Letters of Credit

If you are exporting, or thinking of exporting, one of the issues that you will need to consider is how to collect payment from your buyer. Several options exist. One is to ask the buyer to pre-pay for the goods.  This option provides you with a relatively high degree of assurance that you will actually receive payment.  However, you may find it difficult to find a buyer who will agree to these terms.

Another option is to sell on open account (i.e. to send an invoice to the buyer along with the goods which requests payment of the purchase price).  This approach will certainly be agreeable to any buyer.  However, given the difficulties involved in collecting debts in foreign jurisdictions, you may be ill-advised to agree to this method of payment, especially with a buyer with whom you have not done business previously.

Between these extremes of pre-payment and open account sales is a commercial letter of credit (a commercial credit).  A commercial credit is a document issued by a bank in which the bank agrees to pay money upon the presentation of specified documents.  Using this device, a bank will essentially "step into the shoes" of the buyer for the purpose of guaranteeing payment to you.  It costs money (an increasing amount as the purchase price of the goods increases), but it may significantly reduce your risk of non-payment.  The extent to which it reduces your risk is related to your ability to present documents to the bank that mirror the requirements in the credit, the creditworthiness of the bank, the terms and conditions in the credit, and other factors.

This paper explains the basics of how a commercial credit operates.  It also introduces a related tool of commerce known as a standby letter of credit (a standby credit).  The structure of a standby credit is similar to a commercial credit, but the function is different.  A commercial credit guarantees payment for performance of a contract, whereas a standby credit guarantees payment in the event of non-performance.  Finally, this paper describes the potential for the development of a commercial credit that utilizes electronic messages, rather than paper documents.

Please note this is not a complete guide to commercial and standby credits.  Credits are highly sophisticated tools of commerce.  If structured correctly, they can substantially reduce some of the risks associated with international transactions.  If structured incorrectly, they can lead to unfortunate results that differ significantly from one or more of the parties’ expectations.  We strongly encourage you to seek the advice of competent legal counsel before engaging in any transaction involving credits.


Commercial credits come in all shapes and sizes.  Some involve multiple banks, numerous documents, and specialized terms that perform such functions as providing financing for the buyer or the seller. O ther credits involve only one bank and a few documents.  In general, the terms and conditions (as well as the cost) of a commercial credit vary depending on the value of the underlying transaction, the political and economic risks associated with the transaction, the relative bargaining power of the buyer and the seller, and other factors.

The following outlines the relationships between the three primary parties to a commercial credit transaction -- the Account Party or Applicant (the buyer in the underlying transaction), the Beneficiary (the seller in the underlying transaction), and the Issuing Bank (typically the buyer's bank).

A.  Account Party - Beneficiary

The commercial credit functions as the method of payment in a sales contract between the Account Party (the buyer) and the Beneficiary (the seller).  In the course of negotiating this sales contract, the Account Party and the Beneficiary agree to the terms and conditions under which the commercial credit will be issued.  The following are basic issues which should be resolved in these negotiations.

(1)  What is the maximum amount of drawings available under the credit?

All credits must include a maximum amount of liability, which usually is the purchase price of the goods.

(2)  What is the expiration date for the credit?

All credits must be of limited duration, although "evergreen clauses" may be used to automatically renew credits.

(3)  Is the credit revocable or irrevocable?

A revocable credit can be modified or rescinded by the Account Party at any time.  Therefore, a Beneficiary should insist that the credit be irrevocable (i.e. that the credit cannot be modified or rescinded after issuance without the Beneficiary's approval.)

(4)  What documents must the Beneficiary present in order to receive payment under the credit?

This is a critical issue.  The Beneficiary will not be paid unless she produces each of these documents.  Thus, a Beneficiary should make every effort to keep the documents as simple as possible.  None of the documents should require the signature or approval of the Account Party or the Account Party's agent.  Further, to the extent possible, the Beneficiary should not agree to the inclusion of foreign government documents because they may be difficult to obtain in a timely fashion.

The following is a short description of documents frequently required in commercial credits.

(a)  A Bill of Lading is a receipt that a common carrier gives to the seller for the goods that the carrier will transport.  It frequently serves as a document of title, giving the person who possesses it ownership of the goods.

(b)  A Commercial Invoice is a bill prepared by the seller for submission to the buyer which details all items bought, together with amounts owed.

(c)  A Draft or Bill of Exchange is a negotiable instrument that is payable to the seller and drawn on the issuing bank and/or the buyer.  This document is prepared by the seller, but is analogous to a check written from the buyer to the seller.  Drafts can be either "sight drafts" where the bank pays the full amount of the draft upon the seller's presentation, or "time drafts" where the bank's obligation at the time of presentation is merely to accept the draft for payment at a later date (e.g. 90 days after the seller's presentation).  Time drafts provide the buyer with short-term financing. Often, banks will purchase their accepted time drafts at a discounted rate.

