ABOUT LETTER OF CREDIT (L/C)

LETTER OF CREDIT (L/C) DETAILS:

Letter of Credit L/C also known as Documentary Credit is a widely used term to make payment secure in domestic and international trade. The document is issued by a financial organization at the buyer request. Buyer also provide the necessary instructions in preparing the document.

LC is an instrument for assured payments. It is an undertaking of the issuing bank to make payment to beneficiary, against documents stated in LC.

As per UCPDC in LC’s all parties deal in documents and not goods and services.

Applicant or opening bank cannot refuse payment on the basis of defect in goods and services.

The International Chamber of Commerce (ICC) in the Uniform Custom and Practice for Documentary Credit (UCPDC) defines L/C as:

"An arrangement, however named or described, whereby a bank (the Issuing bank) acting at the request and on the instructions of a customer (the Applicant) or on its own behalf:

1. Is to make a payment to or to the order third party(the beneficiary) or is to accept bills of exchange (drafts) drawn by the beneficiary.
2. Authorized another bank to effect such payments or to accept and pay such bills of exchange (draft).
3. Authorized another bank to negotiate against stipulated documents provided that the terms are complied with.

A key principle underlying letter of credit (L/C) is that banks deal only in documents and not in goods. The decision to pay under a letter of credit will be based entirely on whether the documents presented to the bank appear on their face to be in accordance with the terms and conditions of the letter of credit.

👉 Parties to Letters of Credit:

• Applicant (Opener): Applicant which is also referred to as account party is normally a buyer or customer of the goods, who has to make payment to beneficiary. LC is initiated and issued at his request and on the basis of his instructions.

• Issuing Bank (Opening Bank) : The issuing bank is the one which create a letter of credit and takes the responsibility to make the payments on receipt of the documents from the beneficiary or through their banker. The payments has to be made to the beneficiary within seven working days from the date of receipt of documents at their end, provided the documents are in accordance with the terms and conditions of the letter of credit. If the documents are discrepant one, the rejection thereof to be communicated within seven working days from the date of receipt of documents at their end.  

• Beneficiary : Beneficiary is normally stands for a seller of the goods, who has to receive payment from the applicant. A credit is issued in his favour to enable him or his agent to obtain payment on surrender of stipulated document and comply with the term and conditions of the L/c.
  If L/C is a transferable one and he transfers the credit to another party, then he is referred to as the first or original beneficiary.

If L/C is a transferable one and he transfers the credit to another party, then he is referred to as the first or original beneficiary.

• Advising Bank : An Advising Bank provides advice to the beneficiary and takes the responsibility for sending the documents to the issuing bank and is normally located in the country of the beneficiary.

• Confirming Bank : Confirming bank adds its guarantee to the credit opened by another bank, thereby undertaking the responsibility of payment/negotiation acceptance under the credit, in additional to that of the issuing bank. Confirming bank play an important role where the exporter is not satisfied with the undertaking of only the issuing bank.

• Negotiating Bank:  The Negotiating Bank is the bank who negotiates the documents submitted to them by the beneficiary under the credit either advised through them or restricted to them for negotiation. On negotiation of the documents they will claim the reimbursement under the credit and makes the payment to the beneficiary provided the documents submitted are in accordance with the terms and conditions of the letters of credit.

• Reimbursing Bank : Reimbursing Bank is the bank authorized to honor the reimbursement claim in settlement of negotiation/acceptance/payment lodged with it by the negotiating bank. It is normally the bank with which issuing bank has an account from which payment has to be made.

• Second Beneficiary : Second Beneficiary is the person who represent the first or original Beneficiary of credit in his absence. In this case, the credits belonging to the original beneficiary is transferable. The rights of the transferee are subject to terms of transfer.

👉 Types of Letter of Credit:

1.     Revocable Letter of Credit L/C:

A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification.  It is rarely used in international trade and not considered satisfactory for the exporters but has an advantage over that of the importers and the issuing bank.

There is no provision for confirming revocable credits as per terms of UCPDC, Hence they cannot be confirmed. It should be indicated in LC that the credit is revocable. if there is no such indication the credit will be deemed as irrevocable.

2.     Irrevocable Letter of Credit L/C:

In this case it is not possible to revoked or amended a credit without the agreement of the issuing bank, the confirming bank, and the beneficiary.  Form an exporters point of view it is believed to be more beneficial. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and the terms and conditions are complied with, payment will be made.

3.     Confirmed Letter of Credit L/C:

Confirmed Letter of Credit is a special type of L/C in which another bank apart from the issuing bank has added its guarantee. Although, the cost of confirming by two banks makes it costlier, this type of L/C is more beneficial for the beneficiary as it doubles the guarantee. 

