LOC A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the

correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. Letters of credit are often used in international transactions to ensure that payment will be received . Due to the nature of international dealings including factors such as distance, differing laws in each country and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade. The bank also acts on behalf of the buyer (holder of letter of credit) by ensuring that the supplier will not be paid until the bank receives a confirmation that the goods have been shipped
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. This applies to any defense relating to the underlying contract o f sale. This is as long as the seller performs their duties to an e xtent that meets the requirements contained in the letter of credit. HOW IT WORKS
Why Letter? It is named a Letter because initially the LCs were issued manually in a Letter format address by Issuing Bank to Beneficiary confirming its conditional undertaking to reimburse the Beneficiary, the amount of the LC provided above 2 basic conditions are fulfilled.

Parties involved in LC transaction: 1. The Applicant is the party that arranges for the letter of credit to be issued. 2. The Beneficiary is the party named in the letter of credit in whose favor the letter of credit is issued. 3. The Issuing or Opening Bank is the applicants bank that issues or opens the letter of credit in favor of the beneficiary and substitutes its creditworthiness for that of the applicant. 4. An Advising Bank may be named in the letter of credit to advise the beneficiary that the letter of credit was issued. The role of the Advising Bank is limited to establish apparent authenticity of the credit, which it advises. 5. The Paying Bank is the bank nominated in the letter of credit that makes payment to the beneficiary, after determining that documents conform, and upon receipt of funds from the issuing bank or another intermediary bank nominated by the issuing bank.

6. The Confirming Bank is the bank, which, under instruction from the issuing bank, substitutes its creditworthiness for that of the issuing bank. It ultimately assumes the issuing banks commitment to pay.

[edit] Availability

A letter of credit being an irrevocable undertaking of the issuing bank makes available the Proceeds, to the Ben eficiary of the Credit provided, stipulated documents strictly complying with the provisions of the letter of credit, UCP 600 and other international standard banking practices, are presented to the issuing bank, then:
y

i.if the Credit provides for sight payment by payment at sight against compliant presentation

y y

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;
y

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 )

Typically the documents requested in a Le tter of Credit are the following: * * * * * Commercial invoice Transport document such as a Bill of lading or Airway bill, Insurance document; Inspection Certificate Certificate of Origin But there could be others too.

Letters of credit (LC) deal in documents, not goods. The LC could be 'irrevocable' or 'revocable'. An irrevocable LC cannot be changed unless both the buyer and seller agree. Whereas in a revocable LC changes to the LC can be made without the consent of the beneficiary. A 'sight' LC means that payment is made immediately to the beneficiary/seller/exporter upon

presentation of the correct documents in the required time frame. A 'time' or 'date' LC will specify when payment will be made at a future date and u pon presentation of the required documents.
y

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 the letter of credit issuing bank for reimbursement, without giving of value / agreed to give, does not constitute a negotiation.

[edit] Some of the Documents Called for under a Letter of Credit

y

Financial Documents

Bill of Exchange, Co-accepted Draft

y

Commercial Documents

Invoice, Packing list

y

Shipping Documents

Transport Document, Insurance Certificate, Commercial, Official or Legal Documents

y

Official Documents

License, Embassy legalization, Origin Certificate, Inspection Certificate, Phytosanitary certificate

y

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.

[edit] 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 banks 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. [3] Article 4(a) UCP states this principle clearly. Article 5 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 or der, 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 partys expectations: firstly, if the responsibility for the validity of documents wa s 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. [4] 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 banks 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. [5] The general legal maxim de minimis non curat lex has no place in the field of documentary credits.
[edit] The price of letters of credit

All the charges for issuance of Letter of Credit, negotiation of documents, reimbursements and other charges like courier are to the account of applicant or as per the terms and conditions of the Letter of credit. If the letter of credit is silent on charges, then they are to the account of the Applicant. The description of charge s and who would be bearing them would be indicated in the field 71B in the Letter of Credit.
[edit] 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 banks 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 u nderlying 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 failed to satisfactorily reconcile the banks 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. [6] 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 pro mise, 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.

