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Letter of credit
Meaning of Letter of Credit
A standard, commercial letter of credit is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking.
"Letters of credit are commonly used to reduce credit risk to sellers in both domestic and international sales arrangements. By having a bank issue a letter of credit, in essence, one is substituting the bank's credit worthiness for that of the customer."
The LC can also be the source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, stormwater ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheques. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and documents proving the shipment was insured against loss or damage in transit. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin.
A letter of credit is basically a document issued by a bank guaranteeing a client's ability to pay for goods or services. A bank or finance company issues a letter of credit on behalf of an importer or buyer, authorizing the exporter or seller to obtain payment within a specified timeframe once the terms and conditions outlined in the letter of credit are met. The letter of credit acts like an insurance contract for both the buyer and seller and practically eliminates the credit risk for both parties, while at the same time reducing payment delays. A letter of credit provides the exporter or seller with the greatest degree of safety when extending credit. It is useful when the importer or buyer is not well known and when exchange restrictions exist or are possible.
Documentary or letters of credit, as they are more commonly referred to, come in many forms. These options were created to make this banking instrument flexible and applicable to a wide variety of business transactions. The different types of letters of credit can be used in many combinations or independently. The type of letter of credit chosen for a transaction is based on the parties and countries involved, the risks associated with the transaction as well as the products or services being bought and sold.
Terminology
The English name “letter of credit” derives from the French word “accreditation”, a power to do something, which in turn is derivative of the Latin word “accreditivus”, meaning trust. S.‘The Application any defence relating to the underlying contract of sale. This is as long as the seller performs their duties to an extent that meets the requirements contained in the LC.
How it works
A business called the InCosmetika from time to time imports goods from a business called BLISS, which banks with the ABC Bank. InCosmetika holds an account at the Commonwealth Bank. InCosmetika wants to buy $500,000 worth of merchandise from BLISS, who agrees to sell the goods and give InCosmetika 60 days to pay for them, on the condition that they are provided with a 90-day LC for the full amount. The steps to get the letter of credit would be as follows:
- InCosmetika goes to The Commonwealth Bank and requests a $500,000 letter of credit, with BLISS as the beneficiary.
- The Commonwealth Bank can issue an LC either on approval of a standard loan underwriting process or by InCosmetika funding it directly with a deposit of $500,000 plus fees which are typically between 1% and 8% of the face value of the LC.
- The Commonwealth Bank sends a copy of the LC to the ABC Bank, which notifies BLISS that payment is available and they can ship the merchandise InCosmetika has ordered with the full assurance of payment to them.
- On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of the letter of credit, the Commonwealth Bank transfers the $500,000 to the ABC Bank, which then credits the account of BLISS for that amount.
- Note that banks deal only with documents required in the letter of credit and not the underlying transaction.
- Many exporters have mistakenly assumed that the payment is guaranteed after receiving the LC. The issuing bank is obligated to pay under the letter of credit only when the stipulated documents are presented and the terms and conditions of the letter of credit have been met.
Step-by-step process:
- Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment.
- Buyer applies to his bank for a letter of credit in favor of the seller.
- Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming). The correspondent bank is usually located in the same geographical location as the seller (beneficiary).
- Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary).
- Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a particular company.
- Seller presents the required documents to the advising or confirming bank to be processed for payment.
- Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit.
- If the documents are correct, the advising or confirming bank will claim the funds by:
- Debiting the account of the issuing bank.
- Waiting until the issuing bank remits, after receiving the documents.
- Reimburse on another bank as required in the credit.
- Advising or confirming bank will forward the documents to the issuing bank.
- Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer's account.
- Issuing bank then forwards the documents to the buyer.
