Shipping goods to a buyer you have never met, in a country where you could not realistically sue, is an act of faith — unless the payment structure removes the faith from the equation. That is what a letter of credit does: it substitutes a bank's payment obligation for the buyer's. Used well, it lets a California exporter ship with confidence. Used carelessly, it produces rejected documents and unpaid invoices. Here is how the instrument actually works.
The core mechanics
In a documentary letter of credit, the buyer (the applicant) asks its bank (the issuing bank) to issue a credit in favor of the seller (the beneficiary). The bank commits to pay the seller a stated amount if — and only if — the seller presents documents that comply with the credit's terms: typically a commercial invoice, a transport document such as an ocean bill of lading, a packing list, and often an insurance certificate or inspection certificate. Most commercial credits incorporate the Uniform Customs and Practice for Documentary Credits, UCP 600, the International Chamber of Commerce rules that banks worldwide apply. In the United States, Article 5 of the Uniform Commercial Code also governs, and the two regimes coexist comfortably in a well-drafted credit.
The independence principle: banks pay against paper, not goods
The defining feature of a letter of credit is independence. The bank's obligation is separate from the underlying sales contract. The bank does not inspect the goods, does not care whether they conform, and cannot refuse payment because the buyer claims the shipment was defective — with a narrow exception for material fraud. This cuts both ways. The seller gets paid on compliant documents even if the buyer has second thoughts. But the buyer pays on compliant documents even if the cargo disappoints, and its remedy is a separate claim under the sales contract. The credit protects payment, not quality — quality protection comes from inspection certificates and the underlying contract terms.
Strict compliance: where sellers lose
Banks examine documents under a standard of strict compliance, and industry estimates have long suggested that a majority of first presentations are rejected for discrepancies. The reasons are usually mundane: a company name spelled differently on the invoice than in the credit, a shipment made a day after the latest shipment date, documents presented after the expiry date, a bill of lading missing a required notation. Under UCP 600, the bank has up to five banking days to examine documents and must state every discrepancy when it refuses. A discrepant presentation converts your secured payment into a request for the buyer's waiver — exactly the exposure the credit was meant to eliminate. The practical discipline: review the credit the day it arrives, demand amendments before shipping if any term cannot be met, and prepare documents against the credit's exact wording.
Confirmed credits and country risk
An unconfirmed credit leaves you exposed to the issuing bank — its solvency and its country's transfer restrictions. If the issuing bank sits in a jurisdiction with currency controls or political instability, ask for the credit to be confirmed by a U.S. or other first-rate bank. A confirming bank adds its own independent payment obligation, so you can present documents to that bank and rely on its undertaking rather than solely on that of the foreign issuing bank. Confirmation costs a fee, priced to the issuing bank's risk; for a meaningful shipment into a risky market, it is usually worth it.
Standby letters of credit
A standby letter of credit inverts the documentary credit. It is not the expected payment channel; it is a backstop drawn only on default, typically against the beneficiary's signed statement that the applicant failed to pay or perform. Standbys — often issued under the ISP98 rules rather than UCP 600 — are the international workhorse for securing open-account payment terms, distributor credit lines, and performance obligations, doing the work a personal or parent-company promise might do domestically but with a bank's balance sheet behind it. For a California company extending credit to a foreign distributor, a standby is often the cleanest middle ground between cash-in-advance and unsecured open account.
Negotiating the credit before you sign the sale
The letter of credit should be negotiated as part of the sales contract, not discovered afterward. Specify in the contract: the issuing bank's required standing, whether confirmation is required and who pays for it, the exact documents you will present, shipment and expiry dates with real margin, partial shipment and transshipment permissions, and which party bears bank charges. These details determine whether the credit is an asset or a trap, and they are far easier to fix before signature — a standard piece of international business deal work.
Talk to a California business attorney
If you are exporting on letters of credit — or being asked to open one as a buyer — a review of the credit terms before shipment can be the difference between payment on presentation and a discrepancy fight. Schedule a free consultation or call (949) 418-2113.
This article is attorney advertising and provides general information only. It is not legal advice and does not create an attorney–client relationship. Facts matter; consult a lawyer about your specific situation.
