What Buyers Must Know About Letters Of Credit

An Australian company buys automotive parts from a Thai supplier. The parties agree to settle the transaction through a letter of credit. When the shipment is delivered to the buyer, he finds that the goods are defective. The Australian company calls the issuing bank, i.e. the company’s bank, in order to stop the payment to the supplier. The issuing bank refuses. Who is right?

Credit Transaction VS Sale Transaction

Articles 4 and 5 of the UCP 600 state that the letter of credit transaction and the sale transaction are two separate transactions: one is a transaction of payments against documents, the other is a transaction of payment against goods. One transaction cannot affect the other.

When the Australian company agrees to pay the Thai company through a letter of credit, the Australian company is signing a contract whereby they will receive goods against payment provided through a letter of credit.

When the banks involved agree to a letter of credit transaction between the Australian company and the Thai company, they agree to pay (and to get paid) against presentation of documents defined in the terms of the credit.

The banks will just look at whether the documents comply with what has been negotiated in the letter of credit transaction. They will not assess whether the goods are compliant with what has been negotiated between the parties in the sale transaction.

Principle of autonomy letter of credit

Banks Check The Documents, Not The Goods

Let’s say that the Australian company ordered 1,000 pieces of automotive parts from the Thai supplier. The Australian company will instruct the issuing bank that a bill of lading for 1,000 pieces of automotive parts arriving at the port of Brisbane will be presented by the seller at the advising bank (the seller’s bank).

The issuing bank will check that the bill of lading presented by the seller complies with the bill of lading stated by the buyer in the letter of credit. Therefore, if the Thai supplier presents a bill of lading stating that 997 pieces of automotive parts have been delivered to the port of Brisbane, the issuing bank may refuse to pay.

But if the bill of lading presented by the Thai supplier is for 1,000 pieces of automotive parts, and therefore it complies with the terms of the credit, the bank cannot refuse payment. For the purposes of the letter of credit transaction, everything complies.

Whether those 1,000 pieces of automotove parts are perfect or defective is out of the terms of the letter of credit.

Therefore, the Australian company’s bank is right: the buyer cannot stop payment to the Thai supplier.

The Principle Of Autonomy

This principle that separates the sale and the payment transaction is called principle of autonomy, and it is perhaps the most important thing that the buyer should be aware of when he agrees to settle an international sale contract through a letter of credit. Essentially, the buyer relinquishes his ability to leverage on the seller through payment, because he will have to pay anyway.

The reason behind the principle of autonomy is that the purpose of the letter of credit is to assure payment to the seller. We wrote several articles on other ways to settle and international sale contract, but you will notice that, apart from cash in advance, which is not convenient for the buyer either, the letter of credit is the only payment method that is really secure for the seller.

If buyers could stop payment under a letter of credit unilaterally, this payment method will cease its function of assuring payment to the seller, and international trade will be negatively affected.

Also, the principle of autonomy relieves banks from having to check on the goods, but leaves them only with a formal check; if they had to do a quality control, they might stop outright to offer letters of credit, or the fees to do so would be unbearable.

Know What You Are Signing Up For

To conclude, the principle of autonomy makes perfect sense, but the buyer must know what he is signing up for. Anyway, the buyer is not left completely alone: in case he receives goods that do not comply with the agreed quality, he can always sue the seller on the basis of the sale transaction. That could be perfectly doable in certain situations, for example, where a free trade agreement with mutual assistance in law enforcement exists between the two countries.

He is also protected in case of illegality or fraud, in which case he could even be able to stop payment under a letter of credit, though that will be assesses on a case by case basis.

Globartis Research Center