Payment Documents: Letter of Credit, Bill of Exchange, Trust Receipts, Letter of Hypothecation

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Payment Documents

For winning sales and building brand image among customers globally, it is very important for the exporters to provide attractive sales and payment terms to the customers. The payment system is the backbone of international trade and it is not only confined to quality, price, and delivery schedule. The major characteristics of international trade are that it is not only highly competitive but equally sensitive as well.

The international trade payment is highly organised and there are various steps to make the business safe for both the parties. There are various documents related to payment terms. Let’s take these documents one by one to explain the payment procedure and methods.

Letter of Credit

According to Justice Cameron of Lava Systems, “A letter of credit is a specialised form of commercial credit. It is an autonomous contract between an issuer, normally a bank, and the beneficiary, normally a supplier, customer with a possible warranty claim, or creditor of the bank’s customer. The issuer’s customer is not a party to the letter of credit.

It is one of the most popular payment methods in recent times. The method eliminates the exporter’s fear of credit and payment risks. In the Letter of Credit system, the exporter is not worried about the creditworthiness of the borrower or importer while entering into the contract because bank gives the credit guarantee of importer. There is no payment risk as the bank is liable to make payment to the exporter once the stipulated conditions are met.

One of the main advantages offered to the exporter is that he/she can collect the payment from the bank located in his/her home country.The letter of credit is independent of any agreement or the equities between the beneficiary and the issuer’s customer or the issuer and its customer. Subject to fraud, the letter of credit is payable by the issuer in accordance with its terms, independent of the performance of the underlying contract for which the credit was issued. The funds paid are those of the issuer, not its customer.”

The letter of credit works in the following way:

  • The buyer and seller form an agreement of sale. The agreement states that the letter of credit will be used for the payment transactions.

  • The buyer fills the application for a letter of credit and forwards it to bank. The letter of credit will be issued by a bank.

  • The buyer’s bank will forward the letter of credit to the seller’s bank in the seller’s country.

  • The seller’s bank gives the letter of credit to the seller.

  • After receiving the payment, seller makes the shipping arrangements for the buyer.

According to Article 3 of Uniform Customs and Practices relating to Documentary credits, Documentary Letter of Credit has been defined as “any arrangement whereby a bank acting at the request and in accordance with the instructions of a customer (the importer) undertakes to make payment to or to the order of a third party (the exporter) against stipulated documents and compliance with stipulated terms and conditions”.

On the request of the importer, bank commits to the exporter for making a payment, under certain special circumstances and up to a limit. However, the bank only decides to make payment when all the required letter of credit documents as requested by the importer, are presented in orderly manner. Documents that need to be submitted usually include bill of lading, invoice, and marine insurance policy.

There are various types of letters of credit that are explained as follows:

Documentary Letter of Credit

In this, the exporter has to collect all the documents that he/she has to submit to the importer. It includes following documents:

  • Sight or Usance Bill of Exchange

  • Commercial Invoice/Customs Invoice

  • Consular invoice

  • Packing List

  • Full set clean-on-board Bill of Lading/Airway Bill/Combined Transport Document

  • Inspection Certificate

  • Marine Insurance Policy/Certificate

  • Certificate of Origin

  • Any other document as required by the buyer, mentioned in letter of credit

Revocable and Irrevocable Credit

According to a revocable letter of credit, the opening bank holds the right of cancellation or modification of the credit, at any time. Revocable letters of credit cause apprehension to the exporter as importer may instruct the banker to revoke the credit when the contract is in stage of execution or even after shipment.

In case of irrevocable letter of credit, the bank cannot change the terms of credit, without taking the consent of the beneficiary. The bank is liable to make the payment, if the documents are in accordance to the credit terms specified in the letter of credit. In the absence of any mentioned terms, it is deemed that the letter of credit is irrevocable with due effect from 1stJanuary 1994.

With Recourse or Without Recourse Letter of Credit

In ‘With Recourse” letter of credit, the bank can make the exporter liable in case of default in payment. Under “Without Recourse” letter of credit, the negotiating bank has no recourse to the exporter. However, if the confirming bank and negotiating bank are same then confirming bank have no option of exercising recourse to the exporter. In case, a confirmed letter of credit is issued then it comes without recourse to the beneficiary. While, in case unconfirmed or negotiable letter of credit is issued then it always comes with recourse to the beneficiary.

Commercial Letters of Credit

This is one of the most crucial methods of payment. These letters of credit are based on the latest version of Uniform Customs and Practice for Documentary Credits (UCP).

Standby Letters of Credit

It refers to the guarantee that bank offers for the payment because of the client. This is considered as the payment of last resort, which means if the client fails to make the payment as per the contract then bank will do it.

Unconfirmed Letters of Credit

It refers to those letters of credit that have not earned guarantee or confirmation by any bank other than the bank that opened it.

Confirmed Letter Of Credit

When a second bank guarantees the payment of letter of credit then it is known as confirmed letter of credit.

Clean Letters of Credit

These letters are best suited for different commercial situations where goods movement is not expected. Clean letters of credit are issued only on request.

Transferable Letters of Credit

These are also known as documentary credit, which means it has the option to allow a trader to transfer its rights and obligations to the supplier. During documentation, it should be clearly stated that the credit is transferable otherwise no credit can be transferred regardless of any other terms mentioned.

