Letter of Credit (L/C)

Letter of Credit (L/C) is a banks conditional promise to pay issued by a bank at the request of an importer in which the bank promises to pay an exporter upon presentation of documents specified in the L/C The essence of an L/C is the promise of the issuing bank to pay against specified documents, which means that certain elements must be present for the bank Issuing bank must receive a fee for issuing L/C Banks L/C must contain specified maturity date Banks commitment must have stated maximum amount Banks obligation must arise only on presentation of specific documents and bank cannot be called on for disputed items Banks customer must have unqualified obligation to reimburse bank on same condition of banks payment

Letter of Credit (L/C)



Commercial L/Cs are classified as follows

Irrevocable Vs. Revocable irrevocable letters of credit are non-cancelable while its opposite can be cancelled at any time Confirmed Vs. Unconfirmed An L/C issued by one bank can be confirmed by another bank

Advantages of L/Cs are that it reduces risk of default and a confirmed L/C helps secure financing Disadvantages of L/Cs are the fees charged and that the L/C reduces the available credit of the importer

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Types of L/C - 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. It is hardly 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.
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(B)
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Financing Exporters
Special Type of L/C
While L/Cs can be used strictly as a tool to ensure safe payment procedures, they are often also used to provide financing to the beneficiary (exporter).

a.

Red Clause L/C

RedRed-clause letters of credit enable an exporter to obtain pre-shipment prefinance (a percentage of the L/C amount) from the advising or confirming bank. The loan can be made by the advising bank against bank. either a simple written statement of purpose form the exporter, guaranteeing that the advance will be used for the purpose stated (clean red-clause) or against an undertaking to provide certain red-clause) specified documents (e.g., warehouse receipts) and to deliver shipping (e. documents in accordance with the terms of the L/C (documentary or secured red-clause L/C). redL/C)

b. Green Clause L/C

GreenGreen-clause letters of credit serve the same purpose as red-clause credits redbut differ in that the exporter can only obtain advance payments against actual production not just undertaking to produce, certain documents. documents.
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(B)

Financing Exporters
c. Revolving L/C
A Revolving Letter of Credit is one where, under the terms and conditions thereof, the amount is renewed or reinstated without specific amendment to the credit being needed. It can revolve in needed. relation to time or value. value.

d. Transferable L/C
A letter of credit may also be transferred by the original (first) beneficiary to one or more second beneficiaries under various circumstances. circumstances. For an L/C to be transferable, the first beneficiary must arrange for the (ultimate) buyer to have an L/C opened expressly stipulating that it is transferable. transferable.

e.

Back-to-Back L/C Back-toBack-to-back L/Cs are an alternative to Transferable letters of credit as a method of facilitating transactions arranged by a trading company. Back-to-back L/Cs can be used in similar circumstances than those supporting Transferable L/Cs, i.e. back-to-back L/Cs are often used when the beneficiary is not the ultimate supplier of merchandise but the middleman between the seller and a buyer.

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Types of L/C - 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 merely as a channel of transmission of documents and payment.
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The Letter of Credit Process

How a Letter of Credit is Opened LC Procedures

Sales Contract: If exporter wants to sell any commodity to the importer of another country, who settles with the buyer about the prices, the quantity and quality of goods and moods of making payment. They will enter into an agreement. Document Preparation: The bank will ask the applicant to provide import license and performance invoice. After checking the documents, the banker will ask the importer to file an application.

How a Letter of Credit is Opened LC Procedures

Application Form: The bank will provide a printed application form. If all documents are found in order, the importer will submit an application form with necessary details discussed between exporter and importer, like shipment, insurance and total value of goods. The applicant will request the bank to open an LC in favor of the exporter. * Completion of Application Form: The Letter of Credit form is filled by the banker as per information of applicant and all terms and conditions are stated in the form. The bank can open the LC if all requirements are met and they are the authorised dealers in foreign exchange. 10 *

Letter of Credit Flow Chart

Issuing Bank
6. Opens L/C and forwards details for delivery to exporter 3. After examining documents and clearing up any discrepancies, Negotiating bank presents documents to Issuing bank for payment

Advising Bank

Checks documents and pays Negotiating bank 7. and forwards documents for importer to claim the goods

Negotiating

2.

Request to open L/C by completing application form specifying terms and conditions of the transaction

Advises L/C (validates authenticity of 4. L/C, checks its workability and completeness from a bank perspective, Bank and forwards Presents L/C and require details to exporter) documents for settlement 5. once shipment of goods is arranged

Importer (Applicant)

1. Sales contract agreement (specifying quantity, payment terms and documents)

Exporter (Beneficiary)

The Issuing Bank substitute for the credit-worthiness of the Buyer credit11

Red Clause L/C Flowchart

Opens a red-clause L/C and forwards details to exporter through the advising bank

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After examining documents and clearing up any discrepancies, Negotiating bank presents documents to Opening banks for payment

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Exporter requests loan from advising bank against either clean red-clause L/C or for secured (or documentary) L/C Makes loan

NEGOTIATING BANK
Requests to open a red-clause L/C by completing application form specifying terms and conditions of L/C (details of the parties, sum of transaction, time limit, delivery dates and terms of goods, and list of required documents) Present documents for negotiation and payment

