Letter of Credit
Letter of credit is used in the financing of international trade, when the reliability of contracting parties cannot be readily and easily determined.
Updated: November 10, 2024
Letter of Credit:
Letter of credit (LC), also known as a letter of undertaking (LoU), documentary credit or bankers commercial credit is a payment mechanism that is used in international trade to provide an economic guarantee from a creditworthy bank to an exporter of goods.
Some facts about Letter of credit:
- Mostly, Letter of credit is used in the financing of international trade, when the reliability of contracting parties cannot be readily and easily determined.
- A bank is introduced as an underwriter that assumes the counter party risk of the buyer paying the seller for goods.
- A letter of credit is a letter from a bank guaranteeing that the payment to a seller from a buyer will be received on time and for the correct amount
- The bank will cover the full or remaining amount of the purchase in case the buyer is unable to make a payment on the purchase.
- The use of letters of credit has become a very important aspect of international trade because of the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally.
- Internationally recognized rules and procedures were used to govern letters of credit rather than by national law.
How a Letter of Credit Works:
- The issuing bank pays the beneficiary or any bank nominated by the beneficiary, as a letter of credit is typically a negotiable instrument.
- If the letter of credit is transferable, the beneficiary may assign the right to draw to another entity, such as a corporate parent or third party.
- To issue a letter of credit, banks usually require collateral, typically in the form of pledged securities or cash.
- Banks also charge a service fee, generally a percentage of the letter of credit's value.
- Letters of credit used in international transactions are governed by the International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits.
- This payment method is crucial in international trade, particularly where buyers and sellers do not personally know each other and are separated by distance, customs, and differing national laws.
- A letter of credit reduces the seller’s risk by ensuring payment upon presenting the specified documents in the sales contract between buyer and seller.
- In this arrangement, the seller relies on the creditworthiness of the bank, rather than the buyer, to receive payment, as the bank assumes the payment obligation.
- The bank will pay the seller upon receiving negotiable documents that represent the goods, ensuring that control of the goods remains with the issuing bank until payment.
- If the buyer is unable to pay, the seller can demand payment from the bank, provided the demand complies with the letter of credit’s terms.
- The International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits governs most letters of credit worldwide.
Types of Letters of Credit:
There are several types of letters of credit available that operate in different markets and solve different issues.
Commercial Letter of Credit:
Commercial Letter of Credit, also termed as an import or export letter of credit depending on whose perspective is considered.
It is termed an Import LC or an importer and an Export LC for the exporter of goods.
This is a direct payment method in which the payments are made to the beneficiary by the issuing bank.
Revocable/ Irrevocable Letter of Credit:
It can be determine whether the buyer and the issuing bank are able to manipulate the LC or make corrections without informing or getting permissions from the seller depending on whether a LC is revocable or irrevocable.
In practice the revocable type of LC is increasingly obsolete as all LCs are irrevocable according to UCP 600.
Any changes or cancellation of the LC, except when expired is done by the buyer)through the issuing bank and must be authenticated and approved by the seller.
Confirmed/Unconfirmed Letter of Credit:
A Letter of Credit is considered confirmed when a second bank adds its confirmation or guarantee to honor a complying presentation, as requested or authorized by the issuing bank.
In a confirmed letter of credit, a bank other than the issuing bank guarantees the payment.
Typically, the seller's bank acts as the confirming bank.
The confirming bank ensures payment under the letter of credit if either the buyer or the issuing bank defaults.
This arrangement is commonly requested by the issuing bank in international transactions.
Restricted/ Unrestricted Letter of Credit:
The advising bank can purchase a bill of exchange from the seller in the case of a restricted LC.
The exporter can show the bill of exchange to any bank and receive a payment on an unrestricted LC where the confirmation bank is not specified.
Deferred / Usance Letter of Credit:
Deferred / Usance Letter of Credit is a credit that is not paid immediately after presentation, but will be paid or assigned after an indicated period that is accepted by both buyer and seller.
Typically, buyer are allowed by the seller to pay the required money after taking the related goods and selling them.
Revolving Letter of Credit:
A customer is allowed to make any number of draws within a certain limit during a specific time period in a Revolving Letter of Credit.
Traveler's Letter of Credit:
Traveler's Letter of Credit are or those going abroad, as this letter will guarantee that issuing banks will honor drafts made at certain foreign banks
Specific Terms Relating to the Payment Conditions:
The specific terms relating to the payment conditions which relate to the underlying reference documents are:
At Sight:
At Sight is a credit that the announcer bank immediately pays after inspecting the carriage documents from the seller.
Red Clause:
The seller can receive the prepaid portion of the payment from the bank before sending the products.
The initial part of the credit is drawn to attract the attention of the accepting bank.
