LETTER OF CREDIT (DOCUMENTARY CREDIT)

The D/P and the D/A modes of payment suggest that there is a certain degree of lack
of confidence of the parties in each other. The exporter is not willing to send the goods on
D/P or D/A basis because he is not sure as to whether the importer would make the
payment and if the importer doesn’t pay, then he runs the risk of non-payment. Similarly,
importer may also have the feeling that if he makes advance payment to the exporter and
he does not supply the goods of the quality desired by him on the due date, then he would
also suffer loss. Both the parties would be able to conduct their part of the transaction
smoothly if there is an assurance to them as regards protection of their interests. The
exporter requires an assurance for payment of the goods if he has sent the shipment as per
export order. The importer on the other hand, requires an assurance that the payment
would be released to the exporter only when he has supplied the goods as per the terms
and conditions stipulated in the export contract. This assurance in the form of undertaking
to pay is provided by the importer’s bank and is known as Letter of Credit or the
Documentary Credit.
Letter of Credit refers to a written undertaking given by the importer’s bank, at the
request and instruction of importer (i.e., applicant), to the exporter (i.e., beneficiary) that
the payment shall be made to him against stipulated documents provided that the same
appear on their face to be in accordance with the terms and conditions of the credit, the
applicable provision of UCP 600 and international standard banking practice. These
terms and conditions are indicated by the importer to the bank issuing the letter of credit.
An essential characteristic of the Letter of Credit is that it relies on the doctrine of strict
compliance for making payment to the exporter against the documents stipulated in the
Credit. The banks do not deal in goods; they deal in documents. As such, the importer has
to specify to the bank the documents which it should examine to conclude that the
exporter has sent the shipment in strict compliance with the terms and conditions of the
Credit.

Features of letter of credit

A Letter of credit is characterized by the following features:

1. Parties to a Letter of Credit

The parties to a letter of credit transaction are as follows:

a. Issuing bank I.E., The bank that issues the letter of credit. It is the bank acting
the request… of a customer.
b. Applicant i.e, the customer on whose behalf the letter of credit is issued. In
relation to export – import transaction, the customer is the importer.
c. Beneficiary i.e., the third party to whom the payment shall be made. In relation
to export- import transaction, the beneficiary is the exporter.
d. Negotiating bank i.e., the bank authorized to negotiate the documents stipulated
in the letter of credit.

2 This arrangement, called letter of credit, is an undertaking of the Issuing Bank,

that is, the Issuing Bank shall:

a. make payment to the beneficiary or to a party as per the order of the

beneficiary, of
b. accept and pay the bills of exchange i.e., draft (s) drawn by the
beneficiary, or
c. authorize another bank to effect such payment ( in this case the other bank
shall be called the paying bank) or accept and pay such bills of exchange
(in this case the bank accepting the bill of exchange would be called the
accepting bank)or
d. Authorize another bank to negotiate the stipulated documents (In this case
‘another bank’ is called the negotiating bank).

3 It needs to be clearly understood that this undertaking of the issuing bank is a

conditional undertaking and is subject to the following conditions that the:

a. beneficiary presents the documents as stipulated in the letter of credit and

b. Documents on their face appear to constitute a complying presentation,
that is, presentation of documents is in accordance with terms and
conditions of the credit, the applicable provisions of UCP600 and
international standard banking practice.

Procedure for the issue of Letter of Credit

The procedure for the issue of letter of credit as explained in figure 10.3 is
as follows:

1. The exporter and the importer enter into an export contract which
provides for payment by means of a letter of credit
2. The importer approaches his bank to open the letter of credit in favors of
the exporter
3. The importer’s bank sends the letter of credit to the exporter through one
of its corresponding banks in the exporter’s country, known as advising
bank.
4. Advising bank authenticates the letter of credit and sends it to the
exporter.

