31 October 2023

Letters of Credit in International Settlements: Legal Framework and Practice

October 31, 2023

BRACE Law Firm ©

Settlements with foreign partners represent a primary issue in the conduct of foreign trade, as the risks of failing to receive funds under an international contract are high. Non-payment may result not only from the bad faith of a foreign partner but also from the political and economic situation domestically and globally. Foreign trade participants conduct settlements with each other not only directly but also by utilizing various international financial instruments, one of which is the letter of credit.

For instance, when partners to a foreign trade transaction interact for the first time and wish to secure the transaction, they choose a letter of credit for payment for the delivered goods. However, this is not the only case for using letters of credit in international transactions; for foreign partners, the letter of credit has become a convenient financial instrument that allows for the performance of a foreign trade contract with minimal risks.

The participants in letter of credit settlements for foreign trade transactions include the seller, the buyer, the importer's bank, and the exporter's bank. Both banks verify documents to trigger the letter of credit. The result of letter of credit settlements is that each participant is confident that the seller will receive funds and the buyer will receive their goods. The primary participants in letter of credit settlements are outlined in the Uniform Customs and Practice for Documentary Credits (the "Uniform Rules for Letters of Credit"), according to which:

the applicant means the party on whose request the letter of credit is issued;
the advising bank means the bank that advises the letter of credit at the request of the issuing bank;
the issuing bank means the bank that issues a letter of credit at the request of an applicant or on its own behalf;
the beneficiary means the party in whose favor a letter of credit is issued;
the confirming bank means the bank that adds its confirmation to a letter of credit upon the issuing bank’s authorization or request;
the nominated bank means the bank authorized to make payment under the letter of credit, or any bank in the event that payment under the letter of credit is made by any bank.

Turning to national legislation, Article 862 of the Civil Code of the Russian Federation (the "Civil Code") provides that non-cash settlements may be conducted in the form of payment orders, letters of credit, collections, checks, as well as in other forms provided for by law, banking rules, or customs applied in banking practice. In settlements by letter of credit, the issuing bank, acting on the payer's instructions, undertakes to the recipient of funds to make payments or to accept and pay a bill of exchange issued by the recipient of funds, or to perform other actions to honor the letter of credit upon the presentation by the recipient of funds of the documents provided for by the letter of credit and in accordance with its terms.

The honor of a letter of credit may be performed by way of:

payment to the recipient of funds made by the bank upon presentation of documents complying with the terms of the letter of credit, either immediately or within the period or periods provided for by the terms of the letter of credit;
acceptance of a bill of exchange with its payment upon the maturity date;
other methods specified in the letter of credit.

Importantly, a letter of credit is separate and independent from the underlying contract. This is established by Central Bank of Russia Regulation No. 762-P dated June 29, 2021, On the Rules for Transferring Funds (the "Regulation No. 762-P"); a similar norm is reflected in Article 4 of the Uniform Rules for Letters of Credit, according to which a letter of credit by its nature is a transaction separate from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the letter of credit. Therefore, if, for example, money is paid to the recipient and the underlying contract is subsequently declared void, this does not entail the invalidity of the letter of credit, and the payer will only be able to recover the money from the recipient, but not from the bank. Domestic Russian letters of credit are subject to the rules established in Regulation No. 762-P, which provides that the transfer of a letter of credit, amendments to its terms, documents, applications, notifications, and notices regarding the letter of credit, as well as the exchange of other information, shall be carried out in hard copy and (or) in electronic form using means of communication that allow for the reliable identification of the sender, including information systems, such as distributed ledger systems.

