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Letter of Credit and Contract of Sale

Info: 4561 words (18 pages) Essay
Published: 2nd Aug 2019

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Jurisdiction / Tag(s): UK Law

A general contract of sale between two individuals signifies a consensus between the two parties as to what duties applies to them which they would be liable for were they unable to fulfil them in full. At the heart of this contract, especially with respect to sale of goods contracts, is the agreement between the seller and the buyer with respect to the payment involved in the contract. At an individual level, this payment point may not be an integral part of the contract but when businesses and corporations deal with each other, especially internationally, the payment in question gets understandably substantial enough to give rise to a need for certainty at the hands of the dealing parties. Thus, ever since global trade picked up pace in the early 1900s, the need for certainty in performance of the contract at the hands of the contracting parties grew with it, giving rise to a need for new and more reliable financing methods. The letter of credit, also known as a documentary credit or a banker’s commercial credit; [1] a method of payment that does not only give a sense of security to the sellers who often do not know the full extent of their buyer’s credit history and therefore may be skeptical about parting with goods but alongside, also protects buyers who may be similarly doubtful about the seller’s intentions or abilities to supply the specified goods. Thus, the parties (the buyer and the seller), having agreed to the documentary bill as the preferred method of financing, delegate payment to a mediator such as a bank on the presentation of certain documents and the bank complies with their wishes.

While not completely free of flaws, the letter of credit became the centrepiece of a growing number of financial transactions occurring as a result of the rise in international trade, owing to the benefits it afforded to the parties involved which includes but not limited to, the seller, the buyer and the banks. Their use may have started more than 150 years ago but throughout the 20th century and its evolving eco-political disparity created by the two World Wars, [2] they have slowly carved a niche in modern day cross-border trade, becoming a widely accepted and credit-friendly means of payment in commerce. It is hence no surprise that they are deemed as the “lifeblood of international-commerce”. [3]


While the documentary credit may have gained paramount status in financing international trade in the current environment, the international trading system was riddled with alternatives that were frequently utilized.

The simplest method that was frequently used is the ‘open account’ method where the seller had to pay cash upon ordering the goods. [4] There is an obvious disadvantage in this form of payment as the buyer stands a risk as to whether or not the goods will be delivered by the buyer since the seller may not know if the buyer has a genuine business or not.

The seller was in a particularly disadvantageous spot if the buyer demanded credit, which is not uncommon in trade. This introduces the second method of effecting payments in the international Trading system which is the ‘documentary bill’ method. With this method, the seller who is usually worried about actually receiving payment at the hands of a new buyer or (perhaps an old buyer who might just end up insolvent) is entitled to stipulate a clause into the contract of sale allowing him to retain title in the goods until payment of the goods has been made by the buyer. [5] This clause is sometimes referred to as the Romalpa clause since it takes after the case involving Aluminium Industrie Vaasen v Romalpa Aluminium Ltd. [6] This clause simply allows the seller to retain title in the sale of specific or unascertained goods which are later appropriated to the contract under the rules set out in sections 18, 20(a), and 20(b) of the Sale of Goods Act 1979 until the specified requirements stated in the contract are fulfilled by the buyer (such as payment). It is only then that the property in the goods passes. Such a reservation of the right of disposal is also covered by statute. [7] The conditions become paramount and it is only on their fulfilment that the property passes [8] , so even if the goods are delivered, the seller retains title, causing the buyer to return the bill of lading if it was already transmitted to him. [9] This is an effective method of protecting the seller in case the buyer is rendered insolvent, since the goods do not form part of the buyer’s assets, though admittedly disadvantaging the buyer’s creditors who may be unaware of this retention clause.

