A letter of credit is the most widely used trade finance instrument in the world. It has been used for the last several hundred years and is considered a highly effective way for banks to transact and finance export and import trade. The letter of credit is a formal bank letter, issued for a bank's customer, which authorizes an individual or company to draw drafts on the bank under certain conditions. It is an instrument through which a bank furnishes its credit in place of its customer's credit. The bank plays an intermediary role to help complete the trade transaction. The bank deals only in documents and does not inspect the goods themselves.
Therefore a letter of credit can not prevent an importer from being taken in by an unscrupulous exporter.
The Uniform Commercial Code and the Uniform Customs and Practices for Documentary Credits published by the United States Council of the International Chamber of Commerce set forth the covenants governing the issuance and negotiation of letters of credit. All letters of credit must be issued:
- In favor of a specific beneficiary,
- for a specific amount of money,
- in a form clearly stating how payment to the beneficiary is to be made and under what conditions, and
- with a specific expiration date.
Role of Banks in Documentary Letters of Credit
Compared to other payment forms, the role of banks is substantial in documentary Letter of Credit transactions.
- The banks provide additional security for both parties in a trade transaction by playing the role of intermediaries. The issuing bank working for the importer and the advising bank working for the exporter.
- The banks assure the seller that he would be paid if he provides the necessary documents to the issuing bank through the advising bank.
- The banks also assure the buyer that his money would not be released unless the shipping documents evidencing proper and accurate shipment of goods are presented.
Types of Letters of Credit - 1
A letter of credit may be of two forms: Revocable or Irrevocable
Revocable L/C
This is one that permits amendments or cancellations any time by the issuing bank. This means that the exporter can not count on the terms indicated on the initial document until such a time as he is paid. This form is rarely in use in modern day trade transactions.
Irrevocable L/C
Such a letter of credit cannot be changed unless both buyer and seller agree to make changes. Usually an L/C is regarded as irrevocable unless otherwise specified. Therefore, in effect, all the parties to the letter of credit transaction, i.e. the issuing bank, the seller and the buyer, must agree to any amendment to or cancellation of the letter of credit. Irrevocable letters of credit are attractive to both the seller and the buyer because of the high degree of involvement and commitment by the bank(s). By the 1993 revision of the UCP, credits are deemed irrevocable, unless there is an indication to the contrary.
Types of Letters of Credit - 2
A letter of credit may be of two forms: Confirmed or Unconfirmed.
Confirmed L/C
If the exporter is uncomfortable with the credit risk of the issuing bank or if the country where the issuing bank is situated is less developed or politically unstable, then as an extra measure, the exporter can request that the L/C to be confirmed. This would add further comfort to the transaction; an exporter may request that the L/C be confirmed. This is generally by a first class international bank, typically the advising bank (now the Confirming Bank). This bank now takes the responsibility of making payments if no remittance is received from the issuing bank on due date.
Unconfirmed L/C
In contrast, an unconfirmed credit does not require the advising bank to add its own payment undertaking. It therefore leaves the liability seller with the issuing bank. The advising bank is merely as a channel of transmission of documents and payment.
Methods of Settlement
The documentary letters of credit can be opened in two ways:
- Sight Letter of Credit: A Sight Letter of Credit is a credit in which the seller obtains payment upon presentation of documents in compliance with the terms and conditions.
- Time Draft or Usance Letter of Credit: A Time Draft or Usance Letter of Credit is a credit in which the seller will be paid a fixed or determinable future time. A time Draft or usance letter of credit calls for time or usance drafts to be drawn on and accepted by the buyer, provided that documents are presented in good order. The buyer is obligated to pay the face amount at maturity. However, the issuing bank's obligation to the seller remains in force until and unless the draft is paid.
Financing Importers through Letters of Credit
While the L/C can be used as a payment mechanism, it can also be used to provide financing to the applicant (importer). Deferred and Acceptance credits (i.e. term credits) are considered to be financing instruments for the importer/buyer. Both payment structures provide the importer/buyer the time opportunity to sell the goods and pay the amount due with the proceeds.
Under the Deferred Payment structure payment is made to the seller at a specified future date, for example 60 days after presentation of the documents or after the date of shipment (i.e. the date of the bill of lading).
