How to Avoid a Letter of Credit Being Rejected by the Bank

Documentary Letter of Credit --- This form of service provided by the international banking community promotes the development of international trade. The development of documentary letters of credit has mitigated the risks for cargo owners, fundamentally ensuring that sellers receive payment and buyers receive goods. However, it requires that all parties involved in the letter of credit—banks, buyers, and sellers—must be honest and trustworthy.

The operating procedure of a documentary letter of credit is straightforward. When a buyer imports goods from abroad, he/she applies to his/her domestic bank for a letter of credit to pay the seller (or beneficiary of the L/C). The seller, based on the transportation method specified in the sales contract, presents documents to the bank for negotiation. These documents prove that the goods have been shipped and comply with the L/C requirements. The primary document proving shipment is the bill of lading, together with other documents agreed upon by both parties, such as certificates of origin, commercial invoices, and insurance policies.

So, what role do banks play in the documentary letter of credit system? Once the issuing bank receives the full set of documents that meet the stipulated requirements, it will pay the agreed amount to the seller (or beneficiary). Usually, the issuing bank requires the seller to submit the documents to their local bank, which acts as the negotiating bank. The negotiating bank forwards the complete set of documents by mail to the issuing bank, which then transmits these documents to the buyer (the applicant).

For the documentary credit system to function well and to mitigate the risks for both sellers and buyers, the documents provided by the seller to the bank must be reliable and authentic. Furthermore, the carrier executing the trade contract must be trustworthy. Naturally, the integrity of the banks themselves is also a crucial factor. Under normal circumstances, if the documents provided by the seller comply with the terms of the documentary credit, the bank fulfills its payment obligation. However, banks do not guarantee the authenticity or reliability of the documents. If the bank discovers discrepancies or that the documents are invalid, the documentary credit becomes void. Banks exercise great caution when verifying the correctness of documents—checking for consistency between documents and between documents and the L/C. This is the fundamental reason for banks to accept, reject payment for, or refuse negotiation of documents.

Under the documentary letter of credit system, banks deal with documents, not the goods. For instance, when processing a certificate of origin, the bank does not consider the actual condition of the goods; it only checks whether the document content complies with the L/C requirements. However, some documents are disregarded by banks, such as clauses printed on the reverse side of a bill of lading. The guideline banks follow for handling documents is the International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits, ICC Publication 500.

Under the documentary letter of credit system, how can sellers and buyers mitigate risks?

Firstly, the sales contract must be carefully drafted. International trade begins with the establishment of the contract. The contract should clearly state the terms that the buyer will submit to the bank when applying for the L/C. These terms should be clear, simple, verifiable, and contain few restrictive clauses. The buyer's stipulations regarding transport documents should be specific—for example, the type of bill of lading and by whom it is issued. The buyer should explicitly define the description of the goods and packaging, using clear and unambiguous language that facilitates the bank's document checking. Phrases like "first-class carrier" or "shipment under certain weather conditions" should be avoided. If documents provided by the seller need to meet such vague requirements, the negotiating bank will be at a loss and have to consult the applicant (buyer), inevitably causing delays in negotiation. Besides documents required for import customs clearance and official purposes, the importer (buyer) should not demand excessive documentation. The more documents there are, the greater the chance for the bank to encounter discrepancies, impeding the smooth operation of the documentary credit system.

Secondly, upon receiving the L/C, the seller must review it promptly and carefully. Typically, after receiving the L/C, the seller starts preparing the goods and arranging shipment according to the sales contract terms. However, if the seller finds that the documents prepared according to the sales contract do not conform to the L/C requirements when presented to the negotiating bank—as the bank can only negotiate based on the L/C and has no knowledge of the sales contract—this will inevitably lead to negotiation failure or subject-to conditions. If, upon receiving the L/C, the seller promptly compares it with the sales contract and identifies discrepancies, the seller can notify the buyer to amend the L/C, thereby avoiding such troubles.

Finally, it must be noted that cargo owners should not issue letters of indemnity to carriers in order to obtain clean bills of lading. In reality, cargo owners know perfectly well that documents related to the goods should truly reflect the actual condition of the cargo. This is not only a requirement for banks verifying L/C terms but also a measure against instances of documentation-related fraud. However, to obtain a clean bill of lading, sellers often resort to issuing a letter of indemnity to the carrier in exchange for deleting annotations. In fact, carriers have the right to endorse the condition of goods received for shipment, as this can limit their liability. Banks strongly oppose the practice of issuing letters of indemnity. In some countries, such letters of indemnity are not legally recognized and are considered fraudulent—a collusion between the seller and the carrier to deceive the buyer. The real problem is that once such a letter of indemnity falls into the buyer's hands, the operation of the documentary credit becomes intricate.