Contents of letter of credit

A letter of credit generally contains the following information:

1. Complete and correct name and address of the beneficiary i.e., the
exporter.
2. Complete and correct name and address of her applicant i.e., importer.
3. They of the letter of Credit / Documentary Credit.
4. Amount of credit
5. How the credit shall be available e.g., by sight payment, deferred payment
acceptance or negotiation
6. Name of the nominated bank,(That is , the bank which shall make
payment to the beneficiary.)
7. The name of the drawee of the draft and the tenor of the draft.
8. List of documents required to be submitted by the beneficiary.
9. Description of goods, quantity of the items and the unit price.
10. Port of discharge and the place of final destination.
11. Terms of delivery i.e., FOB, CFR, CIF etc.
12. Status of transshipment i.e. whether allowed or not.
13. status of partial shipment i.e., whether allowed or not
14. The last date of sending shipment.
15. Time period for the presentation of documents for negotiation by the
beneficiary after the dispatch of the shipment.
16. The date and lace of expiry of the letter of credit.
17. Transfer of the letter of credit allowed or not.
18. Mode of advice of the letter of credit i.e., by mail or teletransmission.

Precautions to be taken by the Beneficiary on the Receipt of letter

of Credit

An exporter should scrutinise the letter of credit carefully before proceeding

to execute the export order. He should examine the following points to ensure
that:

1. The letter of credit appears to be a valid letter of credit. He can consult his
banker for this purpose.
2. The type of letter of credit and its terms and conditions are as per the
agreed terms and conditions of the export contract.
3. All the terms and conditions are acceptable and can be complied with. It
should be ensured that the letter of credit does not include any condition
that is unacceptable or cannot be complied with.
4. The documents required under the letter of credit can be obtained and
presented.
5. The description of the goods, quantity and the unit prices are as per the
export contract.
6. there is no clause in the letter of credit that requires payment of costs or
charges not agreed to with importer.
7. The last date for sending shipment and the time allowed for presentation
of the documents are acceptable.
8. The port of loading and the port of discharge are as per the export
contract.
9. The responsibility for the insurance of the goods has been clearly stated.

FORM OF DOCUMENTARY CREDIT

The form of documentary credit is the irrevocable documentary credit or the

letter of credit even if there is no indication that effect. An irrevocable letter of
credit implies that its terms and conditions can be cancelled/ modified only
the express consent of the beneficiary, the issuing bank and the confirming
bank (if any). Thus, an importer cannot get the term and conditions of the
letter of credit modified/ cancelled without the express consent of the
exporter. An irrevocable letter of credit implies an undertaking to the
beneficiary that the issuing bank commits itself to honour the draft/s drawn by
the exporter under the credit provided that all the stipulated documents are
presented and these are in strict compliance with the terms and conditions of
the letter of credit, the applicable provisions of UCP600 and international
standard banking practice. This means that the irrevocable letter of credit
is an insurance against commercial risk to payment. Such risks arise due to
the bankruptcy of importer, dishonest intentions of the importer to make the
payment or the liquidity problems faced by him. These risks would not affect
payment to the exporter.

On the other hand, a letter of credit is known as revocable if its terms and
conditions can be amended, revoked or cancelled without the consent of the
beneficiary and even without giving prior notice to the beneficiary regarding
the likely change in the letter of credit. Such a letter of credit involves lot of
risk to the beneficiary as its terms and conditions can be modified/ cancelled
while the goods are in transit or though the documents have been presented
but before payment could be made. In such a situation, the exporter will face
the problem of realizing payment directly from the importer.

KINDS OF LETTER OF CREDIT

There are various kinds of letter of credit depending upon the features
added to it as desired by the applicant. The various kinds of the letter of credit
are as follows:

1. Sight or Usance letter of credit

2. Confirmed or Unconfirmed letter of credit
3. Negotiable letter of credit
4. Revolving letter of credit
5. Red clause letter of credit
6. Green clause letter of credit
7. Transferable letter of credit
8. Bank to back letter of credit
9. With recourse or without recourse letter of credit
10. Standby letter of credit

Sight or Usance letter of credit

A Letter of credit is known as sight letter of credit or the letter of credit at

sight if it involves payment to the exporter against sight draft. On the other
hand, if the payment is to be made against usance draft, then the letter of
credit is known as Usance letter of credit.