What is a letter of credit, how it works and who needs it..

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• A Letter of Credit is also known as Documentary Credit 
• A Letter of Credit is a primary means of payment in an international trade transaction 
• By default a Letter of Credit is irrevocable

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Many of you would have come across the term Letter of Credit (L/C)..

If you are a shipping line, you would have heard this term from various customers asking you to expedite the draft bill of lading for checking by the bank or for the release of the bill of lading to be expedited because the shipment is under L/C..

If you a freight forwarder or agent, you may have been put under pressure by the BCO to get all the documents required by the L/C sent to them in time..

If you are a BCO, you may have been told by your bank that the documents submitted do not match the requirements of the L/C and some of the documentation may need to be redone..

So what exactly is a Letter of Credit, what is the need for a letter of credit, who issues it and how does it work..

 

What is the need for a Letter of Credit and how does a Letter of Credit work..??

Well, in the beginning, there is a seller and a buyer who want to conclude a business transaction..

They may or may not know each other or may or may not be comfortable with each other as far as financial obligations and payments is concerned..

Because of the time it takes for cargoes shipped from foreign ports to reach their destination, importers have to find a way of guaranteeing payment to exporters before the goods are received..

As discussed in the Beginner’s Guide to Importing, there are several forms of payments each with its own element of risk..

A graphical representation of the element of risk in relation to the buyer and seller is shown below..

A Letter of Credit seems to be a popular method of payment transaction among sellers and buyers because these transactions go through a bank and that offers a level of comfort for both the buyer and the seller..

 

Letter of Credit

A Letter of Credit or Documentary Credit is a promise by a bank on behalf of the buyer (applicant/importer) to pay the seller (beneficiary/exporter) a specified sum in the agreed currency, provided that the seller submits the required documents by a predetermined deadline..

A Letter of Credit is governed by UCP600 (Uniform Customs and Practice) which is an international code of practice (voluntary set of rules) drawn up by the International Chamber of Commerce..

It is essentially an instruction by the importer’s bank to the overseas bank of the seller outlining various aspects relating to the particular trade including payment of funds to the seller..

The buyer (Applicant) sets a list of terms and conditions under which he would like to buy and ship the cargo from the seller (Beneficiary)..

This list generally has

• description of the goods he wants to buy from the seller ;
• quantity of the goods ;
• technical description if any ;
• documentary requirements ;
  • bills of lading ;
  • commercial invoice ;
  • packing list ;
  • certificate of origin ;
  • analysis reports ;
  • other documents
• who the bill of lading must be consigned to – in the case of L/C, generally the issuing bank will be shown as the consignee and they will have control of the cargo until such time they receive the money from the buyer ;
• details of who must be notified of the arrival of the shipment ;
• the latest date of shipment ;
• sometimes the buyer also nominates and specifies on the L/C the shipping line that is to be used ;
• which port pairs to be used (POL/POD) are to be used ;
• what mode of transport is to be used

This L/C is then issued by the buyer’s bank (known as issuing bank) and is sent to the seller and his bank (known as the nominated bank).. There could also be a “confirming bank” requested by the seller.. The confirming bank performs a check that the issued L/C is valid and is usually a bank in the seller’s country..

This additional confirmation of the L/C means that the confirming bank guarantees payment even if the issuing bank fails to make it..

The seller then proceeds to prepare his goods and documents based on the L/C.. Once the shipment has been accomplished, the seller will provide the copies of all the documents as per the instructions on the L/C to his bank..

His bank checks the veracity and correctness of the submitted documents against the L/C specifications.. Remember though that banks do not actually verify if the cargo has been loaded on the vessel or not.. They only verify documents..

One of the main documents in this submission is the Bill of Lading as that is the Document of Title to the goods exchanged in return for the delivery of the goods.. Usually Bills of Lading involved in L/C transactions will be “Negotiable Bills of Lading”..

Once the bank is satisfied that the docs and shipment are in accordance with the L/C, they pay the seller the money that is due to him as per the price agreed between him and the buyer..

The nominated bank, then sends all the docs to the issuing bank who cross verifies the details against the L/C conditions and once they are satisfied with the conditions, they reimburse the receiving bank the money that they paid to the seller..

The issuing bank then advises the buyer that the shipment has been effected and that they are in possession of all the documents.. The buyer then arranges to pay the issuing bank the money that has been paid by them to the receiving bank..