Several types of letters of credit are distinguished:

Irrevocable and Revocable Letters of Credit. As a general rule, a letter of credit is irrevocable. Under an irrevocable letter of credit, the issuing bank, acting on the payer's instructions, undertakes to the recipient to make payments or perform other actions to honor the letter of credit when the recipient presents the necessary documents to the bank. Furthermore, according to the Uniform Rules for Letters of Credit, the irrevocability of a letter of credit is reflected in the very definition of a credit, which constitutes any arrangement, however named or described, that is irrevocable and represents a definite undertaking of the issuing bank to honor a complying presentation at maturity. A revocable letter of credit may be amended or canceled without notice to the recipient of funds; in this case, the payer submits an application to the issuing bank, which sends the recipient of the money a notice of the amendment or cancellation of the letter of credit.
Covered and Uncovered Letters of Credit. In the case of a covered (deposited) letter of credit, the issuing bank must transfer the amount of the letter of credit (the coverage) at the expense of the payer or a credit provided to them to the disposal of the nominated bank for the entire term of the issuing bank's obligation. In the case of an uncovered (guaranteed) letter of credit, the issuing bank may grant the nominated bank, which has accepted the issuing bank's instructions, the right to debit funds from the issuing bank's account maintained with the nominated bank within the amount of the letter of credit, or it may specify another method in the letter of credit for reimbursing the nominated bank for sums paid under the letter of credit.
Confirmed and Unconfirmed Letters of Credit. Confirmation of a letter of credit means that the confirming bank is jointly and severally liable to the recipient of the money along with the issuing bank within the limit of the confirmed amount. As a general rule, a letter of credit is unconfirmed, and the obligation for its performance is borne only by the issuing bank.
Transferable and Non-transferable Letters of Credit. As a general rule, a letter of credit is non-transferable; however, performance of the letter of credit may be made to a person specified by the recipient of funds if the possibility of such performance is provided for by the terms of the letter of credit and the nominated bank has expressed its consent to such performance (a transferable letter of credit).

Additionally, it should be noted that a critical point in settlements by letter of credit is the conditions for the release of the letter of credit, which the recipient of funds must fulfill for the bank to honor the credit. To honor the letter of credit, the recipient of funds presents the documents, including those in electronic form, provided for by the terms of the letter of credit, to the nominated bank or the issuing bank. The nominated bank or the issuing bank, having received said documents, shall verify them within a period not exceeding five business days from the date of their receipt and shall decide whether to pay or refuse payment.

International Legal Regulation of Letters of Credit

International regulatory documents in this field are used for the external economic regulation of letters of credit:

United Nations Convention on Independent Guarantees and Standby Letters of Credit;
Uniform Customs and Practice for Documentary Credits;
ICC Uniform Rules for Bank-to-Bank Reimbursements under Documentary Credits;
International Standby Practices.

It is important to note that most international regulatory documents are advisory in nature and become binding on the parties to a foreign trade contract only if the participants in the international transaction expressly provide for this in the text of the contract.

For the purposes of the United Nations Convention on Independent Guarantees and Standby Letters of Credit, an undertaking means an independent commitment, understood in international practice as an independent guarantee or a standby letter of credit, issued by a bank or other institution or person (the "guarantor/issuer") to pay the beneficiary a certain or determinable amount upon simple demand or upon demand accompanied by other documents, in accordance with any documentary conditions of the undertaking, indicating, or from which it follows, that payment is due because of a default in the performance of an obligation, or because of another contingency, or as payment for borrowed or advanced funds, or as payment to discharge any matured indebtedness of the principal/applicant or another person. An undertaking is international if the places of business of any two of the following persons specified in the undertaking are in different states: the guarantor/issuer, the beneficiary, the principal/applicant, the instructing party, or the confirming party.

The issuance of an undertaking occurs at the time and place when and where the undertaking leaves the sphere of control of the respective guarantor/issuer. Furthermore, an undertaking may be issued in any form which preserves a complete record of the text of the undertaking and provides authentication of its source by generally accepted means or by a procedure agreed upon between the guarantor/issuer and the beneficiary. A demand for payment may be made in accordance with the terms of the undertaking from the time of its issuance, unless the undertaking specifies a different time. An undertaking is irrevocable from the time of issuance unless it states that it is revocable.

The Uniform Rules for Letters of Credit are rules that apply to any documentary credit (including any standby letter of credit, to the extent to which they may be applicable), if the text of the credit expressly indicates that it is subject to the Uniform Rules for Letters of Credit. They are binding on all parties to the credit unless the credit expressly modifies or excludes their provisions.