A few countries including the US (see Article 5 of the Uniform Commercial Code) have created statutes in relation to the operation of letters of credit. These statutes are designed to work with the rules of practice including the UCP and the ISP98. These rules of practice are incorporated into the transaction by agreement of the parties. The latest version of the UCP is the UCP600 effective July 1, 2007. [7] The previous revision was the UCP500 and became effective on 1 January 1994. Since the UCP are not laws, parties have to include them into their arrangements as normal contractual provisions.
Types of Letter of Credit Irrevocable An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all parties to the credit. Under UCP500 all letters of credit are deemed to be irrevocable unless otherwise stated. Here, the importer's bank gives a binding undertaking to the supplier provided all the terms and conditions of the credit are fulfilled. Unconfirmed The advising bank forwards an unconfirmed letter of credit directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity. Confirmed A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This commitment holds even if the issuing bank or the buyer fails to make payment. The added security to the exporter of confirmation needs to be considered in the context of the standing of the issuing bank and the current political and economic state of the importer's country. A bank will make an additional charge for

confirming a letter of credit. In many cases, the confirming bank is located in Beneficiarys country. Confirmation costs will vary according to the country involved, but for many countries considered a high risk will be between 2%-8%. There also may be countries issuing letters of credit, which banks do not wish to confirm - they may already have enough exposure in that market or not wish to expose themselves to that particular risk at all. Standby Letters of Credit A standby letter of credit is used as support where an alternative, less secure, method of payment has been agreed. They are also used in the United States of America in place of bank guarantees. Should the exporter fail to receive payment from the importer he may claim under the standby letter of credit. Certain documents are likely to be required to obtain payment including: the standby letter of credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce publishes rules for operating standby letters of credit ISP98 International Standby Practices. Revolving Letter of Credit The revolving credit is used for regular shipments of the same commodity to the same importer. It can revolve in relation to time or value. If the credit is time revolving once utilised it is re-instated for further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once utilised and paid the value can be reinstated for further drawings. The credit must state that it is a revolving letter of credit and it may revolve either automatically or subject to certain provisions. Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit. Transferable Letter of Credit

A transferable letter of credit is one in which the exporter has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers. Back-to-Back Letter of Credit A back-to-back letter of credit can be used as an alternative to the transferable letter of credit. Rather than transferring the original letter of credit to the supplier, once the letter of credit is received by the exporter from the opening bank, that letter of credit is used as security to establish a second letter of credit drawn on the exporter in favour of his importer. Many banks are reluctant to issue back-to-back letters of credit due to the level of risk to which they are exposed, whereas a transferable credit will not expose them to higher risk than under the original credit. Advantages of Letter of Credit: 1. The beneficiary is assured of payment as long as it complies with the terms and conditions of the letter of credit. The letter of credit identifies which documents must be presented and the data content of those documents. The credit risk is transferred from the applicant to the issuing bank. 2. The beneficiary can enjoy the advantage of mitigating the issuing banks country risk by requiring that a bank in its own country confirm the letter of credit. That bank then takes on the country and commercial risk of the issuing bank and protects the beneficiary.

3. The beneficiary minimizes collection time as the letter of credit accelerates payment of the receivables. 4. The beneficiarys foreign exchange risk is eliminated with a letter of credit issued in the currency of the beneficiarys country.

Risk situations in letter-of-credit transactions Fraud Risks

y y

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

y

Performance of the Documentary Credit may be prevented by government action outside the control of the parties.

Legal Risks
y

Possibility that performance of a Documentary Credit may be disturbed by legal action relating direc tly 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

y y y y y y y

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

y y

Insolvency of the Applicant Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

y

no obligation to reimburse the Claiming Bank unless it has issued a reimbursement undertaking.

Risks to the Beneficiary

y y y

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 Banks only obligation if it accepts the Issuing Banks instructions is to check the apparent authenticity of the Credit and advising it to the Beneficiary

Risks to the Nominated Bank

y

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

y

If Confirming Banks 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 Issuin g Bank to reimburse because of a dispute as to whether or not payment should have been made under the Credit