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The role of letters of credit in the international sale of goods

22 July 2018
– 5 Minute Read


The usual risks associated with a contract of sale are amplified when a sale is international. A sale qualifies as being international if the contracting parties have their place of business in two different countries. Should a seller or buyer in domestic sales not perform its contractual obligations by either failing to deliver the purchased product, in the case of the seller, or not making payment, in the case of the buyer, the innocent party can call upon the local courts for an appropriate remedy. In the case of an international sale, the innocent party would need to go to the country of the other party in order to enforce the contract. Enforcement of a contract in a foreign jurisdiction is something that all traders wish to avoid.

In addition, parties to an international sale faces additional risks not normally encountered in domestic sales. Such risks include risks that are not necessarily associated with the parties themselves but with the countries where they are situated, such as civil unrest, sanctions, failure to obtain the necessary import or export licenses from government, war and increased import tariffs.

Furthermore, in international sales the buyer may have difficulty in ensuring that the product purchased is of desired quality. Not only would inspecting the goods before purchase in a foreign country increase costs for the buyer but should a defective product arrive, notwithstanding an earlier inspection, he would again be forced to enforce his rights in a foreign country.

Transport is another issue in international sales that adds to the burden of the parties. In international sale the transport period can be rather lengthy. There is an increased chance the goods may be damages in transit making insurance a necessity.

Another problem related to the transport is when payment should be made. The seller would prefer to get paid before delivering the goods for transport. The buyer on the other hand would prefer to only make payment upon receipt of the goods and inspecting to make sure that they are of the desired quality.

Each party’s bargaining strength will determine how the above mentioned risks are transposed and importantly how payment is made. If the seller is in strong position, he may insist in payment up front. Conversely, if the buyer is in a very strong bargaining position, he may insist on payment only upon delivery of the purchased product. In international trade however, we often find that the bargaining power of the parties are spread evenly. In order to bridge the insecurities and risks that are associated with payment of the purchase price, the parties may opt to agree that the buyer secure an undertaking from a high creditworthy third party, for instance a bank, to guarantee payment. Such an undertaking by a bank manifest itself in the form of a document called a documentary credit or also known as a letter of credit. Payment however, will only be made by the bank on the presentation by the seller of certain pre-determined documents, which is specified in the letter of credit at the instance of the buyer, accompanied by a demand for payment. The documents specified should ensure that the buyer is actually receiving what he purchased. It is for the buyer to list all the documents he deems necessary to ensure he receives the correct goods. These documents to be delivered to the bank may include a bill of lading (to ensure that ownership of the goods has passed to the buyer), documents evidencing origin and/or quality of the goods and document evidencing arrival of the goods at port of destination.

In practice, payment by letter of credit works as follows: (1) the international sale contract will stipulate that payment of the purchase price will be by way of letter of credit; (2) the buyer will request his bank (the issuing bank) to issue the letter of credit in favour of the seller; (3) the fact that the issuing bank is willing to issue the letter of credit is then communicated to the seller, usually by contacting the seller’s bank (the advising bank) and letter of credit is issued; (4) the documents, as specified in the letter of credit, is presented to the issuing bank and payment is made.

 What then is the benefit to the parties in insisting on payment by way of letter of credit when the fee for the issuing of a letter of credit is rather expensive? First and foremost, the obligation by the issuing bank to pay stands totally independent from the underlying international contract of sale. This independence of the bank’s obligation, called the independence principle, is one of two fundamental principles of letters of credit.  As such, if the documents stipulated in the letter of credit is presented to the bank, the issuing bank must make payment to the seller. The bank cannot refuse to make payment upon the allegation by the buyer that the seller has breached the underlying international sale contract. While the independence principle serves primarily the interest of the seller, the other fundamental principle of letters of credit, called the doctrine of strict compliance, serves the interest of the buyer. In terms of this the issuing bank is under an obligation not to make payment to the seller if the documents presented does not strictly comply with the conditions and stipulations in the letter of credit. Should the seller insist that the documents do comply notwithstanding the bank’s disagreement, then the seller would need to sue the issuing bank, leaving the buyer out of the dispute but still in control of their funds.

Parties to international sales should always seriously consider the use of letters of credit. It protects both parties equally and fairly. While banks do charge for the issuing of the letter of credit, it is marginal when compared to legal costs in enforcing your rights in a foreign jurisdiction for a breach of an international sales contract.