Part two: Letter of Credit defined

What is letter of credit? To understand what letter of credit is, we should first know the standard international rules that governed the operation of letter of credit which is known as Uniform Customs and Practice for Documentary Credits or in short, UCP.

The current UCP is known as Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no 600 or in short, UCP600. This is the sixth revision of the rules since they were first circulated in 1933. The primary objective of UCP is to alleviate the confusion caused by individual countries’ promoting their own national rules on letter of credit practice. UCP was established to create a set of contractual rules that would establish uniformity so that practitioners would not face national regulations conflict.

Under the current UCP600, letter of credit is defined in article 2 which reads as follow:

“Credit means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation…”

In international trade community, letter of credit is known as ‘credit’ or popularly known as ‘LC’. There are few important criteria need to be highlighted from the definition above because they form the basic principle of letter of credit.

Irrevocable – In letter of credit transaction, they are three important parties involved namely, bank, buyer and seller. The letter of credit is issued by a bank which is known as ‘the issuing bank’ which acts on the instruction or at the request of the buyer. The buyer is the party who provides the instruction to the bank via a standard format form. Based upon the instruction or application form received from the buyer, the issuing bank issues the letter of credit to the seller.

Irrevocable here means, in any event, should any of the parties; buyer, seller or bank wishes to cancel the LC that has been issued by the issuing bank, a mutual agreement or consent in writing must first be obtained from the rest of the parties involved in the transaction. In the absent of such agreement or consent in writing, the LC cannot be cancelled or revoked and it stands as an operative instrument.

The LC, once issued, is said to be a definite undertaking of the issuing bank where it encapsulates the ‘guarantee’ or ‘promise’ of the issuing bank to the buyer that payment will be made to the seller. This ‘guarantee’ or ‘promise’ to make payment to the seller by the issuing bank is based on the presentation of the documents (invoice, packing list, Bill of Lading/Air waybill etc) within the stipulated time period as expressly stated in the LC by the seller. Failure to comply with the requirements (terms & conditions) of the LC, the seller would not entitled to the ‘guarantee’ or ‘promise’ of the issuing bank or in other words, he would not get his payment.

This is the first important basic principle on which the LC operates.

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