LETTER OF CREDIT (L/C)

What is Letter of Credit?

What is the purpose of Letter of Credit?

Which Parties involved in a Letter of Credit Transactions?

What are the various types of Letters of Credit?

Which documents involved in a Letter of Credit Transactions?

Flow chart of Letter of Credit

What is Letter of Credit?

Letters of Credit have been described as “as the lifeblood of international trade and commerce”. It is generally accepted that international trade transactions carry inherently more risk than domestic trade transactions because of difference in culture, business processes, laws and regulations prevailing in various countries.

A Letter of Credit is a very common and important instrument in setting trade between nations. Buyers and sellers demanding cash or buyers’ banker’s letter of credit as guarantee for payment before they undertake shipment. A letter of credit adds buyer’s integrity through banker’s guarantee for the payment.

A documentary credit is a signed instrument embodying an undertaking by the buyer’s bankers to pay seller a certain sum of money on presentation of documents evidencing shipment of specified goods though after compliance of stipulated terms and condition of documentary credit. In this case bankers have to see only compliance with respect to terms and conditions of documentary credit and physical receipt of goods by buyer is not necessary before making payment against the documentary credit. Thus Banks accept the documents under letters of credit for what those documents appear to be on their face.

An L/C can be compared to a guarantee given by a bank on behalf of its customer to the effect that the Bank would make payment to the beneficiary when the beneficiary presents the documents as is required in the L/C. They are not negotiable instruments.

•         To illustrate an example

•         Videocon Industries Ltd. in India wants to import certain machinery, which they know is manufactured by M/s Edward & Co. in England.

•         They enter into a contract for purchase of the machinery, payments for which are required to be made by a L/C.  

•         Neither party knows the other; they are not sure whether the other will fulfill his part of the obligation.

In such a situation, Videocon Industries Ltd. will approach its Banker, Bank of India and make a request by an application for opening a L/C in favour of M/s Edward & Co.

•         Bank of India, after opening a L/C in favour of M/s Edward & Co. informs another Bank in England, the UK bank with whom BOI has an arrangement to forward the L/C to M/s Edward & Co. 

•         The UK Bank - Barclays Bank after verifying the authenticity of the L/C and finding it as genuiness forwards the same to M/s Edward & Co.

•         After verifying that the L/C has been drawn according to the sales contract, M/s Edward & Co. ships the machinery to Videocon Industries Ltd.  

•         M/s Edward & Co. now collect the bills of lading handed over by the shipping Co. and other required documents as per LC and draws a bill of exchange under L/C and presents it to its bankers, the Barclays Bank, for negotiating the bill and to obtain payment.    

•         Barclays Bank on their part receives the Bill and the documents from M/s Edward & Co. and checks that they are as per terms of L/C.

•         On finding them to be in order, Barclays Bank negotiates the bill and makes payment to M/s Edward & Co.

•         Barclays Bank thereafter sends the bill and documents to Bank of India.

•         BOI on its part verifies the bill and documents and if found in order sends the bill to Videocon Industries Ltd. for payment.

•         Videocon Industries Ltd. on receiving the bills checks the documents and pays the bill.

On making payment by Videocon Industries Ltd., Bank of India will release the shipping document so that Videocon Industries Ltd. can collect the goods from the shipping company.

•         The above illustrates the simplest form of payment under a letter of credit.

The terms of an L/C are sometimes complicated and various kinds of L/Cs have been devised since the concept of L/C was introduced.

Advantages of Letter of Credit to the Buyer (Importer):

1.     No payment has to be made in advance to the seller.

2.     The buyer can induce the seller to give credit from his supplier, which he may not be otherwise willing to give, since there is a guarantee  from a banker regarding payment on due date.

3.     In most cases the bills are payable over a period of time called (usance bills) thereby giving additional credit to the buyer.

4.     The buyer can, while opening the L/C insists that the quality of goods is certified by an independent body and such certificate be sent along with the bill for negotiation.  In case, the seller does not enclose such a document then the Banks will not make payment on the Bills.  He can also stipulate other terms and conditions to protect his interests and which are also acceptable to the seller.

Advantages of Letter of Credit to the Seller (Exporter):

1.     The seller is assured that he will receive payment on his complying with the terms of L/C.

2.     On shipment of the goods the seller can draw and negotiate the bills thereby getting immediate payment in his country, which payment otherwise would be made only after the goods are received by the buyer, which would cause delay in payment.