Availability
DC being an irrevocable undertaking of the issuing bank makes available the Proceeds, to the Beneficiary of the Credit provided, stipulated documents strictly complying with the provisions of the DC, UCP 600 and other international standard banking practices, are presented to the issuing bank , then :
i.if the Credit provides for sight payment – by payment at sight against compliant presentation
ii.if the Credit provides for deferred payment – by payment on the maturity date(s) determinable in accordance with the stipulations of the Credit; and of course undertaking to pay on due date and confirming maturity date at the time of compliant presentation
iii.a.if the Credit provides for acceptance by the Issuing Bank – by acceptance of Draft(s) drawn by the Beneficiary on the Issuing Bank and payment at maturity of such tenor draft, or
iii.b. if the Credit provides for acceptance by another drawee bank – by acceptance and payment at maturity Draft(s)drawn by the Beneficiary on the Issuing Bank in the event the drawee bank stipulated in the Credit does not accept Draft(s) drawn on it, or by payment of Draft(s) accepted but not paid by such drawee bank at maturity;
iv. if the Credit provides for negotiation by another bank – by payment without recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit, (and so negotiated by the nominated bank )
Negotiation means the giving of value for Draft(s) and/or document(s) by the bank authorized to negotiate, viz the nominated bank. Mere examination of the documents and forwarding the same to DC issuing bank for reimbursement, without giving of value / agreed to give, does not constitute a negotiation.
Some of the Documents Called for under a LC
Financial Documents
Bill of Exchange, Co-accepted Draft
Commercial Documents
Invoice, Packing list
Shipping Documents
Transport Document, Insurance Certificate, Commercial, Official or Legal Documents
Official Documents
License, Embassy legalization, Origin Certificate, Inspection Cert , Phyto-sanitary Certificate
Transport Documents
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, Deliver Challan...etc
Insurance documents
Insurance policy, or Certificate but not a cover note.
Legal principles governing documentary credits
One of the primary peculiarities of the documentary credit is that the payment obligation is abstract and independent from the underlying contract of sale or any other contract in the transaction. Thus the bank’s obligation is defined by the terms of the credit alone, and the sale contract is irrelevant. The defences of the buyer arising out of the sale contract do not concern the bank and in no way affect its liability. Article 3(a) UCP states this principle clearly. Article 4 the UCP further states that banks deal with documents only, they are not concerned with the goods (facts). Accordingly, if the documents tendered by the beneficiary, or his or her agent, appear to be in order, then in general the bank is obliged to pay without further qualifications.
The policies behind adopting the abstraction principle are purely commercial and reflect a party’s expectations: firstly, if the responsibility for the validity of documents was thrown onto banks, they would be burdened with investigating the underlying facts of each transaction and would thus be less inclined to issue documentary credits as the transaction would involve great risk and inconvenience. Secondly, documents required under the credit could in certain circumstances be different from those required under the sale transaction; banks would then be placed in a dilemma in deciding which terms to follow if required to look behind the credit agreement. Thirdly, the fact that the basic function of the credit is to provide the seller with the certainty of receiving payment, as long as he performs his documentary duties, suggests that banks should honour their obligation notwithstanding allegations of misfeasance by the buyer. Finally, courts have emphasised that buyers always have a remedy for an action upon the contract of sale, and that it would be a calamity for the business world if, for every breach of contract between the seller and buyer, a bank were required to investigate said breach.
The “principle of strict compliance” also aims to make the bank’s duty of effecting payment against documents easy, efficient and quick. Hence, if the documents tendered under the credit deviate from the language of the credit the bank is entitled to withhold payment even if the deviation is purely terminological. The general legal maxim de minimis non curat lex has no place in the field of documentary credits.
Legal Basis for Letters of Credit
Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. In addition, the performance of an existing duty under a contract cannot be a valid consideration for a new promise made by the bank: the delivery of the goods is consideration for enforcing the underlying contract of sale and cannot be used, as it were, a second time to establish the enforceability of the bank-beneficiary relation.
Legal writers have analyzed every possible theory from every legal angle and failed to satisfactorily reconcile the bank’s undertaking with any contractual analysis. The theories include: the implied promise, assignment theory, the novation theory, reliance theory, agency theories, estoppels and trust theories, anticipatory theory, and the guarantee theory. Davis, Treitel, Goode, Finkelstein and Ellinger have all accepted the view that documentary credits should be analyzed outside the legal framework of contractual principles, which require the presence of consideration. Accordingly, whether the documentary credit is referred to as a promise, an undertaking, a chose in action, an engagement or a contract, it is acceptable in English jurisprudence to treat it as contractual in nature, despite the fact that it possesses distinctive features, which make it sui generis.
