Trade Finance: Legal instruments for the protection of international payments

Mainstream

International trade finance is not just a banking product. It's legal engineering of payment.

The question is not whether the bank can make the calculations. The main question is who bears the risk of non-payment, and at what point this risk passes from the seller to the buyer, and from the buyer to the bank.

Therefore, effective protection of international settlements is based on three checks:

1. Is the settlement instrument appropriate for the level of trust between the parties?
2. Whether the legal structure of the transaction is in accordance with applicable law and the uniform international rules (UCP 600, URDG 758, ISP98).
3. Whether the paying bank’s obligation is unconditional or whether there are loopholes in it to refuse payment.

If these three issues are not resolved at the contract stage, the company risks shipping the goods and being left without payment, having only a set of useless documents in hand.

When structured trade finance is needed

Trade finance tools become critical when:

• The buyer and seller are in different jurisdictions.
• There is no long credit history between the parties;
• the transaction amount is significant for the financial sustainability of the business;
• the seller must produce or purchase the goods before payment is received;
• the buyer fears that the seller will not ship the goods after prepayment;
• The transaction involves a long transit or several stages of delivery;
• the law of the buyer’s country restricts currency transfers;
• external financing is required against future receivables;
• obligations under the tender, advance payment or guarantee period must be fulfilled;
• The project involves EPC contracts, industrial equipment or complex services.

The mistake that most of the participants make

Many exporters and importers start discussing the deal with the question:

Which bank will open the letter of credit?

That's the wrong first question.

The right question is:

What legal structure of payment would eliminate the risk my company is not prepared to bear?

Sometimes the best result is an irrevocable documentary letter of credit with the confirmation of a first-class bank. Sometimes it is a guarantee of payment on demand. Sometimes it is a documentary collection with post-financing. Sometimes a combination of a standby letter of credit and an open account.

Trade finance does not require a pattern, but a precise setup for a specific risk, jurisdiction and product.

Step 1. Determine the risk profile of the transaction

The first thing to study is not the cost of financing, but who of the counterparties is at risk.

The key risks for the seller (exporter):

• risk of non-payment after shipment (commercial risk);
• the risk of delay or denial of payment due to bureaucratic barriers in the buyer’s country (country risk);
• risk of non-compliance of the submitted documents with banking standards (documentary risk);
• Risk of fraudulent replacement or tampering with instructions.

The key risks for the buyer (importer):

• the risk of payment without actual shipment or shipment of poor quality goods;
• the risk that the goods do not meet the contractual specifications;
• the risk of blocking funds before shipment (liquidity risk);
• The risk of bankruptcy of the seller after receiving the advance.

The right trade finance tool is one that asymmetrically protects the weaker side at a particular point in the trade.

Step 2. Selecting a Trade Finance Instrument

Each instrument has its own legal nature and shifts risk in favor of one of the parties.

Documentary Credit (Letter of Credit, L/C)

This is the obligation of the issuing bank to pay the seller against the submission of documents strictly complying with the terms of the letter of credit. It's regulated by UCP 600.

Perfect when:

• The seller needs confidence in the payment from the bank, not from the buyer.
• The buyer needs a guarantee that the bank will pay only after shipment;
• The parties are located in jurisdictions with high country risks.

The key principle: Banks work with documents, not goods. Payment is made against documents that meet the conditions, even if the goods are still in transit. The legal protection of the seller depends on the accuracy of the wording in the application for a letter of credit.

Bank Guarantee (Demand Guarantee)

It is an independent obligation of the bank to pay the beneficiary at his request, without having to prove a breach of contract. The URDG 758 is regulated.

Types of guarantees:

• tender guarantee (bid bond);
• Guarantee of return of advance payment (advance payment guarantee);
• Guarantee of proper execution (performance bond);
• Retention money guarantee (retention money guarantee).

Key risk: The beneficiary may claim payment in bad faith. The legal protection of the principal is based on the restriction of the right of claim through strict wording of the guarantee text, and not on trust in the beneficiary.

