What is LC ?
The Letter of Credit is a bank undertaking of payment separate from the sales or other contracts on which it is based. It is a way of reducing the payment risks associated with the movement of goods. Expressed more fully, it is a written undertaking by a bank (issuing bank) given to the seller (beneficiary) at the request, and in accordance with the buyer’s (applicant) instructions to effect payment ” that is by making a payment, or by accepting or negotiating bills of exchange (drafts) ” up to a stated amount, against stipulated documents and within a prescribed time limit.
Why use LC ?
The need for a letter of credit is a consideration in the course of negotiations between the buyer and seller when the important matter of method of payment is being discussed. Payment can be made in several different ways: by the buyer remitting cash with his order; by open account whereby the buyer sends payment at an agreed time after receiving the goods; or by documentary collection through a bank in which case the buyer pays the collecting bank for account of the seller in exchange for shipping documents which would include, in most cases, the document of title to the goods. In the aforementioned methods of payment, the seller relies entirely on the willingness and ability of the buyer to effect payment. When the seller has doubts about the buyer’s creditworthiness and wishes to ensure prompt payment, the seller can insist that the sales contract provides for payment by an irrevocable letter of credit. Furthermore, if the bank issuing the letter of credit (issuing bank) is unknown to the seller or if the seller is shipping to a foreign country and is uncertain of the issuing bank’s ability to honor its obligation, the seller can, with the approval of the issuing bank, request its own bank “or a bank of international repute such as HSBC bank or top 50 banks” to assume the risk of the issuing bank by confirming the letter of credit.
Basic Types of Letters of Credit
There are three basic features of letters of credit, each of which has two options. These are described below. Each letter of credit has a combination of each of the three features.
Letters of credit can permit the beneficiary to be paid immediately upon presentation of specified documents (sight letter of credit), or at a future date as established in the sales contract (term/usance letter of credit).
Letters of credit can be revocable. This means that they can be canceled or amended at any time by the issuing bank without notice to the beneficiary. However, drawings negotiated before notice of cancellation or amendment must be honored by the issuing bank. An irrevocable letter of credit cannot be canceled without the consent of the beneficiary.
A confirmed LC is a Bank Credit Letter where the payment guarantee of the seller or exporter is backed up by a second bank or a confirming bank. In simple words, in case the first bank defaults to pay, then the payment will be covered by the second bank. This type of trade finance payment method is used by importers and exporters in international trade where an additional guarantee is provided to the original documentary credit from a second bank. The borrowers are required to apply for the confirmed LC if the seller is not convinced about the creditworthiness of the issuing bank of the original letter.
Contrary to unconfirmed LC, it refers to a documentary credit where the exporters or sellers do not acquire any additional or second guarantee from a second bank. It means unconfirmed LCs are those where there is only a guarantee of payment by the original issuing bank. Here the second bank involves only acts as an intermediary and helps process a transaction. There is no additional confirmation by the secondary bank. Ensuring payment security is the most common reason for acquiring a letter of credit services as a means of payment in international transactions. Therefore, most documentary credits are unconfirmed LCs.
Benefits of LC
- Letters of credit open doors to international trade by providing a secure mechanism for payment upon fulfilment of contractual obligations.
- A bank is substituted for the buyer as the source of payment for goods or services exported.
- The issuing bank undertakes to make payment, provided all the terms and conditions stipulated in the letter of credit are complied with.
- Financing opportunities, such as pre-shipment finance secured by a letter of credit and/or discounting of accepted drafts drawn under letters of credit, are available in many countries.
- Bank expertise is made available to help complete trade transactions successfully.
- Payment for the goods shipped can be remitted to your own bank or a bank of your choice.
- Payment will only be made to the seller when the terms and conditions of the letter of credit are complied with.
- The importer can control the shipping dates for the goods being purchased.
- Cash resources are not tied up.
The Uniform Customs and Practice for Documentary Credits is an internationally agreed upon set of rules for all parties involved in all types of letter of credit transactions. The rules, which were adopted by the International Chamber of Commerce in Vienna in 1933, have been revised several times and are used by banks in practically all countries. The Uniform Customs and Practice for Documentary Credits, currently applicable, is a set of rules which, when not in contravention of local laws, are binding on the parties who have adopted them. The authority of UCP lies in its universal acceptance which is acknowledged by a statement on the letter of credit itself. All Top bank Documentary Letters of Credit are issued subject to UCP. Copies of the Uniform Customs and Practice for Documentary Credits are available upon request from your bank office.
- Letters of credit are separate transactions from the sales or other contracts on which they may be based, and banks are in no way involved with or bound by such contracts, even if reference to them is included in the letter of credit.
- In letters of credit transactions, all parties deal with documents and not with the underlying contracts to which the documents may relate.
- Before payment or acceptance of drafts is effected, banks bear the responsibility for examining the documents to ensure that they appear on their face to be in accordance with the terms and conditions of the letter of credit.
