Section III - Letters of Credit
Letter of Credit Transactions
There are 4 primary actors in a Letter of Credit transaction: importer, the exporter, the issuing bank (acting on behalf of the importer), and the advising bank (acting on behalf of the exporter).
- The importer and exporter agree on the amount, price, method of payment and all other contract details for the goods.
- The importer applies to their bank for a documentary credit in favour of the exporter.
- The bank prepares the documentary credit and forwards it to the exporter (beneficiary) through an advising bank in the exporter's country.
- The advising bank forwards the credit to the exporter.
- The exporter prepares the shipment and documentation. The goods are delivered to the shipping company.
- The original documentary credit, draft and documents are presented to the negotiating or paying bank.
- Draft and documents are sent to the issuing bank.
- The issuing bank examines the documents for compliance with credit terms. Drawing is paid or accepted as appropriate.
- Documents are delivered to the importer.
- The importer obtains the goods from the shipping company, or clears them through Customs.
Documentary Letter of Credit
Issued by a bank on behalf of an importer, a letter of credit guarantees an exporter payment for goods or services, provided the terms of the credits are met.
why use it: Where there is customer credit risk or country political risk, it provides assurance for the seller as well as the buyer. Some governments insist on the use of an LC to pay for imported goods as a way to control foreign exchange.
What is a Letter of Credit?
A letter of credit, also called an L/C or documentary credit, is issued by a bank on behalf of an importer. It guarantees an exporter payment for goods or services, provided the terms of the L/C are met.
Before the credit is issued, the importer and the exporter agree on all terms and conditions in a purchase and sale contract. Then the importing company instructs its bank to issue a documentary credit in accordance with the contract. The documentary credit contains only those details that are to be reflected in the documents to be submitted by the exporter.
A credit can be payable at sight or at term. At sight means that payment is due upon presentation of documents after shipment of the goods or after a service is provided. Alternatively, if the exporter allows the importer an additional period, after presentation of documents, to pay the credit (30, 60, 90 days, etc), then the credit is payable at term.
Advantages for the Importer (Buyer)
Reduces commercial risk by ensuring that your supplier will not be paid until evidence has been provided that the goods have been dispatched. Import L/Cs will also help:
- Conserve importers' cash flow by eliminating the need to make advance payments or deposits
- Demonstrate importers' creditworthiness to suppliers
- Support supplier's access to bank credit (in many countries, L/Cs are pledged by exporters as security against working capital loans)
Advantages for the Exporter (Seller)
Export L/Cs can:
- Assure payment (if the buyer doesnt pay, the bank that issued the L/C is obligated to pay) providing that credit conforming documents are presented at the time specified in the credit.
- Enhance cash flow, if discounted (e.g. the L/C is due in 30 days, but a bank can make the payment today, less a discount fee from the amount you would get if you waited 30 days).
- Provide greater security of payment if confirmed (a confirming bank adds its undertaking on top of the issuing bank's undertaking).
L/Cs do NOT protect against the risk of a trade dispute. It is important to note that the banks obligation is to comply with the stipulations of the Letter of Credit and not the terms of the sales contract. For this reason, it is very important that the terms of the L/C reflect those of the contract.
How it operates
There are 4 primary factors in a Letter of Credit transaction: the importer, the exporter, the issuing bank (acting on behalf of the importer), and the advising bank (acting on behalf of the exporter).
Parties to a Letter of Credit Transaction
Accepting bank : the bank that indicates acceptance of the terms of the draft drawn under a credit by dating, signing across its face and showing the maturity date.
Advising bank : the bank in the beneficiary's country or location to which the credit is forwarded. The advising bank, unless otherwise requested, advises the credit to the exporter without any obligation to pay drawings under the credit.
Applicant : the importer on whose behalf the credit is issued.
Beneficiary : the exporter in whose favour the credit is issued.
Confirming bank : a bank that, at the request of the issuing bank, joins in guaranteeing that drawings under the credit will be honoured, provided the documentation is in order.
Drawee bank : the bank on which the drafts specified in the credit are drawn.
Issuing Bank : the bank that acts on behalf of the applicant, issuing the credit and undertaking to honour the beneficiary's claims. Such claims are to be honoured without recourse to the exporter, provided the terms and conditions have been met.
Negotiating bank : the bank that elects to negotiate or advance funds against the documents, presented by the beneficiary, that are in accordance with the credit.
Paying bank : the bank authorized by the issuing bank to honour sight or deferred payments under the terms specified in the credit. A deferred payment relates to a term drawing when a draft is not used.
Presenter : the remitting bank (or beneficiary) that forwards the documents directly to the issuing bank to obtain settlement.
Reimbursing bank : the bank authorized by the issuing bank to reimburse the drawee bank or other banks submitting claims under the terms of the credit.
Remitting bank : the bank that submits documents and possibly drafts to the issuing bank for settlement.
Transferring bank : as specified in the credit, the bank that can transfer a documentary credit from one beneficiary to another at the request of the first beneficiary.
