Understanding and Using Letters of Credit, Part II

CRF thanks Ron Borcky for his development of this section Purpose The purpose of this document is to provide a general understanding of letters of credit, their use and application. The topics covered are the following:

General background information; Types of letters of credit; Common problems with letters of credit; Procedures for establishing letters of credit; Amendments; and General tips to both buyers and sellers.

In addition, attachments to this document detail a step-by-step letter of credit procedures. Definition Letters of credit are commonly used to reduce credit risk to sellers in both domestic and international sales arrangements. By having a bank issue a letter of credit, in essence, one is substituting the bank's credit worthiness for that of the customer. Types There are two basic forms of letters of credit: Standby and Documentary. Documentary letters of credit can be either Revocable or Irrevocable, although the first is extremely rare. Irrevocable letters of credit can be Confirmed or Not Confirmed. Each type of credit has advantages and disadvantages for the buyer and for the seller, which this information will review below. Charges for each type will also vary. However, the more the banks assume risk by guaranteeing payment, the more they will charge for providing the service. Documentary Revocable Letter of Credit Revocable credits may be modified or even canceled by the buyer without notice to the seller. Therefore, they are generally unacceptable to the seller. Documentary Irrevocable Letter of Credit This is the most common form of credit used in international trade. Irrevocable credits may not be modified or canceled by the buyer. The buyer's issuing bank must follow through with payment to the seller so long as the seller complies with the conditions

listed in the letter of credit. Changes in the credit must be approved by both the buyer and the seller. If the documentary letter of credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable. See Credit Administration, Sample Procedure for Administration of a Documentary Irrevocable Letters of Credit for a systematic procedure for establishing an irrevocable letter of credit. There are two forms of irrevocable credits: Unconfirmed credit (the irrevocable credit not confirmed by the advising bank) In an unconfirmed credit, the buyer's bank issuing the credit is the only party responsible for payment to the seller. The seller's advising bank pays only after receiving payment from the issuing bank. The seller's advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk. Confirmed credit (the irrevocable confirmed credit) In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer's issuing bank. Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the seller. The advising bank will then look to the issuing bank for payment. Confirmed Irrevocable letters of credit are used when trading in a high-risk area where war or social, political, or financial instability are real threats. Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order. A confirmed credit is more expensive because the bank has added liability. Standby Letter of Credit This credit is a payment or performance guarantee used primarily in the United States. They are often called non-performing letters of credit because they are only used as a backup should the buyer fail to pay as agreed. Thus, a stand-by letter of credit allows the customer to establish a rapport with the seller by showing that it can fulfill its payment commitments. Standby letters of credit are used, for example, to guarantee repayment of loans, to ensure fulfillment of a contract, and to secure payment for goods delivered by third parties. The beneficiary to a standby letter of credit can cash it on demand. Stand-by letters of credit are generally less complicated and involve far less documentation requirements than irrevocable letters of credit. See Credit Administration, Sample Procedure for Administration of a Standby Letter of Credit for a systematic procedure for establishing a standby letter of credit. Special Letters of The following is a brief description of some special letters of credit. Credit

Back-to-Back Letter of Credit This is a new letter of credit opened based on an already existing, nontransferable credit used as collateral. Traders often use back-to-back arrangements to pay the ultimate supplier. A trader receives a letter of credit from the buyer and then opens another letter of credit in favor of the supplier. The first letter of credit serves as collateral for the second credit. Deferred Payment (Usance) Letter of Credit In Deferred Payment Letters of Credit, the buyer accepts the documents related to the letter of credit and agrees to pay the issuing bank after a fixed period. This credit gives the buyer a grace period for payment. Red Clause Letter of Credit Red Clause Letters of Credit provide the seller with cash prior to shipment to finance production of the goods. The buyer's issuing bank may advance some or all of the funds. The buyer, in essence, extends financing to the seller and incurs the risk for all advanced credits. Revolving Letter of Credit With a Revolving Letter of Credit, the issuing bank restores the credit to its original amount once it has been used or drawn down. Usually, these arrangements limit the number of times the buyer may draw down its line over a predetermined period. Transferable Letter of Credit This type of credit allows the seller to transfer all or part of the proceeds of the original letter of credit to a second beneficiary, usually the ultimate supplier of the goods. The letter of credit must clearly state that it is transferable for its to be considered as such. This is a common financing tactic for middlemen and is common in East Asia. Assignment of Proceeds The beneficiary of a letter of credit may assign all or part of the proceeds under a credit to a third party (the assignee). However, unlike a transferred credit, the beneficiary maintains sole rights to the credit and is solely responsible for complying with its terms and conditions. For the assignee, an assignment only means that the paying bank, once it receives notice of the assignment, undertakes to follow the assignment instructions, if and when payment is made. The assignee is dependent upon the beneficiary for compliance, and thus this arrangement is riskier than a transferred credit. Before agreeing to an assignment of proceeds arrangement, the assignee should carefully review the original letter of credit.