- Banks bear no responsibility for: the form or genuineness of documents; for the goods described in the documents; or the performance of the seller of the goods.
Special Types of Letters Of Credit
So far a description has been provided of the basic types of letters of credit used to cover the shipment of goods. In addition to these basic types, there are various specialized formats that meet particular sets of circumstances.
A red clause letter of credit incorporates a clause, traditionally written in red, which authorizes the bank acting as the negotiating or paying bank to pay the beneficiary in advance of shipment. This enables the purchase and accumulation of goods from a number of different suppliers, and the arrangement of shipment in accordance with the letter of credit terms. Such advances will be deducted from the amount due to be paid when the documents called for are presented under the letter of credit. If the beneficiary fails to ship the goods or cannot do so before the expiry of the letter of credit, the issuing bank is bound to reimburse the negotiating or paying bank, recovering its payment from the applicant. Variations of such credits may also require that any advances be secured by temporary warehouse receipts until shipment is effected. Beneficiaries of red clause letters of credit are invariably brokers/agents of buyers in a particular field.
A transferable letter of credit allows the beneficiary to act as a middleman and transfer his rights under a letter of credit to another party or parties who may be suppliers of the goods. Depending on whether the letter of credit permits partial shipments, fractional amounts may be transferred to more than one beneficiary. The letter of credit however, can be transferred only once: the secondary beneficiaries cannot transfer their rights to a third party. Transfer of a letter of credit can be made on specific application by the original beneficiary to the authorized transferring bank To be transferable, a letter of credit must be so marked by the issuing bank which can only do so on the applicant’s specific instructions. The applicant should be aware that any second beneficiary, the probable supplier, is usually a party not likely known to the applicant. The terms and conditions of the transferred letter of credit must be identical to those of the original letter of credit with the following exceptions:
- The original beneficiary may be shown as the applicant on the transferred credit.
- The amount of the letter of credit, and unit prices if any, may be less than in the original letter of credit (the difference being the original beneficiary’s profit margin).
- The latest shipment date, if any, and expiry date as shown on the original letter of credit should be shortened.
- The percentage of insurance coverage, if any, should be increased to satisfy the requirements of the original letter of credit.
- When a drawing takes place, the original beneficiary normally substitutes his invoices for those of the second beneficiary for up to the amount and unit prices available under the original letter of credit, and draws the difference as profit.
Although not recorded on a letter of credit, “back-to-back” is a term used in transactions involving two irrevocable letters of credit.
Such transactions originate when a seller receives a letter of credit covering goods which must be obtained from a third party who in turn requires a letter of credit. The “second” issuing bank looks to the first issuing bank for reimbursement after paying under the second letter of credit.
The difference between back-to-back letters of credit and transferable letters of credit, is such that in a transferable letter of credit, the rights under the existing letter of credit are transferred. In a back-to-back transaction, different letters of credit are actually issued. Because technical problems can arise in back-to-back transactions, banks tend to discourage their use.
Steps in an Import LC Transaction
The sales contract is the formal agreement between the buyer and seller specifying the terms of sale that both parties have agreed upon. The contract should include: a description of the goods; the amount; the unit price; the terms of delivery; the time allowed for shipment and presentation of documents; the currency; and the method of payment.
The bank’s letter of credit application and agreement forms, when executed, constitute a payment and reimbursement contract between the issuing bank and its customer. It is also the customer’s instruction to the issuing bank. The letter of credit must be issued exactly in accordance with the customer’s instructions; therefore, it is important that the application be completed fully and accurately, so as to avoid the inconvenience of having to have the letter of credit amended. The agreement constitutes an undertaking by the customer to reimburse the issuing bank for drawings paid in accordance with the terms of the letter of credit, and normally takes the form of an authorization to debit the customer’s account.
The issuing bank prepares the letter of credit as specified in the application and forwards it by tele-transmission or airmail to the advising bank, (a branch or correspondent of the issuing bank). The issuing bank instructs the advising bank as to whether or not to add its confirmation, as per their customer’s instructions.
The advising bank forwards the letter of credit to the beneficiary (seller) stating that no commitment is conveyed on its part. However, if the advising bank has been asked to confirm the letter of credit and agrees to do so, it will incorporate a clause undertaking to honour the beneficiary’s drafts, provided the documents evidence that all terms and conditions of the letter of credit have been complied with.
Documents related LC
There is no limit to the number and variety of documents which letters of credit may stipulate. The following is a list of documents most commonly seen in a letter of credit transaction. Each document is described in brief with a check-list for preparing the document. As already stated, the beneficiary should, on first being advised of the letter of credit, examine it carefully and be satisfied that all the documentary requirements can be complied with. Unless the documentary requirements can be strictly complied with, the beneficiary may not receive payment from the issuing bank. If there are any requirements that cannot be complied with, the beneficiary should immediately request the applicant to arrange for an appropriate amendment to the letter of credit.
