How to reduce risks for both buyers and sellers under a documentary letter of credit

The operational process of a documentary letter of credit is quite straightforward. When a buyer imports goods from abroad, they apply to their local bank to open a letter of credit for payment to the seller (or the beneficiary of the L/C). The seller, based on the mode of transport stipulated in the sales contract, presents documents to the bank for negotiation that prove the goods have been shipped and comply with L/C requirements. The main document proving shipment is the bill of lading, in addition to other documents agreed upon by both parties, such as the certificate of origin, commercial invoice, insurance policy, etc.

So, what role does the bank play in the documentary credit system? When the issuing bank receives a full set of compliant documents, it pays the contracted amount to the seller (or beneficiary). Typically, the issuing bank requires the seller to submit the documents to a bank in their own country, which acts as the negotiating bank. The negotiating bank forwards the complete set of documents by mail to the issuing bank, which then hands them over to the buyer (the applicant).

For the documentary credit system to function well and mitigate risks for both seller and buyer, the documents provided by the seller to the bank must be reliable and authentic, and the carrier executing the trade contract must be trustworthy. Naturally, the bank's own credibility is also a crucial factor. Under normal circumstances, if the documents provided by the seller meet the L/C requirements, the bank fulfills its payment obligation. However, the bank does not guarantee the authenticity or reliability of the documents. If the bank discovers discrepancies in the documents or the documents become invalid, the documentary credit ceases to be effective. The bank exercises great caution when examining documents for correctness; ensuring consistency between documents and their compliance with the L/C is the fundamental reason for the bank to accept, refuse, or reject payment.

Under the documentary credit system, banks deal with documents, not goods. For instance, when processing a certificate of origin, the bank does not consider the actual condition of the goods; it only checks if the document's content complies with L/C terms. However, certain documents are not considered by the bank, such as the terms printed on the back of a bill of lading. The bank's standard for handling documents is the International Chamber of Commerce Publication No. 500, Uniform Customs and Practice for Documentary Credits.

How can sellers and buyers reduce risks under the documentary credit system?

First, the sales contract must be carefully prepared. International trade begins with the contract's formation, which should specify the terms the buyer will present to the bank when applying for the L/C. These terms should be clear, simple, verifiable, and contain minimal restrictions. The buyer should be specific in requirements for transport documents, such as the type of bill of lading and who issues it. The buyer must clearly define the description and packaging of the goods, using clear and straightforward language to facilitate the bank's document examination. The contract should avoid terms like "first-class carrier" or "shipment under specific weather conditions." When the documents the seller needs to present to the bank must meet such vague language, the negotiating bank will be uncertain and have to consult the applicant (buyer), inevitably delaying negotiation. Except for documents required for import customs clearance and mandatory official purposes, the buyer should not demand excessive documentation. The more documents required, the higher the chance the bank may find discrepancies, hindering the smooth operation of the documentary credit system.

Second, 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 for shipment based on the sales contract terms. However, when the seller presents compliant documents to the negotiating bank according to the sales contract, and the bank finds they do not meet the L/C terms, the bank can only negotiate based on the L/C, being unaware of the contractual terms. This inevitably leads to negotiation failure or conditional negotiation. If the seller promptly compares the L/C with the sales contract upon receipt, identifies deviations, and notifies the buyer to amend the L/C, these problems can be avoided.

Finally, it is crucial to note that the cargo owner should not issue a letter of indemnity to the carrier to obtain a clean bill of lading. In reality, cargo owners know that documents related to the goods must truthfully reflect their actual condition. This is not only a requirement for the bank during L/C examination but is also due to document fraud incidents. However, to obtain a clean bill of lading, sellers often request the carrier to remove remarks by issuing a letter of indemnity. In fact, the carrier has the right to make remarks on the condition of goods received for shipment, as this limits the carrier's responsibility. Banks are strongly opposed to the practice of issuing letters of indemnity. Some national laws do not recognize such letters of indemnity and consider them a fraudulent act, a collusion between the seller and the carrier to deceive the buyer. The real issue is that once such a letter of indemnity falls into the buyer's hands, the operation of the documentary credit becomes complicated.