Even though a couple of countries and US states (see eg Article 5 of the Uniform Commercial Code) have tried to create statutes to establish the rights of the parties involved in letter of credit transactions, most parties subject themselves to the Uniform Customs and Practices (UCP) issued by the International Chamber of Commerce (ICC) in Paris. The ICC has no legislative authority, rather, representatives of various industry and trade groups from various countries get together to discuss how to revise the UCP and adapt them to new technologies. The UCP are quoted according to the publication number the ICC gives them. The UCP 600 are ICC publication No. 600 effective July 1, 2007. The previous revision was called UCP 500 and became effective 1993. Since the UCP are not laws, parties have to include them into their arrangements as normal contractual provisions. It is interesting to see that in the area of international trade the parties do not rely on governmental regulations, but rather prefer the speed and ease of auto-regulation.
Letter of Credit Characteristics
Negotiability
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed freely from one party to another almost in the same way as money. To be negotiable, the letter of credit must include an unconditional promise to pay, on demand or at a definite time. The nominated bank becomes a holder in due course. As a holder in due course, the holder takes the letter of credit for value, in good faith, without notice of any claims against it. A holder in due course is treated favorably under the UCC.
The transaction is considered a straight negotiation if the issuing bank's payment obligation extends only to the beneficiary of the credit. If a letter of credit is a straight negotiation it is referenced on its face by "we engage with you" or "available with ourselves". Under these conditions the promise does not pass to a purchaser of the draft as a holder in due course.
Revocability
Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction that involves a revocable letter of credit, it serves as the advising bank.
Once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honored, the letter of credit cannot be revoked. The revocable letter of credit is not a commonly used instrument. It is generally used to provide guidelines for shipment. If a letter of credit is revocable it would be referenced on its face.
The irrevocable letter of credit may not be revoked or amended without the agreement of the issuing bank, the confirming bank, and the beneficiary. 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. If a letter of credit is irrevocable it is referenced on its face.
Transfer and Assignment
The beneficiary has the right to transfer or assign the right to draw, under a credit only when the credit states that it is transferable or assignable. Credits governed by the Uniform Commercial Code (Domestic) maybe transferred an unlimited number of times. Under the Uniform Customs Practice for Documentary Credits (International) the credit may be transferred only once. However, even if the credit specifies that it is nontransferable or nonassignable, the beneficiary may transfer their rights prior to performance of conditions of the credit.
Sight and Time Drafts
All letters of credit require the beneficiary to present a draft and specified documents in order to receive payment. A draft is a written order by which the party creating it, orders another party to pay money to a third party. A draft is also called a bill of exchange.
There are two types of drafts: sight and time. A sight draft is payable as soon as it is presented for payment. The bank is allowed a reasonable time to review the documents before making payment.
A time draft is not payable until the lapse of a particular time period stated on the draft. The bank is required to accept the draft as soon as the documents comply with credit terms. The issuing bank has a reasonable time to examine those documents. The issuing bank is obligated to accept drafts and pay them at maturity.
Risk situations in a DC transaction
General Risks
If goods are being offered for sale at a price that is too good to be true, then it probably is too good to be true’
Fraud Risks
- The payment will be obtained for nonexistent or worthless merchandise against presentation by the Beneficiary of forged or falsified documents.
- Credit itself may be forged.
Sovereign and Regulatory Risks
Performance of the Documentary Credit may be prevented by government action outside the control of the parties.
Legal Risks
Possibility that performance of a Documentary Credit may be disturbed by legal action relating directly to the parties and their rights and obligations under the Documentary Credit
Force Majeure and Frustration of Contract
Performance of a contract – including an obligation under a Documentary Credit relationship – is prevented by external factors such as natural disasters or armed conflicts
Risks to the Applicant
- Non-delivery of Goods
- Short Shipment
- Inferior Quality
- Early /Late Shipment
- Damaged in transit
- Foreign exchange
- Failure of Bank viz Issuing bank / Collecting Bank
Risks to the Issuing Bank
- Insolvency of the Applicant
- Fraud Risk, Sovereign and Regulatory Risk and Legal Risks
Risks to the Reimbursing Bank
No obligation to reimburse the Claiming Bank unless it has issued a reimbursement undertaking.
