Letter of Credit (L/C)
The Letter of Credit has been a key means of payment in international trade for many years. It continues to play an important role in world trade today. A simple reason for its use is that the seller will not usually ship without a bank's assurance of payment. While this is a major factor in its continued use, the Letter of Credit offers other advantages for the buyer and seller.
Both buyers and sellers profit from the distinct uniqueness of a Letter of Credit. However, both parties must be aware of what a Letter of Credit does not do (Kummer et al., 2009):
- It does not provide a total assurance of payment to anyone. A Letter of Credit guarantees payment only if its terms and conditions are satisfied by presenting the necessary documents.
- The value of such a guarantee depends upon the stability of the bank providing its undertaking and the political and foreign exchange stability of the country where the bank is situated.
- It does not give a guarantee that the goods depicted in the presentation documents have been delivered. Banks don’t deal with goods and services; they deal with documents related to the Letter of Credit. The quantity and quality of the goods shipped depends upon the honesty and integrity of the seller that has manufactured or packaged the goods and organized the delivery.
The buyer may stipulate that the Letter of Credit be accompanied by laboratory test certificates, inspection certificates or other documents that confirm the quality or quantity of the goods. Generally, the buyer and seller agree in advance on which party is responsible for the sum of these services.
Other definitions:
"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 letter of credit 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 letter of credit 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."
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Parties and Terms in Letters of Credits
To understand Letters of Credit exactly, the parties and terms which are used in Letters of Credit should be examined. [WBG 2011]
The Parties
The parties concerned with a Letter of Credit are described below [WBG 2011]:
Applicant: The party that organizes for the Letter of Credit to be issued, usually the buyer in a commercial transaction or the borrower in a financial transaction.
Beneficiary: The party named in the Letter of Credit in whose favor the Letter of Credit is issued, it is generally the seller (exporter) in a commercial transaction or the creditor in a financial transaction.
Issuing Bank: The Applicant’s bank that issues its undertaking to the Beneficiary in the form of a Letter of Credit.
Advising Bank: The bank, usually in the Beneficiary’s country, which informs the Beneficiary that another bank has issued a Letter of Credit in their favor.
Letter of Credit Terms and Conditions
The following terms and conditions are basic to most letters of credit [WBG 2011]:
Draft – Letters of Credit usually necessitate that the Beneficiary draw a draft on the Issuing Bank. The period of time from the date on which either the complying documents are presented or the draft is drawn, to the date on which payment is payable is the “tenor” of the draft. If the draft is payable upon presentation, the draft will be drawn payable at ‘’sight.”
If the draft is payable, for example, 30 days after presentation of complying documents (“30 days sight”) or 30 days after the date the draft is drawn (“30 days date”), the draft is a time draft. Time drafts may be drawn for any number of days. For ease in financing, days are usually expressed in 30 day increments, i.e., 30, 60, 90, 120, 150, 180 days. The accepted draft is the unconditional obligation of the Accepting Bank to pay at maturity. When drafts are accepted by an Accepting Bank they take on special properties. [WBG 2011]
Expiration Date – A Letter of Credit should contain a stated expiry date. The Beneficiary is required to present the draft(s) and documents to the Issuing Bank or a Nominated Bank on or before that date. Under the Uniform Customs and Practice for Documentary Credits Act (UCP), published by the International Chamber of Commerce (and incorporated by reference in most commercial letters of credit), if the expiration date falls on a day when banks at the place of presentation are closed, the expiration date is extended to the next business day. Letters of Credit expire at the times and locations specified in the Letter of Credit. [WBG 2011]
Latest Shipping Date – Most Commercial Letters of Credit contain a latest shipping date. The documents confirming shipment must not be dated after that date. When “on board” transportation documents are required, the date indicated in the “on board” notation on the transport documents is considered to be the date of shipment. [WBG 2011]
Marine Bills of Lading are issued in either “Shipped on Board” or “Received for Shipment” form. When a Letter of Credit specifies marine or ocean “on board” bills of lading, “onboard” may be evidenced by:
• A bill of lading being issued using an “on board” form; or
• A bill of lading carrying an “on board” notation.
