CLASS

LC

LETTERS OF CREDIT MEANING

Letters of Credit have been a cornerstone of international trade dating back to the early1900s. They continue to play a critical role in world trade today. For any company entering the international market, Letters of Credit are an important payment mechanism which help eliminate certain risks.

LETTERS OF CREDIT MEANING

In international sales, as the seller and the buyer are in different countries, there is a common problem of payment due to the difference of time between dispatch and delivery. Obviously, seller would like to receive payment for the goods when delivering them to the carrier and the buyer would prefer to delay the payment of the price until receipt of the goods. Therefore, a letter of credit solves this problem between the seller and the buyer.

LETTERS OF CREDIT DEFINITIONS

Definition of a Commercial Letter of Credit A Commercial Letter of Credit may be defined as an order addressed by a commercial house (usually a banker) to the agent or correspondent or branch in another place instructing the latter to honour bills or drafts or cheques drawn upon him by a beneficiary (usually the exporter) named and identified (generally through specimen signature) in the letter of credit upto a stated amount and within a stated period of time. The letter of credit also contains the terms and conditions, if any, under which the payment is made to the beneficiary. It was held in Orr and Barter Vs. Union Bank of Scotland (1854) that a letter of credit is not negotiable instrument. Hence the paying banker must exercise great care about the identity of the beneficiary.

LETTERS OF CREDIT DEFINITIONS

A Letter of Credit, simply defined, is a written instrument issued by a bank at the request of its customer, the Importer (Buyer), whereby the bank promises to pay the Exporter (Beneficiary) for goods or services, provided that the Exporter presents all documents called for, exactly as stipulated in the Letter of Credit, and meet all other terms and conditions set out in the Letter of Credit.

LETTERS OF CREDIT DEFINITIONS

A letter of credit constitutes a definite undertaking of the Issuing Bank to pay the Beneficiary the specific amount, provided that the required documents are presented to the Issuing Bank or Confirming bank or the bank nominated in the credit by the Issuing Bank and that the terms and conditions of the credit are complied.

LETTERS OF CREDIT DEFINITIONS

A commercial letter of credit is a contractual agreement between a bank (issuing bank), on behalf of one of its customers (buyer), authorizing another bank (advising or confirming bank), to make payment to the beneficiary (seller). The issuing bank, on the application of its customer (buyer), opens the letter of credit, and makes a commitment with the buyer to honour the credit on the presentation of the documents, conforming to the terms and conditions of the credit, by the beneficiary. Thus, the issuing bank replaces the bank's customer as the payee

LETTERS OF CREDIT THE TRANSACTION

Generally, there are three separate transactions in a letter of credit transaction. The first is between a seller and a buyer, called an underlying transaction, by which the seller provides contracted goods to the buyer. The second transaction is between the buyer-applicant and the bank (issuer of the letter of credit), in which the bank issues a letter of credit to the seller-beneficiary. Finally, the letter of credit itself creates a relationship between the issuer and the beneficiary, in which, the issuer makes payment for goods upon the beneficiary's presentation of the required documents, in accordance with the terms and conditions of the letter of credit as agreed between seller and buyer.

LETTERS OF CREDIT THE TRANSACTION

The bank's performance of payment is conditional on the delivery of conforming documents by the beneficiary. The banks are called issuers and are usually the applicant's bank. Normally the issuing bank opens a letter of credit in its own name and requests its correspondent bank to notify the seller about the letter of credit. Sometimes, the issuing bank instructs the correspondent bank not only to notify the seller of the issuing bank's undertaking but also to add a confirmation. In this case, the credit is known as a confirmed credit and the correspondent bank as a confirming bank.

LETTERS OF CREDIT THE TRANSACTIONS

The payment obligation of the issuing bank depends upon the beneficiary's presentation of complying documents to the confirming bank or to any other nominated bank, in accordance with the terms and conditions of the credit. Under general practice, presenting complying documents means that they comply with the conditions of the credit on their face.

LETTERS OF CREDIT THE ELEMENTS

Elements of a Letter of Credit A payment undertaking given by a bank (issuing bank) On behalf of a buyer (applicant) To pay a seller (beneficiary) for a given amount of money On presentation of specified documents representing the supply of goods Within specified time limits Documents must conform to terms and conditions set out in the letter of credit Documents to be presented at a specified place Typically the documents requested include a commercial invoice, bill of lading or airway bill and an insurance document; but there are many others. Letters of credit is concerned only with the documents, not with the goods.

LETTERS OF CREDIT THE ELEMENTS

Beneficiary- Beneficiary is normally the provider of the goods or services and is entitled to payment as long as he can provide the conforming documents required by the letter of credit. The letter of credit is a distinct and separate transaction from the underlying contract (contract between seller and buyer). All parties deal in documents and not in goods.

