Letter of Credit (LC): Parties, Types and Documents | Banking

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In this article we will discuss about:- 1. Meaning of Letter of Credit (LC) 2. Parties Involved in the
Letter of Credit (LC) 3. Types 4. Amendment of the Terms 5. Documents 6. Assessment of Exposure
7. Quantitative Assessment.

Meaning of Letter of Credit (LC):

Letter of credit is a letter issued by a bank at the instance of its customer favouring the supplier of
goods, whereby the issuing bank undertakes to make payment on submission of certain documents,
as specified in the letter. Letters of credit issued by banks facilitate trade between two parties, both
at domestic and international levels. Commercial banks play an important role as an intermediary
between two trading parties situated in two distant places.

For example, assume that the buyer of certain merchandise is in Mumbai, India, and the seller of the
said merchandise is in the USA. The buyer and the seller do not know each other and, therefore, the
seller will ask for the payment in advance for shipping the merchandise to the buyer. On the other
hand, the buyer feels that it may not be prudent for him to make advance payment to the overseas
seller whom he does not know.

Under this circumstance, no trade can take place unless there is an intermediary who can bridge the
lack of trust between the buyer and the seller. The commercial bank can play the role of this
intermediary and inspire confidence among the two parties. This can be done by issuing an LC at the
instance of the buyer in favour of the seller.

ADVERTISEMENTS:

The issuing bank undertakes to pay the amount of shipment to the seller, provided the latter
submits the shipping and other documents of title as stipulated in the LC through the bank of the
seller. This kind of letter of credit is also known as Documentary Credit. When an LC is issued on
account of international trade, the buyer is known as the importer of goods and the seller is called
the exporter of goods.

Commercial banks all over the world issue letters of credit and the modalities for issuing
documentary credits are subject to the provisions of Uniform Customs and Practices for
Documentary Credits (UCPDC) framed by the International Chamber of Commerce (ICC). Provisions
of UCPDC are common in all countries, and all commercial banks handle LC business as per the
guidelines of UCPDC.

It is important to bear in mind that under letters of credit, commercial banks deal with documents
and not the underlying goods. If the documents are strictly in compliance, with the terms of LC, the
issuing bank has to make payment to the seller’s bank, irrespective of the condition of the goods.
In an international LC transaction many parties are involved and they are spread over different
countries. They function under different legal systems and jurisdictions. Settlement of any dispute,
arising out of any terms and conditions of the LC, through normal legal channels, may pose
difficulties.

It was against this backdrop that codification and publication of a common set of rules, applicable to
all documentary credits irrespective of which bank has issued it, were framed at the behest of the
ICC. The document, known as the UCPDC, is revised from time to time. In order to ensure that the
rules of UCPDC apply to a documentary credit, it is necessary to declare on the body of the LC that it
is being issued subject to the provisions of UCPDC.

Parties Involved in the Letter of Credit (LC):

A letter of credit transaction involves the following parties:

1. Applicant:

The buyer finalises the terms and conditions of a purchase transaction and submits a request in the
prescribed format to his bank for issuing a letter of credit in favour of the seller. The applicant is also
called the ‘opener’ of the credit.

2. Beneficiary:

The beneficiary of the letter of credit is the person in whose favour the LC has been issued.
Generally, the LC is issued favouring the seller of the goods and services.

3. Opening/Issuing Bank:

On receipt of the application from its customer, the bank examines the proposal and opens a letter
of credit in favour of the beneficiary with the stipulated terms and conditions. This bank is known as
the opening/issuing bank.
4. Advising Bank:

The opening bank identifies a bank near the place of the beneficiary or the seller, and advises the LC
to the seller through that bank. This bank is known as the advising bank. The issuing bank may have
its own branch at the place where the beneficiary is located or may arrange with a correspondent
bank operating at that place in order to render advisory and authentication services.

