A practical guide to the letter of credit, the most secure payment method in international trade, examined under the UCP 600 rules, covering the legal nature of the credit, the parties and contractual layers, the independence principle, the types of credit, presentation and the twenty-one day period, the five banking day examination period, discrepancies and their consequences, the fraud exception, the position of the confirming bank and the eUCP.
The fundamental problem of trust between the seller and the buyer in an international sale is this; the seller bears the risk of shipping the goods yet not receiving the price, while the buyer bears the risk of paying the price yet not obtaining the goods. The parties being located in different countries, not knowing each other and being subject to different legal systems magnifies this risk. The letter of credit is the mechanism that resolves this problem of trust by interposing a bank undertaking, and it is for this reason regarded as the most secure payment method of international trade. Letter of credit practice worldwide is conducted within the framework of the Uniform Customs and Practice for Documentary Credits prepared by the International Chamber of Commerce and in force since 1 July 2007, known by its abbreviation as the UCP 600. This article comprehensively examines the legal nature of the letter of credit, the layers of relationship between the parties, the independence principle, the presentation and examination process, the practice of discrepancies and the fraud exception, in the light of Turkish law and the UCP 600 rules.
1. The Concept and Function of the Letter of Credit
A letter of credit is a payment and security mechanism whereby a bank, upon the instructions of the buyer, undertakes to pay the seller against the presentation of documents complying with the terms of the credit. Its operation is simple in essence; the buyer applies to its bank and has a credit opened in favour of the seller, the seller ships the goods and presents the documents required under the credit to the bank within the prescribed period, and if the documents comply with the terms the bank effects payment. The seller thereby ties the price, once the goods are shipped, to a bank undertaking independent of the buyer's solvency and willingness to pay; the buyer, for its part, is assured that payment will be made only against presentation of the agreed documents. This two-way assurance provided by the credit renders it indispensable particularly in sales where the parties are dealing with each other for the first time, where country risk is high or where the transaction amount is large. The letter of credit is at the same time an instrument of finance; in deferred payment credits, the seller may obtain early collection by discounting the bank undertaking.
2. Legal Nature and the Place of the UCP 600 in Turkish Law
The letter of credit is an innominate contractual relationship not specifically regulated in Turkish legislation. In the case law of the Court of Cassation, the credit relationship is characterised as a sui generis legal relationship carrying predominantly elements of mandate and of a contract for the benefit of a third party. The UCP 600, for its part, is neither a statute nor an international treaty; it is a set of uniform rules prepared by the International Chamber of Commerce and applied by virtue of reference being made to it in the text of the credit. Nevertheless, the Turkish courts accept the UCP rules as international commercial custom established in the field of banking and assess credit disputes according to those rules. In practice, nearly all credits opened state expressly in their text that they are subject to the UCP 600. A further source supplementing the UCP 600 is the ISBP, which sets out international standard banking practice for the examination of documents; its current version, ISBP 821, details the criteria followed by banks in document examination.
3. The Parties to the Credit
There are four principal actors in the credit relationship. The applicant is the party requesting the opening of the credit and corresponds to the buyer in the sale relationship. The issuing bank is the bank which opens the credit upon the applicant's instructions and enters into an undertaking to pay against a complying presentation; it is the principal obligor of the credit undertaking. The beneficiary is the party in whose favour the credit is opened and corresponds to the seller in the sale relationship. Alongside this trio stand the intermediary banks. The advising bank is the bank notifying the beneficiary that the credit has been opened; as a rule it assumes no payment obligation, and merely checks the apparent authenticity of the credit and transmits it. The nominated bank is the bank with which the credit is available and to which presentation is to be made. The confirming bank is the bank which adds its own independent payment undertaking to that of the issuing bank; under a confirmed credit the beneficiary holds two separate bank undertakings, one of the issuing bank and one of the confirming bank. Additional actors such as the reimbursing bank may also come into play according to the structure of the transaction.
4. The Contractual Layers of the Credit Relationship
The credit transaction is not a single contract but the coming together of several legally independent relationships. The first layer is the sale contract, the underlying relationship between the buyer and the seller; the stipulation for payment by letter of credit is agreed in that contract. The second layer is the relationship between the applicant and the issuing bank concerning the opening of the credit; this relationship approximates to mandate and includes the applicant's obligations towards the bank for commission and expenses. The third layer is the credit undertaking between the issuing bank and the beneficiary; the bank undertakes towards the beneficiary to pay against a complying presentation, and that undertaking is irrevocable in nature. In a confirmed credit there is added to this a fourth layer of undertaking between the confirming bank and the beneficiary. Each of these layers is legally independent; a dispute under the sale contract does not, as a rule, affect the bank's credit undertaking. This independence is also the source of the fundamental principle examined below.