3.     The seller need not bother himself about the import regulations of the buyer’s country since this is the responsibility of the buyer. The exporter does not lose his right over the goods till the issuing Bank pays against the documents.

4.     The seller also need not bother about the fluctuations in currency since this will be the responsibility of the buyer.

Limitations of Letter of Credit:

1.     A LC is not a cent percent safe deal either for the exporter or for the importer.

2.     To the exporter, the undertaking of the issuing bank is only conditional.

3.     The documents tendered should strictly comply with requirements of the credit as is only the Bank that would decide if the documents are as per terms of the credit.

4.     To the importer, the major disadvantage is that it does not ensure that he would be receiving the goods of the specific condition  and order, as in LC  transactions all parties deal with documents  and not in goods.

Which Parties involved in a Letter of Credit Transactions?

Parties to Letter of Credit:

       i)            Applicant-Buyer-Importer-Opener: He is the person who applies to the bank to open a letter of credit, since he would be either purchasing goods or availing services for which payment has to be made. In the illustration – Videocon Industries Ltd.

    ii)            Issuing Bank: The bank which opens the letter of credit LC on the request of the applicant/buyer. Also called the opening bank or importers bank. In the illustration-Bank of India.

  iii)            Beneficiary-Exporter-Seller: Is the person who is entitled to receive the benefit under a LC (letter of credit), i.e. the right to receive payment or to draw bills and receive payment as per the terms of the LC. In the illustration –M/s Edward & Co.

  iv)            Advising Bank: The bank in the beneficiary/exporters country through which the letter of credit is advised to the beneficiary. The advising bank only forwards the LC to the beneficiary, thereby enabling the beneficiary to rely on its authenticity and genuineness. The advising bank is also sometimes termed as the Notifying Bank. In the illustration – The UK Bank.

    v)            Negotiating Bank: The bank in the beneficiary/exporters country which negotiates the bills (i.e. make payment on the bills drawn, by the seller and accepts the documents). If the LC specifies a bank then that bank is the negotiating bank and is also called the nominated bank or paying bank. If the LC however does not specify a bank, then any bank can be the negotiating bank, since the issuing banks open invitation contained in the credit is an offer, which is accepted as soon as the negotiating bank negotiates the bills and accepts the documents. In the illustration, Barclays Bank would be the negotiating bank. If Barclays Bank was also specifically mentioned in the credit as the negotiating bank, then Barclays Bank will also be the nominated Bank.

  vi)            Confirming Bank: The advising bank is only required to advise the credit to the beneficiary. If the seller is not conversant with the issuing bank or not satisfied with his financial position, he may ask for an additional assurance/guarantee from another bank located in his country/place and the second guarantee is called confirming the LC. The seller would look to the confirming bank to pay the amount covered by the bill if drawn as per terms of the LC. If however in addition to advising the credit the advising bank were to confirm it, then the advising bank will also be the confirming bank. In such case, the confirming bank is deemed to undertake on its part the liabilities of the credit vis-à-vis the beneficiary or the Negotiating Bank.

vii)            Reimbursing Bank: It is the bank, which is appointed by the Issuing bank to make reimbursement to the negotiating, paying or confirming bank.

What are the various types of Letters of Credit?

       i.            Acceptance Credit: An acceptance credit calls for a usance bill of exchange of a specified period to be drawn under the credit.

For instance, the L/C may require the Exporter to draw 90 days Bill. The advantage under an Acceptance credit is that the buyer need not pay immediately; he pays only on the due date of the bill. Seller gets the bill accepted by the Bank and in case he is in need of funds, discounts it with his Bank.  Thus the seller can also get payment immediately. Duty of issuing bank under this credit is not only to see that the bill is accepted but also to ensure payment on maturity.

     ii.            Irrevocable Credit: An irrevocable credit is a credit that can neither be amended nor cancelled without the consent/agreement of all the parties concerned.   

 The issuing/opening bank is bound by the commitments given in the credit. Bills drawn under an irrevocable credit are readily negotiated by Banks.   As per the latest uniform customs and practice for documentary credits 600, all credits are irrevocable.

  iii.            Revocable Credit: A revocable credit is one which can be cancelled or amended by the Issuing Bank at any time without prior notice to the beneficiary.

