Letter of Credit, Explained!
Letter of Credit (LC) is a secure and widely used payment method in international trade. LC is governed by standardized rules, called Uniform Customs and Practice for Documentary Credit (UCP), published and governed by International Chamber of Commerce (ICC). Banks offer several flexible structures that can satisfy different needs of different types of international trade practitioners.
The buyer and the seller agree a sales agreement. The bank (Issuing Bank) issues a letter of credit pursuant to the LC application submitted by the buyer of goods. The application must show contact information of the parties, the transaction amount, expiration of the letter of credit, terms and conditions for supplying the goods, as well as a list of required documents. The application should also indicate which party bears the potential expenses. If no party is named, the buyer of the goods will bear all bank charges (including foreign bank expenses).
The issuing bank informs the seller’s bank, referred to as the advising bank, that a letter of credit has been issued for carrying out a particular foreign trade transaction. The information is passed either directly or through an internationally recognised bank, which may also be the bank confirming the letter of credit, i.e. the confirming bank. All obligations of the issuing bank are extended to the confirming bank.
The seller’s bank informs the seller that a letter of credit has been issued for its benefit. The seller shall now dispatch the goods specified in the sales agreement to the buyer, submits the shipping documents together with other documents specified in the letter of credit to its bank. A precondition for making the payment is the strict conformity of the documents with the conditions set forth in the letter of credit.
The role of banks is mainly of an intermediary nature. They only check the conformity of documents with the conditions specified in the letter of credit. They are not held responsible for the storage, transport, origin etc. of the goods, nor for accuracy, lawfulness or genuineness of the documents submitted to them. However, the bank that has issued the letter of credit cannot refuse to make the payment if the submitted documents comply with the conditions defined in the letter of credit. The banks are, thus, responsible only for the financial aspects of the transaction. They do not have any relation to the physical goods traded.
Main parties involved in a letter of credit transaction are:
1. Applicant: Applicant is the buyer or importer of goods. Once the LC is issued, payment obligations lie with the issuing bank and not the Applicant.
2. Beneficiary: Beneficiary is the seller or exporter of goods, who ships the goods as required by the LC and presents documents as indicated. Beneficiary will receive payment from the issuing bank as long as it complies with the LC conditions.
3. Issuing Bank: Issuing Bank issues Letter of Credit at the request of the Applicant, and promises payment against presentation of complying documents by the Beneficiary. The bank receives the conditions of the LC and the list of complying documents from the Applicant through LC application form.
4. Advising Bank: Advising Bank passes the LC to the Beneficiary, at the request of the advising bank. It is typically located in the same country with the beneficiary. It has no payment obligation unless it is also the confirming bank.
5. Nominated Bank: Nominated Bank is the bank with which the credit is available. Usually nominated banks are also the advising banks.
6. Confirming Bank: Confirming Bank adds its confirmation to a credit upon the issuing bank’s authorization or request. Usually, a confirming bank is also the advising bank and the nominated bank, and located in the same country as the beneficiary. Confirming bank provides beneficiary an additional payment guarantee separate from the issuing bank’s payment obligation, thereby eliminating country risk of the issuing bank.
7. Reimbursing Bank: Reimbursing Bank is instructed and authorized to provide reimbursement pursuant to a reimbursement authorization issued by the issuing bank.
Letter of credit can be revocable or irrevocable, transferable or non-transferable, confirmed or unconfirmed, deferred or ‘at sight’, restricted or non-restricted, or a combination of these features depending on need.
At Sight: Under ‘at sight’ letter of credit, payment is made to the seller immediately after the required documents have been submitted to the advising bank, provided the conditions in the letter of credit have been met. Banks are, however, allowed a reasonable period of time for checking purposes (typically not more than five to ten working days after they receive the documents).
Deferred: In the case of a letter of credit with deferred payment, the payment to the seller is not made when the documents are submitted, but instead at a later date defined in the letter of credit. In the Far East and some parts of south East Asia, this kind of documentary credit is also known as a "usance LC."
