Letters of Credit and Stand-by Guarantees

Documentary letters of credit as they are understood in the modern sense originated in the nineteenth century. The first documentary credits drew on the language of traveller’s letters of credit: instead of carrying / exchanging cash, an overseas traveller could present a traveller’s letter to a local bank and the bank would disburse cash in return. With reference to international trader, the importer’s bank would issue a similar letter to an overseas exporter, but subject to an additional condition that certain (typically, shipping) documents be presented. The benefit for the exporter was the certainty of the bank’s promise to pay plus the bank’s credit supporting the payment of the purchase price.

Fast forward to the present and we find documentary credits strongly embedded in international trade. Today, documentary credits are understood to be an independent promise by a bank (or another institution) to pay the beneficiary if the beneficiary presents compliant documents in a stipulated manner. Typically, a documentary credit would be issued with reference to a specific sale-purchase, but the credit itself, and the bank’s promise to pay under that credit, are completely independent from the sale-contract. In other words, the bank cannot refuse to pay under a letter of credit if its terms have been met by the beneficiary, albeit that beneficiary (being also the exporter) failed to meet the terms of the sale contract. In fact, it is interesting to note that the terms of the letter of credit may vary the terms of the purchase contract when it comes to payment.

There are many variations to the types of documentary credits. For example, some documentary credits contemplate that the issuing bank pays immediately upon compliant presentation and some contemplate that the issuing bank accepts a time draft payable in, say 60 days.

In a simple scenario, a letter of credit ‘requires’ only three parties: the applicant, who is asking their bank to issue the credit (typically, the applicant is the importer); the issuing bank itself; and the beneficiary to whom the bank issues the credit (the beneficiary is typically the exporter). However, there are many other participants that in practice will be involved. By way of example, they is likely to be a bank local to the beneficiary/importer advising (notifying) the letter of credit to the beneficiary/importer and there may be a confirming bank (often also local to the beneficiary), who will add its own undertaking to pay to the letter of credit.

It should come as no surprise that the rules governing documentary credit have been standardised. Today, practically every documentary credit is subject to the Uniform Customs for Documentary Credits – UCP 600. UCP 600 is a comprehensive document released by the International Chamber of Commerce in 2007 (it replaced the prior version, UCP 500).

More often than not, documentary credits are issued by way of SWIFT messages transmitted between banks, more specifically SWIFT message MT700. Various fields of MT700 are dedicated to specific parameters of a documentary credit. The bank receiving MT700 would then advise the documentary credit to the beneficiary.

A documentary credit is a form of a bank payment undertaking. There are also other forms of bank payment undertakings frequently used in international transaction. We will focus on standby letters of credit (SBLC) and demand guarantees. Whilst the term ‘standby letter of credit’ resembles the terms ‘documentary credit’, the two are very different. Unlike a documentary credit, an SBLC primary function is that of quasi security – it is not meant to a primary source of payment. A payment under and SBLC typically occurs when the underlying obligations ‘secured’ by that SBLC are in default. To demand payment, the beneficiary of SBLC typically has to submit only a certificate to the issuing bank, such certificate simply stating that the relevant obligation has not been performed and a payment is demanded. Demand guarantees are instruments of a similar nature. However, the sets of standardised rules that apply to SBLCs and demand guarantees are different. SBLCs are typically subject to International Standby Practices (ISP98) and demand guarantees are subject to Uniform Rules for Demand Guarantees (URDG). Both ISP98 and URDG are also produced by the International Chamber of Commerce. The role of ISP98 and URDG is somewhat similar to that of UCP600.

When a bank issues a documentary credit, SBLC or a demand guarantee, it accepts the obligation to pay. Of course, the bank must by fully compensated for any payment it makes. The relevant documentation typically takes the form of a finance facility (sometimes, an indemnity letter), although the bank’s margin is likely to be in the form of a commission rather than interest.

Accordingly, the parties must be not only careful as to the terms of any instrument that is requested / issued, but must also be careful to under that the provisions of the underlying facility. On the one hand, the bank would want to be fully indemnified for any payment it makes (or does not make), but the applicant / borrower, would be well advised to seek a more reasonable form of indemnity that incentivises the bank to act prudently.

In larger facilities, composed of commitment of many bank (syndicated facilities), there is an additional layer of complexity. There will be one or a handful of issuing banks, who will bear the risk of payment under the instrument, whilst the whole syndicate would have to support such payments by an indemnity. On the one hand, the relevant types of clauses may be considered ‘standard’, however, to a degree, this view might be too unwarranted for a specific transaction, so that the provisions will also need a careful review.