According to the Uniform Rules for Letters of Credit, a letter of credit by its nature is a transaction separate from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the credit. Consequently, the undertaking of a bank to honor, to negotiate, or to fulfill any other obligation under the credit is not subject to claims or defenses by the applicant resulting from its relationships with the issuing bank or the beneficiary. Under Article 2 of the Uniform Rules for Letters of Credit, negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.

The Uniform Rules for Bank-to-Bank Reimbursements under Documentary Credits apply to any bank-to-bank reimbursement when the text of the reimbursement authorization expressly incorporates them. They are binding on all parties concerned unless otherwise expressly stipulated in the reimbursement authorization. The Issuing Bank is responsible for indicating in the documentary credit that reimbursement claims are subject to the Uniform Rules for Bank-to-Bank Reimbursements under Documentary Credits. These rules do not affect the provisions of the Uniform Customs and Practice for Documentary Credits.

The International Standby Practices reflect generally accepted practice, customs, and usage of standby letters of credit. They establish separate rules for standby letters of credit, similar to how the Uniform Customs and Practice for Documentary Credits and the Uniform Rules for Demand Guarantees apply, respectively, to commercial letters of credit and independent bank guarantees.

Obligations of the Issuing Bank and the Confirming Bank

A transaction using a letter of credit is performed not only between the seller and the buyer but also involves a bank that guarantees the receipt of funds by the seller upon performance of the contractual obligations. The obligations of the issuing bank include:

Provided that the documents stipulated by the letter of credit are presented to the nominated bank or the issuing bank and constitute a complying presentation, the issuing bank must honor the obligation if the letter of credit is available by:

sight payment, deferred payment, or acceptance with the issuing bank;
sight payment with a nominated bank and that nominated bank does not pay;
deferred payment with a nominated bank and that nominated bank does not incur its deferred payment undertaking or, having incurred its deferred payment undertaking, does not pay at maturity;
acceptance with a nominated bank and that nominated bank does not accept a draft drawn on it or, having accepted a draft drawn on it, does not pay at maturity;
negotiation with a nominated bank and that nominated bank does not negotiate.

The issuing bank is bound by an irrevocable obligation to honor the credit from the moment it issues the letter of credit.
The issuing bank must reimburse the nominated bank that has honored or negotiated a complying presentation and forwarded the documents to the issuing bank. Reimbursement of the amount of a complying presentation under a letter of credit available by acceptance or deferred payment is due at maturity, even if the nominated bank paid or purchased before maturity. The obligation of the issuing bank to reimburse a nominated bank is independent of the issuing bank's obligation to the beneficiary.

The obligations of the confirming bank include:

Provided that the documents stipulated by the letter of credit are presented to the confirming bank or any other nominated bank and constitute a complying presentation, the confirming bank must:

honor the obligation if the letter of credit is available by:

– sight payment, deferred payment, or acceptance with the confirming bank;

– sight payment with another nominated bank and that nominated bank does not pay;

– deferred payment with another nominated bank and that nominated bank does not incur its deferred payment undertaking or, having incurred its deferred payment undertaking, does not pay at maturity;

– acceptance with another nominated bank and that nominated bank does not accept a draft drawn on it or, having accepted a draft drawn on it, does not pay at maturity;

– negotiation with another nominated bank and that nominated bank does not negotiate;

negotiate without recourse if the letter of credit is available by negotiation with the confirming bank.

The confirming bank is bound by an irrevocable obligation to honor or negotiate from the moment it adds its confirmation to the letter of credit.
The confirming bank must reimburse another nominated bank that has honored or negotiated a complying presentation and forwarded the documents to the confirming bank. Reimbursement of the amount of a complying presentation under a letter of credit available by acceptance or deferred payment is due at maturity, even if the nominated bank paid or purchased before maturity. The obligation of the confirming bank to reimburse another nominated bank is independent of the confirming bank's obligation to the beneficiary.
If a bank is authorized or requested by the issuing bank to confirm a letter of credit but is not prepared to do so, it must inform the issuing bank without delay and may advise the letter of credit without adding its confirmation.