Risks to the Beneficiary
- Failure to Comply with Credit Conditions
- Failure of, or Delays in Payment from, the Issuing Bank
- Credit Issued by Party other than Bank
Risks to the Advising Bank
The Advising Bank’s only obligation – if it accepts the Issuing Bank’s instructions – is to check the apparent authenticity of the Credit and advising it to the Beneficiary
Risks to the Nominated Bank
Nominated Bank has made a payment to the Beneficiary against documents that comply with the terms and conditions of the Credit and is unable to obtain reimbursement from the Issuing Bank
Risks to the Confirming Bank
If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may not be able to obtain reimbursement from the Issuing Bank because of insolvency of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a dispute as to whether or not payment should have been made under the Credit
Risks in International Trade
- A Credit risk is a risk from a change in the credit of an opposing business.
- An Exchange risk is a risk from a change in the foreign exchange rate.
- A Force majeure risk is 1. a risk in trade incapability caused by a change in a country's policy, and 2. a risk caused by a natural disaster.
- Other risks are mainly risks caused by a difference in law, language or culture. In these cases, the cargo might be found late because of a dispute in import and export dealings.
Parties To A Letter Of Credit
Depeding on the circumstances, various names used in a letter of credit may refer to the same party.
The Applicant opens the letter of credit.
- The buyer, or customer, is the Applicant.
- Sometimes the Applicant is called the account party.
The Opening Bank issues the letter of credit.
- The Opening Bank's credit replaces the buyer's credit.
The Advising Bank is an agent of the Opening Bank.
- Verifies the authenticity of the Opening Bank.
The Confirming Bank is usually the Advising Bank, but it confirms that the credit exists.
- It can negotiate the documents, and can accept the letter of credit the Opening Bank will not pay.
The Paying Bank is also called the drawing bank.
- The Paying Bank may act also the Advising Bank, or the Confirming Bank, or the Opening Bank.
The Beneficiary is often the seller.
- It is party to whom the credit is issued.
Types of Letters of Credit
There are two basic forms of letters of credit: Standby and Documentary. Documentary letters of credit can be either Revocable or Irrevocable, although the first is extremely rare. Irrevocable letters of credit can be Confirmed or Not Confirmed. Each type of credit has advantages and disadvantages for the buyer and for the seller, which this information will review below. Charges for each type will also vary. However, the more the banks assume risk by guaranteeing payment, the more they will charge for providing the service.
Revocable
A revocable letter of credit is one which can be amended or cancelled by the applicant or the issuing bank at any time, without prior notice, discussion or agreement with the beneficiary. A revocable letter of credit offers no protection to the beneficiary and is seldom if ever used.that is in the relation with transferable lc.
Irrevocable
An irrevocable letter of credit can not be amended or revoked without the agreement of ALL the parties to the letter of credit, so it provides the assurance that providing the beneficiary complies with the terms, he/she will be paid for the goods or services. Under UCP 600, a letter of credit is deemed irrevocable unless otherwise stated.
Unconfirmed
An unconfirmed irrevocable letter of credit provides a commitment by the issuing bank to pay, accept, or negotiate a letter of credit. An advising bank forwards the letter of credit to the beneficiary without responsibility or undertaking on its part except that it must use reasonable care to check the authenticity of the credit which it advised. It does not provide a commitment from the advising bank to pay, so the beneficiary is reliant upon the undertaking of the overseas bank. The beneficiary is not protected from the credit risk of the issuing bank nor the country risk.
Confirmed
A confirmed irrevocable letter of credit is one to which the advising bank adds its confirmation, makes its own independent undertaking to effect payment, negotiation or acceptance, providing documents are presented which comply with the terms of the letter of credit. The advising bank, which may also be the confirming bank, assumes the country (political and economic) risk of the applicant’s country as well as the credit risk, failure and default of the issuing bank and effects payment to the beneficiary without recourse.
In order for a letter of credit to be confirmed, a bank accepting this risk would have a correspondent relationship with the issuing bank. If the advising bank does not have such a relationship, the letter of credit can be confirmed by an independent bank. The negative aspect here is the cost of adding another bank to the scenario.
A seller should consider requesting a confirmed credit when
- the credit standing of the issuing bank is unknown to the seller or viewed by the seller as questionable.
