assignment of proceeds under standby letter of credit

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Assignment of Proceeds: Meaning, Pros and Cons, Example

Diane Costagliola is a researcher, librarian, instructor, and writer who has published articles on personal finance, home buying, and foreclosure.

Investopedia / Jiaqi Zhou

What Is an Assignment of Proceeds?

An assignment of proceeds occurs when a beneficiary transfers all or part of the proceeds from a letter of credit to a third-party beneficiary . Assigning the proceeds from a letter of credit can be utilized in many types of scenarios, such as to pay suppliers or vendors in a business transaction or to settle other debts.

Key Takeaways

• An assignment of proceeds can be used to redirect funds from a line of credit to a third party.
• An assignment of proceeds must be approved by the financial institution that granted the line of credit following a request and fulfillment of any obligations by the original beneficiary.
• A benefit of this type of transaction is the ability to redirect only a portion of the proceeds, in which case both the original beneficiary and third party can access the same letter of credit.
• A drawback of this type of transaction is that the original beneficiary is still responsible for fulfilling all requirements under the letter of credit, even when the funds are redirected to the third party.
• This type of transaction is used in a number of circumstances, such as when paying suppliers or vendors, or when settling outstanding debts.

Understanding an Assignment of Proceeds

A letter of credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. The original beneficiary, the named party who is entitled to receive the proceeds from a letter of credit, may choose to have them delivered to a third party instead, through an "assignment of proceeds."

Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.

In order to process an assignment of proceeds, the original beneficiary of the letter of credit must submit a request to the bank or other financial institution issuing the letter of credit requesting to assign the funds to a different individual or company. The assignment of proceeds will need to be approved by the financial institution once it is submitted, pending the fulfillment of any requirements set forth in the letter of credit.

If the original beneficiary does not meet the obligations outlined in the letter of credit, no assignment will take place. Once approved, the bank or other entity will release the money to the specified third party to be drawn upon at will.

Advantages and Disadvantages of an Assignment of Proceeds

The main benefit of an assignment of proceeds is that the original beneficiary has the ability to assign all or just a portion of the letter of credit to the third party. The original beneficiary will retain access to any portion of the proceeds not redirected to the third party. This allows both entities to make use of the same letter of credit when necessary.

This benefit must be weighed against the potential drawback of this type of transaction. When an assignment of proceeds takes place, the financial institution is not contracting directly with the third-party beneficiary. It is only acting as an agent in supplying the funds to the third party. The original beneficiary is still responsible for completing any and all requirements under the letter of credit.

Example of an Assignment of Proceeds

Assume XYZ Customer, in Brazil, is purchasing widgets from ABC Manufacturer, in the United States. In order to sign off on the deal, ABC Manufacturer requires that XYZ Customer obtains a letter of credit from a bank to mitigate the risk that XYZ may not pay ABC for the widgets once ABC has shipped them out of the country.

At this point, ABC Manufacturer is able to request that a portion of these funds be redirected to DEF Supplier, whom ABC still owes money for parts used in making the widgets. Even though a portion of the funds has been redirected to DEF Supplier, ABC Manufacturer still has to fulfill its obligations under the letter of credit, such as shipping out the widgets to XYZ.

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Standby Letter of Credit in Trade Finance | Practical Law

Standby Letter of Credit in Trade Finance

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Standby Letters of Credit (SBLC / SLOC) – 2024 Jargon Buster [UPDATED]

Standby letters of credit (sblcs).

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Letters of credit vs bank guarantees, what is a standby letter of credit (sblc / sloc).

A Standby Letter of Credit (SBLC / SLOC) is a guarantee that is made by a bank on behalf of a client, which ensures payment will be made even if their client cannot fulfill the payment. It is a payment of last resort from the bank, and ideally, is never meant to be used.

How can a contractual SBLC be used and how does it work?

An SBLC is frequently used as a safety mechanism for the beneficiary, in an attempt to hedge out risks associated with the trade. Simplistically, it is a guarantee of payment which will be issued by a bank on the behalf of a client. It is also perceived as a “payment of last resort” due to the circumstances under which it is called upon. The SBLC prevents contracts from going unfulfilled if a business declares bankruptcy or cannot otherwise meet financial obligations.

Furthermore, the presence of an SBLC is usually seen as a sign of good faith as it provides proof of the buyer’s credit quality and the ability to make payment. In order to set this up, a short underwriting duty is performed to ensure the credit quality of the party that is looking for a letter of credit. Once this has been performed, a notification is then sent to the bank of the party who requested the  Letter of Credit   (typically the seller).

In the case of a default, the counter-party may have part of the finance paid back by the issuing bank under an SBLC. Standby Letter of Credits are used to promote confidence in companies because of this.

How can you apply for a Standby Letter of Credit?

There are many aspects that a bank will take into consideration when applying for a Standby Letter of Credit, however, the main part will be whether the amount that is being guaranteed can be repaid. Essentially, it is an insurance mechanism to the company that is being contracted with.

As it is insurance, there may be collateral that is needed in order to protect the bank in a default scenario – this may be with cash or assets such as property. The level of collateral required by the bank and by the size of the SBLC will largely depend on the risk involved, and the strength of the business.

Other Application steps

There are other standard due diligence questions asked, as well as information requests regarding assets of the business and even possibly the owners. Upon receipt and review of the documentation, the bank will typically provide a letter to the business owner. Once the letter has been provided, a fee is then payable by the business owner for each yeah that the Standby Letter of Credit remains outstanding.

What are the fees for Standby Letters of Credit?

It is standard for a fee to be between 1-10% of the SBLC value. In the event that the business meets the contractual obligations prior to the due date, it is possible for an SBLC to be ended with no further charges.

What is the difference between SBLCs and LCs?

A Standby Letter of Credit is different from a Letter of Credit. An SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party.

Letters of credit promote trust in a transaction, due to the nature of international dealings, distance, knowledge of another party and legal differences.

How do SBLCs work in Cross-Border trade?

Where goods are sold to a counter-party in another country, they may have used an SBLC to ensure their seller will be paid. In the event that there is non-payment, the seller will present the SBLC to the buyer’s bank so that payment is received.

A performance SBLC makes sure that the criteria surrounding the trade such as suitability and quality of goods are met.

We sometimes see SBLCs in construction contracts as the build must fulfill many quality and time specifications. In the event that the contractor does not fulfill these specifications then there is no need to prove loss or have long protracted negotiations; the SBLC is provided to the bank and payment is then received.

Standby Letter of Credit: Frequently Asked Questions

Letters of credit are sometimes referred to as negotiable or transferrable. The issuing bank will pay a beneficiary or a bank that is nominated by the beneficiary. As the beneficiary has this power, they may ‘transfer’ or ‘assign’ the proceeds of a letter of credit to another company.

Yes – if it is a transferable letter of credit and it is a deferred instrument then this may be likely. This is so that the funder will provide the beneficiary with a discounted value just after the terms of the letter of credit have been fulfilled.

In order to issue a standby letter of credit, a bank will typically require a pledge of cash as collateral. There is a fee that is collected for this service, which is usually priced at a percentage of the letter of credit value.

The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs the way in which these instruments operate.

An SBLC will be paid in the event that the bank providing the instrument is still in operation and the beneficiary meets the criteria under the letter.

When there is genuine worry that the bank will not pay out, then a confirmed letter of credit may be used. This will be where a ‘stronger’ bank confirms the letter of credit.