5. Confirming Bank:

Though the advising bank may advise the authenticity of the credit to the beneficiary, the latter may
desire to have the comfort of an additional confirmation from a bank in his own place, which
provides its own independent undertaking for making payment, provided the documents are
submitted strictly in terms of the LC.
The beneficiary normally stipulates for additional confirmation, if he feels that there is a risk of
default by the issuing bank in making payment under the LC. If the issuing bank is a relatively small
financial institution, the beneficiary generally asks for confirmation by another bank in his own
country.

6. Negotiating Bank:

The issuing bank may nominate another bank in the beneficiary’s country to whom the beneficiary
presents its documents and obtains payment of the sum against the LC. This bank is known as the
negotiating bank. The role of the negotiating bank may be played by the issuing bank, the advising
bank or any other bank, depending on the terms of the documentary credit. In a freely negotiable
credit, any bank can act as the negotiating bank.

7. Reimbursing Bank:

The issuing bank of the LC may arrange with another bank to reimburse the amount under the LC to
the negotiating bank that has made payment to the beneficiary. Such banks are known as
reimbursing banks.

Types of Letters of Credit:

There are various types of LCs, depending on the method of payment and other conditionalities
envisaged under the credit.

The various types of LCs are, normally, as under:

1. Revocable and Irrevocable Letter of Credit:

Generally, a letter of credit is deemed to be irrevocable and cannot be amended or cancelled

without an express agreement of all the parties concerned, i.e., the applicant, the issuing bank, the
confirming bank, if any, and the beneficiary. On the other hand, a revocable credit issued by a bank
may be amended or cancelled by the issuing bank at any point of time, without giving any notice to
the beneficiary.

In these cases, however, the issuing bank has to reimburse the other bank which has either paid or
has accepted a liability to pay any amount in accordance with the terms and conditions of the credit,
before receipt of a notice of amendment or cancellation of the credit by the issuing bank.

2. Sight Credit and Acceptance (Usance) Credit:

Under sight credits, the issuing bank undertakes to pay the amount mentioned in the documents, on
presentation thereof, provided the documents are strictly in compliance with the terms of the LC. On
receipt of the documents, the opening bank informs the applicant (customer) to make the payment
and collect the shipping documents (bill of lading, airway bill, railway receipt, etc.) to take delivery of
the merchandise from the place of their arrival.

On the other hand, in case of usuance LC, an element of supplier’s credit is involved, which means
that the seller is agreeable to extend credit to the buyer and accept payment after expiry of a certain
period mentioned in the documents submitted under the LC. Upon receipt of the documents, the
opening or issuing bank presents the documents to the buyer (customer) who notifies acceptance of
the documents and commits to pay the amount on the due date.

After the documents are accepted, the issuing bank delivers the shipping documents (bill of lading,
airway bill, railway receipt, etc.) to the buyer to take delivery of the goods from the
port/airport/railway siding.

Red Clause and Green Clause Letter of Credit:

Under a Red Clause LC, the issuing bank authorises the advising bank to advance a part of the LC
amount to the seller in order to meet the pre-shipment expenses for procurement of goods, packing
thereof, etc. The advance is made at the risk of the issuing bank. The amount paid in advance is
recovered with interest from the final payments to be made to the seller against submission of the
relative documents as stipulated in the LC.

In a Green Clause LC, the applicant also agrees to pay for storage facilities at the port of shipment, in
addition to the pre-shipment advance to the beneficiary of the LC, i.e., the seller.

Revolving Letter of Credit:

Often a business enterprise needs to purchase a particular type of material on a regular basis and,
therefore, repeats the purchase order with the same supplier. This is required to replenish the stock
of the said material, when exhausted. In such cases, the buyer may request the bank to issue a letter
of credit for a specific amount, which will get automatically reactivated after the documents are paid
for by the buyer and payment is made to the seller.

As soon as the advice of payment of one set of document is received by the seller’s bank, the LC is
replenished by the amount of the said payment. The seller will be advised that the next LC has been
received. This LC is called a revolving LC and the buyer need not open several LCs favouring the seller
for supply of the same material up to the maximum amount mentioned in the letter of credit.