- exchange controls in the buyer’s country may prevent local banks from honoring certain external payments.
- the importing country is suffering economic difficulties: large external debt and/or high debt service ratios, a persistent negative balance of payments, or a record of being late or having defaulted on its international payments.
Transferable Credit
Under a transferable letter of credit a beneficiary (the first beneficiary) can ask the issuing/advising/confirming bank to transfer the letter of credit in whole or in part to another party/ies such as supplier/s (second beneficiary/ies). A transferable letter of credit is usually used when the beneficiary is not the manufacturer/original supplier of some/all of the goods/services. This process enables the beneficiary to pay the manufacturer/original supplier by letter of credit. If the bank agrees, this bank, referred to as the transferring bank, advises the letter of credit to the second beneficiary/ies in the terms and conditions of the original letter of credit with certain constraints defined in Article 48 of UCP 500.
In general, unless the letter of credit states that it is transferable, it is considered non-transferable.
Assignment of Proceeds
The right to the proceeds of a letter of credit can sometimes be assigned where the beneficiary of a letter of credit is not the actual supplier of all or part of the letter of credit and wants the bank to pay the supplier out of funds received from the letter of credit. The beneficiary may choose this option if he or she
- does not want to request a transferable letter of credit from a buyer in order to keep the buyer from knowing who is the actual supplier of the goods.
- does not have the necessary credit with the bank to issue a new letter of credit to a supplier.
An assignment of proceeds takes the form of an irrevocable instruction from the beneficiary to the bank requesting that it pay the supplier out of the proceeds of the letter of credit which becomes due when documents are presented in compliance with the terms of the letter of credit.
Revolving
Although infrequently used today, revolving letters of credit were a tool created to allow companies conducting regular business to issue a letter of credit that could “roll-over” without the company having to reapply, thus enabling business flow to continue without interruption as long as the terms and conditions, quantities, and other transaction details did not change. In addition, if a letter of credit were a revolving one, there were few ways to stop it from rolling over; so, should a conflict arise between the parties while the letter of credit was in place or should the products change, there was little recourse for either party. In the business world today, the fact is that, unless required by law or because of high risk, on-going business is usually conducted without of letters of credit
Standby
As is the case with the revolving letter of credit, standby letters of credit are infrequently used today. A standby letter of credit is one which is issued as a back-up or form of insurance for the seller should the buyer default on the agreed-upon payment terms. A standby letter of credit is issued in the same way a documentary credit is in that the collateral needed for issuance is required by the issuing bank and the beneficiary must comply with every detail as outlined in the letter of credit. The problem with this instrument is that the applicant has no guarantee, other than the seller’s word, that the standby will not be drawn against even if payment is made as agreed. This situation is challenging, especially if the letter of credit is confirmed and the advising bank sees only documents pertaining to the shipment as outlined in the letter of credit and has no knowledge of other payments being made.
Back-to-Back Letters of Credit
Back-to-back letters of credit are two individual letters of credit that together offer an alternative to a transferable letter of credit. The back-to-back letter of credit allows exporters (sellers or middlemen) who do not qualify for unsecured bank credit to use a letter of credit as security for a second letter of credit in favor of a supplier. In other words, if a foreign buyer will issue a letter of credit to an exporter, certain banks and trade finance companies will issue independent letters of credit to the exporter's suppliers so that the required goods can be purchased. Even if the initial letter of credit is not successfully completed, the second remains valid, and the issuing bank is obligated to pay under its terms.
Although back-to-back letters of credit provide small and medium exporters virtually unlimited working capital to finance their sales and complete more export transactions, many banks are reluctant to take on this type of arrangement. Because back-to-back letters of credit involve two separate transactions, it is likely that several participating banks will be involved and the risk of confusion and dispute is high. To protect itself, a bank generally will require that the exporter present all relevant documents that are part of the first letter of credit before issuing the second letter of credit. The second document is worded to conform precisely to the original and dated to expire at some date prior to the first, ensuring that the seller has sufficient time to present documents within the time limits of the first.
Cash Advance Against Letter of Credit
A cash advance against a letter of credit works like back-to-back letters of credit, with the exception that the bank or financing company will issue cash to the suppliers instead of another letter of credit.