The assigner bank establishes the credit initially to gain the attention of the offering bank.
This is referred to as a "Red Clause" because the terms and conditions were traditionally written in red ink.
Back to Back:
Back-to-back facilitate intermediary trade.
A second credit is opened for another seller to provide the desired goods when a seller who is not able to provide the corresponding goods for unspecified reasons.
Sometimes, intermediate companies such as trading houses required to open LCs for a supplier and receive Export LCs from buyer.
Standby Letter of Credit: (SBLC):
Standby Letter of Credit almost operates like a Commercial Letter of Credit, except that it is retained as a 'standby' instead of being the intended payment mechanism.
SBLC is a security against an obligation which is not performed as a source of payment will be provided in the event of non-performance of contract.
The UCP applies to Standbys.
ISP98 is applied specifically to Standby letters of Credit and the United Nations Convention on Independent Guarantees and Standby Letters of Credit is applied to a small number of countries that have ratified the Convention.
Transferability:
The exporter may make the credit available to one or more subsequent beneficiaries.
Credits can be transferable when the original beneficiary does not provide the documents themselves but instead obtains goods or documents from other suppliers and sends them to the issuing bank.
A letter of credit can be transferred to a second beneficiary at the request of the first beneficiary only if the credit is explicitly marked as "transferable."
A bank is not obligated to transfer a credit.
The credit may be transferred to multiple alternate beneficiaries if partial shipments are allowed.
The terms and conditions of the original credit must be exactly replicated in the transferred credit.
Certain details, such as the amount, unit price of merchandise (if specified), expiry date, presentation period, latest shipment date, or shipment period, may be adjusted or reduced to maintain the functionality of the transferable letter of credit.
The first beneficiary can request the transferring bank to replace the applicant.
The transferred credit must indicate whether a document, other than the invoice, must be issued in such a way that shows the applicant's name.
A transferred credit cannot be transferred to a third beneficiary at the request of the second beneficiary.
Documents Requested For Presentation:
An exporter or shipper must present the documents required by the LC to receive payment.
The type of documents that may be requested by the applicant varies considerably by country and commodity.
An original bill of lading is typically requested by a LC as the use of a title document such as this is critical to the functioning of the Letter of Credit.
However, the list and form of documents might contain requirements to present documents issued by a neutral third party confirming the quality of the goods shipped, or their place of origin or place as it is open to negotiation.
The types of documents in such contracts may include:
Financial documents which is the bill of exchange, co-accepted draft
Commercial documents including invoice, packing list
Shipping documents including bill of lading (ocean or multi-modal or charter party), airway bill, lorry/truck receipt, railway receipt, CMC other than mate receipt, forwarder cargo receipt
Official documents including license, embassy legalization, origin certificate, inspection certificate, phytosanitary certificate
Insurance documents such as insurance policy or certificate, but not a cover note.
Security can be provided by a Documentary Credit for both buyer and seller
An undertaking will be given by the bank, on behalf of buyer (who is often the applicant) to pay the beneficiary the value of the goods shipped if acceptable documents are submitted and if the stipulated terms and conditions are strictly complied with as outlined in the UCP 600.
It can be ensured that the goods expected by the buyer will be received since it will be evidenced in the form of certain documents, meeting the specified terms and conditions.
It can also be ensured that the supplier will receive payment from the issuing bank, who is independent of the parties to the contract if such stipulations are met
Direct payment is other forms of effected payment where the supplier ships the goods and waits for the buyer to remit the bill, on open account terms.
Risk Exposure:
The seller is exposed to a number of risks such as credit risk, and legal risk that can be caused by the distance, differing laws and difficulty in knowing each party personally
Pricing of Letter of Credit:
Charges for Letter of Credit include issuance charges, covering negotiation, reimbursements and other charges that are paid by the applicant.
Charges are paid by the Applicant if the LC does not specify charges.
Legal principles:
Several legal concepts are utilized by a Letter of Credit to achieve the economic effect of shifting the legal exposure from the seller to the buyer.
Although, the bank is required to identify that the correct documents exist, they are not expected to examine whether the documents themselves are valid.
The bank is not responsible for investigating the underlying facts of each transaction, such as the sufficient, specified as well as the quality and quantity of the goods.
It is the document itself which holds the value and not the goods to which the reference as the transaction operates on a negotiable instrument.
So, the bank is only concerned with whether the document fulfils the requirements stipulated in the letter of credit.
The banks must adhere to the 'principle of strict compliance' when evaluating the documents that are presented are those specified in the letter of credit to make the banks' duty of effecting payment easy, efficient and quick against documents.
Guidance to Letter of Credit as well as 'right of access' can be found here.