Letter of credit (L/c) is the most preferred payment option for exporters. Compared to other payment options, L/c has many safeguards for sellers and at the same time assurance for buyers. It is usually issued by larger banks and contain a promise to pay a seller (beneficiary) upon receipt of goods by a buyer if certain conditions outlined in the letter have been met.
What is Letter of Credit ?
Letter of Credit or (L/c) is a legal document to arrange payment between a buyer(importer) and seller (exporter). The bank, as intermediary, ensures security for both parties, giving the exporter confidence that the importer is capable of paying for the goods while assuring the importer that payment will be made to the exporter only after the terms outlined in the letter of credit have been met.
Analysis of typical L/c Transaction
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Step 1 After successful negotiation on price, specification, quality etc, Buyer selects a seller and places order for specified goods
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Step 2 Seller accepts the order
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Step 3 Buyer and Seller agrees on terms and conditions of the sale. Buyer instructs its bank to open a L/c incorporating previously agreed terms of sale
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Step 4 The buyer's bank prepares a Letter of Credit (L/c), including all instructions to the seller's bank concerning the shipment and sends the L/c to the seller's bank, requesting confirmation. The seller may request confirmation from a confirming bank for added security.
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Note: There are often delays at above two steps for various reasons like buyer does not have sufficient funds or seller requests change in L/c terms. Amendments are issued to incorporate changes in L/c terms.
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Step 5 The Seller's bank prepares a letter of confirmation to forward to the seller along with the L/c. The seller reviews carefully all conditions in the L/c specially shipment schedule in consultation with his freight forwarder.
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Step 6 The seller arranges the goods and hand over to freight forwarder for delivery at appropriate port or airport.
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Step 7 Once goods are loaded/shipped, the forwarder completes necessary documentation and hand them over to the seller. The seller then presents the documents to his bank, informing full compliance with terms and conditions of L/c.
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Step 8 The seller's bank reviews the documents. If they are in order, the documents are airmailed to the buyer's bank for review and passing necessary documents to buyer. The buyer gets the documents needed to claim the goods.
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Step 9 The buyer's bank returns accepted draft and informs buyer. Buyer pays bank.
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Step 10 The seller's bank gets payment and pays seller.
The letter of Credit Ensures that:
Payment to the seller will only be made after the terms of the L/c have been met. The documents, which have been reviewed by the bank's experienced staff, are in order. The seller is assured of the buyer's ability to pay and, as a result, a better price and more advantageous
Closer look at some key terminology
Irrevocable Letter of Credit
An irrevocable letter of credit cannot be amended or cancelled without the consent of the issuing bank, the confirming bank (if any), and the beneficiary. The payment is guaranteed by the bank if the credit terms and conditions are fully met by the beneficiary. The words "irrevocable documentary credit" or "irrevocable credit" may be indicated in the L/c.
Irrevocable and Without Recourse Letter of Credit
The irrevocable letter of credit received from an advising bank may be indicated as "irrevocable and without recourse documentary credit". The words "without recourse" mean that the advising bank will not be able to recover the money paid to the beneficiary in case the issuing bank does not pay the advising bank.
Revocable Letter of Credit
A revocable letter of credit can be amended or cancelled by the issuing bank at any time without the consent of the beneficiary, often at the request and on the instructions of the applicant (buyer). There is no security of payment in a revocable letter of credit. The words "this credit is subject to cancellation without notice", "revocable documentary credit" or "revocable credit" usually are indicated in the L/c. Obviously, this type of L/c is highly risky from the beneficiary point of view.
Confirmed Irrevocable Letter of Credit
An irrevocable letter of credit opened by an issuing bank whose authenticity has been confirmed by an advising bank (usually a prime world bank) and where the advising bank has added its confirmation to the credit is known as confirmed irrevocable letter of credit. The words "we confirm the credit and hereby undertake ..." or "we add our confirmation to this credit and hereby undertake ..." normally are included in the L/c. An exporter whose method of payment is a confirmed irrevocable L/c is assured of payment even if the importer or the issuing bank defaults. The confirmed irrevocable L/c is particularly important from buyers in a country which is economically or politically unstable. In a confirmed letter of credit, the exporter or the importer pays an extra charge called the confirmation fee, which may vary from bank to bank within a country. The fee usually is added to the exporter's account. The exporter may indicate in the sales contract that the confirmation fee and other charges outside the seller's country are on the buyer's account.