Documentary Collection (Documentary Collection)

This is a banking operation in which the seller's bank transfers documents to the buyer's bank with instructions to issue them against payment (D/P) or acceptance of a draft (D/A). Regulated by URC 522.

Suitable when:

• The parties have a sufficient level of trust;
• the buyer needs a delay, and the seller retains control over the documents of title;
• The cost of banking services should be lower than with a letter of credit.

The main risk to the seller: The buyer may simply not pick up the documents and not pay for the goods that have already arrived at the port.

Standby Letter of Credit (SBLC)

It is a hybrid instrument that, unlike a commodity letter of credit, is not designed to serve an ongoing supply. It serves as a default insurance and is regulated by UCP 600 or ISP98.

Perfect for:

• payment on an open account;
• guarantees of fulfillment of financial obligations;
• transactions where the documentary letter of credit is excessive and the risk of non-payment remains.

Step 3. Analyze the legal envelope

The choice of tool is only 20% of the work. The remaining 80% is the legal structure. A mistake at this stage makes even a confirmed letter of credit useless.

It is necessary to check:

1. Uniform rules. What set of rules applies (UCP, URDG, ISP, URC) and what exceptions or modifications are made to the text?
2. Applicable law. Which country regulates the bank’s liability? This is critically important, as it determines the limitation period, the possibility of interim measures and injunction of payment.
3. Jurisdiction. Where will disputes between the bank and the beneficiary be dealt with? The inclusion of a court clause at the issuing bank’s location is a standard but not always beneficial practice for the beneficiary.
4. Independence of the obligation. Is the abstract nature of the bank’s obligations clearly stated? Any reference to the main contract in the payment terms of the guarantee (except for the identification of the transaction) creates the risk of reclassification of the guarantee into an accessory guarantee.
5. Terms of payment. What documents should the seller submit? Is a standard bill of lading and invoice sufficient, or can the bank require a certificate issued by the buyer? The latter makes the defense illusory.

Step 4. Structure the terms of payment

The strength of a letter of credit or guarantee is in the details.

It is critical for a letter of credit to record:

• expiration date and place of expiration (preferably in the beneficiary's country);
• the admissibility of partial shipments and transshipments;
• accurate description of the goods and documents;
• Whether the tolerance clause in quantity and amount has been incorporated;
• who pays the bank commissions;
• Can the letter of credit be transferred to the second beneficiary (if the seller is a trader)?

A common mistake: The wording in the letter of credit is copied from the contract automatically, without taking into account the banking practice of checking documents under the doctrine of "strict compliance". Even a typo in the bill of lading, which does not change commercial sense, gives the bank the formal right to refuse payment.

Step 5. Ensure the quality of document management

Trade finance is the management of documents. The court or arbitration will look not at whether the goods have arrived, but at whether the documents were submitted in exact accordance with the instructions.

We need to prepare:

• commercial invoice, exactly repeating the description of the goods from the letter of credit;
• a complete set of clean onboard bills of lading;
• packing sheet;
• Certificate of origin;
• insurance policy or certificate (with coverage not less than 110% of the cost of CIF/CIP);
• transport document without reservations about damage to the cargo;
• certificates of quality, weight, inspection, if any.

Discrepancies (discrepancies) are particularly dangerous. The bank is not obliged to notify them in advance and cannot correct them for the beneficiary. The only protection is a preventive audit of documents before they are submitted to the bank.

Step 6. Use confirmation and discounting

For a seller from Europe working with a buyer from a country with high country risks, it is important not only the obligation of the issuing bank, but also the confirmation (confirmation) of the letter of credit by a first-class European bank.

Confirmation creates an independent obligation of the confirming bank to the beneficiary. This transforms the issuing bank’s country risk into the bank’s risk in an acceptable jurisdiction.

In addition, a confirmed letter of credit with deferred payment can be discounted (accounted for) with the attraction of financing at rates close to the rates of the beneficiary’s country, and not the borrower’s country.

