What is Letter of Credit?
Letter of Credit is one of the important methods of payment in international trade. Letter of credit operations are governed by the provisions of the Uniform Customers and Practice for Documentary Credits (UCP).
A documentary letter of credit is an arrangement whereby a bank, at the request and in accordance with the instructions of a customer (importer), is to make payment to or to the order of a third party (exporter) or is to pay, accept or negotiate bills of exchange drawn by such third party or authorizes such payment or negotiation by another bank, against stipulated documents, provided that the terms and conditions of the credit are complied. Simply stated, a documentary letter of credit is an arrangement whereby the bank undertakes to pay drafts drawn in accordance with the terms of the credit.
Article 2 of the UCP defines a letter of credit as to mean “any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honor a complying presentation”.
The full implication of the definition can be perceived when we combine in one, the definitions of the terms ‘credit’, ‘honor’, ‘presenter’, ‘presentation’ and ‘complying presentation’ given under the same Article. Attempting that exercise, a letter of credit can be defined as:
“any arrangement, however named or described, that is irrevocable and therefore constitutes a definite undertaking of the issuing bank to:
1. pay at sight if the credit is available by sight payment; or
2. incur a deferred payment undertaking and pay at maturity, if the credit is available by deferred payment; or
3. accept a bill of exchange (draft) drawn by the beneficiary and pay at maturity if the credit is available by acceptance;
to the beneficiary, bank or other party that delivers documents under the credit to the issuing bank or nominated bank, in accordance with the terms of the credit, the applicable provisions of these rules and international standard banking practice”.
Two major changes introduced by the current edition of UCP in the definition of letter of credit are:
1. reference to revocable letter of credit has been eliminated and all credits are made irrevocable; and
2. in addition to complying with the provisions of UCP, the parties are required to comply with international standard banking practice.