Definition
In simple terms, a letter of credit is a bank undertaking of payment separate from the sales or other contracts on which it is based. It is a way of reducing the payment risks associated with the movement of goods.
Expressed more fully, it is a written undertaking by a bank (issuing bank) given to the seller (beneficiary) at the request, and in accordance with the buyer’s (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.
Why use a Letter of Credit?
The need for a letter of credit is a consideration in the course of negotiations between the buyer and seller when the important matter of method of payment is being discussed. Payment can be made in several different ways: by the buyer remitting cash with his order; by open account whereby the buyer remits payment at an agreed time after receiving the goods; or by documentary collection through a bank in which case the buyer pays the collecting bank for account of the seller in exchange for shipping documents which would include, in most cases, the document of title to the goods. In the aforementioned methods of payment, the seller relies entirely on the willingness and ability of the buyer to effect 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. 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 bank’s ability to honour its obligation, the seller can, with the approval of the issuing bank, request its own bank — or a bank of international repute such as Scotiabank — to assume the risk of the issuing bank by confirming the letter of credit.
Basic Types of Letters of Credit
There are three basic features of letters of credit, each of which has two options. These are described below. Each letter of credit has a combination of each of the three features.
SIGHT OR TERM/USANCE
Letters of credit can permit the beneficiary to be paid immediately upon presentation of specified documents (sight letter of credit), or at a future date as established in the sales contract (term/usance letter of credit).
REVOCABLE OR IRREVOCABLE
Letters of credit can be revocable. This means that they can be cancelled or amended at any time by the issuing bank without notice to the beneficiary. However, drawings negotiated before notice of cancellation or amendment must be honoured by the issuing bank. An irrevocable letter of credit cannot be cancelled without the consent of the beneficiary.
UNCONFIRMED OR CONFIRMED
An unconfirmed letter of credit carries the obligation of the issuing bank to honour all drawings, provided that the terms and conditions of the letter of credit have been complied with. A confirmed letter of credit also carries the obligation of another bank which is normally located in the beneficiary’s country, thereby giving the beneficiary the comfort of dealing with a bank known to him.