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About the Author

Deepesh Patel is Editorial Director at Trade Finance Global (TFG). In this role, Deepesh leads efforts in developing TFG’s brand, relationships and strategic direction in key markets, including the UK, US, Singapore, Dubai and Hong Kong.

Deepesh regularly chairs and speaks at international industry events with the WTO, BCR, Excred, TXF, The Economist and Reuters, as well as industry associations including ICC, FCI, ITFA, ICISA and BAFT.

Deepesh is the host of the ‘Trade Finance Talks’ podcast and ‘Trade Finance Talks TV’. He is co-author of ‘Blockchain for Trade: A Reality Check’ with the ICC and the WTO, alongside other industry research.

In addition to his work at TFG, Deepesh is a Strategic Advisor for WOA, and works closely with ITFA. He also sits on the Fintech Working Group of the Standardised Trust.

Prior to TFG, Deepesh worked at Travelex where he was responsible for the cards business and the Travelex Money app in Europe, NAM, UK and Brazil. Deepesh is Chair of Governors and co-opted LA Governor of the Wyvern Federation, which has responsibility for 5 primary schools in South London.

Table of Content

What does SBLC stand for?

What is sblc used for, who can issue sbcl, how to get sblc, types of sblc, how does an sblc work, how much does an sblc cost, advantages of sblc, what is the difference between lc, sblc, and bank guarantee, faqs on sblc.

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Standby Letter of Credit [SBLC] | Examples, Costs & Process

‘Standby Letter of Credit (SBLC) is a type of letter of credit (LC) where the issuing bank commits to pay to the beneficiary if the applicant fails to make the payment.

SBLCs, unlike other types of LCs, are a type of contingency plan. In the case of other LCs, the bank makes the payment first, and then the applicant pays to the bank at a later date. However, when a bank issues an SBLC, they are only required to make the payment if the buyer or the applicant defaults.

Any bank or NBFC can issue an SBLC once they are confident about the creditworthiness of the applicant . This is because the banks or the issuing institutions are exposed to the highest risk in the process.

In order to obtain a standby letter of credit, a buyer has to contact a bank and establish their creditworthiness. The bank may ask for additional collateral if the risk or the amount is too high. Once the buyer fulfills all the conditions and the bank deems them fit for receiving the credit, the bank issues them an SBLC and charges 1% to 10% of the total amount as an annual fee for as long as the standby letter of credit is valid.

1) Financial Standby Letter of Credit

A financial SBLC guarantees payment to the seller or the service provider for the goods or the services rendered as per the agreement within the stipulated time frame.

Example: If an edible dye manufacturer sends a shipment to a soft drink company against a financial SBLC, and the company is unable to pay for it, the issuing bank will step in and pay the manufacturer for the dye. Later on, the soft drink company would have to pay the full amount and interest to the issuing bank.

2) Performance Standby Letter of Credit

A performance SBLC is less commonly used compared to a financial SBLC. Performance SBLCs provide a guarantee of completion of a project as per the agreement or the contract. If the service provider fails to complete the project within a stipulated time frame, the bank steps in and reimburses the client.

Example: An IT company hires a contractor to construct a new office. The contractor agrees to complete the construction within a specific time frame but fails to deliver. However, if this deal is protected by a performance SBLC, the issuing bank will pay entire project fees to the IT company and will charge penalties to the contractor. This acts as a safety check to ensure that heavy budget projects are completed in a timely fashion.

3) Advance Payment SBLC

Advance Payment Standby LC provides security against one party’s failure to pay the other party’s advance payment.

4) Bid bond/ Tender SBLC

Bid bond/Tender Standby LCs act as a security against failure to complete the project once the applicant has been awarded the bid or the tender for it.

5) Counter SBLC

Also known as a backstop or a protective standby, Counter SBLC is a type of LC issued by a bank in one country to a bank in another country, asking them to issue a new standby LC to their local beneficiary.

6) Direct Pay SBLC

Direct Pay SBLCs act as a security in the instance of financial instability of the applicant. A direct pay standby is irrevocable.

7) Insurance SBLC

Insurance SBLC provides support to the beneficiary in case the applicant has committed for insurance or reinsurance but fails to do so.

8) Lease Support SBLC

A lease support SBLC is issued by the bank representing the tenant to the landlord. The bank generally takes a deposit as collateral for the SBLC. It pledges to pay the rent to the landlord in case the tenant is not able to do so.

Here’s a step by step process of how an SBLC works:

The process of obtaining an SBLC is fairly simple and similar to that of obtaining any other type of LC or a loan from a bank. A buyer simply walks into a bank or a financial institution and applies for an SBLC.

The bank then starts looking into the creditworthiness of the applicant and decides whether or not the person should be credited with the SBLC. The bank looks into the financial history of the applicant as well as their credit reports and ratings.

If the bank suspects that the buyer will not be able to honor the LC, they may ask for additional collateral to be provided. The size of the collateral depends on the risks as well as the nature of the business.

Once the buyer establishes sufficient creditworthiness, the bank asks for the details of the agreement between the buyer and the seller. Information such as the seller’s name and address, company details, the time period for which SBLC is to be taken as well as shipping documents, etc., are submitted to the bank.

Once the bank is satisfied with all the information at their disposal and their background checks have yielded satisfactory results, it provides an SBLC to the buyer. The bank charges 1% to 10% of the amount of SBLC as a yearly fee, and it’s applicable until the SBLC is valid.

If the buyer meets its obligations in the contract before the due date, the bank will terminate the SBLC without a further charge to the buyer. Once the buyer pays the seller for the goods or the services, the bank terminates the SBLC and doesn’t charge him beyond that point.

As discussed above, SBLC is not actually meant to be used and only acts as a security against default. It comes into action if the buyer is not able to honor the agreement with the seller, the seller goes to the bank and submits the proofs as mentioned in the SBLC. Once the bank verifies the proofs, they release the payment to the seller. The buyer then makes the payment to the bank at a later date along with interest.

Of the total SBLC amount, banks charge about 1% to 10% as annual fees -- depending on the risks and the amount. The charges are applicable as long as the SBLC is valid.

Bridges Trust Deficit

Lack of trust and fear of payment default is one of the key reasons why some international trade deals don't take off. An SBLC is the best way to bridge the gap and ensure that all the worst-case scenarios are dealt with.

Serves as a great proof of creditworthiness

Once a reputed financial institution lends someone a standby letter of credit, they’re practically making a statement about their and their company’s financial situation. This goes a long way in establishing creditworthiness.

Can help with business acquisition

Businesses that are just starting might fail to land big projects because they have no legacy to back them. Companies often get cold feet about working with such individuals or businesses. However, with an SBLC, they have a solid backing of a reputed financial institution and hence can successfully compete for prestigious contracts and big-ticket projects.

The fundamental difference between a Letter of Credit and a standby letter of credit is that the former can be encashed or discounted during a trade transaction. While an SBLC is just a safety measure and is only encashed if any of the parties fail to honor the agreement, one cannot get an SBLC discounted if there is no default. Most trades are honored by all the parties without any irregularities and hence the SBLC is discontinued once the trade takes place.

On the other hand, while a bank guarantee only protects the buyer against a non-performing seller, SBLCs protect both the buyer and the seller -- depending on the type of SBLC issued.

1. Is SBLC safe?

Standby Letters of Credit are highly secure documents that guarantee the payment for the goods in case the buyer defaults or is unable to pay as per the agreement.

2. How do you use SBLC?

An SBLC is used as a safety mechanism in a trade to ensure that the agreement is honored by both parties.

3. Can SBLC be confirmed?

Yes, an SBLC can be confirmed just like a normal letter of credit.

