It has been argued that a form of documentary credit (also known as a letter of credit) has been in existence for thousands of years and dated back to Babylonian times in Mesopotamia (present-day Iraq), when Babylon was a key centre on the Silk Road, the ancient trade route between the Mediterranean Sea and China.
Documentary credits can be a very useful financing tool for small businesses involved in the import and export industry, especially when the buyer and seller involved in a transaction have not done business together before.
To help you get a better understanding of what they are for and how they work, here are answers to eight of the most commonly asked questions regarding documentary credits:
- What is the purpose of a documentary credit?
The aim of a documentary credit is to reduce and, to the furthest extent possible, eliminate risk. Accordingly:
- Parties to a credit must fully understand all elements, including the terms and conditions of a credit.
- It is absolutely essential to fully appreciate UCP 600.
- A working knowledge of ISBP 745 will help avoid most problems.
- Practitioners should keep up-to-date with market developments, which can be as simple as maintaining discussions with your peers.
- What is UCP 600?
Documentary credits are governed by an international code of practice drawn up by the International Chamber of Commerce, known as Uniform Customs and Practice for Documentary Credits (UCP). These rules were originally introduced to alleviate the disparity between national and regional rules on documentary credit practice.
First published in 1933, and revised on five occasions since, the latest version is known as UCP 600. This comprises 39 Articles, which establish the requirements necessary to regulate documentary credit operations.
- What is the difference between a Documentary Credit and a Letter of Credit
Both terms are in common usage and are synonymous. There is no distinction between the two but, as ICC rules commonly refer to ‘documentary credits’, this is the term used within this article.
- Who are the parties involved in a documentary credit?
- Applicant: the party on whose request the credit is issued (the buyer)
- Issuing Bank:the bank that issues a credit at the request of an applicant or on its own behalf.
- Advising Bank:the bank that advises the credit at the request of the issuing bank.
- Confirming Bank:the bank that adds its confirmation to a credit, in addition to that of the issuing bank, to honour or negotiate a complying presentation.
- Nominated Bank:the bank with which the credit is available or any bank in the case it is available with any bank.
- Beneficiary:the party in whose favour the credit is issued and normally the provider of the goods, services or performance (the seller)
- What is good practice for dealing with documentary credits?
Applicant (buyer) must observe three rules:
- Instructions to the issuing bank must be clear, precise, correct and free from excessive details.
- The purpose of the credit is to pay for the goods and not to police the transaction.
- The credit should not call for documents that the seller cannot provide nor set out conditions that the seller cannot meet.
Upon receipt of a documentary credit, the beneficiary (seller) should check, among other things:
- Can the goods be shipped from the stated port of loading to the stated port of discharge?
- Are the merchandise and unit prices correct?
- Is the amount of the credit correct?
- Are the contract terms correctly covered by the credit?
- Can the required documents be obtained in the required form?
- Are names and addresses correct?
- Do the shipment and expiry dates allow enough time to ship the goods and prepare the required documents?
- What are the common discrepancies found in documentary credits?
It is estimated that anything between 65% and 75% of presentations, upon which the documentary credit depends, are refused on first presentation, due to documents failing to meet the terms and conditions of the credit.
Whether or not a bank refuses documents is based upon the content of the documents themselves, and their conformity to the terms and conditions of the credit, the applicable provisions of UCP and international standard banking practice. At the end of the day, the decision to accept or reject is often down to an individual document examiner in assessing compliance or otherwise, based on his or her individual knowledge, experience and judgement.
Whilst there may be regional differences, the most common discrepancies appear to be:
- Conflict of data
- Missing documents
- Late presentation
- Late shipment
- LC expired
- Unauthenticated alterations
- Missing endorsements
- Goods description not as per LC
- Port of loading or discharge incorrect
- Insurance document dated later than date of shipment
- On board notations missing or incomplete
There are a number of simple tasks that can reduce discrepancy rates:
- Improved drafting of LC’s by issuing banks.
- Thorough review of LC’s by advising / confirming banks to understand any risks and implications.
- Beneficiaries (sellers) to clearly understand the implications of providing certain documents and ensure they can meet timeframes and deadlines.
- Close and constant communication between beneficiary (seller) and logistics / document providers.
- Liaison between all parties in case of unforeseen problems: beneficiary (seller) / applicant (buyer) / banks.
- Address problems prior to presentation of documents.
- Avoid … to the maximum possible … credits that exclude specific articles / sub-articles of UCP.
- What is applicable law under a documentary credit?
UCP 600 does not include an article for Governing or Applicable Law. However, this does not prevent an applicable law condition being included within the terms and conditions of a credit, but such inclusion is fairly rare. The exclusion of an article in respect of applicable law partially derives from the fact that a credit is considered to be autonomous, i.e. a separate transaction from any underlying sales contract.
The natural consequence of this is that it is left to a court to decide which law would be applicable – in most circumstances, this is determined to be that of the place where the obligations under the credit are most valid.
- Why would a bank refuse to honor documents and what happens if it does?
When documents are presented under a documentary credit, banks examine such documents against the terms and conditions of the documentary credit on the basis of UCP 600 (provided the documentary credit is subject to it), international standard banking practice and data between the stipulated documents. In the event that the documents do not comply, they are considered to be discrepant, and a refusal notice is issued.
For some common reasons for refusal refer to question 6 – common discrepancies.
A refusal notice must indicate any discrepancies in respect of which the notice has been issued. Each discrepancy should be clearly written so as to highlight the exact reason why the presentation has been refused.
In summary, documentary credits:
- Are arrangements by banks for settling international commercial transactions.
- Provide a form of security for the parties involved.
- Ensure payment provided that the terms and conditions of the credit have been fulfilled.
- Mean that payment by such method is based on documents only, and not on merchandise or services involved or underlying commercial contracts.
You can learn more about documentary credits and other trade financing options at the ICC Academy, the ICC’s online education platform.
- This article is intended to be a practical complement to other training and to provide guidance.
- There are many important regulatory restrictions and requirements as well as business considerations that this guide does not cover.
- Nothing contained herein is to be considered as the rendering of any legal or other professional advice for specific cases and readers are responsible for obtaining such advice from their own legal counsel or other professionals.
David Meynell is a Senior Technical Advisor to the ICC Banking Commission and Co-owner of www.tradefinance.training.
 Rufus Trimble (The Law Merchant and the Letter of Credit, 1947)
 ‘International Standard Banking Practice’ ICC Publication no. 745
 In particular UCP 600 and ISBP 745