This clause effectively retains property to the seller in case the buyer defaults in a local transaction. However, if the sale is international, the seller is in a difficult position because by the time the seller realizes the situation, the goods would be on their way to a different country, leaving the seller with little recourse. The seller retains title but loses possession. Moreover, the buyer acting on bad faith may end up re-selling the goods to a third party and if the third party purchases in good faith without knowledge of the retention of title, the property validly passes to them, [10] thereby ridding the seller completely. If the seller successfully retained title, he would be forced to dispose of the goods in unfavourable circumstances in unfamiliar land. Thus, it is easy to see why the seller’s first preference is always money [11] .

Another method of making payments in a sale contract is the bill of exchange, a traditional and widely utilized method of payment. According to article 3(1)(a) of UNCITRAL Convention on Bills of Exchange, ‘a bill of exchange is a written instrument which contains an unconditional order whereby the drawer directs the drawee to pay a definite sum of money to the payee or to his order’. [12] This could be incorporated into the contract of sale as a preferred means of payment. The seller draws the bill of exchange on the buyer declaring himself as the payee, which is payable ‘…on demand or at a fixed or determinable future time…’. [13] The bill of exchange is then sent to the buyer together with the bill of lading [14] which is then either acted upon (i.e. paid immediately to the order of the money owed if it is a sight bill) by the buyer or accepted (to be paid at a specified date later if it is a term bill). If the buyer declines to accept the bill of exchange, he must return the bill of lading to the seller. [15] If he accepts, then the seller becomes entitled to payment. The bill constitutes a transferable document, [16] so the seller can now raise cash against it with a bank, transferring the right to be paid under it to the bank. This serves well both for the seller and the buyer, as the seller has received the cash (although not the full face value of the bill since the bank may purchase it at a discount) whereas the buyer has deferred the payment. Furthermore, the seller may seek to guard against buyer’s failure to accept the bill of exchange by instructing their own bank (remitting bank) to employ an agent bank (collecting bank) in the buyer’s country, transmitting the documents to it, and instructing not to release them until the buyer accepts or pays. Such an engagement, if the parties agree, can be governed by the Uniform Rules for Collections, [17] introducing a further degree of uniformity into the sale.

However, the seller after discounting the bill of exchange with the bank is not completely secure. In cases where the buyer defaults on the payment, the seller will be liable to the bank unless he specifically excluded himself in the contract. Moreover, the buyer, who may now be in possession of the goods can sell them to a third party who will acquire good title under the exceptions of nemo dat quod non habet. This, of course, would render the seller helpless.

Given these deficiencies listed above in the methods of making payments in an international trading system, the seller would aim to utilize a system of finance in which he is able to get assurance of performance at the hands of the buyer. Far better in this regard is the system of documentary credits.


The letter of credit seeks to provide both the seller and the buyer a sense of security [18] in terms of payment (with regards to the seller) and credit (with regards to the buyer). This is primarily why Kerr LJ gave it the aforementioned status and its increasing widespread use only ensures its further development. The concept of a documentary credit revolves around using the bank, an entity with reputably good creditworthiness, as a mediator between the seller and the buyer in order to effect payment. Letters of credit displays its unique characteristics anytime it’s being used in an intended sale transaction. They are usually flexible in the sense that the seller may decide to nominate any bank to be paid by the issuing bank making it obligatory for the issuing bank to make payment to the beneficiary only in that particular transaction. Negotiable measures are passed on from one party to the other almost the same way as in a cash transaction.

The documentary credit is utilized if it is the agreed method of payment in the sale contract between the two contracting parties. Once the credit is opened, the bank becomes a party to a new separate contract with its own duties and obligations. Thus, there are two distinct contracts in operation, one relating to the documentary credit and the other representing the underlying sale contract, working independently of each other. [19]

The law and procedure relating to documentary credits is seemingly transparent and uniform, bolstering its utility even further. The letter of credit is instigated by the buyer [20] who approaches the bank with an application for one, naming the seller as the beneficiary under the credit for a stipulated amount to be issued to him only on the presentation of certain documents (which generally include shipping documents like bill of Lading, insurance certificates, etc). [21] The sellers bank thus becomes the issuing bank which then sends the same instructions to an advising bank in the seller’s country, directing them to inform the seller that a credit has been opened in their favour. As soon as the advising bank communicates the same to the seller, contractual obligations arise between seller and issuing bank (along with other pre-existing contracts) and it is by virtue of these contractual obligations that assurances of payment are made. The advising bank may also become a confirming bank if the seller or the issuing bank so authorizes it and the bank agrees.