Deferred Payment (Usance) Letter of Credit
In Deferred Payment Letters of Credit, the buyer accepts the documents related to the letter of credit and agrees to pay the issuing bank after a fixed period. This credit gives the buyer a grace period for payment.
Red Clause Letter of Credit
Red Clause Letters of Credit provide the seller with cash prior to shipment to finance production of the goods. The buyer's issuing bank may advance some or all of the funds. The buyer, in essence, extends financing to the seller and incurs the risk for all advanced credits.
Common Problems with Letters of Credit
Most problems result from the seller's inability to fulfill obligations stated in the letter of credit. The seller may find these terms difficult or impossible to fulfill and, either tries to fulfill them and fails, or asks the buyer to amend to the letter of credit. As most letters of credit are irrevocable, amendments may at times be difficult since both the buyer and the seller must agree.
Sellers may have one or more of the following problems:
The shipment schedule cannot be met;
The stipulations concerning freight costs are unacceptable;
The price becomes too low due to exchange rates fluctuations;
The quantity of product ordered is not the expected amount;
The description of product is either insufficient or too detailed; and,
The stipulated documents are difficult or impossible to obtain.
Even when sellers accept the terms of a letter of credit, problems often arise late in the process. When this occurs, the buyer's and seller's banks will try to negotiate any differences. In some cases, the seller can correct the documents and present them within the time specified in the letter of credit. If the documents cannot be corrected, the advising bank will ask the issuing bank to accept the documents despite the discrepancies found. It is important to note that, if the documents are not in accord with the specifications of the letter of credit, the buyer's issuing bank is no longer obligated to pay.
Basic Procedures for Establishing a Letter of Credit
The letter of credit process has been standardized by a set of rules published by the International Chamber of Commerce (ICC). These rules are called the Uniform Customs and Practice for Documentary Credits (UCP) and are contained in ICC Publication No. 500. The following is the basic set of steps used in a letter of credit transaction. Specific letter of credit transactions follow somewhat different procedures.
- After the buyer and seller agree on the terms of a sale, the buyer arranges for his bank to open a letter of credit in favor of the seller. Note: The buyer will need to have a line of credit established at the bank or provide cash collateral for the amount of the letter of credit.
- The buyer's issuing bank prepares the letter of credit, including all of the buyer's instructions to the seller concerning shipment and required documentation.
- The buyer's bank sends the letter of credit to the seller's advising bank.
- The seller's advising bank forwards the letter of credit to the seller.
- The seller carefully reviews all conditions stipulated in the letter of credit. If the seller cannot comply with any of the provisions, it will ask the buyer to amend the letter of credit.
- After final terms are agreed upon, the seller ships the goods to the appropriate port or location.
- After shipping the goods, the seller obtains the required documents. Please note that the seller may have to obtain some documents prior to shipment.
- The seller presents the documents to its advising bank along with a draft for payment.
- The seller's advising bank reviews the documents. If they are in order, it will forward them to the buyer's issuing bank. If a confirmed letter of credit, the advising bank will pay the seller (cash or a bankers' acceptance).
- Once the buyer's issuing bank receives and reviews the documents, it either (1) pays if there are no discrepancies; or (2) forwards the documents to the buyer if there are discrepancies for its review and approval.
The Letter of Credit Application
1. Beneficiary
2. Amount
3. Validity
4. Seller's Bank
5. Type of Payment Availability
6. Desired Documents
7. Notify Address
8. Description of Goods
9. Confirmation Order
Opening a Letter of Credit
Level of Detail
The wording in a letter of credit should be simple, but specific. The more detailed an L/C is, the more likely the seller will reject it as too difficult to fulfill. At the same time, the buyer will wish to define in detail what its is paying for.
Type of Credit
Letters of credit used in trade are usually either irrevocable unconfirmed credits or irrevocable confirmed credits. In choosing which type to open both the seller and the buyer should consider the generally accepted payment processes in each country, the value and demand for the goods, and the reputation of the buyer and seller.