Acceptance: In the case of an acceptance credit, the payment to the seller is not made when the documents are submitted, but instead at a later date defined in the letter of credit. However, the seller can request a discount from the bank that accepted the bill of exchange, or from another bank, and thus draw the amount of the bill minus the discount at any time after the documents have been submitted.
Negotiable: Under UCP 600 (Uniform Customs and Practice for Documentary Credits, 2007 revision, article 2) negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank. Unfortunately, the term "negotiable credit" is understood and applied in different ways in different parts of the world.
There are two types of the letter of credits: Commercial letter of credit and Standby letter of credit. The Commercial LC is the primary payment mechanism, whereas the Standby LC is a secondary payment mechanism to receive payment from issuing bank if the buyer doesn’t honor payment obligations.
Irrevocable LC: Irrevocable LC cannot be cancelled or amended without the written agreement of the credit parties. If credit is unconfirmed then the buyer, the seller and the issuing bank must reach an agreement on the amendments. If credit is confirmed than the buyer, the seller, the issuing bank and the confirming bank must reach an agreement on the amendments.
Revocable LC: Revocable LC can be cancelled anytime without prior notification to the seller / beneficiary. Revocable LC cannot be confirmed. UCP 600 does not allow revocable credits.
Standby LC: Standby LCs are similar to guarantees. If payments are not made in accordance with the seller’s terms, the seller can invoke the bank's obligation to pay by submitting, together with any other documents that the letter of credit might require, and a declaration stating that the letter of credit customer has failed to meet his obligations/payment.
Transferable LC: Transferable LC allow an intermediary to transfer the LC to a supplier, thus enabling the intermediary to reduce the extent to which it uses its own funds to process business transactions. The credit maybe transferred an unlimited number of times under UCC (domestic USA) and only once under UCP (International).
Back-to-back LC: Back-to-back LCs are suitable for intermediaries. There are two separate LCs exist in a back-to-back LC transaction. First, the buyer issues a LC in favor of the intermediary. Then, the intermediary issues second in favor of the ultimate supplier of the goods. Since back-to-back LCs contain two independent credits, the issuing bank of the second LC has to bear substantial amount of payment risk.
Revolving LC: If the buyer and the seller are trading the same commodity regularly over a period of time, or if the buyer requests partial deliveries of the ordered goods at specific intervals (contract for delivery by installments), then a revolving LC may be a better option instead of issuing a new LC every shipment. Payment can be made under the terms of a revolving LC covers the value of each consecutive installment. The bank is normally liable for the total value of all agreed partial deliveries. However, the second partial payment is not effective until the first installment has been paid, and so forth.
Red Clause LC: Under a red clause LC (LC with advance payment), the seller can request an advance for an agreed amount (defined in the terms and conditions of the LC) from the correspondent bank. This advance is normally intended to finance the manufacture or purchase of the goods to be delivered under the letter of credit. The advance is normally paid against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires.
Green Clause LC: Unlike the red clause LC, in the case of a green clause LC, the advance is normally paid not only against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires, but also against receipt of an additional document providing proof that the goods to be shipped have been warehoused.
The letter of credit is an efficient payment tool for risk reduction in international trade transactions. The issuing bank is mandatorily obliged to make the payment to the beneficiary provided the latter submits all requested documents within the time schedule indicated in the conditions of the letter of credit. However all parties to a credit face different set of risks, as payment risks are spread over multiple parties in different layers and timeframes. Fraud, Sovereign, Regulatory, Legal, Insolvency of banks, Frustration of contract, Forced majeure, and Applicant and Beneficiary specific risks are some of the areas worth considering.
Cavendish organizes seminars for trade professionals and bank professionals covering full depth and breadth of LC operation, types, advantages and disadvantages to buyers, seller and banks, risks, risk reduction mechanisms available, and the Uniform Customs and Practice for Documentary Credits. Seminar is delivered by a team of banking, legal and trade professionals with sound theoretical and practical insights. For schedule, venue and other details, please contact email@example.com