Form, Content of the Letter of Credit, and Document Verification in Foreign Trade

Russian Federation legislation does not provide for a single form for a letter of credit; instead, the bank establishes the attributes and form (in hard copy) of the letter of credit. Nonetheless, a letter of credit must contain the following mandatory information:

the number and date of the letter of credit;
the amount of the letter of credit;
the payer's attributes;
the issuing bank's attributes;
the recipient's attributes;
the nominated bank's attributes;
the type of letter of credit;
the expiry date of the letter of credit;
the method of honoring the letter of credit;
the list of documents under the letter of credit and the requirements for them;
the purpose of the payment;
the period for presentation of documents under the letter of credit;
the requirement for confirmation of the letter of credit (if applicable);
the procedure for payment of the banks' commission fees.

Other information may also be specified in the letter of credit.

Furthermore, Article 14 of the Uniform Rules for Letters of Credit establishes criteria for the verification of documents, according to which:

A nominated bank acting on its nomination, a confirming bank, if any, and the issuing bank must examine a presentation to determine, on the basis of the documents alone, whether or not the documents appear on their face to constitute a complying presentation. A presentation means either the delivery of documents under a letter of credit to the issuing bank or nominated bank or the documents themselves so delivered.
A nominated bank acting on its nomination, a confirming bank, if any, and the issuing bank shall each have a maximum of five banking days following the day of presentation to determine if a presentation is complying. This period is not curtailed or otherwise affected by the occurrence on or after the date of presentation of any expiry date or last day for presentation.
A presentation containing one or more original transport documents must be made by or on behalf of the beneficiary not later than 21 calendar days after the date of shipment, but in any event not later than the expiry date of the letter of credit.
Data in a document, when read in context with the credit, the document itself, and international standard banking practice, need not be identical to, but must not conflict with, data in that document, any other stipulated document, or the credit.
The description of the goods, services, or performance in documents other than the commercial invoice may be in general terms not conflicting with their description in the credit.
If a credit requires presentation of a document other than a transport document, insurance document, or commercial invoice, without stipulating by whom the document is to be issued or its data content, banks will accept the document as presented if its content appears to fulfill the function of the required document and otherwise complies with established provisions.
If a document not required by the credit is presented, it will be disregarded and may be returned to the presenter.
If a credit contains a condition without stipulating the document to indicate compliance with the condition, banks will deem such condition as not stated and will disregard it.
A document may be dated prior to the issuance date of the credit but must not be dated later than its date of presentation.
If the addresses of the beneficiary and the applicant appear in any stipulated document, they need not be the same as those stated in the credit or in any other stipulated document, but must be within the same country as the respective addresses mentioned in the credit. Contact details (telefax, telephone, email, etc.) stated as part of the beneficiary's and applicant's address will be disregarded. However, if the applicant's address and contact details appear as part of the consignee or notify party details on a transport document, they must be as stated in the credit.
The shipper or consignor of the goods indicated on any document need not be the beneficiary of the credit.
A transport document may be issued by any party other than a carrier, owner, master, or charterer, provided that the transport document meets the requirements established by the Uniform Rules for Letters of Credit.

Transport documents subject to verification in accordance with the above rules include:

a transport document covering at least two different modes of transport;
a bill of lading;
a non-negotiable sea waybill;
a charter party bill of lading;
an air transport document;
road, rail, or inland waterway transport documents;
courier receipts, post receipts, or certificates of posting.

It should also be noted that, in accordance with Article 27 of the Uniform Rules for Letters of Credit, banks only accept a clean transport document, meaning a document that bears no clause or notation expressly declaring a defective condition of the goods or their packaging. The word "clean" need not appear on a transport document, even if the credit has a requirement for that transport document to be "clean on board".

Standby Letter of Credit

A standby letter of credit is a document according to which a bank guarantees the payment of a certain amount of money to the seller in the event that the buyer fails to perform the terms of an agreement; in essence, it is a bank guarantee formatted as a letter of credit. Within foreign trade relationships, the standby letter of credit is governed by the International Standby Practices (the "Standby Rules"), which were approved by the International Chamber of Commerce (ICC Publication No. 590) and endorsed by the UN Commission on International Trade Law (UNCITRAL) in 2000. The Standby Rules are intended for application to standby letters of credit, including performance, financial, and direct pay standbys. A standby letter of credit is an irrevocable, independent, documentary, and binding undertaking from the moment it is issued.