4. Can SBLC be canceled?

The SBLC is an irrevocable document and hence it cannot be canceled without the consent of all the parties involved.

5. Can SBLC be monetized?

Yes, SBLC can be monetized.

6. Can SBLC be transferable?

An SBLC is transferable in that the beneficiary can sell or assign the rights to the proceeds from the SBLC, but the beneficiary remains the only party who can demand payment of the SBLC.

7. Can SBLC be done without upfront payment?

Many companies and service providers claim that they do provide SBLC without upfront payment. However, experts call it a myth and say that there can be no SBLC without any upfront payment since the risk is too high.

8. Is SBLC legal in India?

Yes, SBLC is legal and fully operational in India when issued by banks certified by the Reserve Bank of India.

9. Can SBLC be discounted?

Yes, an SBLC can be discounted and is often considered a great investment instrument.

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Assignment Of Letters Of Credit And Proceeds

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Assignment of Proceeds

Assignment of Proceeds . It is a legal mechanism by which the beneficiary of a letter of credit may pledge the proceeds of future drawings to a third party. Assigning proceeds involves giving the letter of credit to a financial institution, which holds the letter of credit until drawn upon, along with irrevocable instructions to the financial institution to disburse proceeds,when generated, in a specified way (such as pay 40 percent of each drawing to XXX Corporation). The financial institution acknowledges the assignment to the assignee. It does not have any obligation to pay any funds to the assignee unless the letter of credit is drawn upon by the beneficiary and payment is received from the issuing or confirming financial institution. An assignment of proceeds is not an assignment or transfer of the letter of credit and the assignee acquires no rights to perform under the letter of credit in order to generate funds.

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§ 5-114. Assignment of Proceeds.

(a) In this section, "proceeds of a letter of credit" means the cash, check, accepted draft, or other item of value paid or delivered upon honor or giving of value by the issuer or any nominated person under the letter of credit . The term does not include a beneficiary's drawing rights or documents presented by the beneficiary.

(b) A beneficiary may assign its right to part or all of the proceeds of a letter of credit. The beneficiary may do so before presentation as a present assignment of its right to receive proceeds contingent upon its compliance with the terms and conditions of the letter of credit .

(c) An issuer or nominated person need not recognize an assignment of proceeds of a letter of credit until it consents to the assignment.

(d) An issuer or nominated person has no obligation to give or withhold its consent to an assignment of proceeds of a letter of credit, but consent may not be unreasonably withheld if the assignee possesses and exhibits the letter of credit and presentation of the letter of credit is a condition to honor .

(e) Rights of a transferee beneficiary or nominated person are independent of the beneficiary's assignment of the proceeds of a letter of credit and are superior to the assignee's right to the proceeds.

(f) Neither the rights recognized by this section between an assignee and an issuer , transferee beneficiary , or nominated person nor the issuer's or nominated person's payment of proceeds to an assignee or a third person affect the rights between the assignee and any person other than the issuer, transferee beneficiary, or nominated person. The mode of creating and perfecting a security interest in or granting an assignment of a beneficiary's rights to proceeds is governed by Article 9 or other law. Against persons other than the issuer, transferee beneficiary, or nominated person, the rights and obligations arising upon the creation of a security interest or other assignment of a beneficiary's right to proceeds and its perfection are governed by Article 9 or other law.

The Business Lawyer

Fall 2022 | Volume 77, Issue 4

Letters of Credit

James G Barnes and Carter H Klein

Nov 03, 2022

23 min read

• The Annual UCC Letter of Credit Survey identifies and discusses legal cases from the previous year involving letter of credit issues, disputes and their bank and corporate participants.

This survey concentrates on the most significant letter of credit (“LC”) issues addressed in cases decided in the United States in the year 2021 .

Pre-Honor Cases

Pre-honor cases are those in which a dispute arises before a demand for payment under an LC has been honored.

Wrongful Dishonor

Wrongful dishonor actions typically involve a beneficiary claiming wrongful dishonor by an LC issuer, and they focus on whether: (i) the claim asserted is within the scope of U.C.C. Article 5, (ii) the issuer gave timely and sufficient notice of dishonor and the discrepancies stated in that notice justify dishonor, (iii) there are extraordinary reasons requiring or permitting dishonor, such as forgery or material fraud, injunction, governmental laws, orders or sanctions, or insolvency, and (iv) the claimant’s action for wrongful dishonor is effectively and timely filed against the issuer (or confirmer). Others such as an advising or nominated bank may be liable for the failure of the LC transaction to result in issuance and honor. This survey discusses several cases that address the issuer’s, confirmer’s, and advising bank’s obligations and the remedies available against them separately from wrongful dishonor.

Wrongful dishonor disputes based on facial compliance or preclusion issues continue to be resolved mostly outside the courts. This is attributable to the clarity with which U.C.C. Article 5 recognizes standard LC practice in examining presentations and giving notice of dishonor, including international rules incorporated by reference into an LC, such as the ISP and UCP. Published ICC, BAFT, and IIBLP materials and programs also provide guidance on international standard banking practice of banks that regularly engage in letter of credit transactions.

In wrongful dishonor litigation applying U.C.C. Article 5, the parties and the court should address whether the issuer’s undertaking was an LC, whether timely presentation was made to the issuer, and whether the issuer gave timely notice of dishonor identifying each discrepancy. Assuming that the issuer has not precluded itself from raising any discrepancy defense, the parties and the court would then address whether the applicable LC compliance standard was or was not met, i.e., the “strict” compliance standard based on the observance of standard LC practice as stated in U.C.C. sections 5-108(a) and (e). Finally, they should address whether an action and the damages sought are within the scope of Article 5 and, if so, whether it is brought timely against a party under Article 5’s one-year statute of limitations for recoveries allowed by Article 5.

Characterization Issues—Article 5 vs. Common Law

2021 included several reported opinions that treat the conditions, defenses, and limitations in Article 5 that should apply to claims against an issuer for wrongful dishonor as inapplicable or optional by allowing the beneficiary to proceed under breach of contract or other common law theories of recovery. In doing so, the opinions depart from the statutory goals of Article 5, starting with its intended treatment of an LC within its scope as “an idiosyncratic form of undertaking,” as well as overlook the well-established rule that where the U.C.C. has a specific provision that states an obligation and a remedy for breach, in many cases it displaces common law causes of action. We also discuss two international cases that deal with the question of characterizing a guarantee as an independent vs. suretyship undertaking.

Lost Original

In Windsor Township v. Tompkins Financial Corp ., the court affirmed judgment on the pleadings in favor of the plaintiff who was required, but unable, to present the original LC to the defendant issuer. The Windsor Township opinion states at the outset that “[t]he instant case came before the Court as a complaint couched in breach of contract” and thereafter states “Vist’s objection to honoring the Letter of Credit is solely based on the fact that the Township never received or lost the original copy of the Letter.” The court stated that the issues in the case were not being decided under the U.C.C. and, because the parties agreed that an exact copy of the original LC had been presented to the issuer, the court relied on procedural law to support acceptance of the LC copy. To uphold its decision allowing presentation of a copy instead of the original of the letter of credit, the court did not apply U.C.C. section 5-108’s strict compliance standard, citing the 1978 opinion in Flagship Cruises , which applied a substantial compliance standard. That precedent and the substantial compliance standard that it applied were expressly rejected in the 1995 revision of Article 5. Authorities recognize that presentation of a copy instead of an original document called for by a letter of credit is a discrepancy justifying dishonor unless waived by the issuer.