Back-to-Back Letters of Credit

As the name suggests, in this one irrevocable letter of credit becomes the collateral for other one. In this, two letters of credit are issued that can be used together by the seller for financing the purchase of goods and services.

Advance Payment (Red Clause) Letters of Credit

The main feature of this letter of credit is that it is generally written in red ink. It is an arrangement in which the seller is allowed to withdraw some fixed amount from the advising or paying bank.

Bill of Exchange

Bill of exchange is a negotiable instrument that includes an unconditional order that is signed by the maker who agrees to pay a certain amount of money to the bearer of the instrument. This document is very crucial in international trade as it binds one party to pay agreed amount to another party on a specified time. Bill of exchange can be drawn by individuals or banks and are generally transferable by endorsements.

When the bill of exchange is issued by the bank, it is known as bank draft, whereas, when issued by individuals, it is known as trade draft. It is one of the most important methods of payment where the document is prepared by the exporter and sent to the importer along with the documents through a commercial bank.

Figure shows the format of Bill of Exchange:

Bill of Exchange

Foreign Bill of Exchange

Bills of exchange that are drawn from one country for another country is known as foreign bill of exchange. These bills of exchange are of two types:

Ordinary Foreign Bill

This bill is issued only when exporter has full trust in the credit-worthiness of the importer. It is also referred as Clean Foreign Bill of Exchange.

Documentary Bill

In this bill, documents to the title of the goods are sent along with the foreign bill of exchange. This bill can be further categorised as:

Documents Against Payment

In this, documents are delivered to the importer after making the full payment. The exporter provides clear export-import procedures, documentation, and logistics instruction to the bank including the instruction to clear the full payment.

Documents Against Acceptance

In this method, the exporter instructs the bank to deliver the documents to the importer only when he or she accepts the enclosed bill of exchange. Both exporter and importer have to affix stamps while sending the bill and accepting the bill respectively according to their country’s respective policies.

Trust Receipts

Trust receipt can be defined as the notification given to the buyer by the bank on the release of merchandise, where the bank retains the ownership title for the assets released. It can be defined as a legal document that is made between the bank and person borrowing from the bank.

Figure shows the specimen of Trust Receipt:

In this, the importer has to clear the payment in order to take delivery of goods. In case, the importer fails to clear the payment, on arrival of goods, the importer can execute a trust receipt to take delivery of goods later. The importer can sell the goods and could act as an agent for the bank. In this, the importer informs the bank regarding the sale and deposits the sale proceeds with the bank.

Until importer makes the final settlement, the bank retains ownership for the goods and importer work as an agent of the bank. This arrangement is designed to help the importer to take delivery of goods in case of lack of fund. This method offers flexibility to the importer and protects bank’s interests.

Letter of Hypothecation

Letter of Hypothecation is a written agreement that authorises a bank or lender to repossess and sell the pledged item in case of a default. Letter of hypothecation plays an important role in international trade as it gives authority to the bank to sell the shipment if buyer fails to give acceptance or make payment on time. An example of hypothecation is car loans.

In this case, the car is hypothecated to the bank and if the borrower defaults on the loan the bank has a right to recover the amount by disposing the vehicle. In case of export and import, importers may take a loan from bank to pay for goods and in exchange offer the asset/financial instruments to bank as a pledge. The practice and rules regarding the hypothecation vary depending on the country.

Sample Letter of Hypothecation

Hypothecation Letter

Lender Name: _______
Address: ____________________________

To Whomsoever It May Concern

In order to induce _______________ (“Lender”) to extend credit or other financial accommodation to _____ _______________ (the “Obligor”, whether one or more), for value received, the receipt and sufficiency of which is hereby acknowledged, the undersigned Trustee(s) do each, jointly and severally, consent and agree that the hereinafter described the property, solely owned by the undersigned in Trust, may be pledged or encumbered in favour of the Lender as collateral security for the payment of each and every obligation or liability of the Obligor to the Lender whether now existing or hereinafter acquired, whether matured or not, whether liquidated or unliquidated, whether secured or by other collateral or not, whether original, renewed, or extended, or whether originally contracted with the Lender or acquired by the Lender from another or others, or whether represented or evidenced by negotiable instruments or their writings (collectively the “Obligation”), said property being described as follows:

Street Address:

The undersigned further agree(s) that the Property so pledged or encumbered shall be subject to the provisions of this instrument and also to the provisions of all security agreements, mortgages, deeds of trust, or writings at any time or items evidencing or relating to any Obligation of the Obligor to the Lender to the same extent as if the undersigned had no interest whatsoever herein; that the Lender shall not be in any way obligated to notify or produce the consent of the undersigned as to any matter, event, or any contingency relating in any way to the making, renewing, or extending of any Obligation of the Obligor, such notification or consent being hereby expressly waived.

Witness the following signatures and seals this ____ day of _______, _______________.

_____________ _______________

Name of Trust By: (Name of Trustee), Trustee


By: (Name of Trustee), Trustee

Bank Certificate of Payment

Bank Certificate of Payment is a certificate issued by the negotiating bank to the exporter that the bill covering the shipment has been negotiated through it and export proceeds have been received from the importer. The certificate indicates the details of the merchandise exported. Certificate of payment is a document that exporter has to submit stating that all the export transactions have been concluded by him or her only. For releasing from all the export obligations, it is required to submit this certificate.

Figure shows the specimen of Bank Certificate of Payment:

Bank Certificate of Payment

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