Types of Letter of Credits
Irrevocable credit means the credit cannot be amended or canceled without the agreement of all parties (the beneficiary, the applicant and the issuing bank).
A credit therefore should clearly indicate whether it is revocable or irrevocable. In the absence of such indication, the credit shall be deemed to be irrevocable.
This type of credit may be amended or canceled without the beneficiarys consent. It is generally used when the applicant and the beneficiary are members of the same group of companies.
The strength of a documentary credit is related to the financial standing of the bank that issues it. The economic strength of the country of the issuing bank is also a factor.
In cases where the financial strength of the issuing country and/or bank is in doubt, the exporter may require another bank, preferably in the exporters country, to provide its undertaking that the credit will be honoured. Consequently, the exporter is assured that drawings will be paid by the confirming bank in the event the issuing bank cannot do so, provided the terms and conditions of the credit are met. Remember, only the issuing bank may request another bank to add its confirmation.
Transferable Credit is a credit under which the beneficiary (first beneficiary) may request the transferring bank, or in the case of a freely negotiable credit, the bank specifically authorized in the credit as a transferring bank, to make the credit amount available in whole or in part to other beneficiary(ies).
Only credits designated as transferable by the issuing bank can be transferred. Terms such as divisible, fractionable, assignable and transmissible do not render the credit transferable. If such terms are used, they will be disregarded.
Standby Letter of Credit
These types of credits act more like a guarantee. Like a performance guarantee, a standby letter of credit allows the beneficiary to draw in the event of default on a contract, provided that the complying documents (usually a sight draft) are presented.
Care in preparing and processing documents can prevent delays and avoid the expense of making corrections. This checklist is designed to help minimize errors in preparing common trade documents. It must not be considered as an all encompassing checklist and professional advice must be requested where needed.
- Verifiable evidence in the documents that they all refer to the same transaction
- The quantity of goods (e.g. number of parcels), gross and net weight, the marks and import license number must be consistent on all documents.
- Only goods to be supplied under the credit may appear on the documents.
- Show proof that all dates specified in the credit have been respected.
- All documents should be prepared in the prescribed number of copies.
- If goods being shipped are covered by more than one credit, separate sets of documents must be issued for each credit.
The Bill of Exchange/ Draft
- Prepare according to the exact documentary credit conditions. The draft has to contain all the references to the credit under which it is drawn.
- Date, sign and endorse (if necessary).
- Unless the credit otherwise specifies, the amount of the draft must coincide with the invoice.
- Make it out in the same currency as the credit.
- The applicants address should be the same as specified in the credit.
- The invoice must agree exactly with the credit regarding description of goods, value of goods, individual prices and delivery conditions (if any).
- The invoice must be signed, if required, and any special notations, confirmations and authentications specified in the credit must be included and signed.
- The invoice should illustrate the following: marks/delivery conditions agreed upon, weight data and import license number (if any).
The Insurance Document
- The insurance document has to be the same as specified in the credit, i.e. policy or certificate.
- Insurance is to cover the risks mentioned in the credit in the currency of the credit and for the prescribed amount.
- The policy or certificate must be dated prior to, or on the same date as, the transport document.
- It should agree with the other documents regarding description, weight and marks of the goods, mode of transport and route.
- All copies issued by the insurance company have to be attached and, insofar as necessary, endorsed.
The Transport Document
- Transport documents can be negotiable or non-negotiable. Non-negotiable documents (e.g. air waybills, rail bills of lading) do not provide the same protection against unauthorized access to the merchandise that negotiable documents (e.g. marine/ocean bills of lading) do.
- The transport document should be the type called for in the credit.
- Credit stipulations regarding the parties to be mentioned in the bill of lading (shipper, order/consignees, person to notify) as well as special notations and indications have to be observed.
- The details of package units (cans, number, marks and weight, etc) should agree with the other documents. For CFR and CIF shipments, there should be a notation on the transport document to the effect that freight has been prepaid.
- The transport document has to be properly signed by the carrier or its agent.
- Changes are to be stamped "correction approved" and initialed by the carrier or its agent.
Checklist for Exporters That are Reviewing a Letter of Credit
- Does the credit correspond with the offer/contract with respect to unit price, method of shipment, product description, terms of sale, Incoterm (CIF, FOB, etc)?
- Is the credit amount sufficient?
- Documents requested in the credit: can they be provided in exactly the form requested?
- Can the shipping company or freight forwarder provide the type of transport document specified in the credit?
- If the goods are to be stowed on deck, does the credit permit this?
- Can all the time limits in regard to shipment of the goods, presentation of the documents and possible notification of third parties as stated in the credit be met?
- Can the specifications in regard to place of shipment, stipulations on possible partial shipments or transshipment, or prohibition thereof, be observed?
- In the case of CIF and CIP shipments, can insurance cover be provided as specified in the credit?
- For shipments for which the vessel is being chartered, does the credit permit charter party bills of lading?
If the answer is "No" to any of the above questions, the terms and conditions of the documentary credit may need to be amended.