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Letter of Credit
by Surinderjit Kaur, former Assistant General Manager & Faculty, State Bank of India

All Trade Transactions involve four parties:-

  1. EXPORTER : who sells the goods
  2. CARRIER: who takes the goods from Seller to the Buyer
  3. IMPORTER : who buys the goods
  4. BANK :  who settles the transaction by transferring money from Buyer to Seller

In such Trade Transactions, since the Buyer and the Seller don’t know each other, each gets his own concerns.

CONCERNS of the SELLER :-

  1. He may not receive the payment of exported goods in full 
  2. He may not receive the payment in time
  3. Buyer may become unable to pay on due date
  4. Buyer may deliberately refuse to pay
  5. Buyer may refuse to accept the goods
  6. Buyer may raise a dispute and demand a discount.

CONCERNS of the BUYER :-

  1. He may not receive the goods at all under the contract
  2. He may not receive the goods in time
  3. Goods received may not be as per agreed QUANTITY
  4. Good received may not be as per agreed QUALITY
  5. Goods are not insured against specific risk

Before we discuss the mechanism to address the concerns of the buyer and the seller, first let us know how a trade transaction is settled :-

  1. OPEN ACCOUNT : Here the seller dispatches the goods. On receipt of goods, the buyer makes payment. Such transactions carry risk to the seller.
  2.  ADVANCE PAYMENT : Here the buyer makes payment first and then the seller despatches good. Such transactions carry risk to the buyer.
  3. DOCUMENTARY COLLECTIONS : Here the seller despacthes  goods, entrusts Documents of title to goods to a bank. This bank delivers documents to the buyer on payment. Such transactions also carry risk to the seller, in case the buyer refuses to make payment. Here risk is at mitigated level as compared to the Open Account transaction.
  4. LETTER OF CREDIT / DOCUMENTARY CREDIT : Here Bank acts as intermediary  to address the concerns of both the parties  and   facilitate  the transaction. 

 

Letter  of  Credit or Documentary Credit

Letter of Credit is an undertaking issued by a Bank (Issuing Bank), on behalf of the buyer (importer), to the seller (exporter) to pay for goods and services provided that the seller presents documents which comply with the terms and conditions of the Letter of Credit

As per UCPDC – 600 Edition effective from 1st July 2007:-

“Documentary Credit means any arrangement that is irrevocable and thereby constitutes a definite undertaking  of the issuing bank to honor a complying presentation.”

“Complying presentation” means:-

A presentation that is in accordance with:-

  1. the terms and conditions of the credit
  2. the applicable provisions of  rules (UCP 600) 
  3. International Standard Banking Practice (ISBP 745). 

“Honor” means

  • a. to pay at sight if the credit is available by sight payment. 
  • b. to incur a deferred payment undertaking and pay at maturity if the credit is available by deferred payment. 
  • c. to accept a bill of exchange ("draft") drawn by the beneficiary and pay at maturity if the credit is available by acceptance. 

 

A Letter of Credit carries three underlying main contracts:-

  1. Sale Contract between Buyer & Seller
  2. Application-cum-Guarantee between Applicant(Buyer) and Issuing Bank
  3. LC  itself (contract between Issuing Bank and Beneficiary/Seller)

        ( Letter of Credit is independent of other two contracts)

 

Parties to Letter of Credit and their Responsibilities:-

1. Importer/Buyer

Buyer  is also known as an applicant. He should be a customer of the bank and should be enjoying credit facilities from the bank.  Bank should verify the KYC /CDD/ IEC of the applicant and also check the importability of the item.  Banks should also obtain an Opinion Report on suppliers.

2. Issuing Bank

It Guarantees payment against complying presentation. Since banks deal in documents and not in goods, Issuing Bank guides importers in seeking proper documents, avoid ambiguity about issuers of documents and also avoid putting non-documentary conditions in the Letter of Credit. Once the documents are received from the Exporter’s bank, Issuing Bank does proper scrutiny of documents as per terms of LC and in case discrepancies are found, it will issue a notice  of refusal to the negotiating bank within five working days. 

3. Advising Bank

Advising Bank is mainly responsible for the apparent authenticity of LC. It also provides marketing opportunities for negotiation of documents  under LC and can also guide the exporter on unacceptable LC conditions.

4. Confirming Bank

To get an added surety, sometimes the exporter requires the commitment of a bank in his own country  in case the Issuing Bank fails to meet its commitment to honor its own LC. The bank giving such commitment is called Confirming Bank which stands at par with the Issuing Bank in terms of responsibility. Like Issuing Bank, the Confirming Bank also does  proper scrutiny of documents as per terms of LC and in case discrepancies are found, it is required to  issue a notice  of refusal to the negotiating bank within five working days. After making payment under LC, the Confirming Bank gets Right to Reimbursement from the Issuing Bank.

5. Negotiating Bank

Negotiation means advancing  against a complying presentation on or before reimbursement. The bank giving  advance against such complying documents is called Negotiating Bank. Generally, banks negotiate documents only for their customers after setting up proper sanctioned limits. Negotiating Bank does proper scrutiny of the documents as per LC terms. In case, discrepancies are found in the documents, it guides the exporter to rectify the discripancies or give indemnity for such discrepancies (negotiation with recourse)  to the Negotiating Bank.

6. Exporter / Seller

Here, Exporter is also known as the Beneficiary of Letter of Credit. Generally, he is a customer of the Negotiating Bank which has sanctioned him the Bill Limits after verifying the KYC /CDD/ IEC code. Exporter must present the complying documents OR Indemnify the negotiating bank if submitting a non-complying presentation.

 

Types of Letter of credit

As per Security to beneficiary:-

  • Confirmed Letter of Credit
  • Unconfirmed Letter of Credit

As per Mode of settlement:-

  • Payment/ deferred payment
  • Acceptance
  • Negotiation

Involving middlemen:-

  • Transferable Credit
  • Back to back Credit

Involving advances:-

  • Red Clause Credit
  • Green Clause Credit

Involving repeated transactions:-

  • Revolving Credit
  • Stand-by Credit

While opening LC, Banks to follow guidelines of institutions:-

  • Foreign Trade Policy requirements.
  • FEMA requirements.
  • Credit norms of RBI.
  • UCPDC 600 Provisions.
  • Bank’s Internal Credit Policies/ procedures.
  • Public notices issued by DGFT
  • Uniform Rules for bank-to-bank reimbursements 525
  • Inco-terms 2010 and 2020