Methods for Handling Discrepancies in Letters of Credit

In import letter of credit business, when a foreign party presents documents with discrepancies, what should the issuing bank do?

Currently, the common practice among domestic banks is: conduct a cursory review of the documents to identify obvious discrepancies, note them on the incoming document advice, forward the advice along with the documents to the applicant, and request the applicant to inform the issuing bank of their handling decision regarding the discrepant documents, based on which the issuing bank will decide whether to refuse payment externally.

This approach is generally adopted for the following reasons:

1. The issuing bank can significantly reduce the number of external refusals, thus maintaining a favorable external image. This is because the issuing bank only refuses payment when the applicant rejects the documents.

2. Procedures are simplified, reducing the bank's workload. Specifically, document examination relies primarily on the applicant, lessening the bank's review burden; documents are handed to the applicant, reducing the number of copies held by the bank; fewer refusals occur, thereby diminishing the workload for handling external rejection procedures.

3. Entrusting the decision of whether to refuse to the applicant is more acceptable to the applicant, fostering goodwill in bank-trade relationships.

However, the strengths of this approach are exactly where the issuing bank's risks and hidden hazards lie.

The risks are primarily concentrated in usance acceptance letters of credit. If the applicant's decision to accept the discrepant documents remains unchanged, the issuing bank faces no risk in accepting. But if the applicant changes their mind after the issuing bank has accepted and requests a refusal, the issuing bank is placed in a very awkward position. This scenario is not uncommon, as the applicant's decision on refusal often depends less on the documents themselves and more on factors like the goods and market conditions. Once these factors change out of self-interest, the applicant might request the bank to refuse payment externally despite the prior acceptance. However, changing a bank's acceptance is not easy, as it imposes an unconditional payment obligation. If the applicant obtains a court injunction, the issuing bank finds itself torn between abiding by the court order not to pay and the negotiable instruments law requiring payment—an obviously awkward situation. Even if it eventually makes payment, its reputation has suffered. In practice, to prevent this, issuing banks often agree with the applicant that the company shall bear all possible consequences arising from this.

Furthermore, releasing discrepant documents to the applicant in advance also brings risks to the issuing bank. UCP500 states: if the issuing bank fails to hold the documents at the disposal of, or return them to, the presenter, it is precluded from claiming that the documents do not constitute a complying presentation. It is possible that the applicant, upon receiving the documents, immediately takes possession of the goods but, to delay payment, asks the issuing bank to refuse payment externally. The issuing bank, considering its relationship with the applicant, might refuse externally while not holding the documents. This gambit sometimes works, but if discovered, the issuing bank is liable not only for the principal amount plus interest, but also suffers reputational damage.

Reputation is a bank's most precious asset and the foundation of its interests. Regardless of the business line, protecting reputation is always the priority. This holds true for letter of credit settlement business. So, how to truly protect the bank's reputation when handling discrepant documents? The author argues that correctly understanding the structural characteristics of letters of credit and firmly wielding the weapon of legitimate refusal are key.

A letter of credit is a conditional payment undertaking by the bank; strict compliance is the prerequisite for the issuing bank to pay. Refusing payment when documents are discrepant is the issuing bank's legitimate right, and does not tarnish its image. Discrepant presentations often foreshadow trade disputes, and a refusal allows the issuing bank to proactively change its role to that of a collecting bank, thereby exempting itself from payment liability and avoiding future risks. Of course, to make refusal less blunt in operation, the practice of some foreign banks can be emulated: first state the refusal, then claim that contact will be made with the applicant to accept the documents.

The issuing bank's lawful refusal of discrepant documents not only better protects bank interests but also significantly helps standardize letter of credit operations and harness the guarantee function of L/C settlement for both buyers and sellers: On one hand, the issuing bank's refusal encourages beneficiaries to move beyond over-reliance on applicant credit and promises and underestimation of document preparation, improve documentation, reduce discrepant presentations, and ensure the bank's payment undertaking is received. On the other hand, the bank's refusal first, followed by liaison with the applicant for acceptance, provides the applicant more time for investigation and evidence collection. If the beneficiary has defaulted, it can be detected before acceptance, preventing rushed acceptance followed by external refusal, which would damage the bank's reputation and its own interests. Based on these two points, the author believes that the issuing bank's reasonable refusal will be understood and supported by both buyers and sellers.