Estimated reading time: 0 minutes

Though an important instrument in international trade, letters of credit are complex, and their definition can cause confusion.

I believe the most correct and precise definition of a letter of credit can be found in article 2 of the UCP 600 ICC. 

This article reads as follows: “Credit means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation”

Therefore, a documentary credit is any commitmentwhich is irrevocable and is a precise commitment of an issuing bank to honour a complying presentation.

Definition: “the content beats the title”

A careful analysis of this definition allows us to point out that the name of the undertaking is irrelevant for the purpose of its qualification in accordance with a known principle applied to financial instruments in use in international business transactions. The wording of a document prevails over its title.

Irrevocable vs revocable

Letter of credit also arises irrevocable from the entry into force of the UCP 600 ICC. A credit cannot, therefore, be revoked without the consent of the beneficiary.

Issuing bank & non-bank issuers

The UCP 600 indicates, as an issuer of the credit, an issuing bank, defined as “the bank that issues a credit at the request of an applicant or on its own behalf.” 

The “applicant” is defined as “the party on whose request the credit is issued”. In this regard, it should be noted that a letter of credit can be issued by entities other than a bank, bearing in mind that such rules, being privatised, are derogatory.

Indeed, according to some operators, in the near future, the share of letters of credit issued by non-bank entities (financial institutions, insurance companies, forfaiters, corporates, etc.) will increase considerably.

To honour vs to negotiate

The definition of a letter of credit refers to a precise commitment of the issuer: “to honour a complying presentation”.

What exactly does “to honour” mean? According to the UCP 600 ICC, to honour means: 

• To pay at sight if the credit is available by sight payment. 
• To incur a deferred payment undertaking and pay at maturity if the credit is available by deferred payment. 
• To accept a bill of exchange (“draft”) drawn by the beneficiary and pay at maturity if the credit is available by acceptance.”

Therefore, the word “to honour”, as part of a documentary credit, assumes a very precise meaning:

• To pay at sight if the credit is available by sight payment. 
• To incur a deferred payment undertaking and pay at maturity if the credit is available by deferred payment. 
• To accept a bill of exchange (“draft”) drawn by the beneficiary and pay at maturity if the credit is available by acceptance.

While “to negotiate” refers to what the rules call “negotiation”, which is defined as “the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which the reimbursement is due to the nominated bank.”

With a “negotiation”, a nominated bank – other than the issuing bank – “buys” the drafts and/or documents in a complying presentation, preparing (or being available to do so) the beneficiary at a time earlier than the day that bank should be reimbursed.

Therefore, an issuing bank can only “honour” and cannot make a “negotiation”. Obviously, an issuing bank may “negotiate” under a separate agreement with the beneficiary, as this transaction is not governed by the UCP 600 ICC.

Complying presentation

The UCP 600 ICC also defines what is meant by “complying presentation” which is defined as a “presentation that is in accordance with the terms and conditions of the credit, the applicable provisions of these rules and international standard banking practice.”

Therefore, in order to obtain the expected performance of the bank, the documents submitted must comply with the hierarchy of the credit, the UCP 600 ICC and its uniform international banking practice, broadly but partially encoded in the ISBP Publication 745 ICC. 

This practice also refers to the following sources: ICC Opinions / ICC Decisions and DOCDEX Decisions.

Paper presentation vs electronic presentation

The UCP 600 ICC does not include electronic document submissions.

It is therefore necessary to make presentations exclusively in “paper form”. Please note that fax presentations are not allowed. 

In order “to accommodate the presentation of electronic records alone or in combination with paper documents,” the ICC issued a supplement to the UCP 600 ICC. It is therefore possible to present “electronic records” in combination with paper documents if the credit is governed by the eUCP ICC.

Credits vs contracts

According to article 4 UCP 600 ICC, a credit is, by its nature, a transaction separate from the sales contract or other contracts on which it may be based. 

Article 5, furthermore, strengthens this indication by stating that the banks “deal with documents and not with goods, services or performance to which the documents may relate.”

Conclusion

As you can easily guess from its articulated definition, documentary credit is a very complex instrument. This complexity has greatly increased in recent years due to the remarkable growth of the instrument in international business transactions. Only a thorough knowledge of the rules governing documentary credit can allow traders to create value in international trade.