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EXPORTER (Beneficiary)

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IMPORTER (Applicant)
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Exports commodity

Payment (net of the loan and related interest and fees)

OPENING/ISSUING BANK

ADVISING/ CONFIRMING BANK

Transferable L/C Flowchart

The transaction flow can be summarized as follows : 1. Ultimate Buyer issues L/C in favor of Trading Company (Beneficiary No 1) 2. L/C is issued by Issuing Bank 3. L/C is advised (and maybe confirmed) by Advising Bank 4. Trading Company instructs Advising Bank to transfer the L/C to Exporter (Beneficiary No 2). The respective rights under the L/C are transferred to Beneficiary No 2 (transferee) who must comply with the terms and conditions of the transferred L/C in order to receive payment 5. Commodity is exported 6. Documents are presented by Exporter for negotiation and payment to Advising Bank 7. Advising Bank informs Trading Company that it is holding the Exporter's documents 8. Trading Company may substitute its own invoice and documents 9. Payment is made to Exporter by Advising Bank which claims reimbursement on Issuing Bank 10. Buyers pays Issuing Bank.

PRODUCT

BUYER
CONTRACT

TRADER (AGENT)
Beneficiary 1

PRODUCT CONTRACT

SELLER
Beneficiary 2

ISSUING BANK
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ADVISING/ CONFIRMING BANK

Back to back L/C Flowchart

Trading company

BUYER
(Ultimate buyer)

CONTRACT

SELLER

= BUYER

SELLER
CONTRACT
(Ultimate seller)

L/C 1

Back-to-Back L/C 2

ISSUING BANK 1

ADVISING BANK 1

ISSUING BANK 2

ADVISING BANK 2

payment
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payment

How Does the Letter of Credit Process Work?

Export Letter of Credit Cycle
5. Product is
Shipped

1.
Beneficiary Exporter/Seller Buyer & Seller Agree

1. 2.
Application Applicant Importer/Buyer

4. 6.
Letter of Credit

Documents

8.
Documents

2.

10. 3. Letter of Credit 7. Documents

Exporters Bank/ Advising Bank

9.

Importers Bank/ Issuing Bank

How Does the Letter of Credit Process Work?

Confirmed Letter of Credit Cycle
5. Product is
Shipped

1.
Beneficiary Exporter/Seller

1.
Buyer & Seller Agree

4. 6.

2.
Application

Confirmed Letter of Credit Documents Confirming Bank

Applicant Importer/Buyer

8.
Documents

2.

10.

3. Letter of Credit 7. Documents

Exporters Bank/ Advising Bank/ Confirming Bank

9.

Importers Bank/ Issuing Bank

How Does the Letter of Credit Process Work?

Transferable Letter of Credit
3. Transferable LC $30,000 7. Documents & BL
Seller/Exporters Bank Advising Bank Transferring Bank Exporter/Seller

2. Transferable LC $50,000 8. Documents & BL

Manufacturers Bank

4. LC $30,000 6. Documents & BL 10. $30,000 Received

9. $50,000 Received

Importers Bank/ Issuing Bank

9. Documents & BL

1. LC Application

Product

5. Product Shipped to Seller or directly to Importer

Importer

Risk Perspective Least secured for Exporter/Seller Most secured for Importer/Buyer

Open account Documentary collections Documentary credits Payment/cash in advance

Most secured for Exporter/Seller

Least secured for Importer/Buyer

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(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.


Bill of Lading Contract with carrier, shippers receipt and control Commercial Invoice Authoritative description of product Insurance Under a floating policy for all cargoes Certificate of inspection Attesting the specification of the goods shipped Consular Invoice To allow items to enter country

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(3)

Methods of Settlement

The documentary letters of credit can be opened in two ways:



1. 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. 2. Timer or Usance Letter of Credit: A Time or Usance Letter of Credit is a credit in which the seller will be paid a fixed or determinable future time. A time or usance letter of credit calls for time or usance drafts to be drawn on an 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 banks obligation to the seller remains in force until and unless the draft is paid.

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Payment mechanisms

Open Account

Payment in Advance

Documentary Collections

Documentary Credit

Revocable D/C Document against Payment Document against Acceptance

Irrevocable D/C

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A.

Open Account

Open account means exporter selling on credit terms to the buyer This is the most secure method of payment for the importer. It allows the importer to make payments at some specific date in the future and without the buyer issuing any negotiable instrument evidencing his legal commitment to pay at the appointed time. On the part of the seller, it is therefore the most risky payment mechanism the buyer bears the cost of financing and the credit risk of the buyer Open account does not involve the bank very much except in moving the funds from buyer to seller, in due course. This mechanism offers the seller no protection in case of non-payment. However, an exporter can structure his open account sale transaction to minimize the risk of non-payment; for example, reducing the repayment period and retaining title to the goods until payment is made. Even then, it is difficult to enforce this especially if the goods have been either resold by the buyer or consumed in some other processing activity.
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Open Accounts - summary



 

Informal arrangement whereby goods are shipped and the importer is billed later (Invoice sent with or after shipment). Provides great flexibility. Useful when customers are well known good credit risks and common with longstanding good customer-supplier relationships Typical risks include: Customer refuses to take possession Customer unable or unwilling to pay Customer restricted from paying by its central bank

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B.

