Letter of Credit

A letter of credit: is a document from a bank guaranteeing that a seller will receive payment in full as long as certain delivery conditions have been met. In the event that the buyer is unable to make payment on the purchase, the bank will cover the outstanding amount.

They are often used in international transactions to ensure that payment will be received where the buyer and seller may not know each other and are operating in different countries. In this case the seller is exposed to a number of risks such as credit risk, and legal risk caused by the distance, differing laws and difficulty in knowing each party personally. A letter of credit provides the seller with a guarantee that they will get paid as long as certain delivery conditions have been met. For this reason the use of letters of credit has become a very important aspect of international trade.

Credit risk: A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances.

A credit risk can be of the following types:

a.        Credit default risk — The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.

b.      Concentration risk — The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration.

c.       Country risk — The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk); this type of risk is prominently associated with the country's macroeconomic performance and its political stability.

Legal risk: There is no standard definition, but there are at least two primary/secondary definition sets in circulation. Legal risk is the risk of loss to an institution which is primarily caused by:

(a) a defective transaction; or

(b) a claim (including a defense to a claim or a counterclaim) being made or some other event occurring which results in a liability for the institution or other loss (for example, as a result of the termination of a contract) or;

(c) failing to take appropriate measures to protect assets (for example, intellectual property) owned by the institution; or

(d) change in law.

The Uniform Customs and Practice for Documentary Credits (UCP:  is a set of rules on the issuance and use of letters of credit.

An advising bank:  (also known as a notifying bank) advises a beneficiary (exporter) that a letter of credit (L/C) opened by an issuing bank for an applicant (importer) is available. Advising Bank's responsibility is to authenticate the letter of credit issued by the issuer to avoid fraud.

Trade finance:  signifies financing for trade, and it concerns both domestic and international trade transactions. A trade transaction requires a seller of goods and services as well as a buyer.

Documents that can be presented for payment: To receive payment, an exporter or shipper must present the documents required by the LC. Typically, the payee presents a document proving the goods were sent instead of showing the actual goods. The original bill of lading (BOL) is normally the document accepted by banks as proof that goods have been shipped. However, the list and form of documents is open to negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin or place. Typical types of documents in such contracts include:

a.       Financial documents — bill of exchange, co-accepted draft

b.      Commercial documents — invoice, packing list

c.        Shipping documents — transport document, insurance certificate, commercial, official or legal documents

d.      Official documents — License, embassy legalization, origin certificate, inspection certificate, phytosanitary certificate

e.      Transport documents — bill of lading (ocean or multi-modal or charter party), airway bill, lorry/truck receipt, railway receipt, CMC other than mate receipt, forwarder cargo receipt

f.        Insurance documents — Insurance policy or certificate, but not a cover note.

  

Types of Letter of Credit:

1.          Import/export — The same credit can be termed an import or export LC[4] depending on whose perspective is considered. For the importer it is termed an Import LC and for the exporter of goods, an Export LC.

2.       Revocable — The buyer and the bank that established the LC are able to manipulate the LC or make corrections without informing or getting permissions from the seller.

3.       Irrevocable — Any changes (amendment) or cancellation of the LC (except it is expired) is done by the applicant through the issuing bank. It must be authenticated and approved by the beneficiary.

4.       Confirmed — An LC is said to be confirmed when a second bank adds its confirmation (or guarantee) to honor a complying presentation at the request or authorization of the issuing bank.

5.        Unconfirmed — This type does not acquire the other bank's confirmation.

6.       Restricted — Only one advising bank can purchase a bill of exchange from the seller in the case of a restricted LC.

7.       Unrestricted — The confirmation bank is not specified, which means that the exporter can show the bill of exchange to any bank and receive a payment on an unrestricted LC.

8.       Transferrable — The exporter has the right to make the credit available to one or more subsequent beneficiaries. Credits are made transferable when the original beneficiary is a middleman and does not supply the merchandise, but procures goods from suppliers and arranges them to be sent to the buyer and does not want the buyer and supplier know each other.

 The middleman is entitled to substitute his own invoice for the supplier's and acquire the difference as profit. A letter of credit can be transferred to the second beneficiary at the request of the first beneficiary only if it expressly states that the letter of credit is "transferable". A bank is not obligated to transfer a credit. A transferable letter of credit can be transferred to more than one alternate beneficiary as long as it allows partial shipments. The terms and conditions of the original credit must be replicated exactly in the transferred credit. However, to keep the work ability of the transferable letter of credit, some figures can be reduced or curtailed.

a.        Amount

b.      Unit price of the merchandise (if stated)

c.        Expiry date

d.      Presentation period

e.      Latest shipment date or given period for shipment.

9.        Untransferable — A credit that the seller cannot assign all or part of to another party. In international commerce, all credits are untransferable.

10.   Deferred / Usance — A credit that is not paid/assigned immediately after presentation, but after an indicated period that is accepted by both buyer and seller. Typically, seller allows buyer to pay the required money after taking the related goods and selling them.

11.       At Sight — A credit that the announcer bank immediately pays after inspecting the carriage documents from the seller.

12.       Red Clause — Before sending the products, seller can take the pre-paid part of the money from the bank. The first part of the credit is to attract the attention of the accepting bank. The first time the credit is established by the assigner bank, is to gain the attention of the offered bank. The terms and conditions were typically written in red ink, thus the name.

13.       Back to Back — A pair of LCs in which one is to the benefit of a seller who is not able to provide the corresponding goods for unspecified reasons. In that event, a second credit is opened for another seller to provide the desired goods. Back-to-back is issued to facilitate intermediary trade. Intermediate companies such as trading houses are sometimes required to open LCs for a supplier and receive Export LCs from buyer.

14.    Standby Letter of Credit: - Operates like a Commercial Letter of Credit, except that typically it is retained as a "standby" instead of being the intended payment mechanism.