This notation (often a superimposed stamp) must be dated. The “on board” date (the shipping date) cannot be later than the “latest shipping date” specified in the Letter of Credit. [WBG 2011]
Unless the Letter of Credit otherwise states, the UCP requires that marine bills of lading show that the goods are on board. This means that the Beneficiary must either provide an “on board” bill of lading or have the carrier’s “on board” notation put on the bill of lading.
Latest Date for Presentation – Unless the credit stipulates otherwise, the UCP requires that documents be presented within 21 days of the date of shipment or at another such period stated in the Letter of Credit. For Marine Bills of Lading, the “on board” date is seen as the shipment date. [WBG 2011]
Commercial Letters of Credit are often issued with a latest shipping date that is more than 21 days prior to the Letter of Credit expiration date. This is due to the fact that the most common amendment to a commercial Letter of Credit is to extend the shipping date. The additional period permits the shipping date to be adjusted without the expiration date being extended. The additional time is not a “cure” period for documents under discrepancy. [WBG 2011]
Types of Letter of Credit
All Letters of Credit are issued in either a "revocable" or an "irrevocable" form and “confirmed" or "unconfirmed." They should be read carefully and understood to determine the advantages and to decide which one is fitting for a particular situation. [WBG 2011]
Revocable Letter of Credit
Unless stated otherwise all credits are revocable. The term indicates that the credit is not a legally binding undertaking and can be changed or with drawn at any time without the permission or knowledge of the beneficiary. However, it gives no assurance of payment. When the seller doesn’t needs require a guarantee other than the buyer's reputation, a letter of credit serves no purpose unless it is used as a suitable means of exchanging documents and payment (TD Commercial Banking). [WBG 2011]
Irrevocable Letter of Credit
With this type of credit the buyer's bank has given an irrevocable promise to pay the seller, on his/her proof of compliance with the set conditions of the Letter of Credit, and the bank without the authorization of the exporter cannot change this. The buyer has no responsibility to agree to changes to the Letter of Credit. If it includes conditions that are inconsistent with the sales-purchase agreement, then this is a subject to be settled between the buyer and seller; the bank has no responsibility to involve itself with the particulars of the agreement. [WBG 2011]
Confirmed
A confirmed letter of credit is when a second guarantee is added to the document by another bank. The advising bank, the branch or the correspondent through which the issuing bank directs the letter of credit, adds its undertaking and commitment to pay the letter of credit. This confirmation means that the seller/beneficiary may also look at the credit worthiness of the confirming bank for payment guarantee (2001, Equipment). [WBG 2011]
Special Letters of Credit
A short description of some special Letters of Credit can be found below [WBG 2011]:
Red Clause Letter of Credit
Red Clause Letters of Credit supply the seller with cash before shipment so he/she can finance the production of goods. The buyer's Issuing Bank may forward some or all of the funds. In other words, the buyer offers financing to the seller and therefore sustains the risk for all advanced credits. [WBG 2011]
Deferred Payment (Usance) Letter of Credit
In Deferred Payment Letters of Credit, the buyer accepts the documents associated with the letter of credit and agrees to pay the issuing bank after a fixed period. This credit gives the buyer a grace period for payment. [WBG 2011]
Revolving Letter of Credit
With a Revolving Letter of Credit, the issuing bank restores the credit to its original amount once it has been used or drawn down. Generally, these arrangements limit the number of times the buyer may draw down its line over a predetermined period. [WBG 2011]
Back-to-Back Letter of Credit
This is a new letter of credit opened based on an already existing, nontransferable credit that is used as collateral. Traders often use back-to back arrangements to pay the ultimate supplier. A trader receives a letter of credit from the buyer and then opens another letter of credit in favor of the supplier. The first letter of credit serves as collateral for the second credit. [WBG 2011]
Transferable Letter of Credit
This type of credit allows the seller to transfer all or part of the proceeds of the original letter of credit to a second beneficiary, usually the ultimate supplier of the goods. The letter of credit must state that it is transferable for it to be considered as such. This is a widespread financing method used by middlemen and is common in East Asia. [WBG 2011]