LETTERS OF CREDIT THE MAIN BANKS INVOLVED

Issuing Bank is the financial institution who issues the letter of credit, (to the buyer) and whose duty it is to make payment . Generally, the beneficiary wants to use a local bank to ensure that the letter of credit is valid. An advising bank is usually a foreign correspondent bank of the issuing bank which advises the sellerbeneficiary. In addition, the advising bank is responsible for sending the documents to the issuing bank. At the request of the issuing bank, the correspondent bank may confirm the letter of credit for the sellerbeneficiary and obligates itself to insure payment under the letter of credit. The confirming bank is usually the advising bank.

LETTERS OF CREDIT THE PROCESS

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 favour 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).

LETTERS OF CREDIT THE PROCESS

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. Payment is made if documents found correct

LETTERS OF CREDIT THE PROCESS

If the documents are correct, the advising or confirming bank will claim the funds by: Debiting the account of the issuing bank. OR Waiting until the issuing bank remits, after receiving the documents. 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. Buyer takes delivery of goods producing the documents.

The most common documents

Commercial Invoice It includes a description of merchandise, price, FOB origin, and name and address of buyer and seller. The buyer and seller information must correspond exactly to the description in the letter of credit. Bill of Lading It is a document which shows the receipt of goods for shipment by a freight carrier. It is an evidence of the control of the goods and also acts as an evidence of the carrier's obligation to transport the goods to their proper destination.

The most common documents

Warranty of Title A warranty given by a seller to a buyer of goods that states that the title being conveyed is good. It is generally issued to the purchaser

Letter of Indemnity It is a letter specifically indemnifies the purchaser against a certain stated circumstance. Indemnification is generally used to guarantee that shipping documents will be provided in good order when available.

Common Defects in Documentation

A discrepancy is an irregularity in the documents that causes them to be in non-compliance with the terms of the letter of credit. Requirements mentioned in the letter of credit cannot be altered by the issuing bank without the express consent of the buyer-applicant. The beneficiary should prepare all documents carefully before presentation to the issuer to avoid any delay in receipt of payment. Commonly found discrepancies include:

Common Defects in Documentation

Letter of Credit has expired prior to presentation of draft. Bill of Lading evidences delivery prior to or after the date range stated in the credit. Stale dated documents. Changes included in the invoice not authorized in the credit.

Common Defects in Documentation

Inconsistent description of goods. Insurance document errors. Invoice amount not equal to LC amount. Ports of loading and destination not as specified in the credit. Description of merchandise is not as stated in credit.

Common Defects in Documentation

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.

LETTERS OF CREDIT -TYPES

Revocable Letter of Credit A revocable letter of credit may be revoked or modified by the issuing bank, for any reason at any time, without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction involving a revocable letter of credit, it serves as the advising bank. A letter of credit can not be revoked, once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honoured. The revocable letter of credit is not a commonly used instrument.

LETTERS OF CREDIT -TYPES

Irrevocable Letter of Credit

This is the most common form of credit used in international trade. The irrevocable letter of credit may not be revoked or amended without the consent of the issuing bank, the confirming bank, and the beneficiary. The buyer's issuing bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the letter of credit. Changes in the credit must be approved by both the buyer and the seller. If the documentary letter of credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable.

LETTERS OF CREDIT -TYPES

Unconfirmed credit In an unconfirmed credit, the buyer's bank issuing the credit is the only party responsible for payment to the seller. The seller's advising bank pays only after receiving payment from the issuing bank. The seller's advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk.

LETTERS OF CREDIT -TYPES

Confirmed credit

In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer's issuing bank. Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the seller. The advising bank will then look to the issuing bank for payment.

LETTERS OF CREDIT -TYPES

Confirmed Irrevocable letters of credit are used when trading in a high-risk area where war or social, political, or financial instability are real threats. Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order. A confirmed credit is more expensive because the bank has added liability.

LETTERS OF CREDIT -TYPES

Sight and Time Drafts All letters of credit require the beneficiary to present a draft and required 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.

LETTERS OF CREDIT -TYPES

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.

LETTERS OF CREDIT -TYPES

Documentary and Clean Letters of Credit A clean or open letter is a letter of credit which neither stipulates any conditions for payment to the beneficiary not calls for any security from the person at whose request it is opened. It is opened only in the case of parties of sound financial position. If a letter of credit lays down the conditions that the documents of title to goods should be attached to the bill of exchange drawn under it, it is a documentary or secured letter of credit. The interests of the banker who opens the letter of credit are safe-guarded this way, as the documents of title to goods provide security to him, if the importer makes default in payment.

LETTERS OF CREDIT -TYPES

Fixed and Revolving Letters of Credit If a letter of credit specified the amount up to which the beneficiary can draw bills of exchange within the specified period of time, it is a fixed letter of credit. A revolving letter of credit is one where the amount of credit reverts back to the original amount after such amount has been paid on presentation of the bill.