Suretyship vs. Independent Undertaking

While not argued under Article 5 of the U.C.C. or the ISP, an English court and a French court each decided the issue of whether a guarantee was an independent undertaking or a suretyship obligation. The English case is Shanghai Shipyard Co Ltd v Reignwood International Investment (Group) Company Limited , and the French case is McNeil & NRM Inc. & SA Audi Bank France v. Kolon DACC Composite, Ltd . If the undertaking is an independent obligation commonly known as a first demand guarantee or bank guarantee, the advantage to the beneficiary is that it need not prove that it is entitled to payment in order to obtain payment; the beneficiary’s timely documentary demand and, where called for or if the URDG governs the guarantee, presentation of a certification of default, is usually sufficient to entitle the beneficiary to payment. On the other hand, if the undertaking is determined to be a suretyship obligation or accessory guarantee, the guarantor can resist payment until after a court determines by proof that a default has occurred entitling the beneficiary to the amount demanded or drawn under the guarantee. That is the position the guarantors took in the Shanghai Shipyard and Audi Bank cases.

In the Shanghai Shipyard case, a $170 million long-term irrevocable and unconditional guarantee was issued by a non-bank entity to ensure payment for an oil drilling ship that took three years to construct. When it came time to pay the installment due at turnover of the constructed ship, the purchaser and guarantor refused to pay on the ground that the ship had serious defects and was not constructed according to specifications. The guarantee at issue read like a well-drafted corporate guarantee might read as commonly used in the United States, except that it provided that payment need not be made until an arbitration is resolved if arbitration is demanded. Further, the guarantor was the original purchaser of the ship but later became the guarantor when the purchase contract was transferred to a special purpose vehicle (”SPV”) established by the guarantor. The court declined to liken the guarantee of the SPV’s purchase obligation to a corporate guarantee or suretyship obligation. After discussions of and quoting the language of numerous English cases on the subject, the court determined that the guarantee was independent and that arbitration was not timely demanded so that the right to withhold payment on that basis was lost. The case has created uncertainty in English courts about the proper criteria to use to determine if a guarantee is independent.

In McNeil & NRM Inc. & SA Audi Bank France v. Kolon DACC Composite, Ltd ., an advance payment guarantee was issued by a French bank to a Korean purchaser of sophisticated manufacturing equipment. When progress on the development and manufacture of the machinery ordered was delayed for extended periods of time, the Korean beneficiary requested the manufacturer–applicant to return its advance payment. When the manufacturer refused to do so, the beneficiary claimed under the bank guarantee. The applicant applied to the Paris Commercial Court to stop payment by arguing that the bank guarantee was not an independent guarantee used in international transactions but a contract of guarantee that is co-extensive with the principal contract so that payment should only be made after an arbitral award settling the contract dispute between the applicant and beneficiary, i.e., that a default was first proven. The bank guarantee issued by Bank Audi used wording indicating the intention of the bank to pay upon a proper demand for payment, i.e., before proof of default. The French court confirmed that the demand under the guarantee and its payment were only subject to the condition of a declaration by the beneficiary of a contractual default by the supplier. Payment was not conditioned on any other event of a contractual nature, including the materiality of the alleged breach of contract.

While distinguishing independent undertakings (LCs) from dependent undertakings (guarantees) has been a significant problem outside the United States, the 1995 revision of U.C.C. Article 5 greatly diminished the problem in the United States. The publication of Restatement (Third) of Suretyship & Guaranty contemporaneously with the promulgation of Article 5 of the U.C.C. recognized the effort to separate LC obligations from suretyship or accessory guarantee obligations.

In Vanpoy Corp. S.R.L. v. Soleil Chartered Bank the court awarded “breach of contract” damages against a bank that issued an undertaking identified as a standby letter of credit and later refused full payment after receiving a request for drawdown by SWIFT messages from the beneficiary’s bank. It is unclear from the opinion if there was a “presentation” under a letter of credit. It is also unclear from the opinion whether the bank’s undertaking was a suretyship undertaking. What is clear is that the Vanpoy opinion does not mention U.C.C. Article 5 or any LC practice rules but does mention that the underlying export sale contracts and invoices were included as part of the beneficiary’s summary judgment motion.

Statute of Limitations

Three 2021 cases decided whether U.C.C. section 5-115’s one-year statute of limitations or a longer common law statute of limitations applies to three different types of actions involving letters of credit— Zions Bancorporation, N.A. v. JPMorgan Chase Bank, N.A ., Puget Soundkeeper Alliance v. APM Terminals Tacoma LLC , and Viele v. Williams . Puget Soundkeeper and Viele were post-honor cases and are discussed below under that heading.

In the Zions Bancorp case, JPMorgan Chase Bank, N.A. (“JPM”), as confirming bank, refused to fully honor conforming documents presented because the applicant had obtained injunctions in Brazil against Banco Bradesco as issuing bank and JPM enjoining honor of 50 percent of the amount drawn on the LC. Zions Bank filed its complaint against JPM more than one year after dishonor and expiration of the letter of credit. New York law governed JPM’s confirmation of the LC. The California court mistakenly determined that U.C.C. section 5-115’s one-year statute of limitations did not apply because the letter of credit at issue was governed by the UCP and because Zions Bank filed suit for breach of contract instead of wrongful dishonor under Article 5.

Zions Bancorp , Windsor Township , and Vanpoy were not decided under applicable Article 5 law; they do not treat the unpaid undertakings as within the scope of U.C.C. Article 5 but rather as contracts (but not as suretyship contracts). Neither the issuer nor the beneficiary of a letter of credit within the scope of U.C.C. Article 5 should be able to avoid or circumvent application of section 5-108 (strict compliance), section 5-111 (remedies against an LC issuer), or section 5-115 (statute of limitations) by pleading contract claims or defenses that would be available if the undertaking were a common law contract rather than an LC. Otherwise, the carefully crafted rules governing rights, duties, and liabilities of financial institutions in LC transactions set forth in Article 5, the UCP, and the ISP could be readily circumvented.

Fraud Defenses and Injunctions

U.C.C. section 5-109 applies to a presentation of documents that on their face comply with the terms of the letter of credit. Notwithstanding a facially compliant presentation, section 5-109 allows the issuer or applicant to assert a defense or claim that a required document is forged or materially fraudulent or that honor would facilitate a material fraud by the beneficiary. Issuers are not legally obligated to raise a fraud defense and are reluctant, if not unable, to do so. Accordingly, most LC fraud claims decided by courts are raised in emergency actions brought by applicants to obtain injunctive relief to prevent honor when a drawing is about to occur or be honored.

U.C.C. section 5-109 dictates how U.S. courts should balance an LC’s independence from the underlying transaction while at the same time providing a way to deter a fraudulent drawing. Few U.S. cases enjoin beneficiaries from presenting and issuers from honoring complying draws on LCs based on claims of forged or materially fraudulent presentations, a tribute to the specificity with which the LC fraud exception is addressed in section 5-109 and in its official comments and to the imposition of fees and costs on an applicant or issuer that unsuccessfully invokes the LC fraud exception.

