What is Letter of Credit (LC)?
Letter of Credit (LC) is the most secured and widely used form of international trade transaction method. An LC is a commitment on behalf of the importer by a bank in the importer’s country that the payment will be made to the exporter if he meets the terms and conditions as stated in the LC. LCs are also called Documentary Credits (DCs).
The main difference in DCs as compared to Documentary Collections is that the importer’s bank is now responsible for the payment. If the exporter meets all the conditions of the LC, the importer’s bank needs to necessarily make payment to the exporter even if the importer defaults.
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One important aspect of the LCs is that banks deal only with documents and not with the real goods. This means that the importer’s bank cannot refuse to make payment if the quality of goods is found to be bad later. The LC issuing bank needs to verify only the veracity of documents (and not the quality of the goods) and the compliance with LC terms which might however include quality certificates, etc. The LC contract is a separate contract from the sales contract on which it is based upon. Thus, the banks are concerned only with the terms of the LC contract and not the fulfillment of the terms of the sales contract.
Steps in Letter of Credit (LC)
The following steps are involved in an LC transaction:
- The exporter and importer agree on sale contract terms. The exporter might insist on the issue of LC by the importer’s bank. The terms will be mutually agreed between the exporter and importer.
- The importer asks his bank (“issuing bank”) to open an LC in favour of the exporter for a specific amount and currency.
- The issuing bank from the importer’s country, through SWIFT message, transmits the LC to the ‘Advising Bank’. The ‘Advising Bank’ notifies the exporter after ensuring its authenticity. It may be same as the exporter’s bank or a different one.
- On receipt of LC, the exporter prepares the documentation as per the LC terms and forwards the goods and documents to a freight forwarder.
- The exporter submits the documents required by the LC (which would include documents like the original bill of lading, bill of exchange, invoice, pa cking list, quality certificate, etc.) to the ‘nominated bank’. The ‘nominated bank’ is responsible for verifying the documents and sending it to the LC issuing bank.
- The LC issuing bank verifies the document for compliance with LC terms and presents the documents to the importer. If the LC involves demand bills (document against payment), the importer’s account is debited and the original documents are released to him. The amount is transferred to the nominated bank for onward credit to the exporter’s account (or as per reimbursement terms if negotiation credit is applicable). If the terms involve document against acceptance, the issuing bank gets acceptance of the bill by the importer before releasing the
title to the goods.
- The importer obtains goods on presentation of the documents at customs. He also makes payment on the due date if the bills are of DA type for onward remission to the nominated bank/negotiation bank.
The terms of negotiation depends on LC. Depending on the payment type, LCs can be classified as Sight LC, Acceptance LC, Deferred Payment LC or Negotiation LC. The sight LC and acceptance LC are used when the DCs involve DP and DA bills, respectively. The deferred payment credit is similar to the acceptance LC but does not require bills which might involve additional costs like stamp duties.
Apart from different LCs that are based on payments methods, like sight LC, acceptance LC, negotiation LC and deferred credit LC.
Types of Letter of Credit (LC)
If the exporter is not comfortable with the creditworthiness of the importer’s bank or his country, he may ask the issuing bank to get ‘confirmation’ from a bank in exporter’s country. This means the ‘confirming bank’ commits to make payment to the exporter even if the importer’s bank fails to make payment. Such LCs are termed as confirmed LCs. The confirming bank steps into the shoes of the issuing bank and performs all functions of the issuing bank.
LCs can be one-off or it may be issued in a series of transactions. In such cases, they are termed as revolving LCs. The issuing bank restores the credit to its original amount each time it is drawn down.
Revocable and Irrevocable LCs
By default, all LCs are considered ‘irrevocable’ unless stated otherwise. This means that the document may not be changed unless all the parties, such as the importer, banks and the exporter agree. If the LC is specified as ‘revocable’, the issuing bank can amend or cancel the LC at any point of time without the consent of any other party. However, if payment has been made on the revocable LC before receipt of the cancellation notice by the negotiating bank, then the issuing bank is liable. The revocable credits are rare and not part of UCP 600 anymore.
Red Clause LCs
A ‘Red Clause’ LC authorises the nominated bank to provide pre-shipment credit (advance before shipment of goods) to the exporter. It is guaranteed by the issuing bank, in case, the exporter defaults on submitting the shipment documents.
Back to Back LC
In this case, the exporter arranges to issue an LC in the favour of a local supplier on the strength of the LC received from the issuing bank of the importer. It can be used for procurement of raw material locally or for the import of goods to meet original LC commitments.
A standby LC is issued as a substitute for bank financial guaranty. These can be governed by UCP 600 or International Standard Practices (ISP)-98.