The cancellation or amendment however, takes effect against the Bank which has negotiated the bills under the credit only on receipt of notice of such cancellation or amendment. Issuing Bank is liable for bills negotiated conforming to the terms & conditions of the credit before the notice of revocation is received by the negotiating bank.

  iv.            Confirmed Credit: When a L/C is advised to the beneficiary through a Bank in the beneficiary’s country, it may request the other bank to add its confirmation or merely advise the credit to the beneficiary without adding its confirmation. If the advising bank adds its confirmation to the credit it becomes a confirming bank and the credit is confirmed credit.

 All confirmed credits are also irrevocable L/C. This is because no bank in the exporter’s country would be willing to undertake a liability on a revocable credit on which there is no definite undertaking by the issuing bank.

     v.            Unconfirmed Credit: When the advising bank does not add its confirmation but merely forwards the credit to the beneficiary, the credit remains unconfirmed. 

  vi.            Without Recourse: The bill of exchange drawn under a letter of credit indicates that it is drawn without recourse to the drawer. Unless the credit authorizes drawing a without recourse bill of exchange, it is not proper to present such a bill of exchange. Recourse denotes the parties involved viz. the negotiating bank, confirming bank and the issuing Bank .The exporter’s intention in drawing a without recourse bill of exchange  is to ensure that in case  the documents are  rejected by the issuing bank or payment is not made by the issuing bank for any reason, he should not be called upon to pay back  the amount he received  earlier on negotiation of documents. 

 However, as per the current guidelines from RBI, banks are not supposed to accept any inland bill drawn ‘without recourse’ for negotiation.

vii.            Transferable Credits: As stated earlier, a letter of credit is not a negotiable instrument, though the bills of exchange drawn under it are negotiable. As such, the rights under an L/C cannot be transferred and is vested in the beneficiary. A transferable credit is one under which the beneficiary can transfer his rights to third parties (second beneficiaries). Unless specifically stated an L/C is not transferable.

viii.            Back-to-Back Credits: This a credit which is an offshoot of the credit issued to the beneficiary. In a back-to-back credit, the beneficiary in whose favour an LC is issued uses the same to open another credit from his (beneficiary’s) bank in favour of his supplier. There are thus three banks involved in a back-to-back credit. First, the bank issuing the original credit to the beneficiary, the second, the advising bank through which the credit has been advised to the beneficiary and the third the bank, which issues an ancillary credit against the security of the original credit.

  ix.            Anticipatory Letter of Credit:

i.                   Red Clause letter of credit: In usual LC transaction, the beneficiary will be entitled to receive payment only on his handing over the documents and the bills drawn under the LC to the negotiating bank. However, in certain credits the beneficiary will be entitled to get an advance of the price. These credits contain a ‘red clause’ (because the clause is printed in red) which authorizes an intermediary bank to make an advance to the beneficiary before shipment. Red Clause LCs are however dying out.

ii.                 Green Clause letter of credits: This is a refinement of the ‘Red Clause’. This type of LC not only permits pre shipment advance but also permits advances to the exporter to cover storage at the port of shipment. The red clause and green clause credit are called anticipatory credits since payment of an advance is provided for in anticipation of the seller making shipment.

     x.             Revolving Letter of Credit: In a regular LC transaction, once the bills are negotiated the entire transaction comes to an end. If fresh shipment is to be made, another LC will have to be drawn. This procedure becomes time consuming especially when there is regular trade between the same parties. In such cases, it is preferable to open a revolving letter of credit. In this type of credit though the amount is fixed, it can be renewed as soon as the earlier bills have been paid.

Which documents involved in a Letter of Credit Transactions?

Due to the prime importance given to documents under a letter of credit transaction, it is necessary for a banker to understand the documents that accompany a letter of credit.

i.                    Bill of Exchange:

This is a financial document; Payment is made on this document. This for brevity sake is called ‘bill’ and is sometimes referred to as ‘draft; (to be distinguished from a ‘demand draft’). In a letter of credit transaction the right to draw a bill is conferred only on the beneficiary. The bill amount should be within the limit fixed in the letter of credit. The tenor, endorsement and the drawee should be the same as given in the letter of credit. This document should be distinguished from ‘bills of lading’, which is transport document and is discussed later on in this chapter. Bills or drafts can be payable on presentation (sight bills) or on a certain date (usance bill).

ii.                 Invoice:

This is the basic commercial document. This document gives details of the sale. It should be made in the name of the opener/importer unless required otherwise in the letter of credit. All the details mentioned in the invoice must tally with those mentioned in the letter of credit, failing which it may amount to a discrepancy, making the documents liable for rejection. Where the quantities are specified in a letter of credit, the form in which they are specified should be adhered to. For example, if the letter of credit calls for 100 kg of tea, the invoice should be made accordingly and converting the measure to equivalent pounds or quintals would make it liable to be rejected. A further problem posed is whether it would be in order, whereas per the credit the value of the shipment  is Rs. 15 lakh and the goods shipped is worth Rs. 20 lakh, with a request that Rs. 15 lakh be paid and excess Rs. 5 lakh collected to be repaid later. This would not comply with the credit terms and the opener/buyer/importer would be legally entitled to reject the documents.

iii.              Transport Documents:

The mode of dispatch of goods or the transporting of goods would depend on the terms of contract between the buyer and the seller and the same is incorporated in the letter of credit. The two main modes of transport of goods are either by sea or by air. In case the goods are shipped, the document evidencing the shipment of the goods is called the ‘Bill of Lading’. In case the goods are transported by air, the documents evidencing receipt of goods would be the ‘Airway Bill’ in case the goods are directly handed over to an Airline or its agent. In case goods are transported through postal system or courier service, the document evidencing receipt of goods would be either the ‘Post Parcel Receipt’ or the ‘Courier Receipts’.

iv.              Bills of Lading:

Bills of Lading are of two types – one, the traditional ship bill of lading and the other, the ‘Combined Transport Bill’; a creation of modern age containerization of shipments which permits more than one means of carriage and is also known as ‘Multimodal Transport’. Bill of lading is a document to title to goods, i.e. they are representatives of the goods and holder of the same is entitled to get possession of the goods. A bill of lading, to a certain extent is negotiable inasmuch as a bona fide transfer of the same by endorsement entitles the transferee the right to the goods. A bill of lading is issued in sets of 2, 3, or 4 and all are termed as originals. A banker should see that all the originals are received. Unless otherwise specified in the letter or credit, a bill of lading must be a ‘shipped’ bill of lading and a received for shipment’ or ‘transportation’ bill of lading or a ‘charter party’ bill of lading is not acceptable. This is because the shipped bill indicates that the goods have been taken on board of a specified ship and the journey has commenced while in the case of received for shipment bill though the goods have been to the transporter the journey is yet to commence.

v.                 Airway Bill:

This is a document, which evidences that the goods have been received by an airline company or its agent. Unlike a bill of lading an airway bill does not carry with it the right to the goods, i.e., it is not a document of title to the goods. If however the letter of credit terms permit acceptance of an airway bill then the banker is within his rights to accept it.

vi.              Post Parcel Receipt and Courier Receipts:

When the goods to be sent are small in quantity, then they can be sent through post or courier. The document issued by the postal department or the courier are similar in nature to the airways bill. They are not title to goods and only evidence that the goods have been entrusted for transportation to either the postal department or the courier company and most often than not the goods are addressed directly to the buyer.

vii.            Insurance Documents:

 The goods shipped, if required to be insured under the terms of the letter of credit should be so insured and the insurance document as required in the letter of credit should be enclosed with the other documents. Either an insurance company or underwriter or their agents should sign it. The type of insurance cover should be the same as specified in the credit. The requirements of the buyer regarding the amount of the policy, the currency, the risk to be covered and the place of payment in case of claim are to be strictly complied with.

viii.          Other documents:

 Over and above, the major documents discussed above which are required in all letters of credit transaction, the letter of credit may also call for certain other documents among which include certificate of origin, certificate of weight or quality or analysis, Health authorities certificate, etc. Such documents/enclosures are mandatory with the other documents, failing which payment can be refused. In interpreting these documents too, the Courts have applied the principle of strict interpretation.

 

Flow Chart of Letters of Credit

Flow Chart of Letter of Credit

 

1.     The exporter and importer sign a bill of sale contract.

2.      The importer applies to his bank, the issuing bank, to open a letter of credit.

3.      The issuing bank sends the advice of the credit to the advising bank.

4.     The exporter is advised of the credit.

5.      Following shipment of the goods, the exporter presents the documents to the advising bank  (the paying agent).

6.      After checking the documents and confirming that they agree with the letter of credit terms, payment is made to the exporter. At the same time, the advising bank sends the documents to the issuing bank and requests reimbursement for the letter of credit amount plus the advising bank's fees and expenses.

7.     The issuing bank sends the documents to the importer and debits his account for the letter of credit amount plus the fees and expenses of the banks involved.