At this point the contracts in operation apart from the underlying sale contract are those between the seller and the issuing bank, between the issuing bank and the advising bank, the issuing bank and the seller and the confirming bank and the seller. All these contracts ultimately seek to provide assurance to the buyer, along with the seller, that the beneficiary would be paid on the presentation of conforming documents, stated in the credit agreement, to the paying bank. The paying bank would be conveniently placed in the seller’s country, and thus the seller would handle all correspondence with the paying/confirming bank, a system that opens a wealth of doors in its quest to provide ease of use to the seller. Letter of credit therefore in effect will be described as a document issued on behalf of a buyer by a bank that essentially acts as a guarantee of payment to the seller.


To achieve an even greater level of uniformity, the contract of sale may stipulate the use of the Uniform Customs and Practices for Documentary Credits (UCP) governing the credit transaction. [22] This body of rules was set up by the International Chamber of Commerce (ICC) which was established in 1919 simply to endorse payments and international trade transactions. [23] The first UCP came into effect in 1933, whereas the current one (referred to as the UCP 600) came into force on 1st July 2007. [24] The last version, UCP 500, had been in force since 1993. [25] The UCP serves as a governing statute if the underlying contracts expressly stipulate its use. [26] Hence, its presence is not automatic. Indeed, the parties may choose to ignore its provisions altogether but given how it transcends boundaries to be applied within any jurisdiction where the case may end up being tried, the parties would rarely opt out. This invigorates the freedom of contract principle between the contracting parties, rendering their agreement autonomous which means that they could still exclude certain terms of the UCP expressly if they so wish.

However, the use of the UCP to govern the use of documentary credits has since gained increasing acceptance at the hands of the bankers of the world, thereby offering an incentive to the courts to imply an intention to use it in agreements which do not specifically mention. [27] The UCP is thus regarded as the forefront authority in matters of regulation of documentary credits. Their importance can be judged by the fact that the courts are expected to consult the credit agreement in order to circumvent any conflict with the UCP, instead of the other way round. [28] As in Glencore International AG v Bank of China, [29] Thomas Bingham MR puts it:

…a code of rules settled by experienced market professionals and kept under review to ensure that the law reflects the best practice and reasonable expectations of experienced market practitioners. When Courts, here and abroad, are asked to rule on questions such as the present they seek to give effect to the international consequences underlying the UCP. [30]


The contracts arising under the documentary credit agreement set in motion several actions that in commercial trade, seem to be automatic. The seller, the issuing bank, the confirming bank and the buyer all have distinct rights in relation to each other which protect their interests and allow them to seek protection from the courts in case of any unpredicted incident. This is especially useful in incidents of the discovery of fraudulent acts in the trading process as stated by Kerr J in the RD Hardbottle (Mercantile) Ltd v National Westminster Bank Ltd , …Except possibly in clear cases of fraud of which the banks have notice, the court will leave the merchants to settle their disputes under the contracts by litigation or arbitration as available to them or stipulated in the contracts…’ [31] Though the seller is entitled to the payment if he adheres to the terms of the documentary credit, the mode of payment is governed by the type of credit used which is normally stipulated in the credit agreement. One of four payment modes could be chosen; payment at sight, deferred payment, acceptance credit and negotiation credit. [32]