Erroneous Legal Conclusion vs. Factual Misrepresentation

In TC Skyward Aviation U.S., Inc. v. Deutsche Bank AG , New York Branch , the issuer dishonored a facially complying presentation made under a $12,020,000 LC one day after the applicant filed for bankruptcy even though no regularly scheduled lease payments were in default. When sued by the beneficiary for wrongful dishonor, the issuer defended on the basis that because the beneficiary had no colorable basis to draw, the drawing was materially fraudulent under U.C.C. section 5-109(a)(2). The LC secured a lease of an inventory of spare parts for Boeing 777 aircraft, on which payments were being made on time. Although the lease had an acceleration clause in the event of bankruptcy, as a bankruptcy law matter, acceleration was prevented by the ipso facto clause of the Bankruptcy Code. The LC required the following signed statement to be made for a drawing: “THE AMOUNT OF USD X HAS BECOME DUE AND PAYABLE BY THE APPLICANT UNDER THE LEASE.” While the language could have been made clearer on the effect of bankruptcy and the ipso facto clause on the right to draw, the court granted summary judgment against Deutsche Bank, stating that the allegation of fraud was based on plaintiff’s legal interpretation of the effect of bankruptcy on the underlying contract, and was not a statement that misrepresented facts justifying the “narrow” fraud exception to the issuer’s duty to honor conforming draws. In effect, the court held that a showing of wrongful intent was necessary and not present because the draw was based on a legal conclusion interpreting a lease in bankruptcy.

Foreign Court Injunction Against Honor

In Zions Bancorp , JPM as confirming bank did not pay Zions Bank as assignee of the beneficiary beyond 50 percent of the amount drawn on the LC confirmed by JPM on the ground that doing so was enjoined by a Brazilian court. The injunction was obtained in Brazil by the Brazilian buyer against JPM as confirmer as well as against the Brazilian bank issuer. The court did not discuss U.C.C. Article 5 defenses or claims on which the injunction was based (e.g., fraudulent drawing). The facts and procedural status of the case, however, raise the question of whether a confirming bank may defend on the ground of substantive and procedural law based on foreign sovereign compulsion and the recognition of foreign court orders compelling dishonor of LC obligations. The court did not discuss the merits of JPM’s defense on compulsion, which is of considerable interest because there are very few reported decisions on the treatment of foreign court interference with the independence of LC obligations. This issue and the previous leading case in the United States were the subject of extensive discussion in The B usiness Lawyer survey of 2006 LC cases.

Article 5 vs. Incorporated UCP600

Of immediate concern in Zions Bancorp is the mistreatment of ordinary LC issues. The opinion on the defendant bank’s motion to dismiss concludes that a confirmed LC, despite its express choice of New York law, is not governed by New York’s U.C.C. Article 5 if it also states that it is subject to UCP600. Treating all of New York’s U.C.C. Article 5 as displaced by UCP600 contradicts section 5-116(c) as it was revised and became effective in New York in 2000 (and in the forum state of California in 1997). That subsection deliberately rejected New York’s then non-uniform total deference to UCP.

The Zions Bancorp opinion treats Article 5 as wholly inapplicable and not simply as displaced by any conflicting UCP600 provision. Accordingly, the opinion disregards the section 5-115 one-year statute of limitations and section 5-111 on remedies against issuers (including confirmers). Plaintiff Zions Bank was the assignee of LC proceeds with the rights and remedies under New York’s sections 5-114 and 5-111(c) of an assignee who has been recognized by the confirmer’s consent to assignment, but is also subject to the section 5-115 one-year limitations period, as well as any meritorious defense the confirming bank has against the beneficiary’s right to honor based on the Brazilian court injunction discussed above.

Insolvency of the Issuer

If a bank or credit union becomes insolvent, under powers granted to the receiver under federal law, the FDIC, as receiver, in its discretion, can disaffirm or repudiate the institution’s outstanding letters of credit which it determines are burdensome and interfere with the orderly administration of the insolvent financial institution’s estate. The beneficiary of an LC which has been disaffirmed or repudiated may file a claim for damages against the estate of the insolvent financial institution, provided that its claim under the LC had already matured at the time the receivership commenced. The FDIC’s and NCUA’s power to disaffirm and repudiate letters of credit was shown in Lexon Insurance Co. v. FDIC . That case demonstrates the need for beneficiaries to select financially sound banks as letter of credit issuers, to monitor the issuer’s credit standing, to obtain a provision in their underlying agreement allowing the LC to be drawn on or replaced if a credit downgrade event occurs, and to act with promptness to require the LC issuer to be timely replaced or draw on the LC before, and not after, the issuer’s receivership.

In Lexon , Lexon Insurance issued approximately $11 million in bonds to the Bureau of Ocean Energy Management securing obligations of Linder Oil Company. Linder’s reimbursement obligation to Lexon was supported by two automatically renewable LCs issued by First NBC of Louisiana totaling $9,985,000. First NBC was placed into receivership. The FDIC as receiver for NBC disaffirmed the two Lexon LCs six months thereafter as burdensome contracts that would interfere with the orderly administration of the insolvent bank’s estate. The LC applicant, Linder Oil, also filed for bankruptcy, leaving Lexon exposed without a source of reimbursement for claims on its sizable bonds. Lexon argued that the FDIC had no power to reject letters of credit because they were not “contracts” within the meaning of 12 U.S.C. § 1821(e), that Lexon had actual damages in the full amount of the LCs based on its bond exposure, and that the FDIC did not act within a reasonable time to reject the LCs issued to Lexon. The court rejected all three arguments: relying on Granite Re, Inc. v. National Credit Union Administration Board for rejecting the first; noting that no evidence of any actual damages at the time of receivership was presented to reject the second; and analyzing the facts and circumstances of the receivership to reject the third. Because the First NBC LCs automatically extended while it was under a consent decree with the FDIC prior to receivership which prevented First NBC from extending further credit on loans classified as loss or doubtful, Lexon argued that the FDIC was negligent by not enforcing the decree. The court rejected that argument as well, noting first that the FDIC in its corporate capacity did not have a duty to Lexon as a third party to prevent the letters of credit from renewing, and second, that the consent decree did not affect or prevent renewal of existing lines of credit for the same amount as opposed to extending new additional credit to the applicant.

Setoff Against Assignee of LC Proceeds

There is authority that the issuer of an LC can assert a setoff of debt owed to it by the beneficiary against the beneficiary’s draw on the issuer’s LC. U.C.C. section 5-114 provides that an acknowledged assignee of LC proceeds is limited to what the issuer would otherwise be obligated to pay to the LC beneficiary–assignor. Accordingly, the assignee of proceeds of an LC should ordinarily be subject to the issuer’s right of offset against the beneficiary. One way to avoid the issuer’s offset rights as an assignee of the LC’s proceeds is to obtain a clear waiver of the right of offset from the issuer.

That was the question in BNP Paribas, Singapore Branch v. Natixis, New York Branch . There, the court ordered the issuer of a standby letter of credit to pay the amount demanded by the acknowledged assignee of the beneficiary’s right to LC proceeds. The issuer’s refusal to pay the acknowledged assignee was based on the issuer’s contractual right of setoff against the beneficiary–assignor. The court held in a parallel case that the issuer’s setoff right was waived in the issuer’s SWIFT message acknowledging the setoff. The court deemed the issuer’s acceptance of this message as an “unequivocally clear” waiver of setoff rights by the issuer. These two cases were decided under New York’s summary procedure for enforcement of an instrument for the payment of money only. They do not mention the U.C.C. or any ICC rules. Given that the claimant is a mere assignee of LC proceeds, these two cases would not qualify as U.C.C. section 5-111(a) wrongful dishonor cases.

