LC vs Contract: What Happens When Goods Fail but Documents Pass?

When the contract collapses but the credit stands firm — Mr. Old Man untangles the rules, rights, and realities behind this classic trade finance dilemma.

QUESTION

Dear Mr. Old Man,

I came to know you through the praise and recommendation of my university lecturer. And when I encountered difficulties, the first person I thought of was not ChatGPT, but your valuable guidance.

Here is the issue I’m facing:

“An international sales contract serves as the basis for issuing a letter of credit (L/C), yet the two are legally independent. Suppose the seller delivers goods that do not meet the quality stated in the contract, but still presents documents that fully comply with the L/C terms and therefore receives payment.

In such a case, while the contract may have been terminated, what about the L/C?

There are two opposing views:

1. The contract and the L/C are closely connected, so if the contract is terminated, the L/C also becomes invalid.
2. The contract and the L/C are legally independent, so even if the contract is cancelled, the L/C remains valid.”

Please help me, because I believe ChatGPT alone cannot provide the most comprehensive perspective.

TM

___________

ANSWER

Dear TM,

Thank you for your question — and please send my regards to your lecturer for the kind introduction.

Chat GPT is indeed a powerful tool, but like all AI, it learns from existing online data and may not always provide precise interpretations in complex trade finance cases. So your choice to ask a human is well placed.

Let’s break it down with the relevant UCP 600 provisions:

Article 2 – Definition of Credit

A credit is an irrevocable undertaking by the issuing bank to honor a complying presentation.

Article 4 (a) – Credit vs Contract

A credit is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contracts — even if the credit references the contract.

Article 5 – Documents vs Goods, Services or Performance

Banks deal with documents, not with the actual goods or services.

Article 7 (a) – Issuing Bank Undertaking

If complying documents are presented, the issuing bank must honor the presentation.

Conclusion:

The letter of credit is independent of the sales contract. Once issued, the L/C remains valid until it expires or until all involved parties (issuing bank, confirming bank if any, and the beneficiary) agree to cancel it.

So even if the contract is terminated, the L/C stays alive — and if documents comply, payment must be made.

Can the buyer sue the seller if goods are not as per contract?

Yes — under the sales contract, not the L/C. Termination of the contract may limit some claims, but not all. For example:

• If the seller breached ongoing obligations like warranty or after-sales service, and the buyer suffered losses, legal action for damages may still be possible.
• You should consult a lawyer with expertise in international contract law, especially if the seller is overseas.

On injunctions against L/C payment:

If the issuing bank hasn’t paid yet, a buyer might try to seek a court injunction to stop payment. However:

• Courts are generally reluctant to intervene in L/C operations due to the autonomy principle.
• Even if granted, the injunction may be overturned — especially if the documents have already been negotiated by another bank.

So this path is not recommended, and should be a last resort under exceptional circumstances (e.g., fraud).

I hope this helps clarify the issue. The world of LCs is fascinating — where documents reign supreme, and trust is enforced by structure, not sentiment

Warm regards,

Mr. Old Man