Common Problems with Letters of Credit Most problems result from the seller's inability to fulfill obligations stated in the letter of credit. The seller may find these terms difficult or impossible to fulfill and, either tries to fulfill them and fails, or asks the buyer to amend to the letter of credit. As most letters of credit are irrevocable, amendments may at times be difficult since both the buyer and the seller must agree. Sellers may have one or more of the following problems:

The shipment schedule cannot be met; The stipulations concerning freight costs are unacceptable; The price becomes too low due to exchange rates fluctuations; The quantity of product ordered is not the expected amount; The description of product is either insufficient or too detailed; and, The stipulated documents are difficult or impossible to obtain.

Even when sellers accept the terms of a letter of credit, problems often arise late in the process. When this occurs, the buyer's and seller's banks will try to negotiate any differences. In some cases, the seller can correct the documents and present them within the time specified in the letter of credit. If the documents cannot be corrected, the advising bank will ask the issuing bank to accept the documents despite the discrepancies found. It is important to note that, if the documents are not in accord with the specifications of the letter of credit, the buyer's issuing bank is no longer obligated to pay. Basic Procedures for Establishing a Letter of Credit The letter of credit process has been standardized by a set of rules published by the International Chamber of Commerce (ICC). These rules are called the Uniform Customs and Practice for Documentary Credits (UCP) and are contained in ICC Publication No. 500. The following is the basic set of steps used in a letter of credit transaction. Specific letter of credit transactions follow somewhat different procedures. 1. After the buyer and seller agree on the terms of a sale, the buyer arranges for his bank to open a letter of credit in favor of the seller. Note: The buyer will need to have a line of credit established at the bank or provide cash collateral for the amount of the letter of credit. 2. The buyer's issuing bank prepares the letter of credit, including all of the buyer's instructions to the seller concerning shipment and required documentation.

3. The buyer's bank sends the letter of credit to the seller's advising bank. 4. The seller's advising bank forwards the letter of credit to the seller. 5. The seller carefully reviews all conditions stipulated in the letter of credit. If the seller cannot comply with any of the provisions, it will ask the buyer to amend the letter of credit. 6. After final terms are agreed upon, the seller ships the goods to the appropriate port or location. 7. After shipping the goods, the seller obtains the required documents. Please note that the seller may have to obtain some documents prior to shipment. 8. The seller presents the documents to its advising bank along with a draft for payment. 9. The seller's advising bank reviews the documents. If they are in order, it will forward them to the buyer's issuing bank. If a confirmed letter of credit, the advising bank will pay the seller (cash or a bankers' acceptance). 10. Once the buyer's issuing bank receives and reviews the documents, it either (1) pays if there are no discrepancies; or (2) forwards the documents to the buyer if there are discrepancies for its review and approval. Opening a Letter of Credit Level of Detail The wording in a letter of credit should be simple, but specific. The more detailed an L/C is, the more likely the seller will reject it as too difficult to fulfill. At the same time, the buyer will wish to define in detail what its is paying for. Type of Credit Letters of credit used in trade are usually either irrevocable unconfirmed credits or irrevocable confirmed credits. In choosing which type to open both the seller and the buyer should consider the generally accepted payment processes in each country, the value and demand for the goods, and the reputation of the buyer and seller. Documents In specifying required documents, it is very important to include those required for customs and those reflecting the agreement reached between the buyer and the seller. Required documents usually include the bill of lading, a commercial and/or consular invoice, the bill of exchange, the certificate of origin, and the insurance document.

Other documents required may be an inspection certificate, copies of a cable sent to the buyer with shipping information, a confirmation from the shipping company of the state of its ship, and a confirmation from the forwarder that the goods are accompanied by a certificate of origin. Prices should be stated in the currency of the letter of credit and documents should in the same language as the letter of credit. The Letter of Credit Application The following information should be addressed when establishing a letter of credit. 1. Beneficiary The seller should provide to the buyer its full corporate name and correct address. A simple mistake here may translate to inconsistent or improper documentation at the other end. 2. Amount The seller should state the actual amount of the letter of credit. One can request a maximum amount when there is doubt as to the actual count or quantity of the goods. Another option is to use words like "approximate", "circa", or "about" to indicate an acceptable 10 % plus or minus from the stated amount. For consistency, if you use this wording you will need to use it also in connection with the quantity. 3. Validity The seller will need time to ship and to prepare all the necessary documents. Therefore, the seller should ensure that the validity and period for document presentation after the shipment of the goods is long enough. 4. Seller's Bank The seller should list its advising bank as well as a reimbursing bank if applicable. The reimbursing bank is the local bank appointed by the issuing bank as the disbursing bank. 5. Type of Payment Availability The buyer and seller may agree to use sight drafts, time drafts, or some sort of deferred payment mechanism. 6. Desired Documents The buyer specifies the necessary documents. Buyers can list, for example, a bill of lading, a commercial invoice, a certificate of origin, certificates of analysis, etc. The seller must agree to all documentary requirements or suggest an amendment to the letter of credit.