LETTERS OF CREDIT -TYPES

In a revolving letter of credit the amount up to which bills drawn may remain outstanding at a time is mentioned and not the amount up to which the bills may be drawn. So the beneficiary or exporter can draw fresh bills as soon as the old bills are paid for. This type of letter of credit is more advantageous to the exporter because he is entitled to draw bills of a higher amount within the specified period than in the case of a fixed letter of credit.

LETTERS OF CREDIT -TYPES

Transferable and Non-transferable Letters of Credit If the beneficiary is given the right to transfer his power of drawing bills to some one else, under a letter of credit, such a letter of credit is knows as a transferable letter of credit. Even the total amount of credit can be divided into more than one part and each part may be transferred to a different person. Transferable letters of credit are normally issued when the beneficiary is only an intermediary and not the exporter.

LETTERS OF CREDIT -TYPES

A letter of credit under which the beneficiary has no right of transfer of his power to draw bill is non-transferable letter of credit. If a beneficiary requests the banker to open a new letter of credit in favour of some other persons on the security of the non-transferable letter of credit and the same is done, such a letter of credit is known as a Back to Back letter of credit

LETTERS OF CREDIT -TYPES

With and Without Recourse Letter of Credit In the case of a letter of credit with recourse, the banker can recover the amount of the bill from the drawer (usually the exporter) if the drawee of the bill (usually the importer) fails to honour, i.e., the banker has recourse to the drawer. The drawer or exporter may prefer a letter of credit without recourse under which the banker has no recourse to the drawer.

LETTERS OF CREDIT -TYPES

A letter of credit used to guarantee either a monetary or a non monetary obligation (such as the performance of construction work), whereby the issuing bank agrees to pay the beneficiary if the bank customer defaults on its obligation. This type of letter of credit is mostly used in service contracts or where parties have to perform in future in timely manner, for example in construction contract or outsourcing. In this seller arranges to issue letter of credit in favor of buyer to pay back if seller fails to perform and ultimately buyer gets payments under it on seller's failure. The purpose of this letter of credit is to give surety to buyer that seller is able to perform his work for which buyer is going to pay him.

LETTERS OF CREDIT BANKS INVOLVED

Issuing Bank is the financial institution who issues the letter of credit, and whose duty it is to make payment . Advising Bank is the bank to which the Issuing Bank forwards the Letter of Credit with instructions to notify the Exporter (Beneficiary) and which informs the beneficiary about the opening of the letter of credit account . Confirming Bank is the bank which, at the request of the Issuing Bank, adds its confirmation to the Letter of Credit. In doing so, the Confirming Bank undertakes to make payment to the Exporter upon presentation of documents under the Letter of Credit. The confirming bank shares the responsibility of payment with the issuing bank to the beneficiary .

LETTERS OF CREDIT BANKS INVOLVED

Available with Bank is the bank authorized in the Letter of Credit to effect payment under the Letter of Credit. It is the bank which in fact makes the process of monetary transfer on the account of the beneficiary. Reimbursing Bank is the bank designated in the Letter of Credit to reimburse the available with Bank which submits payment claims under the Letter of Credit.

LETTERS OF CREDIT BANKS INVOLVED

It is not necessary that Issuing bank, Advising Bank, Confirming Bank and available with Bank are branches of the same bank. Therefore there need to be some cooperation between those banks. There must be an agreement that the issuing bank will pay money (through channel of advising bank and confirming bank) to the available with bank provided that the required documents are presented to the Issuing Bank.

LETTERS OF CREDIT ADVANTAGES AND DISADVANTAGES

Advantages to the Importer Importer is assured that the Exporter will be paid only if all terms and conditions of the Letter of Credit have been met. Importer is able to negotiate more favourable trade terms with the Exporter when payment by Letter of Credit is offered. Disadvantages to the Importer A Letter of Credit does not offer protection to the Importer against the Exporter shipping inferior quality goods and/or a lesser quantity of goods. Consequently, it is important that the Importer performs the appropriate due diligence to assess the reputation of the Exporter. If the Exporter acts fraudulently, the only recourse available to the Importer is through legal proceedings.

LETTERS OF CREDIT BANKS INVOLVED

It may be necessary for the Importer to have a line of credit with a bank before the bank is able to issue a Letter of Credit. The amount outstanding under each Letter of Credit issued is applied against this line of credit from the date of issuance until final payment.

LETTERS OF CREDIT BANKS INVOLVED

Advantages to the Exporter The risk of payment relies upon the creditworthiness of the Issuing Bank and the political risk of the Issuing Banks domicile, and not the creditworthiness of the Importer. Exporter agrees in advance to all requirements for payment under the Letter of Credit. If the Letter of Credit is not issued as agreed, the Exporter is not obligated to ship against it. Disadvantages to the Exporter Documents must be prepared and presented in strict compliance with the requirements stipulated in the Letter of Credit. Some Importers may not be able to open Letters of Credit due to the lack of credit facilities with their bank which consequently inhibits export growth.