Unconfirmed Irrevocable Letter of Credit
An irrevocable letter of credit opened by an issuing bank but not confirmed by an advising bank (usually a prime world bank) is known as an unconfirmed irrevocable letter of credit. The promise to pay comes from the issuing bank only, unlike in a confirmed irrevocable L/c where both the issuing bank and the advising bank promise to pay the beneficiary.
Restricted Negotiable Letter of Credit
In a restricted negotiable letter of credit, the authorization from the issuing bank to pay the beneficiary is restricted to a specific nominated bank.
Freely Negotiable Letter of Credit
In a freely negotiable letter of credit, the authorization from the issuing bank to pay the beneficiary is not restricted to a specific bank, any bank can be a nominated bank as long as the bank is willing to pay, to accept draft(s), to incur a deferred payment undertaking, or to negotiate the L/c. The words "this credit is not restricted to any bank for negotiation" or "this credit may be negotiated at any bank", or similar words, may be indicated on the L/c.
Revolving Letter of Credit
When a letter of credit is specifically designated "revolving letter of credit", the amount involved when utilized is reinstated or replenished. In other words, once supply has been made and beneficiary receives payment for the shipment, the L/c amount becomes available again without issuing another L/c and usually under the same terms and conditions. The revolving L/c is used for regular shipment of a large quantity over a period of time (several months).
Latest Negotiation Date
The latest negotiation date is the last day of the period of time allowed by the letter of credit for the presentation of documents to the bank. The latest negotiation date may not necessarily be the L/c expiry date. For example, the latest negotiation date can be July 31, 2001 or 15 days after the date of shipment, whichever comes first. In case the L/c does not stipulate the latest negotiation date, it is within 21 days after the date of issuance of the transport documents, but on or before the L/c expiry date.
Expiry Date and Place
The expiry date and place is the last day of validity of the credit and the place allowed by the letter of credit for the presentation of documents for payment, acceptance or negotiation. In case the validity of an L/c is stated in a period of time, for example "this credit is valid for three months" or "this credit is available for two months" or "this credit is good for one month", but does not specify the date from which the time is to run, its validity starts from the issuance date of L/c by the issuing bank. The bank normally discourages stating the L/c validity in a period of time. In case the expiry date and/or the latest negotiation date falls on a day on which the bank is closed for reasons not including the acts of God, strikes, riots, civil commotions, lockouts, insurrections, wars or any other causes beyond the bank's control, the expiry date and/or the latest negotiation date is extended to the succeeding first day on which the bank is opened. Such extension, however, does not extend the latest date of shipment.
Latest Shipment
The latest shipment---latest date of shipment or last date for shipment---is the last day of the period of time allowed by the letter of credit for shipment, dispatch or taking in charge.
Transferable Letters of Credit
A letter of credit can be transferable or non-transferable. The L/c usually indicates "transferable" in the case of a transferable credit. In the absence of such indication, the L/c is deemed to be non-transferable. In a transferable letter of credit, the first beneficiary (the exporter) may request the paying, accepting or negotiating bank to make the credit available in whole or in part to one or more second beneficiary or beneficiaries. The second beneficiary can be another exporter, trader or manufacturer. The L/c is expressly designated "transferable" by the issuing bank on instructions of the applicant. The letter of credit that was transferred or made available to the second beneficiary is known as the transferred credit. The bank that makes the transfer is known as the transferring bank.
Non-transferable Letter of Credit
In a non-transferable letter of credit, the beneficiary cannot transfer the credit to other beneficiary. The L/c usually indicates "non-transferable" or "not transferable. " Even if such indication in not there, the L/c is deemed to be non-transferable.