4.     D.P (Documents against payment) Sight Credit and D.A (Documents against Acceptance) Usance/Deferred Credit  L/C:

Sight credit states that the payments would be made by the issuing bank at sight, on demand or on presentation. In case of usance credit, draft are drawn on the issuing bank or the correspondent bank at specified usance period. The credit will indicate whether the usance draft are to be drawn on the issuing bank or in the case of confirmed credit on the confirming bank.

5.     Back to Back Letter of Credit L/C:

Back to Back Letter of Credit is also termed as Countervailing Credit. A credit is known as back to back credit when a L/C is opened with security of another L/c.

A back to back credit which can also be referred as credit and counter credit is actually a method of financing both sides of a transaction in which a middleman buys goods from one customer and sells them to another.

The parties to a Back to Back Letter of Credit are:
    1.  The buyer and his bank as the issuer of the original Letter of Credit.
    2.  The seller/manufacturer and his bank,
    3.  The manufacturer's subcontractor and his bank.

The practical use of this Credit is seen when L/C is opened by the ultimate buyer in favour of a particular beneficiary, who may not be the actual supplier/ manufacturer offering the main credit with near identical terms in favour as security and will be able to obtain reimbursement by presenting the documents received under back to back credit under the main L/c.

The need for such credits arise mainly when :

1. The ultimate buyer not ready for a transferable credit
2. The Beneficiary do not want to disclose the source of supply to the openers.
3. The manufacturer demands on payment against documents for goods but the beneficiary of credit is short of the funds.

6.     Transferable Letter of Credit L/C:

A transferable documentary credit is a type of credit under which the first beneficiary which is usually a middleman may request the nominated bank to transfer credit in whole or in part to the second beneficiary.

The L/C does state clearly mentions the margins of the first beneficiary and unless it is specified the L/C cannot be treated as transferable. It can only be used when the company is selling the product of a third party and the proper care has to be taken about the exit policy for the money transactions that take place.

This type of L/C is used in the companies that act as a middle man during the transaction but don’t have large limit. In the transferable L/C there is a right to substitute the invoice and the whole value can be transferred to a second beneficiary.

The first beneficiary or middleman has rights to change the following terms and conditions of the letter of credit:

1. Reduce the amount of the credit.
2. Reduce unit price if it is stated
3. Make shorter the expiry date of the letter of credit.
4. Make shorter the last date for presentation of documents.
5. Make shorter the period for shipment of goods.
6. Increase the amount of the cover or percentage for which insurance cover must be effected.
7. Substitute the name of the applicant (the middleman) for that of the first beneficiary (the buyer). 

7.    Revolving Letter of Credit L/C:

One L/C but several times shipment like $100 L/C, 5 times shipment each shipment $20. After expire the L/C date customer can be amended, also amount can be increase again & again. It can be readjusting this is called by revolving letter of credit. 

8.     Red & Green Clause Letter of Credit L/C:

It provides for some advances to beneficiary for manufacture, packing, dispatch & shipment of goods.

Advance is in local currency of seller, where buyer & seller have some working relationship.

Advance is allowed by a correspondent bank, given authority by issuing bank, to allow advance (in red ink)

Beneficiary need not offer any security, other that LC to secure this advance. Hence risk is of issuing bank.

In a normal LC, the nominated bank is exposed to credit risk when it purchases documents under LC.

This advance is adjusted out of the proceeds of documents, to be submitted by beneficiary, later.

Green Clause L/C- Unlike the red clause letter of credit, in the case of a green clause letter of credit, 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 documents providing proof that the goods to shipped have been warehoused.

9. Standby Letter of Credit:

Initially used by the banks in the United States, the standby letter of credit is very much similar in nature to a bank guarantee.  The main objective of issuing such a credit is to secure bank loans. Standby credits are usually issued by the applicant’s bank in the applicant’s country and advised to the beneficiary by a bank in the beneficiary’s country.

 Unlike a traditional letter of credit where the beneficiary obtains payment against documents evidencing performance, the standby letter of credit allow a beneficiary to obtains payment from a bank even when the applicant for the credit has failed to perform as per bond. 

A standby letter of credit is subject to "Uniform Customs and Practice for Documentary Credit" (UCP), International Chamber of Commerce Publication No 500, 1993 Revision, or "International Standby Practices" (ISP), International Chamber of Commerce Publication No 590, 1998.

SBLC is a guarantee of a bank on behalf of its client, in favour of a beneficiary to pay if the client fails to pay or perform his part.  

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