Letter of Credit

Letter of credit is a written undertaking by a bank (issuing bank) given to the seller (beneficiary)
at the request, and in accordance with the buyers (applicant) instructions to effect payment, that
is by making a payment, or by accepting or negotiating bills of exchange (drafts), up to a stated
amount, against stipulated documents and within a prescribed time limit.
Working with an overseas buyer can be risky, as the buyer is unknown, business troubles or
political unrest can delay your payment. When the seller has doubts about the credit-worthiness
of the buyer and wishes to ensure prompt payment, the seller can insist that the sales contract
provides for payment by irrevocable letter of credit.
The bank will only issue a letter of credit if the bank is confident that the buyer will pay. Some
buyers have to deposit enough money to cover the letter of credit, and some customers use a line
of credit with the bank (in other words, a loan is created when the payment is made).
Furthermore, if the bank issuing the letter of credit (issuing bank) is unknown to the seller or if
the seller is shipping to a foreign country and is uncertain of the issuing banks ability to honor
its obligation, the seller can, with the approval of the issuing bank, request its own bank or a
bank of international repute to assume the risk of the issuing bank by confirming the letter of
credit.

Fig:- Flow of goods and flow of LC

Parties Involved in a Letter Of Credit Transaction

Following is a brief description of the parties most commonly involved in a letter of credit
transaction

Accepting Bank - The bank named in a letter of credit on whom term drafts are drawn
and who indicates acceptance of the draft by dating and signing across its face, thereby
incurring a legal obligation to pay the amount of the draft at maturity.

Advising Bank - A branch or correspondent bank at or near the domicile of the

beneficiary, to which the issuing bank either sends the letter of credit, or a notification
that a letter of credit has been issued, with instructions to notify the beneficiary. The
advising bank advises the beneficiary of the letter of credit without engagement.
Applicant - The buyer or the party who requests the letter of credit to be issued.

Beneficiary - The seller or the party to whom the letter of credit is addressed.

Confirming Bank - A bank usually in the country of the beneficiary which, at the request
of the issuing bank, joins that bank in undertaking to honor drawings made by the
beneficiary, provided the terms and conditions of the letter of credit have been complied
with.

Discounting Bank - A bank which discounts a draft for the beneficiary after it has been
accepted by an accepting bank.

Drawee Bank - The bank named in the letter of credit on whom drafts are to be drawn.

Drawer - The beneficiary of the letter of credit who will draw the draft in accordance
with the terms of the letter of credit.

Issuing Bank- The bank which opens a letter of credit on behalf of the applicant and
forwards it to the advising bank for delivery to the beneficiary.
Negotiating Bank - Usually the beneficiarys bank which, after satisfying itself that the
documents conform with the letter of credit, agrees to purchase the draft (pay the
beneficiary).

Paying Bank - The bank named in the letter of credit where drafts are to be paid. It is not
necessarily the issuing bank, but often a branch of the issuing bank or its correspondent.
Once drafts have been paid or accepted by the paying/drawee bank, there is no recourse
to the drawers.

Reimbursing Bank - The bank authorized by the issuing bank to reimburse the drawee
bank or other banks submitting claims under the letter of credit.

Second Beneficiary - Second Beneficiary is the person who represents the first or original
Beneficiary of credit in his absence. In this case, the credits belonging to the original
beneficiary is transferable. The rights of the transferee are subject to terms of transfer.

In every case the bank will be rendering services not only to the Issuing Bank as its agent
correspondent bank but also to the exporter in advising and financing his export activity.

Advising an Export L/C

The basic responsibility of an advising bank is to advise the credit received from its
overseas branch after checking the apparent genuineness of the credit recognized by the
issuing bank.
It is also necessary for the advising bank to go through the letter of credit, try to
understand the underlying transaction, terms and conditions of the credit and advice the
beneficiary in the matter.
The main features of advising export LCs are:
1. There are no credit risks as the bank receives a onetime commission for the advising
service.
2. There are no capital adequacy needs for the advising function.

Advising of Amendments to L/Cs

Amendment of LCs is done for various reasons and it is necessary to fallow all the
necessary the procedures outlined for advising. In the process of advising the
amendments the Issuing bank serializes the amendment number and also ensures that no
previous amendment is missing from the list. Only on receipt of satisfactory information/
clarification the amendment may be advised.

Confirmation of Export Letters of Credit

It constitutes a definite undertaking of the confirming bank, in addition to that of the
issuing bank, which undertakes the sight payment, deferred payment, acceptance or
negotiation.
Banks in India have the facility of covering the credit confirmation risks with ECGC
under their Transfer Guarantee scheme and include both the commercial and political
risk involved.

Discounting/Negotiation of Export LCs

When the exporter requires funds before due date then he can discount or negotiate the
LCs with the negotiating bank. Once the issuing bank nominates the negotiating bank, it
can take the credit risk on the issuing bank or confirming bank.
However, in such a situation, the negotiating bank bears the risk associated with the
document that sometimes arises when the issuing bank discover discrepancies in the
documents and refuses to honor its commitment on the due date.