Payment/Cash in Advance

In contrast to open account, payment against documents is the most secure payment method for the exporter but most risky for the buyer since goods are not shipped until payments are received in part or full. In this arrangement, the seller retains total control over the transaction and there is no guarantee that goods paid for will even be delivered in good time. There is very limited bank involvement in this method of payment since the seller sends the documents directly to the buyer. The bank only comes in to effect payment which is usually wired from the buyers bank to the sellers bank. Cash in advance can be expensive to the exporter since buyers who are forced to pay in advance may ask for a discount on the value of the exports.

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When is Payment in Advance used?

1. This method of payment is usually used only for small purchases. 2. Essentially, sellers request payment in advance when foreign buyer's credit status is doubtful and unsatisfactory and/or the country political and economic risks are very high. In this circumstance, the seller does not want his funds to be trapped in a foreign land on grounds of buyer failure or difficulties in remittance due to exchange restrictions by the government.

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Cash in Advance - summary



Occurs when exporter is in strong bargaining position relative to importer Relationship between parties unestablished Typical Risks include: Supplier may not ship Supplier may ship late, low grade or less than agreed Supplier may not be permitted to export by authorities

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Letter of credit Summary

  

Provides exporter the greatest degree of safety when extending credit Useful when importer is not well known Useful when exchange restrictions exist or are possible

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Risk situations in letter-of-credit letter-oftransactions

Fraud Risks The payment will be obtained for nonexistent or worthless merchandise against presentation by the beneficiary of forged or falsified documents. Credit itself may be forged. Sovereign and Regulatory Risks Performance of the Documentary Credit may be prevented by government action outside the control of the parties. Legal Risks Possibility that performance of a Documentary Credit may be disturbed by legal action relating directly to the parties and their rights and obligations under the Documentary Credit

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RISK OF L/C

Force Majeure and Frustration of Contract Performance of a contract including an obligation under a Documentary Credit relationship is prevented by external factors such as natural disasters or armed conflicts Risks to the Applicant Non-delivery of Goods Short Shipment Inferior Quality Early /Late Shipment Damaged in transit Foreign exchange Failure of Bank viz Issuing bank / Collecting Bank
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RISK TO L/C

Risks to the Issuing Bank Insolvency of the Applicant Fraud Risk, Sovereign and Regulatory Risk and Legal Risks Risks to the Reimbursing Bank no obligation to reimburse the Claiming Bank unless it has issued a reimbursement undertaking. Risks to the Beneficiary Failure to Comply with Credit Conditions Failure of, or Delays in Payment from, the Issuing Bank Credit Issued by Party other than Bank Risks to the Advising Bank The Advising Banks only obligation if it accepts the Issuing Banks instructions is to check the apparent authenticity of the Credit and advising it to the Beneficiary

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RISK

Risks to the Nominated Bank Nominated Bank has made a payment to the Beneficiary against documents that comply with the terms and conditions of the Credit and is unable to obtain reimbursement from the Issuing Bank Risks to the Confirming Bank If Confirming Banks main risk is that, once having paid the Beneficiary, it may not be able to obtain reimbursement from the Issuing Bank because of insolvency of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a dispute as to whether or not payment should have been made under the Credit

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ADVNATGES TO EXPORTER

Guaranteed payment upon presentation of the documents specified in the terms of the letter of credit. Reducing the production risk, first of all, for the situations when the buyer cancels or changes his order. The ability to structure the delivery schedule according to the exporters interests. The chance to obtain financing for production or purchase of goods (pre-export finance). The chance to get financing in the period between the shipment of the goods and receipt of payment (especially, in case of delayed payment). The buyer cannot refuse to pay due to a complaint about the goods. The importer must raise any complaints/claims about the delivered goods separately from the letter of credit, which provides the exporter with a significant advantage in resolving such issues.
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ADVANTAGES TO EXPORTER


Using documentary letters of credit allows the exporter to significantly reduce the risk of non-payment for delivered goods, as in case of presentation of fully credit conform documents by the seller, the issuing bank pays the agreed-upon amount independently of the importer.

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ADVANATGES TO IMPORTER

The possibility to structure the payment plan in the contract according to the importers interests. Certainty that the payment will be made only upon presentation of the documents confirming shipment of the goods. The use of a letter of credit allows the importer to avoid or reduce pre-payment. The seller must fulfill all terms of the contract, as indicated in the letter of credit (shipment of the goods, meeting delivery terms on stock, amount, and deadlines) in order to receive the payment. Having opened a letter of credit, the importer proves his ability to pay and can count on more favorable payment terms in the future.
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ADVANATGES TO IMPORTER


Documentary letters of credit help the importer significantly reduce the risk connected with the seller not meeting its delivery obligations. The imported goods will be delivered in accordance with all the conditions specified in the letter of credit, and the agreed-upon documents will be received relatively quickly.

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