Definition
Bank payment undertaking.
Instrument for payment in international trade.
Etymology & Origin
From Latin 'littera' (letter, epistle) and 'credere' (to believe, to trust). A 'letter of credit' is, etymologically, a 'letter of trust' — a written instrument by which the issuer extends its credit to the beneficiary. The instrument originated in medieval international trade, where merchants required a means of payment that did not depend on the physical transportation of gold across dangerous routes. The modern letter of credit, governed by the Uniform Customs and Practice for Documentary Credits (UCP 600) published by the International Chamber of Commerce, is the lineal descendant of these medieval instruments.
Full Legal Analysis
Letter of Credit: The Engine of International Trade
International trade presents a fundamental problem of trust. A seller in one country does not wish to ship goods before receiving payment, fearing the buyer may not pay; a buyer in another country does not wish to pay before receiving the goods, fearing the seller may not ship. The letter of credit resolves this impasse by interposing a bank's credit between the parties. The buyer's bank issues a written undertaking to the seller: upon presentation of the specified documents (typically, a bill of lading showing shipment, an invoice, an insurance certificate, a certificate of origin), the bank will pay. The seller ships, presents the documents, and is paid by the bank — which then reimburses itself from the buyer.
The Doctrine of Independence and Strict Compliance
Two principles govern letters of credit. The first is the doctrine of independence: the letter of credit is a separate and independent transaction from the underlying sale contract. The bank's obligation to pay against compliant documents is not affected by disputes about the goods or the underlying bargain. The bank deals in documents, not goods; it examines the documents presented and pays if they conform on their face to the requirements of the credit, without investigating the actual state of the underlying transaction. The second principle is strict compliance: the documents presented must comply strictly with the terms of the credit. Even minor discrepancies — a misspelled name, a date out of range, a missing signature — may justify the bank in refusing payment. The strictness reflects the bank's need for clear, mechanical standards that it can apply without becoming an arbiter of commercial disputes.
Types of Credit and the Fraud Exception
Letters of credit take several forms. A revocable credit may be amended or cancelled by the issuing bank without notice; an irrevocable credit cannot be amended or cancelled without the consent of all parties and is now the commercial norm. A confirmed credit carries the additional undertaking of a second bank (typically, a bank in the seller's country), giving the seller the protection of two banks' credit. A sight credit is payable upon presentation of compliant documents; a usance credit is payable at a deferred date. The independence doctrine is qualified by the fraud exception: where there is clear evidence of fraud by the beneficiary in the underlying transaction — forged documents, a sham shipment, the knowing presentation of false documents — the bank may refuse payment, and the court may enjoin payment, on the ground that the doctrine of independence cannot shield outright fraud. Indian courts apply the UCP 600 framework and these common-law principles, recognising the letter of credit as the indispensable engine of international trade.
“The letter of credit is the bridge over the chasm of distance and distrust that separates buyer from seller in international trade. The bank stands between them, dealing in documents and not in goods, paying on compliance and withholding on discrepancy. The system works because its rules are mechanical, its independence unshakeable — and because, when fraud appears, the law reserves the power to pierce the instrument and reach the truth beneath.”