Under the Acceptance structure the exporter is required to draw a draft (bill of exchange) either on the issuing or confirming bank. The draft is accepted by the bank for payment at a negotiated future fixed date. This gives the importer the potential time needed to sell the product and pay off the Acceptance at due date. For example, payment date under an acceptance credit may be at sight or after 90 days from presentation of the documents or from the shipment of goods.
Special Note on Documentary Letters of Credit
Documentary Letters of Credit hinge much on the appropriateness of documents. Banks involved in the transaction do not need to know about the physical state of the goods in question but concern themselves only with documents. If proper documents are presented, banks will make payment whether or not the actual goods shipped comply with the sales contract.
Thus, special care needs to be taken in preparation of the documents since a slight omission or discrepancy between required and actual documents may cause additional costs, delays and seizures or even total abortion of the entire deal.
(1) Documents associated with an L/C
Documents are the key issue in a letter of credit transaction. Banks deal in documents, not in goods. They decide on the basis of documents alone whether payment, negotiation, or acceptance is to be effected. A single transaction can require many different kinds of documents. Most letter of credit transactions involve a draft, an invoice, an insurance certificate, and a bill of lading. Transactions can culminate in sight drafts or acceptances. Because letter of credit transactions can be so complicated and can involve so many parties, banks must ensure that their letters are accompanied by the proper documents, that those documents are accurate, and that all areas of the bank handle them properly.
The four primary types Documents associated with an L/C are as follows:
- Transfer documents
- Insurance documents
- Commercial documents
- Other documents
Transfer documents are issued by a transportation company when moving the merchandise from the seller to the buyer. The most common transfer document is the Bill of lading. The bill of lading is a receipt given by the freight company to the shipper. A bill of lading serves as a document of title and specifies who is to receive the merchandise at the designated port (as specified by the exporter). It can be in nonnegotiable form (straight bill of lading) or in negotiable form (order bill of lading). In a straight bill of lading, the seller (exporter) consigns the goods directly to the buyer (importer). This type of bill is usually not desirable in a letter of credit transaction, because it allows the buyer to obtain possession of the merchandise without regard to any bank agreement for repayment. A straight bill of lading may be more suitable for prepaid or open account transactions. With an order bill of lading the shipper can consign the goods to the bank, which retains title until the importer acknowledges liability to pay. This method is preferred in documentary or letter of credit transactions. The bank maintains control of the merchandise until the buyer completes all the required documentation. The bank then releases the bill of lading to the buyer, who presents it to the shipping company and gains possession of the merchandise.
Insurance documents, normally an insurance certificate, cover the merchandise being shipped against damage or loss. The terms of the merchandise contract may dictate that either the seller or the buyer obtain insurance. Open policies may cover all shipments and provide for certificates on specific shipments.
Commercial documents, principally the invoice, are the seller's description of the goods shipped and the means by which the buyer gains assurances that the goods shipped are the same as those ordered. Among the most important commercial documents are the invoice and the draft or bill of exchange. Through the invoice, the seller presents to the buyer a statement describing what has been sold, the price, and other pertinent details. The draft supplements the invoice as the means by which the seller charges the buyer for the merchandise and demands payment from the buyer, the buyer's bank, or some other bank. Although a draft and a check are very similar, the writer of a draft demands payment from another party's account.
In a letter of credit, the draft is drawn by the seller, usually on the issuing, confirming, or paying bank, for the amount of money due under the terms of the letter of credit. In a collection, this demand for payment is drawn on the buyer. The customary parties to a draft, which is a negotiable instrument, are the drawer (usually the exporter), the drawee (the importer or a bank), and the payee (usually the exporter), who is also the endorser. A draft can be "clean" (an order to pay) or "documentary" (with shipping documents attached).
A draft that is negotiable:
- Is signed by the maker or drawer
- Contains an unconditional promise to pay a certain sum of money
- Is payable on demand or at a definite time
- Is payable to order or to bearer
- Is two-name paper
- May be sold and ownership transferred by endorsement to the "holder in due course."
The holder in due course has recourse to all previous endorsers if the primary obligor (drawee) does not pay. The seller (drawer) is the secondary obligor if the endorser does not pay. The secondary obligor has an unconditional obligation to pay if the primary obligor and the endorser do not, therefore the term "two-name paper."
Other documents include certain official documents that may be required by governments in order to regulate and control the passage of goods through their borders. Governments may require inspection certificates, consular invoices, or certificates of origin. Transactions can entail notes and advances collateralized by trust receipts or warehouse receipts.