7. Notify Address This is the address to notify upon the imminent arrival of goods at the port or airport of destination. A notification listing damaged goods is also sent to this address, if applicable. 8. Description of Goods The seller should provide a short and precise description of the goods as well as the quantity involved. Note the comments in step #2 above concerning approximate amounts. 9. Confirmation Order With international arrangements, the seller may wish to confirm the letter of credit with a bank in its country. Amendment of a Letter of Credit For the seller to change the terms noted on an irrevocable letter of credit, it must request an amendment from the buyer. The amendment process is as follows: 1. The seller requests a modification or amendment of questionable terms in the letter of credit; 2. If the buyer and issuing bank agree to the changes, the issuing bank will change the letter of credit; 3. The buyer's issuing bank notifies the seller's advising bank of the amendment; and 4. The seller's advising bank notifies the seller of the amendment. Tips for Buyers and Sellers Seller 1. Before signing a sales contract, the seller should make inquiries about the buyer's creditworthiness and business practices. The seller's bank will generally assist in this investigation. 2. In many cases, the issuing bank will specify the advising and/or confirming bank. These designations are usually based on the issuing bank's established correspondent relationships. The seller should ensure that the advising/confirming bank is a financially sound institution. 3. The seller should confirm the good standing of the buyer's issuing bank if the letter of credit is unconfirmed. 4. For confirmed letters of credit, the seller's advising bank should be willing to confirm the letter of credit issued by the buyer's bank. If the advising bank refuses to

do so, the seller should request another issuing bank as the current bank may be or is in the process of becoming insolvent. 5. The seller should carefully review the letter of credit to ensure its conditions can be met. All documents must conform to the terms of the letter of credit. The seller must comply with every detail of the letter of credit specifications; otherwise the security given by the credit is lost. 6. The seller should ensure that the letter of credit is irrevocable. 7. If amendments are necessary, the seller should contact the buyer immediately so that the buyer can instruct the issuing bank to make the necessary changes quickly. The seller should keep the letter of credit's expiration date in mind throughout the amendment process. 8. The seller should confirm with the insurance company that it can provide the coverage specified in the letter of credit and that insurance charges listed in the letter of credit are correct. Typical insurance coverage is for CIF (cost, insurance and freight) often the value of the goods plus about 10 percent. 9. The seller must ensure that the goods match the description in the letter of credit and the invoice description. 10. The seller should be familiar with foreign exchange limitations in the buyer's country that could hinder payment procedures. Buyer 1. When choosing the type of letter of credit, the buyer should consider the standard payment methods in the seller's country. 2. The buyer should keep the details of the purchase short and concise. 3. The buyer should be prepared to amend or re-negotiate terms of the letter of credit with the seller. This is a common procedure in international trade. With irrevocable letters of credit, the most common type, all parties must agree to amend the document. 4. The buyer can reduce the foreign exchange risk by buying forward currency contracts. 5. The buyer should use a bank experienced in foreign trade as its issuing bank.

6. The validation time stated on the letter of credit should give the seller ample time to produce the goods or to pull them out of stock. 7. A letter of credit is not fail-safe. Banks are only responsible for the documents exchanged and not the goods shipped. Documents in conformity with the letter of credit specifications cannot be rejected on grounds that the goods were not delivered as specified in the contract. The goods shipped may not in fact be the goods ordered and paid for. 8. Purchase contracts and other agreements pertaining to the sale between the buyer and seller are not the concern of the issuing bank. Only the letter of credit terms are binding on the bank. 9. Documents specified in the letter of credit should include those the buyer requires for customs clearance.

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 nonperformance. 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. I. THE COMMERCIAL CREDIT TRANSACTION -- A BASIC MODEL 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 thestrict 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

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. II. A. STANDBY LETTERS OF CREDIT 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. III. ELECTRONIC LETTERS OF CREDIT

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 statutesone 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 Lawss (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 5102(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 5108(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." IV. CONCLUSION AND GENERAL RECOMMENDATIONS

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.