Understanding Letters Of Credit In Nigeria: How It Works

1. Introduction
   
   A Letter of Credit ("LoC") is a trade finance tool that ensures a seller gets paid for goods, and the buyer gets the goods paid for. It is a contractual commitment by a foreign buyer's (importer's) bank that payment will be made to a beneficiary (exporter), provided that the terms and conditions stated in the letter of credit have been met as evidenced by the presentation of specified documents. See Conoil v. Vitol. S. A.¹ A guiding principle of an LoC is that the issuing bank will make payment based solely on the documents presented, and the issuing bank is not required to physically ensure the shipping of the goods or the genuineness of the documents presented.² If the documents presented are in accord with the terms and conditions of the LoC, the bank has no reason to deny the payment. More so, where the bank complies strictly with the buyer's instructions in making payment, the bank is entitled to the indemnity of an agent.³
   

• Importance of Letter of Credit in International Trade
  
  Trading globally involves a lot of unique factors and risks — that are not seen in domestic trade. Countries have different laws; it can take weeks for goods to be shipped; there is the risk of non-payment or non-delivery; and parties often do not know each other personally. Thus, the use of LoCs has become a very important aspect of international trade to protect buyers and sellers. On the part of the seller, LoCs guarantee payment upon fulfillment of the stipulated contractual conditions thereby mitigating the risk of non-payment, while on the buyer's part, it ensures that money is not released until the goods have been shipped or delivered.

2. Who are the parties involved?
   
   At its simplest, an LoC involves three main parties: the Applicant (Buyer), the Beneficiary (Seller), and the Issuing Bank (Buyer's Bank). However, the process can often involve additional parties to increase security and/or manage risks.
   
   The Parties in LoC transactions include:
   
   
   • Buyer (Applicant/Importer): the party who requests his bank to issue a letter of credit.
   • Seller (Beneficiary/Exporter): the party who receives his payment upon fulfilment of the terms and conditions of the transaction.
   • Issuing Bank: Also called an opening bank⁴ is responsible for opening and issuing the LoC at the buyer's request. It may specify a reimbursing bank where payments will be made.
     
     Additional Parties may include:

• Advising Bank: Usually located at the Seller's country, is the bank that advises the Seller that the LoC has been issued upon receipt from the Issuing bank. The advising bank may also verify the authenticity of the LoC but are not responsible for making payment. The Advising Bank could be a branch office of the Issuing Bank or a correspondent bank, or a bank appointed by the beneficiary.
• Confirming Bank: This bank provides an additional guarantee to the Issuing bank. This comes in, where the beneficiary seeks additional assurance of payment.
• Negotiating Bank: This bank could be a separate bank or an advising bank.⁵ It is responsible for negotiating the documents related to the LoC submitted by the Seller. That is, it receives and examines the seller's documents to ensure they adhere to the terms and conditions specified in the LoC. It makes payments to the Seller, subject to the completeness of the documents and claims reimbursement under the credit.⁶ So, it may either immediately credit or pay the seller/exporter based on the LoC terms, or, alternatively, it may pay the exporter once it has received funds from the issuing bank.
• Reimbursing Bank: This bank is responsible for making payments to the negotiating bank upon receipt of the necessary documents and verification that the conditions in the LoC have been fulfilled. This could be the correspondent bank of the issuing bank.

3. How does a Letter of Credit work?
   
   Usually, the seller demands an LOC while entering a sales contract. The buyer upon agreement on the terms of the sales contract, applies to a financial institution usually a bank to issue an LoC in favour of the Seller by submitting a written application and relevant documents. The issuing bank evaluates the buyer's creditworthiness and issues the LoC. ⁷
   
   The issuing bank sends the LoC to the advising bank which upon verification of its authenticity and approval of the terms therein, informs the Seller that the LoC has been issued. Along with the LoC, the Seller furnishes various documents like an airway/shipping bill, packing list, commercial invoice, insurance certificate, certificate of origin, certificate of inspection, and lading bill as proof of the fulfilment of the LoC stipulated conditions.8 The issuing bank makes payment to the Seller or the negotiating bank upon fulfilment of the requisite conditions and obligations.⁹
   
   It bares noting that, once an LoC has been issued and confirmed, the issuing bank has an absolute obligation to pay the Seller if the documents are in order and the terms of the credit are satisfied, irrespective of any dispute there may be between the seller and the buyer as to whether the goods are up to the underlying contract or not. Any such dispute between buyer and seller must be settled between themselves. See Nasaralai Enterprises Ltd v. Arab Nank (Nig) Ltd.¹⁰
   
   Below is a graphical representation of this process;
   
   

• Any difference between Letters of Credit and Bank Guarantees?
  
  LoCs and Bank Guarantees are both financial instruments in trade financing used as evidence of creditworthiness, risk mitigator, and peculiar to where parties do not have an established business relationship.¹¹ Despite these features, LoCs and Bank Guarantees have distinctive features and serve different purposes.
  
  LoCs are especially indispensable in international trade due to the difference in trade laws and the existence of impersonal relationship between parties. While bank guarantees can be utilised in both domestic and international trade but are often used in real estate contracts and infrastructure projects.¹²
  
  Under LoCs, banks undertake greater liability to ensure payment upon fulfilment of conditions specified without necessarily waiting for the buyer's default. In contrast, for bank guarantees, the bank is only required to step in when the buyer defaults on payment.¹³
  
  LoCs primarily address payment risks in international trade, while bank guarantee on the other hand addresses both performance or contractual defaults which could be in terms of goods or services delivery (i.e. performance-based guarantee), or payment (i.e. finance-based guarantee) or other contractual obligations.
  
  Parties under Bank guarantees consist of three (3)- both parties involved in the contract and the financial institution. On the other hand, parties in an LoC may consist of more than three (3) depending on the structure of the transaction.