Liability of Advising Bank for Issuer’s Wrongful Dishonor

In ERA Capital L.P. v. Soleil Chartered Bank , the plaintiff sued Soleil Chartered Bank and Soleil Capitale Corporation (together, Soleil) as the LC issuer for wrongful dishonor and breach of contract and also Regions Bank for negligence and breach of fiduciary duty for failing to conduct sufficient due diligence on Soleil. Soleil unsuccessfully objected to the forum and to the sufficiency of ERA Capital’s pleadings. Regions Bank unsuccessfully argued that its liability was determined by U.C.C. Article 5, which limits the role of a bank that undertakes to advise another bank’s LC, but does not undertake to confirm it or to give value under it. The court denied Regions Bank’s motion to dismiss because ERA Capital’s complaint was based on alleged oral statements made by Regions Bank personnel about Soleil on which ERA Capital relied to its detriment and not on Regions Bank’s limited undertaking under U.C.C. section 5-107(c) or UCP Article 9. Issuing banks routinely require applicants to accept in writing full responsibility for the selection as well as conduct of other banks, but banks requested to advise or otherwise act on another bank’s LC do not routinely require written agreements documenting the differences between confirming bank and advising bank obligations to the beneficiary.

Oral Commitment to Act as Nominated Bank and Facilitate Beneficiary’s Assignment of LC Proceeds

In Lamda Solutions Corp. v. HSBC Bank USA, N.A ., Lamda, a broker, sued HSBC as nominated bank for breach of contract, promissory estoppel, and breach of U.C.C. section 5-114 for committing, but failing, to consent to assignment to the Mexican iron ore producer of proceeds of an Industrial and Commercial Bank of China (“ICBC”) commercial letter of credit for Chinese purchases from Lamda of 80,000 metric tons of iron ore. Lamda alleged lengthy negotiations and numerous inquiries by HSBC and responses by Lamda leading up to HSBC’s “commitment” to act as a nominated bank and facilitate an assignment by Lamda of the LC’s proceeds, including Lamda’s opening an account at HSBC in New York City, sending $30,000 to China to pay for costs of issuance of the ICBC LC, structuring the transaction with HSBC, and negotiating the form of assignment agreement. After HSBC asked for an explanation about Lamda’s calculation of the purchase price on the transaction, HSBC decided, without explaining its reasons, not to proceed further. Lamda claimed all issues had been adequately resolved. The court dismissed the complaint for failure to plead that HSBC entered into a binding agreement, because it lacked sufficient factual allegations of an offer, promise, and unconditional consent by HSBC to commit to an assignment agreement relating to the proceeds of the ICBC LC. The case exemplifies the desirability of obtaining a pre-agreement acknowledgment that there is no commitment or agreement until the committed party signs one.

Post-Honor Cases

Disputes that arise after the issuer honors an LC typically focus on: (i) whether the issuer is entitled to reimbursement, indemnification, subrogation, or other recovery from the applicant or, in some cases, from the beneficiary or other presenter, or (ii) whether the applicant or beneficiary may have impaired or enhanced rights against each other based on honor of the LC.

Statute of Limitations Cases

In Viele v. Williams , suit was filed on behalf of Beth’s Bail Bonds, Inc. as applicant of an LC issued to the Arkansas Bail Bondsman Licensing Authority (“ABBLA”), alleging negligence, conspiracy, conversion, and breach of contract by the LC issuing bank that paid the beneficiary’s demand and then applied the applicant’s CD collateral to reimburse itself. The court affirmed summary judgment under U.C.C. section 5-115’s one-year statute of limitations because the complaint was filed over three years after the LC was honored and the applicant’s complaint was in substance a claim for wrongful honor under Article 5. The court rejected the applicant’s attempt to circumvent Article 5’s one-year time bar by “couching” its claim for wrongful honor as common law causes of action. The applicant argued, unsuccessfully, that the bank’s reimbursement of itself from a CD pledged as collateral allowed for a valid and separate cause of action not subject to U.C.C. section 5-115’s one-year statute of limitations.

Under a fairly complex set of facts and parties, in Puget Soundkeeper Alliance v. APM Terminals Tacoma LLC , APM Terminals sought to add as a party counterclaim defendant the Tacoma Port employee who presented a draft and certificate to draw on a letter of credit procured by APM to secure its lease obligations to Tacoma Port in connection with its operations at the port facilities which had recently terminated. The employee was alleged to have committed fraud and converted LC proceeds by his action. The Port Authority argued that the alleged wrongful draw on the letter of credit was in effect a breach of warranty claim covered by U.C.C. section 5-110 and therefore was barred by U.C.C. section 5-115’s one-year statute of limitations. The court agreed that the fraud claim was barred by Article 5’s one-year statute of limitations, noting that fraudulent drawing is covered by U.C.C. section 5-109. As to the conversion claim, the court held otherwise, because that claim was possibly based on an underlying common law duty not to convert the applicant’s funds.

It should be noted that the section 5-110 warranties (of no fraud and no violation of underlying agreement) are made by the beneficiary of an honored drawing and that the opinion in Puget Soundkeeper does not explain the treatment of the Tacoma Port’s individual officer as an LC beneficiary. Also, there was apparently no allegation of breach of any of the section 5-110 warranties by the individual officer. The opinion’s reliance on sections 5-110 and 5-115 is explained by its citation to and lengthy discussion of an en banc Washington Supreme Court opinion that concluded that the section 5-110(a)(2) warranty “creates an auxiliary cause of action to protect the applicant from wrongful drawings by the beneficiary in cases where the applicant lacks a common law contractual basis for his claims.” Further, “whether that auxiliary cause of action displaces [the applicant’s] common law claims, thereby rendering them claims that ’arise under’ Article 5 and are subject to its limitations period, accordingly depends on whether his claims are based on an underlying contract . . . or some independent duty owed by [the beneficiary to the applicant].”

Subrogation

In Solferini as Trustee of Corradi S.p.A. v. Corradi USA, Inc., Banca Nazionale del Lavoro S.p.A. (“BNL”) issued an $800,000 LC at the request of the Italian applicant, Corradi S.p.A., to Bank of the West to secure an $800,000 loan to the applicant’s subsidiary, Corradi USA. When Corradi S.p.A. became bankrupt, Bank of the West drew on the BNL LC for the full amount; BNL, in turn, was only able to recover an amount (in Euros) equal to $115,667 in Corradi S.p.A.’s bankruptcy proceeding. Solferini, as trustee for the bankrupt applicant Corradi S.p.A., sued its U.S. subsidiary for recovery of the $800,000 benefit it had received on theories of equitable subrogation, statutory subrogation under U.C.C. section 5-117, and quantum meruit. The district court rejected these claims and the Fifth Circuit affirmed, denying subrogation for any amounts under section 5-117 because subrogation was not properly pled in the trustee’s complaint. The complaint pled the subrogation right of the unreimbursed issuer, and the trustee raised too late its claim to be subrogated as an applicant that arguably partially reimbursed the issuer.

The court of appeals also affirmed the award of $272,127.50 in attorneys’ fees to the defendant Corradi USA as the prevailing party under U.C.C. section 5-111(e) in its defense against the inaptly pled statutory subrogation right of an unreimbursed issuer (as distinguished from the possibly apt, but unpled, subrogation right of an applicant that has reimbursed the issuer). The district court, after the mandate issued, on motion of Corradi USA, Inc. added another $120,895.10 in attorneys’ fees plus costs incurred by Corradi USA, Inc. on appeal.

LC Errors to Avoid

Four cases were decided in 2021 which touch upon specialized situations where what was done in the LC transaction or its aftermath had repercussions—three for the issuer and one for the beneficiary.