Step 7. Minimize the sanctions risks

Modern trade finance is impossible without multi-level compliance checks.

Any bank in the chain (issuing bank, confirming bank, ramboursing bank) checks:

• whether the goods are subject to export controls or dual-use
• Whether the parties, their beneficiaries or vessels are sanctioned (EU, US, UN);
• Does the ship not enter ports under embargo?
• Do not make payments through the subsanctioned correspondent banks?

If at any stage the bank refuses to make a payment, citing a sanctions clause, it is likely to be right. The legal protection here is not to challenge the refusal, but to structure the transaction with pre-verified participants and routes.

Step 8. Prepare a plan of action in case of a dispute

Even with impeccable documents and a first-class bank, force majeure, bankruptcy of the issuing bank or unfair actions of the counterparty can occur.

The emergency response strategy includes:

1. Injunction. The possibility to quickly obtain in court of the country of the guarantor bank or issuer a ban on payment in case of proven fraud of the beneficiary (exception of fraud). This is an extraordinary measure that requires a very high standard of proof.
2. Interim measures. Arrest of funds in correspondent accounts of a debtor bank in third countries until the dispute is resolved on the merits.
3. Assignment of proceeds. Structure future proceeds under a letter of credit or guarantee to attract financing or protect against the seller's creditors.
4. Escalation on the banks. Use of SWIFT (MT799, MT999) and interbank correspondence procedures to fix a position and expedite payment before the trial phase.

Comparison of trade finance instruments in terms of protection

How to strengthen your position before signing a contract

The best settlement protection is not created at the time of a dispute, but at the time of agreement of the Payment Terms section.

The international contract of sale must include:

• A clear indication of the type of instrument and the applicable rules (e.g., UCP 600, ISP98);
• the time of opening a letter of credit or issuing a guarantee (is a condition preceding shipment);
• the requirement for the rating of the issuing bank and the obligation to confirm by a bank with a rating not lower than A;
• the buyer’s obligation to ensure that the credit is amended if reasonably requested by the seller;
• distribution of all bank commissions;
• provision that the risk of delay in payment due to the fault of the issuing bank lies with the buyer;
• a condition on the seller's right to suspend shipment if the instrument is not opened on time;
• a sanction clause giving the bank the right to refuse the transaction, but not exempting the buyer from searching for an alternative payment method;
• the exact details of the instrument in the annex to the contract (proforma letter of credit or guarantee text) to avoid a dispute over compliance at the issuing stage.

Common Mistakes in Using Trade Finance

1. Shipment before receipt of notice of opening If the seller shipes the goods without confirmation from the advising bank, he acts at his own risk, even if the buyer sent a copy of SWIFT.

2. The presence of the clause "payment against the acceptance certificate signed by the buyer" in the terms of the letter of credit puts the seller in complete dependence on the will of the counterparty and destroys the independent nature of the letter of credit.

3. A letter of credit expiring on a bank holiday is automatically extended until the next business day, but it is better to avoid such uncertainty.

4. A contract may be subject to English law, and a letter of credit to the law of the country of the issuing bank. In a dispute, this creates two parallel legal realities.

5. The warranty subordinate to URDG 758 gives the beneficiary maximum protection. Attempting to apply national law to it may lead to the court seeking proof of damages, which makes the guarantee meaningless.

6. Second-tier risk transfer: This is the risk of a correspondent bank, banking system or country through which payment is made. They need to be mapped in advance.

Checklist for exporter before shipment

Before sending the goods to the trade finance instrument, make sure that:

1. The instrument is issued in an agreed form and has entered into force.
2. You received it through an advising bank, not directly from the buyer.
3. The terms of the instrument are fully in line with the contract.
4. All necessary documents can be obtained by you without the participation of the buyer.
5. The transport document will be “clean” (without any damage clauses).
6. The insurance cover meets the requirements of the instrument.
7. The validity period is sufficient for shipment and submission of documents to the bank.
8. All parties, the ship and the route were checked for sanctions risks.
9. The documents before filing with the bank are checked by the internal auditor for discrepancies.
10. You have a plan of action if the bank wrongfully refuses to pay.

