A letter of credit is a written undertaking issued by buyer’s bank to pay a certain sum of money within a stipulated period against a specified set of documents. It is a conditional undertaking. It undertakes to pay a certain amount of money on presentation of stipulated documents and the fulfillment by the exporter of all the terms and conditions incorporated in the L/C. The Letter of credit is a separate and distinct contract from the underlying sale contract, and the bank is not responsible for the fulfillment of the terms of the sale contract. The essential and basic provisions of the sale contract must be incorporated in the letter of credit. In addition, the amount of credit, its expiry date, the tenor of the draft to be drawn, party on whom the draft is to be drawn, the documents to be presented, brief description of the goods, must be precisely stated in the letter of credit.
A guarantee is understood as a supplementary contract. A (designated as ‘debtor’) and B (designated as ‘creditor’) enter into a main contract in terms of which A promises to do something to B. Now B wants safeguards in case A fails to perform what he has promised and demands from A to provide him a guarantor. In this contract C at the request of A comes forward and enters into a Contract of Guarantee with B. This is thus a supplementary contract entered by C with B. In terms of this contract of guarantee C promises to B that in case A fails to perform his obligations under the main contract to B, C will perform the same or compensate the loss of B, as may be provided in the contract of Guarantee. A contract of guarantee is called a contingent guarantee.
Differences between Letter of Credit and Guarantee are given below.
- In a letter of credit there are only two contracting parties, i.e. the Banker and the beneficiary. The Banker opens the L/C on behalf of the buyer, but the buyer is not a contracting party, AS THE Letter of credit is a distinct and independent contract. In a Guarantee there are always three parties, 1. The Debtor 2. The Creditor (beneficiary of the guarantee) and 3. The Guarantor.
- The guarantee is a supplementary contract based on an already existing original contract between the Debtor and Creditor (beneficiary of the guarantee. The Letter of credit however is a distinct contract (original contract) and it is not in any way linked with any supply contract excising between the seller (beneficiary of the guarantee) and the buyer (on whose behalf the Bank issues the Guarantee to the beneficiary
- In a letter of credit the Banker accepts accept certain obligations distinctly and directly, upon the beneficiary fulfilling the terms and conditions of the L/C. In a guarantee however, the agreement is between the Debtor and the beneficiary (i.e. seller and buyer). In a guarantor however the rights of the beneficiary on the guarantor is of a contingency right. The beneficiary can have recourse to the guarantor, only in case of failure of the principal debtor to perform the contact.
- Cancellation of the original sale/purchase agreement between the seller and buyer will not automatically affect the Letter of credit, since it is an independent contract. However cancellation of the original contract between the Debtor and the beneficiary will have the effect to nullify the guarantee and the beneficiary will not be Able to claim the benefits of the guarantee, when he has no valid claim on the debtor.
- L/C creates two way obligations. The beneficiary of the L/C can claim payment for his bills only after consigning the goods and presenting the documents drawn strictly in terms of the L/C to the Banker. This sort of enforcement of dual discipline is not possible, in case of a Guarantee.
- In a guarantee only one Branch of the Bank will be normally be involved with the beneficiary. But in a L/C the L/C is established by the overseas Bank and it is advised by a local correspondent normally, who adds his confirmation. This is the established convention and sellers will only accept such an L/C
- A documentary L/C covering merchandise provides a ready security (or collateral) to the Banker, as the Banker gets a general lien on the goods covered by the consignment. No such security accrues to the Bank in a guarantee transaction in the normal course, and hence the Banker will seek in addition to Margin deposit, mortgage of immovable properties as collateral security. In view of this a L/C is deemed a self-liquidating credit, while a Guarantee is deemed as an unsecured commitment.
- Letter of credit can be negotiated in parts stretched over a period. A guarantee cannot be invoked more than once.
- In view of several limitations of Guarantee it is not normally availed of a facility in export or Inland Trade. Letters of credit either Foreign or Inland is considered as the convenient tool. It is possible to issue a single revolving Letter of credit and cover all sales/purchases done periodically during a course of a year. Such flexibility and ease are not available under a guarantee. However a Guarantee from a Bank is considered appropriate in case deferred payment sale of equipment. The seller supplies (sells) a costly equipment on deferred payment (quarterly/half year or annual payments) over 3 to 5 years. As the seller has no security in case of default by the buyer, he insists of a Bank guarantee. Such a guarantee called Deferred Payment Guarantee is normally issued by the Bank.
- A Letter of credit initiates a new line of operations and serves as an integral part thereto. On the other hand a Guarantee being a provision for a specific contingency comes into focus only when there is a break in the regular transactions and an exception development (i.e. default by the guarantee giver) takes place. If there is no such default by the guarantee giver, the guarantee never comes into focus and gets automatically discharged on the completion of the transaction. Based on this criterion we may say that the L/C is a driving force, while the guarantee is an exception handler.