Documents
In specifying required documents, it is very important to include those required for customs and those reflecting the agreement reached between the buyer and the seller. Required documents usually include the bill of lading, a commercial and/or consular invoice, the bill of exchange, the certificate of origin, and the insurance document. Other documents required may be an inspection certificate, copies of a cable sent to the buyer with shipping information, a confirmation from the shipping company of the state of its ship, and a confirmation from the forwarder that the goods are accompanied by a certificate of origin. Prices should be stated in the currency of the letter of credit and documents should in the same language as the letter of credit.
The Letter of Credit Application
The following information should be addressed when establishing a letter of credit.
- Beneficiary - The seller should provide to the buyer its full corporate name and correct address. A simple mistake here may translate to inconsistent or improper documentation at the other end.
- Amount - The seller should state the actual amount of the letter of credit. One can request a maximum amount when there is doubt as to the actual count or quantity of the goods. Another option is to use words like "approximate", "circa", or "about" to indicate an acceptable 10 % plus or minus from the stated amount. For consistency, if you use this wording you will need to use it also in connection with the quantity.
- Validity - The seller will need time to ship and to prepare all the necessary documents. Therefore, the seller should ensure that the validity and period for document presentation after the shipment of the goods is long enough.
- Seller's Bank - The seller should list its advising bank as well as a reimbursing bank if applicable. The reimbursing bank is the local bank appointed by the issuing bank as the disbursing bank.
- Type of Payment Availability - The buyer and seller may agree to use sight drafts, time drafts, or some sort of deferred payment mechanism.
- Desired Documents - The buyer specifies the necessary documents. Buyers can list, for example, a bill of lading, a commercial invoice, a certificate of origin, certificates of analysis, etc. The seller must agree to all documentary requirements or suggest an amendment to the letter of credit.
- Notify Address - This is the address to notify upon the imminent arrival of goods at the port or airport of destination. A notification listing damaged goods is also sent to this address, if applicable.
- Description of Goods - The seller should provide a short and precise description of the goods as well as the quantity involved. Note the comments in step #2 above concerning approximate amounts.
- Confirmation Order - With international arrangements, the seller may wish to confirm the letter of credit with a bank in its country.
Amendment of a Letter of Credit
For the seller to change the terms noted on an irrevocable letter of credit, it must request an amendment from the buyer. The amendment process is as follows:
- The seller requests a modification or amendment of questionable terms in the letter of credit;
- If the buyer and issuing bank agree to the changes, the issuing bank will change the letter of credit;
- The buyer's issuing bank notifies the seller's advising bank of the amendment; and
- The seller's advising bank notifies the seller of the amendment. Tips for Buyers and Sellers
Seller
- Before signing a sales contract, the seller should make inquiries about the buyer's creditworthiness and business practices. The seller's bank will generally assist in this investigation.
- In many cases, the issuing bank will specify the advising and/or confirming bank. These designations are usually based on the issuing bank's established correspondent relationships. The seller should ensure that the advising/confirming bank is a financially sound institution.
- The seller should confirm the good standing of the buyer's issuing bank if the letter of credit is unconfirmed.
- For confirmed letters of credit, the seller's advising bank should be willing to confirm the letter of credit issued by the buyer's bank. If the advising bank refuses to do so, the seller should request another issuing bank as the current bank may be or is in the process of becoming insolvent.
- The seller should carefully review the letter of credit to ensure its conditions can be met. All documents must conform to the terms of the letter of credit. The seller must comply with every detail of the letter of credit specifications; otherwise the security given by the credit is lost.
- The seller should ensure that the letter of credit is irrevocable.
- If amendments are necessary, the seller should contact the buyer immediately so that the buyer can instruct the issuing bank to make the necessary changes quickly. The seller should keep the letter of credit's expiration date in mind throughout the amendment process.
- The seller should confirm with the insurance company that it can provide the coverage specified in the letter of credit and that insurance charges listed in the letter of credit are correct. Typical insurance coverage is for CIF (cost, insurance and freight) often the value of the goods plus about 10 percent.
- The seller must ensure that the goods match the description in the letter of credit and the invoice description.
- The seller should be familiar with foreign exchange limitations in the buyer's country that could hinder payment procedures.
Buyer
- When choosing the type of letter of credit, the buyer should consider the standard payment methods in the seller's country.
- The buyer should keep the details of the purchase short and concise.