For convenience, standby letters of credit are usually classified descriptively based on their function in the underlying transaction or other circumstances not always directly related to the terms of the credit itself:

a performance standby ensures the performance of the applicant's contractual obligations other than the obligation to pay; including for the purpose of indemnifying for losses arising from the applicant's default in performing the underlying transaction;
an advance payment standby ensures the obligation to account for an advance payment made by the beneficiary to the applicant;
a bid bond/tender bond standby ensures the performance of the applicant's obligations to enter into a contract in connection with a tender won by them;
a counter standby ensures the issuance by the beneficiary of a separate standby letter of credit or other undertaking;
a financial standby ensures the performance of obligations to pay funds, including obligations to repay borrowed funds;
a direct pay standby ensures the payment provided for by an underlying payment obligation (usually in connection with a financial standby), in a timely manner and regardless of the default in such underlying obligation;
an insurance standby ensures the performance of the applicant's insurance or reinsurance obligation;
a commercial standby ensures the performance of the applicant's obligation to pay for goods (works, services) in the event that payment is not made by other means.

A standby letter of credit is used in foreign trade or domestic transactions when the parties to the transaction do not know each other and want to insure against possible risks associated with the transaction being concluded. Furthermore, the Standby Rules allow for calling a standby letter of credit a "Standby".

Chapter 2 of the Standby Rules establishes obligations according to which:

the issuer undertakes to the beneficiary to honor a Standby against a presentation that appears on its face to comply with the terms of the Standby as established in the Standby Rules, as well as standard standby letter of credit practice;
the issuer honors a complying presentation made to it by paying the required amount at sight;
the issuer is deemed to be acting timely if it pays at sight, accepts a draft, or incurs a deferred payment undertaking (or gives notice of dishonor) within the period established for examining the presentation and sending a notice of refusal;
the issuer honors the obligation by paying in funds that can be immediately used, in the currency specified in the standby letter of credit, except for cases where the Standby indicates it is payable;
in units of account, in which case the obligation consists of payment in such unit of account;
by transfer of other types of values, in which case the obligation consists of transferring such values.

By signing a foreign trade contract, foreign trade participants in such transactions want to be confident in their performance with minimal possible risks of failing to receive funds. To regulate payment under foreign trade contracts, banks offer various services guaranteeing the performance of obligations in international transactions, which include letters of credit; the competent formalization of these allows a party to a foreign trade transaction not only to receive funds for the delivered goods or rendered services but also to comply with the entrepreneur's domestic legislation.

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References

Original text of the article Application of Letters of Credit in International Settlements, October 31, 2023.
Article 2 of the Uniform Rules for Letters of Credit.
Clause 1 of Article 867 of the Civil Code.
Article 871 of the Civil Code.
Clause 6.3 of Regulation No. 762-P.
Clause 4 of Article 869 of the Civil Code.
Clause 1 of Article 868 of the Civil Code.
Clause 3 of Article 867 of the Civil Code.
Clause 1 of Article 870 of the Civil Code.
The Convention was approved by the UN General Assembly on December 11, 1995. The Convention entered into force on January 1, 2000. Russia does not participate in this Convention.
International Chamber of Commerce Publication No. 525. Effective date: July 1, 1996.
International Standby Practices. Effective since January 1, 1999. ICC Publication No. 590.
Article 7 of the UN Convention on Independent Guarantees and Standby Letters of Credit.
Article 7 of the Uniform Rules for Letters of Credit.
Article 8 of the Uniform Rules for Letters of Credit.
Clause 6.7 of Regulation No. 762-P.
Article 19. Ibid.
Article 20. Ibid.
Article 21. Ibid.
Article 22. Ibid.
Article 23. Ibid.
Article 24. Ibid.
Article 25. Ibid.
Preface to the International Standby Practices.