A. The Seller

Once the advising bank communicates the establishment of the credit to the seller, the issuing bank is under a contract with the seller and is under a duty to pay him on the presentation of the conforming documents. The payment method is as stipulated in the credit terms of the sale agreement. A sight payment would guarantee the seller payment on the presentation of documentation [33] as is the case in most CIF contracts unless stipulated otherwise in the contract, [34] a deferred payment would stipulate a future date of payment [35] an acceptance credit would allow the seller to draw bills of exchange on the bank which would be accepted as a guarantee to be paid by the bank [36] and finally a negotiating credit where the advising bank negotiates the bill of exchange produced by the seller. [37] It is important to note that the credit is to be opened before the stipulated date of shipment in the contract of sale, thereby assuring the seller of payment before the goods have to set sail. [38] More protection to the seller is given with the buyer’s obligation to open credit being treated as a condition precedent to seller’s obligation to ship, unless expressly agreed otherwise. [39]

According to article 2 of UCP 600 a credit can be described as ‘…irrevocable undertaking thereby constituting a definite undertaking by the issuing bank’. This implies that the issuing bank has to make available the payment for the seller provided he provides conforming documents satisfying the relevant terms of the credit. [40] Moreover, once the seller is paid, any changes to the credit agreement by the issuing bank will have to be consented to by him. [41] UCP 600 does not give room for revocable credits possibly because it may be more often than not unsecured. According to article 8(a) of UCP 500, [42] a revocable credit ‘… may be amended or cancelled by the issuing bank at any moment and without prior notice to the beneficiary’.

By agreement, the seller may also choose to utilize one of the other forms of credit that offer their own benefits. Options include a transferable credit [43] where rights under the credit agreement may be transferred to a third party, Revolving Credit where payment is to be made by instalments in cases or regular or long term business contracts. [44] In this sense, instead of issuing a separate letter of credit for each transaction, the same letter of credit could be used but making payments according to the agreed amounts. In a standby credit, [45] the actual mode of payment could be different as the letter of credit actually acts as collateral or a guarantee of payment to the beneficiary. When the sale involves a middleman, a back-to-back letter of credit will come to play where the middleman draws the credit for payment with regards to the manufacturer and then presents the documents provided by the manufacturer as a tender to the buyers bank for payment. [46] Moreover, the credit has to conform to the sale contract, so the beneficiary can reject a credit which does not conform, or waive discrepancies off. [47]

B. The buyer

The buyer is afforded similar protections (as the seller) as a result of the credit agreement. The most important benefit for the buyer lies in the fact that the credit agreement and the contract of sale are both treated separately. The buyer, who is engaged in a credit contract with the issuing bank, which in turn has to strictly adhere to his instructions regarding the requirement of documents, is allowed to reject goods if they do not comply [48] with established statutes (such as the Sale of Goods Act 1979) even after he has received the documents and the payment has been made, and sue the seller under the sale contract to recover the loss.

The buyer’s instructions to the bank as to the requirement of documents are also of paramount importance, for he may reject the documents if they do not comply. The threshold is extremely narrow, and it seems like even insignificant discrepancies such as missing the name and documentary credit number could amount to non-compliance [49] even though the case involving Glencore International AG v Bank of China suggests that typing errors can be overlooked. [50]


Given the rapidly advancing trade practices of contemporary businesses, it is not a surprise to see that the most convenient and relatively secure methods of payment get preferential treatment in order to keep cross-border trade running smoothly. While letters of credit may not be flawless as, for instance, certainly the right of the bank to choose another bank to carry out the buyer’s instructions at the buyer’s risk, and not their own [51] , may counts as a flaw. Also due to the cost involved to cover the bank charges and the whole procedure, they may prefer other methods of payment such as the open account method especially when they are able to envisage some level of trust in the sale system. [52] Even though these may be disadvantageous in the documentary credit, it is relatively much more secure than other methods of payment which often render the innocent party at bay. Kerr LJ hence correctly described letters of credit as the ‘lifeblood of international commerce’ since it is preferable both in theory and in practice than to other more vulnerable methods discussed above. Even if the buyer has to withstand a fee at the hands of the bank, they improved cash flow more than makes up for it.

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