(d)  A Consular Document shows that the goods satisfy the relevant regulatory requirements of the importing country.

(e)  An Insurance Certificate shows that the Beneficiary obtained insurance for transportation of the goods.  (Appropriate only if the seller agrees to be responsible for the insurance.)

(f)  An Inspection Certificate shows that the goods have passed a quality inspection prior to shipping.  Either an independent third party or an agent of the buyer can perform the inspection.  However, if it is an agent of the buyer, the seller should recognize that the buyer may block payment under the Credit until any dispute regarding the conformity of the goods is resolved.

(5)  Where must the Beneficiary present the documents required under the credit?

The Beneficiary may find it difficult to make a document presentation in a foreign country.  Therefore, the appropriate place for presentation may be the Issuing Bank's office in the Beneficiary's country.  If none exists, the credit may designate another bank (the Nominated Bank) to serve as the place for presentation. I t is important to note that while the Nominated Bank is authorized to act on behalf of the Issuing Bank to honor the credit obligation, the Nominated Bank itself has no obligation that runs directly to the Beneficiary.

(6)  Should the credit be confirmed by another bank?

A commercial credit is only as good as the bank that issued it.  A Beneficiary that is uncertain of the creditworthiness of the Issuing Bank, or uncertain of the political risks associated with the country in which the Issuing Bank is located, should consider requesting that the credit be confirmed by another bank (the Confirming Bank).  The Confirming Bank adds its obligation to that of the Issuing Bank to honor the credit.  A confirmation from a strong bank in the Beneficiary's country affords the Beneficiary a high degree of protection from the risk of non-payment.

(7)  Does the credit incorporate the Uniform Customs and Practices for Documentary Credits ("UCP"), International Chamber of Commerce Publication 500?
Banks routinely incorporate the UCP into credits.  The UCP is a set of rules that outlines the customs and standards of performance for credit transactions.  Domestically, credit transactions are also governed by Article 5 of the Uniform Commercial Code ("UCC") and provisions in several other UCC articles.

B.  Account Party -- Issuing Bank

The Account Party applies with the Issuing Bank (typically the Account Party's own bank) for a commercial credit that satisfies the specifications in the sales contract.  The Issuing Bank examines the Account Party's credit in the same manner as it would for any loan application, and decides whether to issue the credit.  Assuming the bank decides to issue the credit in the form requested, the Account Party enters into a reimbursement agreement with the Issuing Bank.

If and when the Issuing Bank ultimately pays money under the credit, it will seek reimbursement from the Account Party.  n exchange, the Issuing Bank will forward the bill of lading and other relevant documents to the Account Party.  This will enable the Account Party to claim the goods from the independent carrier.

C.  Issuing Bank - Beneficiary

(1)  Issuing Bank Advises Beneficiary that the Credit is open.   The Issuing Bank advises the Beneficiary that the credit is open in its favor.  The letter in which the Issuing Bank provides this advice is literally the "letter of credit."  It specifies the terms and conditions under which the credit operates.

As soon as the Beneficiary receives the credit, she should review it to ensure that it is consistent with the terms and conditions in the underlying sales contract (or any amendments to the sales contract).  The Beneficiary should promptly contact the Issuing Bank and the Account Party if there are any errors in the credit.

(2)  Beneficiary Performs in Accordance with the Terms in the Credit.  The Beneficiary will only be paid under the credit if she makes a documentary presentation that conforms to the time, place and manner requirements in the commercial credit.

(a)  Time:  The Beneficiary must meet at least two deadlines.

(i)  Date of Expiry:  The documents must be presented on or before the date of expiry specified in the credit.  The Beneficiary, however, should make her presentation well ahead of this date of expiration.  Banks have a reasonable period of time (not to exceed 7 days) to examine a presentation, and decide whether the documents conform to the credit.  A Beneficiary who has made her presentation less than 7 days before the date of expiry may not have an opportunity to cure any defects.

(ii)  Expiration of Transport Documents:  Unless the credit specifies otherwise, banks will not accept bills of lading and other transport documents which are not presented within 21 days after the date of shipment.

(b)  Manner:  It is critical that the Beneficiary present all the documents specified in the credit in a form that complies with the requirements in the credit.  Banks traditionally apply a high standard, known as the strict compliance rule, for determining whether documents comply with the credit.  If the documents (especially the commercial invoice) vary in any respect, the bank may reject the presentation.

In one case, the credit described the goods in the underlying contract as "100% Acrylic Yarn."  The bank denied payment because the Beneficiary's invoice described the goods as "Imported Acrylic Yarn."  The Beneficiary sued, but the court ultimately held in favor of the bank, stating that the invoice did not "strictly comply" with the requirements of the credit. Courtaulds North America, Inc. v. North Carolina National Bank, 528 F. 2d 802 (4th Cir. 1975).