A draft is a bill of exchange and a legally enforceable instrument that may be regarded as the formal evidence of debt under a letter of credit. Drafts drawn at sight are payable by the drawee on presentation. Term (usance) drafts, after acceptance by the drawee, are payable on their indicated due date.
Checklist :
- Drafts must show the name of the issuing bank and the number and date of the letter of credit under which they are drawn.
Drafts must be drawn and signed by the beneficiary of the letter of credit. - The terms of the draft must be expressed in accordance with the tenor shown in the letter of credit; e.g., at sight or at a stated number of days after the bill of lading/shipment date.
- The amount in words and figures must agree and be within the available balance of the letter of credit and in the same currency as the letter of credit.
- The amount must agree with the total amount of the invoices unless the letter of credit stipulates that drafts are to be drawn for a given percentage of the invoice amount.
The commercial invoice is an itemized account issued by the beneficiary and addressed to the applicant, and must be supplied in the number of copies specified in the letter of credit.
Checklist :
- The invoice description of the goods must be identical to that stipulated in the letter of credit.
- Unit prices and shipping terms, ie., CIF, FOB, etc., must be as stipulated in the letter of credit. Extensions and totals should be checked for arithmetical correctness. For definitions of CIF, FOB etc.,
An air waybill is a receipt issued by an air carrier indicating receipt of goods to be transported by air and showing goods consigned to a named party. Being a non-negotiable receipt it is not a document of title.
Checklist :
- Only the goods invoiced and specified in the letter of credit may be covered by the air waybill.
- If the letter of credit stipulates that freight is to be prepaid; or if the invoice is priced CIF or CFR; or if freight is otherwise included in the invoice: the air waybill must indicate that freight has been paid.
- The airport of departure and airport of destination must be as stipulated in the letter of credit.
- The number of packages and gross weight shown on the air waybill must be consistent with the other documents.
- An air waybill issued by a forwarder is not acceptable.
Under the terms of a CIF contract, the beneficiary is obliged to arrange insurance and furnish the buyer with the appropriate insurance policy or certificate. The extent of coverage and risks should be agreed upon between the buyer and seller in their initial negotiations and be set out in the sales contract. Since the topic of marine insurance is extremely specialized and with conditions varying from country to country, the services of a competent marine insurance broker are useful and well-advised.
As the name suggests, a certificate of origin certifies as to the country of origin of the goods described and should comply with any stipulations in the letter of credit as to originating country and by whom the certificate is to be issued. The certificate should be consistent with and identified with the other shipping documents by shipping marks and numbers, and must be signed.
When a letter of credit calls for an inspection certificate it will usually specify by whom the certificate is to be issued; otherwise, the same general comments as in the case of the certificate of origin apply. As a preventative measure against fraud or as a means of protecting the buyer against the possibility of receiving substandard or unwanted goods, survey or inspection certificates issued by a reputable third party may be deemed prudent. Such certificates indicate that the goods have been examined and found to be as ordered.
A packing list is usually requested by the buyer to assist in identifying the contents of each package or container. It must show the shipping marks and number of each package. It is not usually required to be signed.
Steps in an Export LC Transaction
Upon receiving the letter of credit, the beneficiary should examine it carefully and be satisfied that all the terms and conditions can be complied with. If this is not possible, the beneficiary should request the applicant to arrange an amendment to the letter of credit. Once completely satisfied, the beneficiary will then be in a position to assemble and ship the goods.
The beneficiary prepares an invoice in the number of copies required, with the description of goods shown exactly as stipulated in the letter of credit. The beneficiary obtains the bill of lading and/or other transport documents from the carrier and prepares and/or obtains all other documents required by the letter of credit. These are attached to the draft, drawn on the bank indicated and at the term stipulated in the letter of credit, and are presented to the advising/confirming/negotiating bank.
The advising/confirming/negotiating bank checks the documents presented by the seller against the letter of credit. If the documents meet the requirements of the letter of credit, that bank will send them to the issuing bank, claiming reimbursement and paying the seller.
The issuing bank will also check the documents for compliance and then deliver them to the applicant either against payment or as an undertaking to pay on maturity of the drawing under the letter of credit.
Payment Procedure
On presentation of the documents called for under the letter of credit, provided they are in compliance with its terms, the advising/negotiating bank, in the case of an unconfirmed letter of credit, may pay/negotiate the draft. In the case of a confirmed letter of credit, the confirming bank is obliged to honour the drawing without recourse to the beneficiary.
The advising / confirming / negotiating bank will claim reimbursement from the issuing bank.
On receipt of conforming documents, the issuing bank will also be responsible for checking documents and will charge the applicant’s account under the terms of the letter of the credit application and agreement forms, effecting reimbursement to the negotiating bank
