How to Identify Soft Clauses in a Letter of Credit

Various soft clauses in operations often lead to losses for exporters. Based on my own experience and knowledge, I have roughly summarized the types and main manifestations of soft clauses in letters of credit. 

A Brief Analysis of Soft Clause Letters of Credit While letters of credit are divided into revocable and irrevocable categories, there actually exists a third category: letters of credit that, despite bearing the title "irrevocable," are in fact attached with numerous soft clauses. This so-called soft clause L/C is essentially a letter of credit that allows the issuing bank to absolve itself of responsibility at any time. Looking at current international operational practices, soft clause letters of credit are on the rise. In the past, people seemed always to be extremely cautious about transferable L/Cs, paying special attention to their risks. However, a letter of credit with soft clauses is, in a sense, nothing less than a form of fraud, and its risk level surpasses that of a transferable L/C. 

For example, a letter of credit issued by an Italian bank stated that the L/C would only become effective upon receipt of the Italian importer's import license, and this effectiveness also required authorization from the applicant. Furthermore, the negotiating bank had to present a certificate of inspection from the applicant, and only after confirmation by the applicant could the issuing bank credit the relevant account. This is a relatively typical letter of credit with soft clauses. Although this L/C bears the words "irrevocable," anyone with a basic knowledge of international settlement can see that its actual operation is no different from a revocable L/C. This is because the applicant (importer) controls the entire transaction from start to finish, while the beneficiary (exporter) is completely in a passive position. 

Another example, from a bank in Pakistan, was even more blatant: the L/C explicitly stipulated that payment was conditional upon an independent inspection agency examining the quality and quantity of the goods at a specific location—the Karachi docks—before the final payment amount could be determined. As is well known, both UCP 400 and Publication 500 of the Uniform Customs and Practice for Documentary Credits clearly stipulate the independence of documents under a letter of credit; in L/C operations, the parties concerned deal only with documents, not with the goods, services, or other performance to which the documents relate. 

It is particularly noteworthy that Publication 500 (UCP500) of the International Chamber of Commerce, which came into effect in 1994, changed the word "deal in" from Article 4 of the former UCP400 regarding documents and goods to "deal with," once again emphasizing the principle that L/C operations only handle documents, not goods, and that documents and goods are absolutely independent. The main characteristic of a letter of credit with soft clauses is precisely setting traps regarding the goods to lure people into being deceived. The so-called payment after inspection is, in essence, that the issuing bank assumes no responsibility for payment or documents, leaving the beneficiary with virtually no control over the goods or title to them, in a distressed and unprotected state. It should be said that such letters of credit completely contradict the spirit of the ICC's Uniform Customs and Practice for Documentary Credits. 

Common soft clauses can generally be summarized into four types: 

1. Disguised revocable credit clauses: When certain conditions are not met (such as not receiving the counterparty's remittance, L/C, or guarantee), the issuing bank can use the clause to unilaterally relieve itself of its payment obligation at any time. 

2. Non-effective clauses: The L/C is issued but does not take effect; it only becomes effective upon separate notification or an amendment notice from the issuing bank. 

3. Applicant-decides clauses: The L/C contains terms that cannot proceed according to normal procedures without instructions from the applicant. For example, shipment requires the applicant's notice, or the means of transport, port of loading, or port of destination require the applicant's confirmation. 

4. Zero letter of credit: The L/C is issued without an amount; it is increased via amendments or can only be recorded as entries, without actual cash payment. Typically, the more classic soft-clause L/Cs with non-effective terms can also be summarized with a few "do not"s. That is, the issuing bank does not notify effectiveness, does not issue amendments, the applicant does not issue certificates or receipts, does not come for inspection, does not notify the ship's name, etc., and often includes a requirement for the exporter to pay 5% or even higher performance bonds upfront, with many such terms already stipulated in the contract outside the L/C. 

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