Reimbursement of Export LCs

Sometimes reimbursing bank, on the recommendation of issuing bank allows the
negotiating bank to collect the money from the reimbursing bank once the goods have
been shipped. It is quite similar to a cheque facility provided by a bank.
In return, the reimbursement bank earns a commission per transaction and enjoys float

income without getting involve in the checking the transaction documents.

reimbursement bank play an important role in payment on the due date ( for usance LCs)
or the days on which the negotiating bank demands the same (for sight LCs)

UCPDC Guidelines
Uniform Customs and Practice for Documentary Credit (UCPDC) is a set of predefined
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 updating it throughout the years.

Documents required under Letter Of Credit

The following is a list of documents most commonly seen in a letter of credit transaction. Each
document is described in brief with a check-list for preparing the document.
The documentary requirements can be strictly complied with, the beneficiary may not receive
payment from the issuing bank, If there are any requirement that cannot be complied with, the
beneficiary should immediately request the applicant to arrange for an appropriate amendment to
the letter of credit.
Draft
A draft is a bill of exchange and a legally enforceable instrument which may be regarded as the
formal evidence of debt under a letter of credit. Drafts drawn at sight are payable by the drawee
on presentation.
Term (usance) drafts, after acceptance by the drawee, are payable on their indicated due date.
Commercial Invoice
The commercial invoice is an itemized account issued by the beneficiary and addressed to the
Bill of Lading
A bill of lading is a receipt issued by a carrier for goods to be transported to a named destination,
which details the terms and conditions of transit. In the case of goods shipped by sea, it is the
document of title which controls the physical custody of the goods.
Air Waybill
An air waybill is a receipt issued by an air carrier indicating receipt of goods to be transported by
air and showing goods consigned to a named party. Being a non-negotiable receipt it is not a
document of title.

Insurance Policy or Certificate

Under the terms of a CIF contract, the beneficiary is obliged to arrange insurance and furnish the
buyer with the appropriate insurance policy or certificate. The extent of coverage and risks
should be agreed upon between the buyer and seller in their initial negotiations and be set out in
the sales contract.
Since the topic of marine insurance is extremely specialized and with conditions varying from
country to country, the services of a competent marine insurance broker are useful and welladvised.
Certificate of Origin
As the name suggests, a certificate of origin certifies as to the country of origin of the goods
described and should comply with any stipulations in the letter of credit as to originating country
and by whom the certificate is to be issued. The certificate should be consistent with and
identified with the other shipping documents by shipping marks and numbers, and must be
signed.
Inspection Certificate
When a letter of credit calls for an inspection certificate it will usually specify by whom the
certificate is to be issued; otherwise, the same general comments as in the case of the certificate
of origin apply.
As a preventative measure against fraud or as a means of protecting the buyer against the
possibility of receiving substandard or unwanted goods, survey or inspection certificates issued
by a reputable third party may be deemed prudent. Such certificates indicate that the goods have
been examined and found to be as ordered.
Packing List
A packing list is usually requested by the buyer to assist in identifying the contents of each
package or container. It must show the shipping marks and number of each package. It is not
usually required to be signed.
10

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 in international trade and not
considered satisfactory for the exporters but has an advantage over that of the importers
and the issuing bank.
There is no provision for confirming revocable credits as per terms of UCPDC, Hence
they cannot be confirmed. It should be indicated in LC that the credit is revocable. If
there is no such indication the credit will be deemed as irrevocable.

Irrevocable Letter of Credit

In this case it is not possible to revoke or amended a credit without the agreement of 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

Revolving

A Revolving letter of credit is recyclable. The letter may be used several times, for several
identical transactions occurring at different times. If a vendor buys a product every month from
the same seller, purchasing the same amount of product at the same price, a revolving letter of
credit means that a new letter for each transaction is not needed.

Transferable Letter of Credit

A transferable documentary credit is a type of credit under which the first beneficiary which is
usually a middleman may request the nominated bank to transfer credit in whole or in part to the
second beneficiary.
The L/C does state clearly mentions the margins of the first beneficiary and unless it is specified
the L/C cannot be treated as transferable. It can only be used when the company is selling the
product of a third party and the proper care has to be taken about the exit policy for the money
transactions that take place.
This type of L/C is used in the companies that act as a middle man during the transaction but
dont have large limit. In the transferable L/c there is a right to substitute the invoice and the
whole value can be transferred to a second beneficiary.
The first beneficiary or middleman has rights to change the following terms and conditions of the
letter of credit:
a. Reduce the amount of the credit.
b. Reduce unit price if it is stated
c. Make shorter the expiry date of the letter of credit.
d. Make shorter the last date for presentation of documents.
e. Make shorter the period for shipment of goods.
f. Increase the amount of the cover or percentage for which insurance cover must be
effected.
g. Substitute the name of the applicant (the middleman) for that of the first beneficiary
(the buyer).

