligation to pay had arisen. Nevertheless, the Court of Appeal held that the beneficiary was still entitled to claim under the standby LC (which was governed by English law).
The other main advantage of the LC is familiarity. On the whole, businesses do not like surprises. The majority of LC transactions are governed by the ICC Uniform Customs and Practice for Documentary Credits (UCP 600), which standardise international banking practice as to the way LCs are operated. This means everyone knows what to expect and how to deal with problems when they arise. The UCP 600 have not been updated since July 2007, which indicates that the market is happy with the terms contained therein and that they are operating effectively. Longevity is a factor here too: since the system has worked in the same way for a long time, users are comfortable with it.
Choosing English law and jurisdiction to govern an LC can increase the advantage that familiarity offers because the English court system is widely regarded as reliable, efficient and commercially aware, with law based on precedent offering users certainty of outcome. Many LCs are governed by English law but there are relatively few English law cases relating to them. That is a good sign because it means that the system is working effectively and does not give rise to many claims. Some might prefer the freedom that choosing local law to govern can offer, however, there is no doubt that this can make the outcome of a claim more uncertain and the enforcement of a successful judgment or award more challenging.
Drawbacks of LCs
Despite their advantages, LCs also have their drawbacks:
- They can cause delay
- They are susceptible to fraud
- They are cumbersome and expensive to operate
The rise of fintechs, set on developing new, faster, cheaper methods of cross border payment, is offering a challenge to this long-established system.
The security which an LC offers may not necessarily outweigh its potential disadvantages. For well-established, long term business relationships where the risk of default is seen as low, trading parties might not feel the need for the security of payment which is the principal benefit of the LC system, given the cost and other disadvantages involved. The speed and flexibility of open account trading may be more appealing in those circumstances and the growing availability of trade credit insurance offers a further cushion against non-payment.
We have also seen situations where the security of an LC arrangement can come under pressure where a buyer has a strong relationship with the issuing bank and can influence whether the bank honours the LC. This can occur particularly in circumstances where prices fall and the underlying sale contract is no longer appealing to the buyer, who then exerts undue influence on the issuing bank not to perform the LC contract. However, such scenarios are rare, especially as most reputable banks are keen to maintain their independence and standing within the market.
Letters of Credit and their changing role in international trade
Trade finance is particularly sensitive to the risk of fraud and the level of human involvement and reliance on physical documents in the LC system means that it is hard to protect against that risk.
LCs are rigid, cumbersome and administratively burdensome for the banks, as well as for the traders. It does not require much imagination to see this. Post-pandemic, the heavy reliance on paper is not compatible with a world where flexible working is on the rise. Where a document checker with English as their second or even third language is required to scrutinise papers for strict compliance, the scope for error and delay is obvious. Where payment hinges on conformity, trivial mistakes in presentation can be disproportionately costly. There are cases where documents have been held to be non-conforming due to courier charges being certified at the issuing bank’s cost rather than that of the beneficiary, or as the minimum protein content was specified as 67% rather than 70%; or even for the omission of an ampersand (“&”) or the word “and” from a company name.
There is also time pressure. Under the UCP 600, a bank has a maximum of 5 banking days following the day of presentation to determine if that presentation is compliant (UCP 600 Article 14(b)). And there is case law to say that where a bank rejects a presentation and elects to return documents, it must do so “reasonably promptly.
The momentum towards digitisation in trade finance is growing and it is not yet clear whether this poses a threat to LCs. Some digital platforms are issuing digital LCs regularly; others do not offer them at all. The use of digital platforms could be beneficial for LCs – reducing the risk of fraud and increasing efficiency would resolve some of the disadvantages to the system whilst retaining the benefit of security.
Let’s not get carried away – for now, the LC remains a key instrument in international trade finance; however, it is possible to imagine that its star could wane.
About the authors
Andrew Williams, Partner at HFW
Andrew is a Partner at HFW handling a number of high profile commodities and commercial litigation / arbitration matters. Andrew’s general dispute resolution work spans a wide range of areas including banking, financial services, insolvency, director / shareholder, fraud and general contract / tort disputes. He is regarded within HFW as a specialist in letters of credit and UCP 600 and regularly writes articles and give seminars / presentations on this topic.
Amanda Rathbone, Professional Support Lawyer at HFW
Amanda is a Professional Support Lawyer at HFW with particular responsibility for commodities. Prior to working in knowledge management, she gained 15 years’ experience as a shipping and international trade lawyer, largely on the contentious side.