At its discretion, the Issuing Bank may ask the Account Party to waive any discrepancies between the document presentation and the credit.  However, a Beneficiary should not rely on the generosity of the Issuing Bank and Account Party to accept non-conforming presentations.

(c)  Place:  The Beneficiary must make her document presentation at the place specified in the credit.  Note that if the credit identifies a Nominated Bank as the place of presentation, and the Nominated Bank refuses to honor, the Beneficiary may be required to make its presentation directly to the Issuing Bank.

(3)  Issuing Bank's Duty to Honor if Presentation Conforms to Credit:  n determining whether to honor drafts under the credit, the Issuing Bank does not examine the good, or otherwise consider whether the Beneficiary has complied with the underlying contract.  The Issuing Bank focuses on the documents.  If the documents comply with the credit, and are not fraudulent, the Issuing Bank must honor the Beneficiary's drafts.  This separation between the commercial credit and the
underlying contract is called the independence principle.

"Honor" means different actions depending on the Issuing Bank's obligations under the credit.  If the credit calls for a sight draft, the Issuing Bank will honor by paying the draft promptly.  If the credit calls for a time draft, the Issuing Bank will honor by accepting (i.e. signing) the draft promptly, and paying it upon maturity.  Beneficiaries often sell accepted time drafts to Issuing Banks at a discounted rate immediately after acceptance.

D.  Functions of a Commercial Credit

A commercial credit has several basic functions.  It is important to note, however, that the parties can modify or change these basic functions to tailor the credit to their own needs.

(1)  Prompt Payment:  The Beneficiary is paid promptly after shipping her goods.  Without the credit, the Beneficiary would have to require pre-payment for the goods or would have to wait until after the Account Party received the goods.

(2)  Substituting Credit:  The Beneficiary may be reluctant to sell on open account if it does not know enough about the credit worthiness of the Account Party.  The credit helps to overcome the Beneficiary's reluctance to do business with the Account Party.

(3)  Shifting Litigation Costs:  Every sales contract carries a risk of a dispute concerning whether the goods conform to the contract. If the method of payment is an open account, the seller most likely will bear the cost of litigating that dispute without the purchase price.  A commercial credit re-allocates this cost to the buyer, because the seller receives the purchase price promptly when he presents conforming documents to the Issuing Bank.

(4)  Shifting the Forum:  The holder of the purchase money has little incentive to initiate litigation.  Since the commercial credit places the purchase money in the hands of the seller, the buyer will likely need to pursue the purchase money by entering the forum of the seller.


A.  Purpose

The purpose of a standby credit is to reduce the risk associated with nonperformance in a contract that calls for performance. In this sense, standby credits are comparable to performance bonds.  For example, a standby credit can be used when a city hires a contractor to build a structure.  The city may require the contractor to open a standby credit with a local bank, and name the city as the beneficiary.  If the contractor ultimately fails to perform under the terms of the construction contract, the city can collect money under the standby credit.  The city can use this money to hire another contractor, or otherwise complete the project.

B.  Structure

The structure of a standby credit transaction is similar to a commercial credit transaction.  A bank issues the credit at the request of the Account Party (e.g. a contractor) and in favor of the Beneficiary (e.g. a city).  The credit is independent from the underlying contract between the Account Party and the Beneficiary, and payment is contingent upon the Beneficiary's presentation of documents that conform to the credit's time, manner, and place requirements.  Typically, the documentary requirements under a standby are: (1) a draft or bill of exchange, and (2) a certificate from the Beneficiary stating that the Account Party has failed to perform its obligations under the contract.

C.  Difference Between Standby and Commercial Credits

A fundamental difference between a standby credit and a commercial credit is that the standby credit is payable against documents that show the Account Party has failed to perform its obligations in the underlying contract.  In contrast, the commercial credit is payable against documents showing that the Beneficiary has completed performance of its obligations in the underlying contract.  Thus, the presentation of documents under a standby credit is an indication that something has gone wrong in the underlying transaction, whereas the presentation of documents in a commercial credit is a sign that the transaction is generally proceeding according to schedule.  Not surprisingly, Issuing Banks and Account Parties are less likely to waive documentary discrepancies in standby credits.

As demonstrated above, a letter of credit transaction is awash in paper documentation -- the letter of credit itself, the draft or bill of exchange, the bill of lading, insurance certificates, and other accompanying documents.  The ordering, drafting, sending, and processing of each of these paper documents requires time and money.