Upon receipt of these funds, the issuing bank then endorses the bill of lading to the buyer so that the cargo can be released to the buyer..

So begins and ends the process of a Letter of Credit..

 

L/C Extension

If there is a requirement for an L/C to be extended for whatever reason, the seller has to contact the buyer who opened the L/C and they will have to in turn contact the issuing bank with valid reasons for the extension.. Based on this reason the L/C may or may not be extended..

Usual reasons for L/C extension requests could be :

• delay in the export material being ready
• delay in the carrying vessel – due to weather or issues from the shipping line’s side
• if there are any unprecedented customs stop on the export cargo
• non-availability of a suitable container
• cargo inspection certificates not ready
• non-availability of a vessel during the time frame required

 

Types of Letter of Credit

There are a few different types of letter of credit with different uses.. The most popular types are :

Irrevocable

• The instructions or terms on this type of L/C cannot be amended or cancelled without the agreement of the beneficiary and the confirming bank.. By default, a L/C is irrevocable even if it is not indicated anywhere, so take this as the default setting..

Revocable

• This type of L/C can be amended or cancelled by the issuing bank at any time and therefore attention needs to be paid to this type of L/C.. Although this type is not covered in UCP600, this can be issued if such terms are incorporated into the credit and this could happen occasionally, possibly due to ignorance, but banks generally do not confirm a revocable documentary credit.. Let this be in the back of your mind..

Confirmed

• This is type of L/C involves a confirming bank.. The role of the confirming bank is to ensure (at the behest of the beneficiary) that the L/C issued by the issuing bank is valid and to ensure that the issuing bank has the ability to honour its financial undertaking and the country that the issuing bank is based in is not facing any financial risk..

Revolving

• In order to avoid credit that has been partially utilised, a revolving credit may be used for the value of the credit to be restored… These revolving credits can be in terms of
  • Cumulative (any sum not utilised can be carried forward to the next month) ;
  • Non-cumulative (specific shipment each month) ; or
  • Reinstated each time a shipment is made
• This type of credit is useful when there are repetitive shipments between the same parties regularly

Silent Confirmation

• Is when the advising bank adds a conditional guarantee of payment to the beneficiary without the knowledge of the issuing bank because in some cases the issuing bank may consider themselves creditworthy enough and do not see the need for a confirming bank..

Transferable

• In this type, the seller is allowed to transfer the credit either fully or partially to one or more parties provided the L/C clearly states that it is transferable..

Back to Back

• Some transactions require the use of middle-men or brokers in which case two different credits are issued because a transferable L/C may be unsuitable.. The two credits are a Master credit (to the broker) and a Back to Back credit (to the supplier)..

Standby letter of credit

• Is basically a credit assurance from a bank that a buyer is able to pay a seller.. But, this credit is considered to be a secondary credit covering only default and if there is non-performance.. Such credit is usually used to cover the risks that can occur in finalising a contract between a buyer and seller..

Red Clause

• Is a type of credit containing special Red Clauses (due to the colour of the ink used in writing this clause) which allows the beneficiary to access the credit even prior to the shipment of goods and/or presentation of documents.. A Clean Red Clause allows this access with the required documents but does not include the evidence of goods whereas a Documentary Red Clause allows this access against presentation of warehouse receipts along with the beneficiary’s undertaking to deliver the required documents upon shipment..

Green Clause

• Is a type of credit containing special Green Clauses (due to the colour of the ink used in writing this clause) which allows the beneficiary to access the credit even prior to the shipment of goods and/or presentation of documents.. Using the Green Clause, the beneficiary can get advance payment but by lodging the goods under storage in the name of the bank as security..

 

Conclusion

Letter of credit is basically an arrangement entered into between banks, on how the payments in an international commercial transaction can be settled while ensuring the security of both the parties involved..

A letter of credit is autonomous in nature which means, it has its own terms and conditions and is not reliant on the terms or performance of the sales contract or the contract of carriage..

Payments secured through Letter of Credits are based on documents only and not on the goods or services covered by sales or commercial contracts and the receipt of goods or payment is conditional upon the beneficiary’s compliance in the presentation of the required/listed documents..

This autonomy makes the Letter of Credit a primary means of payment in an international trade transaction where a documentary credit is involved..

 

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