5. The Independence Principle and Dealing in Documents
The cornerstone of the law of letters of credit is the independence principle. Under the UCP 600, a credit is a transaction separate from and independent of the sale or other contract on which it may be based; banks are in no way concerned with or bound by such contract. Its twin principle is the rule of dealing in documents; banks deal with documents and not with goods, services or performance to which the documents may relate. The practical consequence is this; the goods proving defective, being delivered short, or any other breach of the sale contract does not remove the bank's payment obligation so long as the documents presented comply with the terms of the credit. The buyer's objections concerning the goods are to be raised not against the bank but against the seller on the basis of the sale contract. The independence principle is the essence of the security function of the credit; by insulating the undertaking from disputes other than documentary compliance, the seller can await payment with a confidence approaching that of a bank guarantee. The only significant exception to this principle is the case of fraud, examined separately below.
6. Types of Credit
Under the UCP 600 every credit is irrevocable in nature; unless otherwise agreed, a credit may not be amended or cancelled without the consent of the beneficiary. The principal distinctions in practice are the following. Under an unconfirmed credit the beneficiary relies solely on the undertaking of the issuing bank; under a confirmed credit it obtains the additional undertaking of a bank in its own country or of a bank it trusts, a difference which is decisive where the country risk of the issuing bank is high. According to the time of payment, a credit may be available by sight payment or by deferred payment; in the deferred structure the possibility of discounting comes into play. A transferable credit enables the beneficiary to transfer the credit in whole or in part to second beneficiaries and is used in intermediated export models. A revolving credit renews itself automatically over specified periods and accommodates continuous supply relationships. Back-to-back credits rest on the opening of a second credit against the security of a first credit. The standby letter of credit, finally, serves as a guarantee rather than as an instrument of payment; the beneficiary claims payment by presenting documents declaring that the applicant has breached its obligation, and this structure approximates functionally to a bank letter of guarantee.
7. The Opening of the Credit and the Drafting of Its Terms
The credit process begins with payment by letter of credit being agreed in the sale contract. The buyer gives its bank an instruction to open the credit; since that instruction determines the content of the credit text, it is the most critical document of the process. The instruction must be clear, precise and in accordance with the terms agreed with the seller. A significant part of the problems in practice arises from the careless drafting of credit terms. The type, issuer and content of the documents required must be defined in a manner leaving no room for doubt; the shipment date, the expiry date of the credit and the presentation period must be fixed realistically. The golden rule for the seller is to examine the credit text line by line before shipment and to accept no condition it cannot fulfil or document; where necessary, an amendment of the credit must be requested before shipment. Vague or contradictory terms are the principal source of the risk of discrepancies later. The credit must also regulate clearly with which bank and by which method it is available, and whether partial shipment and transhipment are permitted.
8. Presentation, the Expiry Date and the Twenty-One Day Rule
The beneficiary's entitlement to payment depends on presenting the documents at the right place, within the right period and in compliance with the terms. Under the UCP 600 every credit must state an expiry date for presentation; presentation must in any event be made within that expiry date. For presentations including a transport document there is an additional time rule; unless the credit provides for a different period, presentation must be made not later than twenty-one calendar days after the date of shipment, and in any event not later than the expiry date of the credit. Where a shorter presentation period such as seven, ten or fourteen days has been stipulated in the credit, that period governs. Where the expiry date or the last day for presentation falls on a day on which the bank is closed, the period is extended to the first following banking day; that extension does not, however, cover closures resulting from force majeure. Missing the periods renders the presentation non-complying even where the documents are flawless in content, and removes the bank's payment obligation. The beneficiary must therefore plan the operational process between shipment and the obtaining of documents according to the presentation calendar.
9. The Examination of Documents and the Five Banking Day Rule
The bank receiving the presentation examines the documents on their face alone and determines whether the presentation is complying. A complying presentation is one in accordance with the terms and conditions of the credit, the applicable provisions of the UCP 600 and international standard banking practice. The maximum period for the bank to complete this examination is five banking days following the day of presentation; under the previous set of rules that period was seven days, and it was reduced to five by the UCP 600. Within that period the bank either finds the presentation complying and effects payment or its undertaking, or gives notice that it refuses the presentation. The examination is conducted on the documents alone; the bank is not obliged to investigate the goods themselves, the sale relationship or the material authenticity of the documents. The documents must not conflict with one another, and the data in them must be consistent with the credit and with each other. The detail of the examination criteria is given concrete form in the ISBP; technical matters such as when spelling differences amount to a discrepancy, and signature and date requirements, are assessed according to those standards.
10. Discrepancies and Their Consequences
The non-conformities identified by the bank in a presentation are known in practice as discrepancies. Discrepancies are the most common problem of credit practice; industry figures show that a very high proportion of first presentations is found discrepant. Among the principal causes of discrepancies are presentation or shipment being made out of time, the description of the goods in the documents not matching the credit, inconsistencies between documents, missing documents and missing endorsements. A bank refusing a presentation must give its notice of refusal in a single notice, stating all the discrepancies, within five banking days; the notice must also state the disposition of the documents. A bank which fails to give notice of refusal within the period and in the proper form loses the right to invoke the discrepancies and becomes obliged to pay; this rule is a strong safeguard for the beneficiary. Upon notice of refusal the beneficiary may, if time permits, correct the documents and re-present them; where time does not permit, recourse is had in practice to the applicant waiving the discrepancies, in which case payment remains dependent on the applicant's approval and the security function of the credit is in fact weakened. The beneficiary's objective must therefore be to present discrepancy-free documents at the first presentation.