The text of the letter of credit will mention that the amount of credit will revolve___ times to
maximum Rs________. After the shipment has reached the maximum amount mentioned in the LC,
either a new LC is to be opened or the same LC can be reactivated or rolled over by an amendment.
This type of LC is cost effective for the buyer.

Transferable and Back to Back LCs:

Transferable LCs are generally issued in favour of the middle man, where the beneficiary may
request the advising bank to transfer the credit available, either in whole or in part, to one or more
other beneficiary. The LC should contain the condition that it is a transferable LC. In these cases, the
original beneficiary of the LC makes the documentary credit available to the actual producer of
goods, without making use of his own credit lines from his banker.

Standby Letters of Credit:

A standby letter of credit is very similar in nature to a bank guarantee. In countries like the USA and
Japan, standby credits are issued by the banks as an alternate to guarantee bonds. The text of the
standby LC is different from that of other traditional LCs, where the beneficiary is entitled for
payment once he has submitted the documents in strict compliance with the stipulations in the LC.

Whereas, in standby LCs, the beneficiary is eligible for payment from the issuing bank when, the
applicant fails to perform his obligations. A normal letter of credit is used as a payment mechanism
for a trade transaction, but a standby LC is used as a backup undertaking to pay, by the issuing bank,
in case the applicant (opener of LC) fails to pay or perform.

To collect payment under standby LC, the beneficiary has to demand payment from the issuing bank
and provide relative documents evidencing the non-performance by the opener of the LC. There is
normally a stipulation to the effect that the beneficiary must present a signed statement that the
applicant is in breach of his obligations, and the nature of such breach is included in the credit.
Standby LC can perform the functions of different forms of bank guarantees like advance payment
guarantee, performance guarantee, etc., by suitably amending the wordings in the LC.

Amendment of the Terms of LC:

With the mutual agreement of the buyer and the seller, the terms, conditions and stipulations of an
LC can be amended by the issuing bank. If the amendments are accepted by the seller, the original
LC is to be read in conjunction with the amendments made later.

Documents under a Letter of Credit:

Normally, the following documents are handled in a transaction under a letter of credit: Transport
Documents, viz., bill of lading, airway bill, railway/lorry receipts, etc. These documents are also
known as documents of title, i.e., the holder of such documents can take delivery of the
merchandise. Other documents include bills of exchange drawn by the seller on the buyer,
commercial invoice, certificate of origin, packing list, inspection/quality certificate, etc.

Assessment of Exposure under LC:

In a letter of credit, the commitment of the LC opening bank to the beneficiary is absolute and not
dependent on the payment by the applicant/customer. The opening bank always runs the risk that
the applicant may not honour his commitment to pay and take delivery of his documents. This may
entail a loss for the bank.
Such crystallisation of the liability under the LC, at the hands of the issuing bank, is commonly known
as ‘Devolvement’, which signifies an irregular situation created by the failure of the applicant to
honour his commitment. Under this situation, the non-fund-based facility gets converted into a
fund-based credit facility.

A critical appraisal of a letter of credit facility, therefore, involves a study of both the customer and
the proposal submitted by him, in the same line of credit appraisal for fund-based credit facilities.

Letters of credit are employed by the parties desiring to enter into commercial transactions, not for
the benefit of the issuing bank but mainly for the benefit of the parties to the original transactions.
With the letter of credit from the issuing bank, the party who applied for and obtained it may
confidently present the letter of credit to the beneficiary as a security to convince the beneficiary to
enter into the business transaction. On the other hand, the other party to the business transaction,
i.e., the beneficiary of the letter of credit, can be rest assured of being empowered to call on the
letter of credit as a security in case the commercial transaction does not push through, or the
applicant fails to perform his part of the transaction. It is for this reason that the party who is
entitled to the proceeds of the letter of credit is appropriately called “beneficiary.” (Transfield
Philippines, Inc. vs. Luzon Hydro Corporation, et al., G.R. No. 146717, November 22, 2004, [Tinga])

In commercial transactions involving letters of credit, the functions assumed by a correspondent

bank are classified according to the obligations taken up by it. The correspondent bank may be
called a notifying bank, a negotiating bank, or a confirming bank. (Feati Bank & Trust Company vs.
CA, G.R. No. 94209, April 30, 1991, [Gutierrez, Jr.])