4. Types of Letters of Credit
   
   LoCs can vary widely based on factors not limited to, the purpose of the transaction, specific requirements of the parties, payment terms, creditworthiness of the parties, regulatory considerations, industry-specific needs, and whether the LoC is revocable or irrevocable. As a result, there are several types of LoCs, each suited to different business needs and transaction structures, including commercial LoCs, standby LoCs, revolving LoCs, and transferable LoCs, among others.

• Commercial LoCs: one of the commonest form of LoCs, also called a documentary credit. In this form of LoC, the issuing bank makes payment directly to the seller as the beneficiary upon the fulfilment of the specified conditions.
• Revolving LoCs: Under this LoC, the issuing bank allows a customer (the buyer) make multiple number of draws up to a set limit over a specified period of time. They are most ideal for ongoing trade arrangement between an importer and exporter (e.g., regular shipments over a specified period). This LoC eliminates the need for multiple LoCs for each transaction and minimises amendments.
• Transferable or non-transferable LoCs: A transferable LoC can, with the seller's consent, be transferred in whole or part to a second beneficiary. They are commonly used when intermediaries are involved in a transaction. For example, when the beneficiary is a middleman who needs to pay suppliers. Usually, the transferee cannot transfer it further to another beneficiary, unless the LoC expressly provides otherwise.¹⁴ Under a non-transferable LoC, the Seller cannot transfer the credit to a third party and it is not convenient in transactions involving an intermediary.
• Revocable or Irrevocable LoCs: A revocable LoC can be altered or cancelled by the issuing bank without prior notice to the beneficiary. On the other hand, an irrevocable LoC cannot be altered or cancelled without the consent of the parties involved. An irrevocable LoC provides more security to a seller as the terms cannot be changed unilaterally unlike revocable LoCs. 
  
  On circumstances when a letter of credit may be revoked, the Court of Appeal has held that it can be cancelled at the stage of processing. However, it cannot be cancelled when the credit has been issued and forwarded to the confirming bank. Hence, it is advised that an importer that seeks to cancel a letter of credit should do so before it is issued and forwarded to the confirming bank.¹⁵ In Akinsanya v UBA Ltd. 16, the Supreme Court held that where a buyer or the issuing bank has cause to challenge the compliance with the conditions of the letter of credit and therefore desires to repudiate the contract, then he must act quickly.¹⁷
  
  Other instances where LoCs can be cancelled or revoked includes where the LoC is a Revocable LoC, which can be cancelled or amended at any time by the issuing bank or the buyer without the seller's consent, provided that the beneficiary has not yet presented the required documents for payment.

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Footnotes

1. (2018) 9 NWLR (Pt. 1625) 463.

2. See Nasaralai Enterprises Ltd v. Arab Nank (Nig) Ltd (1986) LPELR-1942(SC) where the Supreme Court held that "[t]he bank is under no duty to take any further steps to investigate the genuineness of a signature which, on the face of it, purports to be the signature of the person named or described in the letter of credit." The Apex Court further held that the duty of the issuing bank is to examine documents with reasonable care to ascertain that they appear on their face to be in accordance with the terms and conditions of the credit.

3. UBN Ltd. v. Osezuah (1997) 2 NWLR (Pt. 485) 28, P.40G-H.

4. Muskan S, "Letter of Credit (LC): Parties, Types and Documents" accessed at https://www.yourarticlelibrary.com/banking/letter-of-credit/letter-of-credit-lcparties-types-and-documents-banking/99061

5. Ibid.

6. Siddhi Parekh, "Letter of Credit (LC) - Meaning, Process & Role In International Trade" (August 31, 2022) accessed at https://www.dripcapital.com/resources/blog/letter-of-credit-lc

7. Banks usually impose a certain fee (usually a specific percentage of the LoC amount which may vary by bank and/or the size of the LoC) for extending these services.

8. All LoCs must stipulate an expiry date for presentation of documents for payments, acceptance or negotiation, notwithstanding the stipulation of a latest date for shipment. See Akinsanya v UBA Ltd (1986) LPELR-355(SC)

9. Supra. The bank can reject documents which do not comply with the terms and conditions of the letter of credit. See Nasaralai Enterprises Ltd v. Arab Nank (Nig) Ltd. (1986) LPELR-1942(SC) Pp 26 - 26 Paras A - D.

10. (1986) LPELR-1942(SC) Pp 23 - 23 Paras A – E. It is also worthy to note that the bank's obligation to honour the credit remains even if the bank has knowledge that the seller has allegedly committed a breach of the underlying contract with the buyer, which would have ordinarily allowed the buyer to rescind the contract, reject the goods, and refuse payment. This would not prevent the bank from honouring its obligation to pay, provided the documents provided comply with the requirements of the LoC. See The Export-Import Bank of the USA v. NDIC (2021) LPELR-53399(CA) Pp 20 - 24 Paras F – D.

11. Key Differences, Difference Between Letter of Credit and Bank Guarantee accessed at https://keydifferences.com/difference-between-letter-of-credit-and bank-guarantee.html

12. Ibid

13. Ibid. Except where the LoC is a standby LoC (SBLC). See standby LoC (SBLC) discussed below.

14. WallStreetMojo Team, "Letter of Credit" (November 10, 2021) accessed at https://www.wallstreetmojo.com/letter-of-credit-lc/

15. UBN Ltd. v. Okwara 1998) 1 NWLR (Pt. 532) p. 118 at 126 Para H; Akinkunmi Abolade, "Understanding Letters of Credit & The UCP 600 Rules in Nigeria" (February 9, 2024)

16. Akinsanya v UBA Ltd. (1986) 4 NWLR (Pt. 35) 273.

17. supra.

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