11. The Fraud Exception and Interim Injunctions
The absolute application of the independence principle could open the door to serious abuses of the credit mechanism. For this reason, in comparative law and in Turkish practice, the case of fraud is recognised as the exception to the independence principle. In cases such as the beneficiary procuring a forged bill of lading without shipping any goods at all, or the documents being materially forged, it is accepted that the security function of the credit may not be hidden behind. The operation of the exception is, however, subject to strict conditions; the fraud must be established by clear, serious evidence capable of being demonstrated at the time of payment. Mere allegations of breach of the sale contract, objections that the goods are defective, or commercial disputes between the parties are not assessed within this scope. In practice the applicant may, on an allegation of fraud, seek from the court an interim injunction restraining the bank from paying; the Turkish courts approach such applications with caution, having regard to the function of trust that the credit performs in international trade, and grant the injunction only where strong indicia of fraud exist. A contrary approach would allow every commercial dispute to lock the credit by way of injunction and would cause the reliability of the mechanism to collapse.
12. The Position of the Confirming Bank
Confirmation is the assumption by another bank, in addition to the undertaking of the issuing bank, of a definite undertaking to pay against a complying presentation. The confirming bank is not the representative of the issuing bank but an independent and primary obligor towards the beneficiary; where the beneficiary makes a complying presentation to the confirming bank, that bank must pay irrespective of whether it has received cover from the issuing bank. The practical value of confirmation lies in the risk of the issuing bank or of its country being taken off the beneficiary; risks such as transfer restrictions, moratoria or a banking crisis are assumed by the confirming bank. Having paid, the confirming bank has recourse against the issuing bank; that recourse relationship is subject to interbank reimbursement arrangements. For the Turkish exporter, requiring that the credit be confirmed by a bank in Türkiye or in a reliable centre is one of the most effective instruments of collection security in sales to risky countries. The confirmation commission is a cost item, but compared with the risk assumed it is in most cases bearable.
13. Recourse and Reimbursement Relationships between the Parties
Once the credit amount has been paid, the relationship turns into recourse and reimbursement claims between the layers. The nominated or confirming bank which has paid against a complying presentation claims reimbursement from the issuing bank. The issuing bank, having paid in accordance with the terms of the credit, has recourse against the applicant; the applicant is obliged, within the framework of the credit-opening relationship, to pay the bank the amount, the commissions and the expenses. That obligation of the applicant is generally secured by collateral taken by the bank; in practice it is common for the documents, and hence the power of disposal over the goods, to be retained by the bank until the amount is paid. Where the bank has paid notwithstanding a discrepant presentation contrary to the terms of the credit, it may lose its right of recourse against the applicant; that risk is also the reason for the meticulousness of banks in document examination. Where the documents subsequently prove to be forged, the protection of the bank which paid in good faith on the basis of an apparently complying presentation is the principle; the loss is placed on the party committing the fraud and on the link in the chain of relationships closest to it.
14. Electronic Presentation and the eUCP
The digitalisation of foreign trade is transforming credit practice as well. The International Chamber of Commerce has published the eUCP rules permitting the presentation of electronic documents; in its current version the eUCP applies, as a supplement to the UCP 600, where express reference is made to it in the credit, and regulates the presentation of electronic records alone or in mixed form together with paper documents. In electronic presentation, the format of the document, the electronic address to which it is to be presented and the methods of authentication are determined in the credit. The legal infrastructure work directed at moving the bill of lading into the electronic environment, and the model law initiatives concerning digital trade documents, will increase the share of electronic presentation in credit practice in the coming period. That said, as matters stand the greater part of practice still rests on the paper document basis, and electronic presentation is becoming widespread particularly in institutional relationships working with standard document sets. Where the parties envisage electronic presentation, the express regulation in the credit text of the eUCP reference and of the technical requirements is essential.
15. Conclusion and Practical Recommendations
The letter of credit is a mechanism which, when structured correctly, provides strong security to both sides of an international sale, but which is strictly tied to documentary discipline. The prominent practical considerations are the following. For the seller, the credit text must be examined line by line before shipment, amendments must be requested for conditions that cannot be fulfilled, and the objective must be to present discrepancy-free documents at the first presentation; the presentation period and the expiry date must be planned in harmony with the operational calendar. In risky country and bank relationships, confirmation should be required. For the buyer, the credit-opening instruction must be prepared with care, the documents required must be selected so as reasonably to reflect the conformity of the goods with the contract, but it must be borne in mind that the documentary character of the credit is no substitute for warranties concerning the goods. For the banks, compliance with the five banking day examination period and with the rule of a single and complete notice of refusal is the precondition of preserving rights of recourse. In allegations of fraud, the interim injunction must be seen as an exceptional instrument and operated only on strong evidence. The legal review of the credit terms and of the document set is the most productive investment to be made at the very outset of the process.
For advisory services on letter of credit transactions, the review of documents and terms under the UCP 600 rules, discrepancy disputes, litigation and injunction proceedings arising from credits, and the structuring of international sale and payment arrangements, you may contact us at info@guzeloglu.legal.