What to do if the bank does not pay on the letter of credit

Five-step action plan:

1. Request a written reasoned refusal from the bank. The bank must indicate each discrepancy in the documents on the basis of which it refuses. Under UCP 600, the bank loses the right to invoke discrepancies not specified in this notice (the “preclusion” rule).
2. Analyze the discrepancies. If technical, submit the corrected documents within the term of the credit.
3. Send an official objection through your bank with reference to the strict compliance doctrine and the International Standard of Banking Practice (ISBP 745).
4. To demand payment from the buyer, since the refusal of the bank on formal grounds does not terminate the buyer's obligation to pay for the goods accepted under the main contract.
5. Initiate a dispute. Depending on the jurisdictional clause, this may be arbitration or a lawsuit in court at the location of the issuing bank to recover the amount of the letter of credit as a contractual debt.

FAQ

Which is more reliable: Letter of credit or bank guarantee?

These are tools for different tasks. A letter of credit protects both the seller and the buyer, making the bank a payer for the transaction. A warranty on demand is a financial sword in the hands of the beneficiary that provides payment on demand. For the exporter shipping the goods, a letter of credit with confirmation gives more comprehensive protection. For a contractor requiring a refund of an advance, a warranty is appropriate.

Can the risk of a bank’s refusal to pay under a letter of credit be completely eliminated?

Risk cannot be completely ruled out, since there is always the human factor and the doctrine of strict conformity. But it can be minimized to statistical error, involving professional consultants to reconcile the text of the letter of credit and audit documents before they are submitted to the bank.

What to do if the issuing bank goes bankrupt?

If the letter of credit has been confirmed, the obligation of the confirming bank shall remain in full. If not, the seller becomes the bank’s competitive creditor. That is why confirmation of a letter of credit in a highly rated bank is not a transaction cost, but a charge for the transfer of credit risk.

How to deal with unfair claims under guarantee?

It is necessary to urgently apply to the court with jurisdiction over the guarantor bank with a statement on the prohibition of payment (injunction) on the basis of obvious fraud of the beneficiary (exception of fraud). The standard of proof is very high: It is required to prove that the claim is knowingly unfair, and not just a dispute under the contract.

Does trade finance apply only to goods?

Nope. The tools are used extensively in services transactions, construction (EPC), mergers and acquisitions (to provide assurances and guarantees), and to secure litigation costs.

What is structured trade finance?

This is a combination of classic instruments (letters of credit, guarantees, insurance) with supply chain financing mechanisms (supply chain finance), forfeiting and securitization of receivables, which allows you to optimize the balance sheet and attract capital for a portfolio of trading assets.

Related services

• International Trade, Distribution & Cross-Border Transactions
• Commercial Contracts
• International Arbitration, Commercial Litigation & Cross-Border Disputes
• Sanctions, Export Controls & International Compliance
• Asset Tracing & International Enforcement
• Banking & Finance Law

Related material

• How to choose an arbitration clause for an international supply contract
• How to Create an International Supply Contract Without Critical Errors
• Sanctions clauses in international contracts: work
• Force majeure and hardship in supply chains: protection in 2024
• How to check a foreign counterparty before concluding a contract
• Execution of foreign judgments and arbitral awards in Europe
• Bank guarantees URDG 758: How not to lose the right to payment
• Legal risks of documentary operations: Review of ICC Practice

Conclusion

Trade finance is not a banking formality, but a legal infrastructure of trust in an international transaction.

A strong position is not based on the assumption that the counterparty is in good faith, but on the engineering of the payment obligation, where the obligor is a first-class bank, and the terms of payment exclude freedom of appreciation.

In international trade, the winner is not the one who offered the best price, but the one who legally structured the cash flow, leaving himself the right to receive money in any event.