Letter of Credit (LC) / Documentary Credit
What is a Letter of Credit ?
A Letter of Credit (L/C) or Documentary Credit is a Written commitment to pay, by a buyer's or importer's bank (called the issuing bank) to the seller's or exporter's bank (called the accepting bank, negotiating bank, or paying bank). A L/C guarantees payment of a specified sum in a specified currency, provided the seller meets precisely-defined conditions and submits the prescribed documents within a fixed timeframe. These documents almost always include a clean bill of lading or air waybill, commercial invoice, and certificate of origin To establish a L/C in favor of the seller or exporter (called the beneficiary) the buyer (called the applicant or account party) either pays the specified sum (plus service charges) up front to the issuing bank, or negotiates credit. L/Cs are formal trade instruments and are used usually where the seller is unwilling to extend credit to the buyer. In effect, a L/C substitutes the credit worthiness of a bank for the credit worthiness of the buyer. Thus, the international banking system acts as an intermediary between far flung exporters and importers Since the unambiguity of the terminology used in writing a L/C is of vital importance, the International Chamber Of Commerce (ICC) has suggested specific terms (called Incoterms) that are now almost universally accepted and used. Unlike a bill of exchange, a L/C is a non-negotiable instrument but may be transferable with the consent of the applicant.
A key principle underlying letter of credit (L/C) is that banks deal only in documents and not in goods. The decision to pay under a letter of credit will be based entirely on whether the documents presented to the bank appear on their face to be in accordance with the terms and conditions of the letter of credit.
Parties to a Letters of Credit
Applicant (Opener) : Applicant is normally a buyer of the goods, who has to make payment to beneficiary. L/C is initiated and issued at his request and on the basis of his instructions.
Issuing Bank (Opening Bank) : The issuing bank creates a letter of credit and takes the responsibility to make the payments on receipt of documents in accordance with the terms and conditions of the L/C. from the beneficiary or through their banker.
Beneficiary : Beneficiary is normally the seller of goods, who has to receive payment from the applicant. A credit is issued in his favour to enable him or his agent to obtain payment on submission of stipulated document as per the term and conditions of the L/c.
If L/c is a transferable one and he transfers the credit to another party, then he is referred to as the first or original beneficiary.
Advising Bank : An Advising Bank advices the beneficiary and takes the responsibility for sending the documents to the issuing bank and is normally located in the country of the beneficiary.
Confirming Bank :Confirming bank adds its guarantee to the L/C opened by another bank, thereby undertaking the responsibility of payment / negotiation / acceptance under the L/C, in additional to that of the issuing bank. Confirming bank play an important role where the exporter is not satisfied with the undertaking of only the issuing bank.
Negotiating Bank: The Negotiating Banks negotiate documents submitted by the beneficiary drawn under the L/C either advised through them or restricted to them for negotiation. On submission of documents as par the terms and conditions of the L/C, the Negotiating Bank makes payment to the beneficiary by negotiating the documents and claims reimbursement from the Issuing Bank / Reimbursing Bank.
Reimbursing Bank : Reimbursing Bank is the bank authorized to honor reimbursement claim in settlement of negotiation/acceptance/payment lodged with it by the negotiating bank. It is normally the bank with which issuing bank has an account from which payment has to be made.
Types of Letter of Credit
Revocable Letter of Credit
A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. It is rarely used international trade and not considered satisfactory for the exporters but has an advantage over that of the importers and the issuing bank. It should be indicated in the LC that it is revocable else it will be deemed as irrevocable.
Irrevocable Letter of Credit
Irrevocable Letter of Credit cannot be revoked or amended without consent of all the parties i.e. the issuing bank, the confirming bank, and the beneficiary. Form an exporters point of view it is believed to be more beneficial. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and the terms and conditions are complied with, payment will be made.
Confirmed Letter of Credit Confirmed Letter of Credit is has added of another bank apart from that of the issuing bank. Although, the cost of confirming by another banks makes it costlier, this type of L/c is issued in cases where the beneficiary wants guarantee from a bank in his country.
Sight Letter of Credits
In Sight Letter of Credits the payments would be made by the issuing bank at sight, on demand or on presentation.
Usance Letter of Credit
In Usance Letter of Credit, draft are drawn on the issuing bank or its correspondent bank for specified usance period.
Back to Back Letter of Credit A Letter of Credits is known as Back to Back Letter of Credits when it is opened on the security of another Letter of Credit.
Transferable Letter of Credit In a Transferable Letter of Credit the first beneficiary (which is usually a middleman) can request the nominated bank to transfer credit in whole or in part to the second beneficiary.
Uniform Customs and Practice for Documentary Credit (UCPDC) is a set of rules established by the International Chamber of Commerce (ICC) on Letters of Credit. The UCPDC is used by bankers and commercial parties in more than 200 countries including India to facilitate trade and payment through LC.
UCPDC was first published in 1933 and subsequently updated from time to time. The latest revision was approved by the Banking Commission of the ICC at its meeting in Paris on 25 October 2006.