A.  Effects of the Internet and Electronic Commerce

Electronic Data Interchange ("EDI") is often used to permit computer to computer communication of the information contained in commercial transactions.  Even parties using different computer systems can reliably perform an entire transaction without creating a single paper document. Today, the Internet is revolutionizing how companies do business.  The ability of the different parties to quickly transfer information around the world has made possible the conclusion of a letter of credit transaction that is not dependent on paper documents.  Instead, the necessary information can be transmitted over the Internet without any delay. The latest revision of Article 5 of the Uniform Commercial Code (UCC), which governs letters of credit, provides the basis for the use of electronic letters of credit.  Some definitions in the UCC still have not evolved to address explicitly electronic transactions, but for the most part, these transactions are contemplated by the legal regime.

Two other statutes–one federal, the other a uniform statute adopted in most states–address electronic signatures and contracting. Both the Electronic Signatures in Global and National Commerce Act (E-SIGN) and the National Conference of Commissioners on Uniform State Laws’s (NCCUSL) Uniform Electronic Transactions Act (UETA) address issues arising from the use of electronic contracts.  They both provide that a contract may not be denied legal effect merely because it is evidenced by electronic records or because it uses electronic signatures.  However, transactions governed by Article 5 of the UCC are specifically exempted from the application of both statutes.  Therefore, E-SIGN and UETA do not help answer the question of the need for paper documentation in letter of credit transactions.

B.  The UCC and the Use of a Paperless Credit

Paperless letters of credit are currently used in many contexts.  It is clear that the drafters of revised Article 5 anticipated that the use of electronic letters of credit would become ever more prevalent.  The formal requirements for a letter of credit now allow the letter of credit to "be issued in any form that is a record".  UCC 5-104. The 1995 revision of UCC Article 5 also clarifies that records include "information that is inscribed on a tangible medium, or that is stored in an electronic or other medium." UCC 5-102(a)(14).  It also defines "documents" to include records. UCC 5-102(a)(6).  That same definition permits the letter of credit documents to be "presented in a written or other medium permitted by the letter of credit or, unless prohibited by the letter of credit, by the standard practice referred to in Section 5-108(e)." UCC 5-102(a)(6).

Letters of credit are also required to be authenticated either "(i) by a signature or (ii) in accordance with the agreement of the parties or the standard practice referred to in Section 5-106(e)." UCC 5-104.  This clearly permits the use of electronic authentication by the agreement of the parties or if it is the standard practice of "financial institutions that regularly issue letters of credit." See UCC 5-106(e).  Article 1 of the UCC, which contains definitions applicable to all the other Articles, defines signature to include any "symbol executed or adopted by a party with the intention to authenticate a writing." UCC 1-201(46). This definition does not specifically require handwritten signatures and is general enough to include the application of electronic authentication techniques. In any case, the drafters’ commentary on these formal requirements in the 1995 revision makes it clear that "the way to interpret this language is, simply, to say that a written document is no longer absolutely necessary to establish the existence of a valid letter of credit or of any other associated obligation."


If the three most important things in real estate are location, location, location, the three most important things in commercial and standby credits are documents, documents, documents.  If you are a U.S. exporter, your right to payment under a commercial credit depends to a large extent on your ability to present conforming documents to the right bank at the right time.

We offer these general recommendations:

Educate yourself on the rules.  The great majority of all international credits incorporate by reference the UCP, and transactions in the U.S. are often subject to UCC Article 5.

Control the Process from the Start.  Limit the number and complexity of the documents required under the credit.  Do not permit documentary requirements which are contingent upon the approval of the buyer, and do not allow documentary requirements which are impossible to fulfill.

Be Disciplined in Your Presentation.  Make sure that you present all of the documents required in the credit, and nothing more. Ensure that all the documents precisely comply with the requirements in the credit, especially the commercial invoice.  A good practice is to draft the commercial invoice with the credit in hand.  In addition, make sure that you make your initial presentation well in advance of the expiration date in order to allow an opportunity to cure any defects.

Request a Confirming Bank if You Are Uncertain of the Issuing Bank's Ability to Pay.  A commercial credit is only as good as the bank that issues it. If you are uncertain of the credit of the issuing bank, or uncertain of the political stability of the country in which the issuing bank is located, a confirming bank in the U.S. will assume these risks for you.

Hire Counsel.  Competent counsel can be instrumental in helping you to handle the technical issues involved in commercial credits.

The following are some additional resources you may wish to consult for further information.  In addition, you can contact our office directly if you have any questions.

1.  Larry Lawrence, Anderson on the Uniform Commercial Code, Volume 7A, Third Edition (2001)
2.  John F. Dolan, The Law of Letters of Credit, Commercial and Standby Credits, Revised Edition (1996)
3.  Brooke Wunnicke, Diane B. Wunnicke (Editor), Paul S. Turner, Standby and Commercial Letters of Credit (1996)


Adam Bobrow

Office of the Chief Counsel for International Commerce

U.S. Department of Commerce

Tel:  202-482-0937

Fax: 202-482-4076



July 2002

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