Letter of Credit – Definition, Types and Process

Letter of Credit is one of the most popular and more secured of method of payment in recent times as compared to other methods of payment. A Letter of Credit refers to the documents representing the goods and not the goods themselves. Banks are not in the business of examining the goods on behalf of the customers. Typical documents, which are required includes commercial invoice, transport document such as Bill of lading or Airway bill, an insurance documents etc. L/C deals in documents and not goods.

Definition of Letter of Credit

A Letter of Credit can be defined as “an undertaking by importer’s bank stating that payment will be made to the exporter if the required documents are presented to the bank within the validity of the L/C”.

A commercial letter of credit is a contractual agreement between a bank (issuing bank), on behalf of one of its customers (buyer), authorizing another bank (advising or confirming bank), to make payment to the beneficiary (seller). The issuing bank, on the application of its customer (buyer), opens the letter of credit, and makes a commitment with the buyer to honor the credit on the presentation of the documents, conforming to the terms and conditions of the credit, by the beneficiary. Thus, the issuing bank replaces the bank’s customer as the payee.

Parties Involved in Letter of Credit

  1. Applicant: The buyer or importer of goods.
  2. Issuing bank: The issuing bank’s duty to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the law provisions the bank is entitled to have a reasonable time after receipt of the documents to honor the draft. The issuing bank’s duty is to provide a guarantee to the seller that if complying documents are presented by the seller, then the bank will make the payment to the seller, and will only pay if these documents comply with the terms and conditions set out in the letter of credit. Typically the documents requested include a commercial invoice, bill of lading or airway bill and an insurance document; but there are many others. Letters of credit only concerns with the documents, not with the goods.
  3. Beneficiary: Beneficiary is normally the provider of the goods or services and is entitled to payment as long as he can provide the conforming documents required by the letter of credit. The letter of credit is a distinct and separate transaction from the underlying contract (contract between seller and buyer). All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the buyer and seller. The issuing bank’s obligation to the buyer-applicant is to examine all documents to insure that they are in compliance with the terms and conditions of the credit. To get the payment it is for the beneficiary to provide all the required documents. If the seller-beneficiary conforms to the letter of credit, the seller must be paid by the bank.
  4. Advising bank: An advising bank is usually a foreign correspondent bank of the issuing bank which advises the seller-beneficiary. Generally, the beneficiary wants to use a local bank to insure that the letter of credit is valid. In addition, the advising bank is responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. Therefore, if the issuing bank does not pay the beneficiary, the advising bank is not obligated to pay.
  5. Confirming bank: At the request of the issuing bank, the correspondent bank may confirm the letter of credit for the seller-beneficiary and obligates itself to insure payment under the letter of credit. The confirming bank is usually the advising bank.
  6. Negotiating bank: The bank to whom the beneficiary presents his documents for payment under L/C.

Elements of a Letter of Credit

  • A payment undertaking given by a bank (issuing bank)
  • On behalf of a buyer (applicant)
  • To pay a seller (beneficiary) for a given amount of money
  • On presentation of specified documents representing the supply of goods
  • Within specified time limits
  • Documents must conform to terms and conditions set out in the letter of credit
  • Documents to be presented at a specified place

Types of Letter of Credit

Letters of credit may be either revocable or irrevocable.

1. Revocable Letter of Credit

A revocable letter of credit may be revoked or modified by the issuing bank, for any reason at any time, without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction involving a revocable letter of credit, it serves as the advising bank. A letter of credit can not be revoked, once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honored. The revocable letter of credit is not a commonly used instrument.

2. Irrevocable Letter of Credit

This is the most common form of credit used in international trade. The irrevocable letter of credit may not be revoked or amended without the consent of the issuing bank, the confirming bank, and the beneficiary. The buyer’s issuing bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the letter of credit. Changes in the credit must be approved by both the buyer and the seller. If the documentary letter of credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable. There are two forms of irrevocable credits:

  1. Unconfirmed credit: In an unconfirmed credit, the buyer’s bank issuing the credit is the only party responsible for payment to the seller. The seller’s advising bank pays only after receiving payment from the issuing bank. The seller’s advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk.
  2. Confirmed credit: In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer’s issuing bank. Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the seller. The advising bank will then look to the issuing bank for payment. Confirmed Irrevocable letters of credit are used when trading in a high-risk area where war or social, political, or financial instability are real threats. Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order. A confirmed credit is more expensive because the bank has added liability.