In case of a notifying bank, the correspondent bank assumes no liability except to notify and/or
transmit to the beneficiary the existence of the letter of credit. (Kronman and Co., Inc. v. Public
National Bank of New York, 218 N.Y.S. 616 [1926]; Shaterian, Export-Import Banking, p. 292, cited in
Agbayani, Commercial Laws of the Philippines, Vol. 1, p. 76). A negotiating bank, on the other hand,
is a correspondent bank which buys or discounts a draft under the letter of credit. Its liability is
dependent upon the stage of the negotiation. If before negotiation, it has no liability with respect to
the seller but after negotiation, a contractual relationship will then prevail between the negotiating
bank and the seller. (Scanlon v. First National Bank of Mexico, 162 N.E. 567 [1928]; Shaterian,
Export-Import Banking, p. 293, cited in Agbayani, Commercial Laws of the Philippines, Vol. 1, p. 76)

In the case of a confirming bank, the correspondent bank assumes a direct obligation to the seller
and its liability is a primary one as if the correspondent bank itself had issued the letter of credit.
(Shaterian, Export-Import Banking, p. 294, cited in Agbayani Commercial Laws of the Philippines, Vol.
1, p. 77)

A notifying bank is not a privy to the contract of sale between the buyer and the seller, its
relationship is only with that of the issuing bank and not with the beneficiary to whom he assumes
no liability. It follows therefore that when the petitioner refused to negotiate with the private
respondent, the latter has no cause of action against the petitioner for the enforcement of his rights
under the letter. (See Kronman and Co., Inc. v. Public National Bank of New York, supra)

As earlier stated, there must have been an absolute assurance on the part of the petitioner that it
will undertake the issuing bank’s obligation as its own. Verily, the loan agreement it entered into
cannot be categorized as an emphatic assurance that it will carry out the issuing bank’s obligation as
its own. (supra)
The case of Scanlon v. First National Bank (supra) perspicuously explained the relationship between
the seller and the negotiating bank, viz:

It may buy or refuse to buy as it chooses. Equally, it must be true that it owes no contractual duty
toward the person for whose benefit the letter is written to discount or purchase any draft drawn
against the credit. No relationship of agent and principal, or of trustee and cestui, between the
receiving bank and the beneficiary of the letter is established. (P.568)

Whether therefore the petitioner is a notifying bank or a negotiating bank, it cannot be held liable.
Absent any definitive proof that it has confirmed the letter of credit or has actually negotiated with
the private respondent, the refusal by the petitioner to accept the tender of the private respondent
is justified. (supra)

The relationship between the issuing bank and the notifying bank, on the contrary, is more similar to
that of an agency and not that of a guarantee. It may be observed that the notifying bank is merely
to follow the instructions of the issuing bank which is to notify or to transmit the letter of credit to
the beneficiary. (See Kronman v. Public National Bank of New York, supra). Its commitment is only to
notify the beneficiary. It does not undertake any assurance that the issuing bank will perform what
has been mandated to or expected of it. As an agent of the issuing bank, it has only to follow the
instructions of the issuing bank and to it alone is it obligated and not to buyer with whom it has no
contractual relationship.

In fact the notifying bank, even if the seller tenders all the documents required under the letter of
credit, may refuse to negotiate or accept the drafts drawn thereunder and it will still not be held
liable for its only engagement is to notify and/or transmit to the seller the letter of credit.

Finally, even if we assume that the petitioner is a confirming bank, the petitioner cannot be forced
to pay the amount under the letter. As we have previously explained, there was a failure on the part
of the private respondent to comply with the terms of the letter of credit. (Feati Bank & Trust
Company vs. CA, G.R. No. 94209, April 30, 1991, [Gutierrez, Jr.]