Sight LC

When the LC is opened, stipulating the condition that, on presentation of the negotiable set of
shipping document by the seller as per the terms of the LC are made, the buyers bank will make

payment at sight meaning immediately to the sellers bank subject to fulfillment of terms and
conditions of the LC being fulfilled, the LC is called Sight LC.

Future or Credit LC

If the payment schedule under the said LC stipulates payment at certain future dates after
presentation of negotiable set of shipping documents by the Seller and fulfilling the LC terms
and conditions, such an LC is termed Future LC or Credit LC. It is quite normal for sellers to
extend credit of 30 days to 60 days under LCs. However the shipping documents would have to
be presented to the bank immediately so that they documents reach the buyer well ahead in time
before the consignment reaches the foreign shores and the buyer is able to clear the consignment
and take delivery.

Confirmed Letter of Credit L/C

Confirmed Letter of Credit is a special type of L/C in which another bank apart from the issuing
bank has added its guarantee. Although, the cost of confirming by two banks makes it costlier,
this type of L/c is more beneficial for the beneficiary as it doubles the guarantee.

Back to Back Letter of Credit L/c

A back to back letter of credit which can also be referred as credit and counter credit is actually a
method of financing both sides of a transaction in which a middleman buys goods from one
customer and sells them to another.
The practical use of this Credit is seen when L/c is opened by the ultimate buyer in favour of a
particular beneficiary, who may not be the actual supplier/ manufacturer offering the main credit
with near identical terms in favor as security and will be able to obtain reimbursement by
presenting the documents received under back to back credit under the main L/c.
The parties to a Back to Back Letter of Credit are:
1. The buyer and his bank as the issuer of the original Letter of Credit.
2. The seller/manufacturer and his bank,
3. The manufacturer's subcontractor and his bank.

Standby Letter of Credit L/c

Initially used by the banks in the United States, the standby letter of credit is very much similar
in nature to a bank guarantee. The main objective of issuing such a credit is to secure bank loans.
Standby credits are usually issued by the applicants bank in the applicants country and advised
to the beneficiary by a bank in the beneficiarys country.
Unlike a traditional letter of credit where the beneficiary obtains payment against documents
evidencing performance, the standby letter of credit allow a beneficiary to obtains payment from
a bank even when the applicant for the credit has failed to perform as per bond.

Steps in an Export Letter Of Credit

Shipment of Goods

Upon receiving the letter of credit, the beneficiary should examine it carefully and be satisfied
that all the terms and conditions can be complied with. If this is not possible, the beneficiary
should request the applicant to arrange an amendment to the letter of credit. Once completely
satisfied, the beneficiary will then be in a position to assemble and ship the goods.

Presentation of Documents by Beneficiary

The beneficiary prepares an invoice in the number of copies required, with the description of
goods shown exactly as stipulated in the letter of credit. The beneficiary obtains the bill of lading
and/or other transport documents from the carrier and prepares and/or obtains all other
documents required by the letter of credit.
These are attached to the draft, drawn on the bank indicated and at the term stipulated in the
letter of credit, and are presented to the advising/confirming/negotiating bank.

Sending Documents to the Issuing Bank

The advising/confirming/negotiating bank checks the documents presented by the seller against
the letter of credit. If the documents meet the requirements of the letter of credit, that bank will
send them to the issuing bank, claiming reimbursement and paying the seller.

Delivering Documents to the Applicant

The issuing bank will also check the documents for compliance and then deliver them to the
applicant either against payment or as an undertaking to pay on maturity of the drawing under
the letter of credit.
Advantages for sellers
By asking for an appropriate letter of credit a seller is reassured that they will receive their
money in full and on time. A letter of credit is one of the most secure methods of payment for
exporters as long as they meet all the terms and conditions. The risk of non-payment is
transferred from the seller to the bank (or banks).
Advantages for buyers
When a buyer uses a letter of credit they get a guarantee that the seller will honour their side of
the deal and provide documentary proof of this.

Other things to consider

Its important to be aware of the additional costs involved in using a letter of credit. Banks make
charges for providing them, so its sensible to weigh up the costs against the security benefits.
If youre an exporter you should be aware that youll only receive payment if you keep to the
strict terms of the letter of credit. Youll need to give documentary proof that you have supplied
exactly what you contracted to supply. Using a letter of credit can sometimes cause delays and
other administrative problems.
Pitfalls of Letters of Credit
Letters of credit make it possible to do business worldwide. They are important and helpful tools,
but you should be careful when using letters of credit.
As a seller, make sure you:

Carefully review all requirements for the letter of credit before moving forward with a
deal
Understand all the documents required

Are truly able to get all the documents required for the letter of credit

Understand the time limits associated with the letter of credit, and whether they are
reasonable

Know how quickly your service providers (shippers, etc) will produce documents for you

Can get the documents to the bank on time

Make all documents required by the letter of credit match the letter of credit application
exactly

11