Letter of Credit Process

  1. Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment.
  2. Buyer applies to his bank for a letter of credit in favour of the seller.
  3. Buyer’s bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming). The correspondent bank is usually located in the same geographical location as the seller (beneficiary).
  4. Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary).
  5. Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a particular company.
  6. Seller presents the required documents to the advising or confirming bank to be processed for payment.
  7. Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit.
  8. If the documents are correct, the advising or confirming bank will claim the funds by:
  9. Debiting the account of the issuing bank.
  10. Waiting until the issuing bank remits, after receiving the documents.
  11. Reimburse on another bank as required in the credit.
  12. Advising or confirming bank will forward the documents to the issuing bank.
  13. Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer’s account.
  14. Issuing bank then forwards the documents to the buyer.

Letter of Credit Documents

The most common documents include:

  • Commercial Invoice: It includes a description of merchandise, price, FOB origin, and name and address of buyer and seller. The buyer and seller information must correspond exactly to the description in the letter of credit.
  • Bill of Lading: It is a document which shows the receipt of goods for shipment by a freight carrier. It is an evidence of the control of the goods and also acts as an evidence of the carrier’s obligation to transport the goods to their proper destination.
  • Warranty of Title: A warranty given by a seller to a buyer of goods that states that the title being conveyed is good. It is generally issued to the purchaser.
  • Letter of Indemnity: It is a letter specifically indemnifies the purchaser against a certain stated circumstance. Indemnification is generally used to guarantee that shipping documents will be provided in good order when available.

Sample Document: Letter of Credit (Documentary Credit)

THE MOON BANK
INTERNATIONAL OPERATIONS
5 MOONLIGHT BLVD.,
EXPORT-CITY AND POSTAL CODE
EXPORT-COUNTRY
OUR ADVICE NO.
MB-5432
ISSUING BANK REF. NO. & DATE
SBRE-777     January 26, 2005
To,

UVW Exports
88 Prosperity Street East, Suite 707
Export-City and Postal Code

Dear Sirs:
We have been requested by The Sun Bank, Sunlight City, Import-Country to advise that they have opened with us their irrevocable documentary credit number SB-87654

For account of DEF Imports, 7 Sunshine Street, Sunlight City, Import-Country in your favor for the amount of not exceeding Twenty Five Thousand U.S. Dollars (US$25,000.00) available by your draft(s) drawn on us  at sight for full invoice value

Accompanied by the following documents:

  1. Signed commercial invoice in five (5) copies indicating the buyer’s
    Purchase Order No. DEF-101 dated January 10, 2005
  2. Packing list in five (5) copies.
  3. . Full set 3/3 clean on board ocean bill of lading, plus two (2) non-negotiable copies, issued to order of The Sun Bank, Sunlight City, Import-Country, notify the above accountee, marked “freight Prepaid”, dated latest March 19, 2005, and showing documentary credit number.
  4. Insurance policy in duplicate for 110% CIF value covering Institute Cargo Clauses (A), Institute War and Strike Clauses, evidencing that claims are payable in Import-Country.

Covering:     100 Sets ‘ABC’ Brand Pneumatic Tools, 1/2″ drive,
complete with hose and quick couplings, CIF Sunny Port

Shipment from:Moonbeam Port, Export-Country to Sunny Port, Import-Country
Partial shipmentProhibited
Tran-shipmentPermitted
Special conditions:

  1. All documents indicating the Import License No. IP/123456 dated January 18, 2005.
  2. All charges outside the Import-Country are on beneficiary’s account
Documents must be presented for payment within 15 days after the date of shipment.
Draft(s) drawn under this credit must be marked

Drawn under documentary credit No. SB-87654 of The Sun Bank,
Sunlight City, Import-Country, dated January 26, 2005

We confirm this credit and hereby undertake that all drafts drawn under and in conformity with the terms of this credit will be duly honored upon delivery of documents as specified, if presented at this office on or before     March 26, 2005

Very truly yours,

__________________________

Authorized Signature

Unless otherwise expressly stated, this Credit is subject to the Uniform Customs and Practice for Documentary Credits, 1993 Revision, International Chamber of Commerce Publication No. 500.