Protecting the Issuing Bank in the Applicant’s Bankruptcy

In the case of In re Kimmel’s Coal & Packaging, Inc ., litigation arose from a section 363 sale under the Bankruptcy Code, where the purchaser’s obligation to replace a prepetition environmental security LC for mining on leased land or to assume the debtor’s reimbursement obligation was dependent on the purchaser of a bankrupt coal company’s assets and business obtaining transfer of the debtor’s permits for coal mining on the leased land in question. The section 363 bankruptcy sale order provided for all the debtor–applicant’s assets, including the issuing bank’s collateral, to be sold to the purchaser free and clear of the issuing bank’s liens and security interests in them. The court initially held that under the terms of the parties’ agreement to the section 363 order, the purchaser was obligated to apply for permits to replace the LC in question even though transfers of permits depended on the landlord’s transferring the leases for mining land which had not occurred. In the later opinion, the court held that the purchaser of the bankrupt seller’s coal operations and business was contractually obligated to apply for and accept transfer of whatever portion of the permits that it could even if that portion is something less than 100 percent. A clearer drafting of the section 363 sale terms could have avoided the issuer’s problem of having its bankrupt debtor’s assets pledged to secure its outstanding LC transferred free and clear of the issuer’s liens without its LC being replaced and terminated or the reimbursement obligations assumed or collateralized by the purchaser.

Fraudulent Transfer by Use of LCs

In another bankruptcy case, In re Essar Steel , the court found that substantial amounts of the debtor’s estate were transferred to foreign affiliates via draws on LCs on which the debtor was the applicant. The officers of the applicant were sued for breach of their fiduciary duty in facilitating the LC transfers at a time when the U.S. applicant was insolvent.

Inability to Use IRAs Pledged as LC Collateral

In Cassidy v. Signature Bank , the court found that IRA account collateral pledged to secure the applicant’s LC reimbursement obligation could not be offset by the issuing bank to satisfy other debt owed to it. The basis of the court’s holding was that the pledge agreement specifically denied setoff rights against retirement account collateral and under Illinois law IRA accounts are considered to be “special deposits” creating a trust relationship between the depositor and the bank which cannot be used to satisfy general indebtedness.

Late Response to LC Complaint

In White Stag Aircraft Leasing U.S. LLC v. JP Morgan Chase Bank, N.A ., the court accepted the issuing bank’s argument of excusable neglect for failing to timely file a response to a beneficiary’s complaint alleging breach of the LC issuing bank’s obligations. That allowed a default judgment to be vacated and the issuer to plead that the presentation made under its LC did not strictly comply with the terms of the LC and that the complaint was filed beyond the one-year statute of limitations for filing an action for wrongful dishonor.

LC Transaction Red Flags

Letter of credit scams of various types keep occurring. Any party, especially a party unsophisticated in letter of credit transactions, that is approached to participate in an LC transaction where the returns are too good to be true, should avoid them. These include so-called prime bank instruments, monetizing letters of credit, advance fees paid into unsafe escrow arrangements that allow the defrauding party to remove funds unilaterally, and many other schemes.

Three cases reported in 2021 involved substantial amounts of money through use of an LC in questionable transactions or with questionable parties or arrangements. In two of them, extraordinary commissions were to be earned, and in the third, $2.5 million in advance fees were to be placed in escrow with a sole practitioner pending release of a $500 million LC. All the cases led to litigation and losses. The features of these cases—large brokerage fees and sole practitioners involved with acting as escrow agent for $500 million LCs—are red flags or warnings indicating unreal expectations or possible scams.

Both authors are collaborators on letter of credit law developments with Professor James E. Byrne, a previous co-author of this survey and the founder of the Institute of International Banking Law & Practice (“IIBLP”) and the monthly journal Documentary Credit World (“DCW”), whose death in 2018 was memorialized in a previous survey volume. In Memoriam Professor James E. Byrne, 73 BUS. LAW. 1203 (2018). The continuing assistance of IIBLP’s CEO Michael Byrne and of DCW Executive Editor Christopher S. Byrnes is gratefully acknowledged. The authors also are grateful for the careful edits and review of this survey by Wayne Barnes of Texas A&M University School of Law and Gregory M. Duhl of the Mitchell Hamline School of Law.

James G Barnes

Baker McKenzie

JAMES G. BARNES graduated from Yale University and the University of Michigan Law School and practiced law as an associate/partner/senior counsel with Baker & McKenzie until his retirement as a lawyer in...

View Bio →

Carter H Klein

Jenner & Block LLP

Carter H. Klein   Carter H. Klein is currently Of Counsel with Jenner & Block, LLP and has practiced in its Commercial and Corporate Law Departments since 1974 after a two year judicial clerkship. He is liaison for...

This content was produced by:

• Banking Law Committee
• Dispute Resolution Committee
• International Business Law Committee

NEWS / BLOG

Letters of Credit: What Are The Different Types?

In the trade finance market, there are really only two basic forms of letters of credit: The Standby Letter of Credit (SBLC) and Documentary Letter of Credit (DLC) .

Revocable or Irrevocable Documentary Letters of Credit

Documentary Letters of Credit (DLC) can be issued as either revocable or irrevocable. Most all Documentary Letters of Credit are issued as an irrevocable DLC as revocable DLCs are very rare.

Revocable Documentary Letters of Credit

Revocable Documentary Letters of Credit may be altered or even canceled by the buyer without any notice to the seller.

Due to this, they are more often than not unacceptable to the seller.

Irrevocable Documentary Letters of Credit

Being the most commonly used type of letter of credit in global trade, Irrevocable Documentary Letters of Credit cannot be altered or canceled by the buyer.

As long as the seller complies with the terms and conditions of the letter of credit, the buyer's issuing bank must make payment to the seller when it is.

Any alterations to the Irrevocable Documentary Letter of Credit must be approved by both parties involved in the transaction.

Unless stated as revocable, a Documentary Letter of Credit automatically is considered irrevocable.

Confirmed or Unconfirmed Documentary Letters of Credit

Irrevocable Documentary Letters of Credit are issued as confirmed or not confirmed. Both types of credit have their own advantages and disadvantages for the buyer and seller.

The cost of each type varies as well. In general, the more risk a bank assumes by guaranteeing payment, the higher the cost will be for providing the letter of credit.

Unconfirmed Documentary Letters of Credit

This type of letter of credit is an irrevocable credit that is not confirmed by an advising bank.

In an Unconfirmed Documentary Letter of Credit , the buyer's issuing bank is the only party responsible for guaranteeing payment to the seller.

Payment is made to the seller by the advising bank only after it has received payment from the issuing bank. The advising bank is simply a middleman between the issuing bank and the seller.

Confirmed Documentary Letters of Credit

This type of letter of credit is an irrevocable credit that is confirmed by an advising bank.

The advising bank and issuing bank both guarantee payment to the seller when demanded.

The advising bank first reviews and confirms that all of the documentary requirements in the credit are met and pays the seller.

The advising bank then goes directly to the issuing bank to receive payment.

Confirmed Irrevocable Documentary Letters of Credit are often used when trade is done in an area where political, social, or instability are common.

They are also common when the seller is unfamiliar with the bank or financial institution issuing the letter of credit, or when a seller needs to obtain bank financing with the use of the Confirmed Documentary Letter of Credit .

A Confirmed Documentary Letter of Credit is usually provided for a higher fee as the bank takes on more liability.

Find Out How To Get A Documentary Letter Of Credit Here!

Standby Letters of Credit

This type of letter of credit is a payment or performance guarantee utilized throughout the world.

