Letters of Credit (LCs) are among the most influential and widely used instruments in international trade. They bridge the trust gap between exporters and importers, shift risk from commercial parties to banks, and create a legally autonomous system designed to ensure payment—not based on whether the underlying goods are satisfactory, but based on documents alone.
Understanding LCs is essential for banking lawyers, compliance teams, and anyone involved in international transactions. This post explains the underlying legal principles, regulatory framework, types of LCs, bank liabilities, and common disputes.
1. What is a Letter of Credit? (Core Definition)
A Letter of Credit (LC) is a binding undertaking by a bank to pay a seller (beneficiary) upon presentation of specified documents, provided they strictly comply with the terms of the LC.
Key points:
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It is bank-to-bank trust, not seller-to-buyer trust.
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The bank’s duty to pay arises independently of the underlying sales contract.
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The LC operates on documents, not goods (“doctrine of strict compliance”).
In other words:
If the documents conform, the bank must pay—even if the goods are defective.
2. Why LCs Are Crucial in International Trade
2.1. Solves the trust problem
Exporters fear non-payment; importers fear shipment of defective goods.
LCs replace commercial risk with bank risk, which is far lower.
2.2. Neutral third-party involvement
Banks act as professional intermediaries.
2.3. Cross-border neutrality
LCs follow international rules (UCP 600), reducing uncertainty in multi-jurisdictional trade.
2.4. Financing function
3. The Key Legal Principle: The “Autonomy Principle”
The LC is legally independent from the underlying sale contract.
This means:
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Banks do not check goods or inspect performance.
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Banks only examine documents.
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Disputes between buyer and seller cannot block LC payment, except in fraud cases.
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Courts respect this autonomy rigidly to maintain international certainty.
This principle is central to the global economy.
4. The Doctrine of Strict Compliance
A bank is obligated to pay only if the presented documents strictly match the LC terms.
Even minor discrepancies—misspelling, date mismatch, missing stamp—can justify refusal.
Documents usually include:
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Bill of lading
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Commercial invoice
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Packing list
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Insurance certificate
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Certificate of origin
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Inspection certificate
Banks examine documents “with reasonable care” but without tolerating deviations.
5. Legal Framework: UCP 600 and Other International Rules
5.1. UCP 600 (Uniform Customs and Practice for Documentary Credits)
Published by the ICC (International Chamber of Commerce), UCP 600 is the global standard governing:
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LC issuance
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amendment
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presentation
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document examination
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refunding
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bank liabilities
It is not law by itself, but becomes binding when incorporated into the LC.
5.2. ISP98 (International Standby Practices)
Used for standby LCs, especially in the U.S.
5.3. URR 725
Rules for reimbursement arrangements between banks.
5.4. Local laws
UCP governs operation,
but local contract law governs:
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formation
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validity
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fraud exception
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enforceability
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court remedies
6. The Parties in an LC Transaction
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Applicant – the buyer/importer
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Issuing Bank – bank that issues the LC
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Beneficiary – exporter/seller
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Advising Bank – bank in seller’s country, authenticates LC
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Confirming Bank (optional) – adds its own guarantee to pay
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Negotiating Bank – may purchase/discount documents
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Reimbursing Bank – pays the claiming bank on behalf of the issuing bank
Each party has distinct legal obligations.
7. Types of Letters of Credit
7.1. Revocable vs Irrevocable
Under UCP 600, all LCs are irrevocable:
they cannot be changed without the consent of all parties.
7.2. Confirmed vs Unconfirmed
7.3. Sight vs Deferred Payment
7.4. Transferable LCs
Beneficiary can transfer rights to another seller.
Used in supply chains or intermediated trade.
7.5. Standby Letters of Credit (SBLC)
Act as guarantees: payment occurs only if the applicant fails to perform.
Common in construction, project finance, leasing, and bond issuance.
7.6. Red Clause & Green Clause LCs
Allow the beneficiary to receive advance payments against a guarantee.
7.7. Back-to-back LCs
A trader uses an LC issued in their favour to secure another LC for their own supplier.
8. The LC Process: Step-by-Step
Step 1: Sales Contract
Buyer and seller agree payment via LC.
This contract triggers the banking process but does NOT govern the bank’s obligations.
Step 2: Buyer Applies for LC
The applicant requests their bank to issue the LC.
Step 3: Issuing Bank Issues LC
Bank sends LC to the beneficiary’s advising bank (usually via SWIFT).
Step 4: Shipment and Document Preparation
Seller ships goods and prepares required documents.
Step 5: Beneficiary Presents Documents
Documents must be submitted within specified time limits.
Step 6: Banks Examine Documents
Examination must occur within 5 banking days under UCP 600.
Step 7: Payment or Refusal
Step 8: Reimbursement & Final Settlement
Issuing bank reimburses paying/confirming bank.
9. Bank Liabilities Under a Letter of Credit
Banks are contractually liable to the beneficiary, not the buyer, for:
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honouring compliant presentations
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examining documents with reasonable care
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following UCP 600 rules and deadlines
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handling documents accurately
A wrongful refusal to pay exposes the bank to heavy legal liability.
Conversely, a wrongful payment (e.g., paying despite discrepancies) may breach the bank’s contract with the applicant.
Banks operate between two legal risks—paying too early vs refusing wrongfully.
10. The Fraud Exception (One of the Few Ways to Stop LC Payment)
The only widely accepted exception to autonomy is fraud.
Fraud usually means:
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forged documents
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knowingly false statements
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fraudulent bills of lading
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intentional deception in presentation
Courts can issue an injunction only if fraud is clear, proven, and attributable to the beneficiary.
Mere disputes about the goods (e.g., defects) do not qualify.
11. Common Disputes in LC Operations
11.1. Document Discrepancies
Most litigation concerns:
11.2. Late Presentation
Presentation must be within required timeframe.
11.3. Fraud & forged documents
Especially in shipping documents.
11.4. Wrongful dishonour or wrongful honour
11.5. Conflict of laws
When courts must decide applicable law for:
12. Economic and Legal Function of LCs
Letters of Credit achieve three fundamental goals:
(1) Risk Mitigation
They eliminate:
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non-payment risk
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foreign exchange risk (with confirmed LCs)
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political and transfer risk
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performance risk (with SBLCs)
(2) Liquidity Creation
Beneficiaries can:
(3) Enforcement Efficiency
LC obligations are:
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fast
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documentary
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judicially respected
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globally standardised
Unlike general contract disputes, LC payment is straightforward and enforceable.
Conclusion: Why LCs Are the Backbone of Global Trade
Letters of Credit represent a sophisticated legal “payment machine” built to function across borders, legal systems, and political environments.
They:
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stabilise global trade flows
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transform private trust into bank trust
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operate under internationally uniform rules
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provide certainty where ordinary contract law would collapse
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allow billions in goods to move daily with predictable payment outcomes
The LC is not just a banking product—it is a legal architecture that keeps world commerce running smoothly.