- The buyer should be prepared to amend or re-negotiate terms of the letter of credit with the seller. This is a common procedure in international trade. With irrevocable letters of credit, the most common type, all parties must agree to amend the document.
- The buyer can reduce the foreign exchange risk by buying forward currency contracts.
- The buyer should use a bank experienced in foreign trade as its issuing bank.
- The validation time stated on the letter of credit should give the seller ample time to produce the goods or to pull them out of stock.
- A letter of credit is not fail-safe. Banks are only responsible for the documents exchanged and not the goods shipped. Documents in conformity with the letter of credit specifications cannot be rejected on grounds that the goods were not delivered as specified in the contract. The goods shipped may not in fact be the goods ordered and paid for.
- Purchase contracts and other agreements pertaining to the sale between the buyer and seller are not the concern of the issuing bank. Only the letter of credit terms are binding on the bank.
- Documents specified in the letter of credit should include those the buyer requires for customs clearance.
Receiving A Letter Of Credit
Here is a partial list of questions you need to ask once you have received a letter of credit.
- Is the letter of credit irrevocable?
- Is the letter of credit at sight?
- Do you trust the Paying Bank?
- Can you convert the currency to your currency?
- Are the value and quantities correct?
- Are the shipping terms correct?
- Can you provide the required documents?
- Are the letter of credit fees as you had agreed?
- Is the merchandise correctly described?
- Is there sufficient time to meet the shipping date and expiration date?
- Are the shipping terms correct?
- Specify which documents that are required for payment.
Do not ship the goods if you are unable or unwilling to meet all the conditions stated in the letter of credit.
- Request an amendment to the letter of credit.
Common Mistakes Made With Letters Of Credit
About half of all drawings presented contain discrepancies. A discrepancy is an irregularity in the documents that causes them to be in non-compliance to the letter of credit. Requirements set forth in the letter of credit cannot be waived or altered by the issuing bank without the express consent of the customer. The beneficiary should prepare and examine all documents carefully before presentation to the paying bank to avoid any delay in receipt of payment. Commonly found discrepancies between the letter of credit and supporting documents include:
- Presenting documents late, after the letter of credit has expired.
- Shipping their goods after the specified date.
- Stale dated documents.
- Changes included in the invoice not authorized in the credit.
- Inconsistent description of goods.
- Insurance document errors.
- Invoice amount not equal to draft amount.
- Ports of loading and destination not as specified in the credit.
- Description of merchandise is not as stated in credit.
- Making a partial shipment when partial shipment is not allowed.
- Not presenting the proper documents.
- A document required by the credit is not presented.
- Documents are inconsistent as to general information such as volume, quality, etc.
- Names of documents not exact as described in the credit. Beneficiary information must be exact.
- Invoice or statement is not signed as stipulated in the letter of credit.
- Not legalizing the documents.
- Not obtaining completed bills of lading.
- Not obtaining required insurance.
- Submitting copies instead of originals.
- Spelling mistakes.
- Mathematical mistakes.
In addition to creating payment problems, mistakes can also cause problems for the importer when clearing customs.
When a discrepancy is detected by the negotiating bank, a correction to the document may be allowed if it can be done quickly while remaining in the control of the bank. If time is not a factor, the exporter should request that the negotiating bank return the documents for corrections.
If there is not enough time to make corrections, the exporter should request that the negotiating bank send the documents to the issuing bank on an approval basis or notify the issuing bank by wire, outline the discrepancies, and request authority to pay. Payment cannot be made until all parties have agreed to jointly waive the discrepancy.
Tips for Exporters
- Communicate with your customers in detail before they apply for letters of credit.
- Consider whether a confirmed letter of credit is needed.
- Ask for a copy of the application to be fax to you, so you can check for terms or conditions that may cause you problems in compliance.
- Upon first advice of the letter of credit, check that all its terms and conditions can be complied with within the prescribed time limits.
- Many presentations of documents run into problems with time-limits. You must be aware of at least three time constraints - the expiration date of the credit, the latest shipping date and the maximum time allowed between dispatch and presentation.
- If the letter of credit calls for documents supplied by third parties, make reasonable allowance for the time this may take to complete.
- After dispatch of the goods, check all the documents both against the terms of the credit and against each other for internal consistency.