Standby Letters of Credit (SBLC) are also often referred to as non-performing letters of credit because they are usually only used as a backup or an insurance policy should the buyer fail to pay the seller.

The Standby Letter of Credit (SBLC) allows a customer establish rapport with a seller by showing that it can and will fulfill its payment commitments to the seller.

These types of letters of credit can be used to guarantee full payment of a contract, repayment of a loan, or payment for goods that are delivered by a third party.

The seller/beneficiary of the Standby Letter of Credit receives payment from the issuing bank by demanding it directly to issuing bank.

Standby Letters of Credit are usually much less complicated and require fewer documentation requirements than Irrevocable Documentary Letters of Credit .

Start The Standby Letter Of Credit Process Here!

Other Types of Letters of Credit

Back-to-Back Letters of Credit

A Back-to-Back Letter of Credit is when a nontransferable, existing letter of credit is used for collateral for opening a fresh, new letter of credit.

Import companies often use Back-to-Back Letters of Credit to pay the buyer’s end supplier while being the middleman.

An import company receives a letter of credit from the buyer and then immediately opens another new letter of credit in favor of the supplier. The first letter of credit is used as collateral for the second letter of credit.

Deferred Payment Letters of Credit

In a Deferred Payment Letter of Credit, the buyer agrees to pay the issuing bank after a fixed period agreed upon in the letter of credit’s documents.

Red Clause Letters of Credit

A Red Clause Letter of Credit provides the seller advanced cash from the buyer’s issuing bank before goods are shipped in order to finance the production of the goods.

In this, a buyer can essentially extend financing to a seller, by guaranteeing all of the advanced money.

Revolving Letters of Credit

A Revolving Letter of Credit is a letter of credit that is restored to its original amount as soon as been used or drawn down.

Many times, these types of letters of credit limit the number of times a buyer can draw down on its line over a particular predetermined period.

Transferable Letter of Credit

This type of letter of credit allows a seller/beneficiary to transfer all or part of the proceeds of the original letter of credit to a second beneficiary, usually the end supplier of the goods or service.

To be considered as a Transferable Letter of Credit , the letter of credit must clearly state that it is transferable.

This is most commonly used for middlemen importer/exporters all across the world.

Assignment of Proceeds

If needed, a beneficiary may assign all or a part of a letter of credit to a third party, but, unlike a Transferable Letter of Credit, the beneficiary maintains sole rights to the letter of credit and is solely responsible for complying with its terms and conditions.

For the third party who the letter of credit was assigned to, an assignment only means that the paying bank follows the assignment instructions if and when payment is to be made.

This type of deal is riskier as the third party involved is dependent upon the beneficiary for compliance.

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Letters of Credit/Types of Letters of Credit

• 1.1 Revocable
• 1.2 Irrevocable
• 1.3 Unconfirmed
• 1.4 Confirmed
• 1.5 Transferable Credit
• 1.6 Assignment of Proceeds
• 1.7 Revolving
• 1.8 Standby

Types of Letters of Credit

A revocable letter of credit is one which can be amended or cancelled by the applicant or the issuing bank at any time, without prior notice, discussion or agreement with the beneficiary. A revocable letter of credit offers no protection to the beneficiary and is seldom if ever used.

Irrevocable

An irrevocable letter of credit can not be amended or revoked without the agreement of ALL the parties to the letter of credit, so it provides the assurance that providing the beneficiary complies with the terms, he/she will be paid for the goods or services. Under UCP 500, a letter of credit is deemed irrevocable unless otherwise stated.

Unconfirmed

An unconfirmed irrevocable letter of credit provides a commitment by the issuing bank to pay, accept, or negotiate a letter of credit. An advising bank forwards the letter of credit to the beneficiary without responsibility or undertaking on its part except that it must use reasonable care to check the authenticity of the credit which it advised. It does not provide a commitment from the advising bank to pay, so the beneficiary is reliant upon the undertaking of the overseas bank. The beneficiary is not protected from the credit risk of the issuing bank nor the country risk.

A confirmed irrevocable letter of credit is one to which the advising bank adds its confirmation, makes its own independent undertaking to effect payment, negotiation or acceptance, providing documents are presented which comply with the terms of the letter of credit. The advising bank, which may also be the confirming bank, assumes the country (political and economic) risk of the applicant’s country as well as the credit risk, failure and default of the issuing bank and effects payment to the beneficiary without recourse.

In order for a letter of credit to be confirmed, a bank accepting this risk would have a correspondent relationship with the issuing bank. If the advising bank does not have such a relationship, the letter of credit can be confirmed by an independent bank. The negative aspect here is the cost of adding another bank to the scenario.

A seller should consider requesting a confirmed credit when

• the credit standing of the issuing bank is unknown to the seller or viewed by the seller as questionable.
• exchange controls in the buyer’s country may prevent local banks from honoring certain external payments.
• the importing country is suffering economic difficulties: large external debt and/or high debt service ratios, a persistent negative balance of payments, or a record of being late or having defaulted on its international payments.

Transferable Credit

Under a transferable letter of credit a beneficiary (the first beneficiary) can ask the issuing/advising/confirming bank to transfer the letter of credit in whole or in part to another party/ies such as supplier/s (second beneficiary/ies). A transferable letter of credit is usually used when the beneficiary is not the manufacturer/original supplier of some/all of the goods/services. This process enables the beneficiary to pay the manufacturer/original supplier by letter of credit. If the bank agrees, this bank, referred to as the transferring bank, advises the letter of credit to the second beneficiary/ies in the terms and conditions of the original letter of credit with certain constraints defined in Article 48 of UCP 500.

In general, unless the letter of credit states that it is transferable, it is considered non-transferable.

Assignment of Proceeds

The right to the proceeds of a letter of credit can sometimes be assigned where the beneficiary of a letter of credit is not the actual supplier of all or part of the letter of credit and wants the bank to pay the supplier out of funds received from the letter of credit. The beneficiary may choose this option if he or she

• does not want to request a transferable letter of credit from a buyer in order to keep the buyer from knowing who is the actual supplier of the goods.
• does not have the necessary credit with the bank to issue a new letter of credit to a supplier.

An assignment of proceeds takes the form of an irrevocable instruction from the beneficiary to the bank requesting that it pay the supplier out of the proceeds of the letter of credit which becomes due when documents are presented in compliance with the terms of the letter of credit.

Although infrequently used today, revolving letters of credit were a tool created to allow companies conducting regular business to issue a letter of credit that could “roll-over” without the company having to reapply, thus enabling business flow to continue without interruption as long as the terms and conditions, quantities, and other transaction details did not change. In addition, if a letter of credit were a revolving one, there were few ways to stop it from rolling over; so, should a conflict arise between the parties while the letter of credit was in place or should the products change, there was little recourse for either party. In the business world today, the fact is that, unless required by law or because of high risk, on-going business is usually conducted without of letters of credit

As is the case with the revolving letter of credit, standby letters of credit are infrequently used today. A standby letter of credit is one which is issued as a back-up or form of insurance for the seller should the buyer default on the agreed-upon payment terms. A standby letter of credit is issued in the same way a documentary credit is in that the collateral needed for issuance is required by the issuing bank and the beneficiary must comply with every detail as outlined in the letter of credit. The problem with this instrument is that the applicant has no guarantee, other than the seller’s word, that the standby will not be drawn against even if payment is made as agreed. This situation is challenging, especially if the letter of credit is confirmed and the advising bank sees only documents pertaining to the shipment as outlined in the letter of credit and has no knowledge of other payments being made.

• International Finance

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