A Letter of Credit (L/C) or documentary credit is an undertaking issued by a bank, on behalf of the buyer (the importer), to the seller (exporter), to pay for the goods and services, provided that the seller presents documents, which comply with the terms and conditions of the letter of credit.
Letters of credit are classified in to various categories on the basis of their nature which are used depending on the needs of the importer/opener.
- Revocable Letter of Credit: A revocable L/C is one that can be amended or cancelled at anytime by the issuing bank without the notice or reference to the beneficiary, consequently, revocable credit does not constitute a legally binding undertaking between the banks and the beneficiary as it can be modified or cancelled at any time without notice to the Beneficiary.
- Irrevocable Letter of Credit: An irrevocable L/C constitutes a definite undertaking of the issuing Bank, provided that the stipulated documents are presented to the nominated bank or to the issuing bank and that the terms and conditions of the credit are complied with.
- Confirmed Irrevocable Letter of Credit: A confirmation of an irrevocable credit by another bank (confirming bank) up on the authorization or at the request of the issuing (add its confirmation to L/C) constitutes a definite undertaking of the confirming bank, in addition to that of the issuing bank, provided that the stipulated documents are presented to the confirming bank or to any other nominated bank, meet the terms and that the conditions of the credit are complied with.
- Transferable L/C: A credit under which the Beneficiary (first Beneficiary) may request the bank authorized to pay, incur deferred payment undertaking, accept or negotiate (the transferring bank) or in the case of freely negotiable credit, the bank specifically authorized in the credit, as a transferring bank, to make the credit available whole or in part to one or more beneficiary/ies (i.e. second beneficiary). The L/C is transferable only if the issuing bank so specifically states. The benefit of a transferable credit is that if the beneficiary is only an intermediary between the opener and the manufacturer and is interested in the margin/spread that he can make without employing his own funds. Transferable credit can be transferred only once. The second beneficiary cannot transfer it again. However a part or fraction can be transferred provided it does not excess the total quantity/value of the original L/C and provided that partial shipment is allowed.
- Revolving Letter of Credit: A revolving letter of credit is where the credit available to the beneficiary gets reinstated after being utilized once. The amount of the credit is renewed or reinstated from time to time without a specific amendment. This credit may be limited by the overall credit available or the time period in which such a credit may be utilized or both.
- Back-to-Back Letter of Credit: A back-to-back credit is issued on the strength of a credit already acquired. It is in fact a secondary or counter credit of a primary credit and is issued for some reason a credit cannot be issued in a transferable form. Back-to-back credit is opened with another letter of credit as the security. It may be opened by the beneficiary when he does not wish to reveal the identity of the producer from the importer or when the importer does not want to open a transferable letter of credit. However it should be ensured that the second credit terms and conditions are identical to these of the first credit, the difference being mainly the date of expiry and the amount. Also the second credit must expire before the first credit and the amount of the second credit will have to be less than that of the first credit.
- Anticipatory Credit or Red Clause Letter of Credit: Under the Red Clause Letter of Credit some part payment is made to the beneficiary before shipment of goods and submission of documents stipulated in the credit. It is a method of financing and it is so called as this clause authorizing the advising bank is typed or printed in red and hence the name. This is to enable him to purchase the required raw material, goods, etc. for the exporter. This amount of advance is either to be repaid by the exporter/beneficiary or is adjusted from the negotiation amount of the bill. If the exporter beneficiary fails to repay or fails to submit the documents for negotiation, the ultimate responsibility is of the L/C opener to repay the monies so advanced.
- Green Clause Letter of Credit: It is an extension of the Red Clause Letter of Credit in as much as in addition to advance payment, it envisages the grant of storage facilities at the port of shipment and its cost is met by the opener including insurance charges. These are very uncommon.
- Deferred Payment Letter of Credit: It is a letter of credit which allows payment under the L/C in installment to the beneficiary and each installment is covered by a separate Draft. The issuing bank will accept the drafts when the documents are submitted in accordance with the terms and conditions of the letter of credit. The exporter can also get the drafts discounted with his banker or the issuing bank if the drafts are drawn under the credit.
- Standby Letter of Credit: It is not a letter of credit but it is a guarantee for the performance of a contract, and is realizable on the presentation of a declaration to the issuing bank stating that the named party has not fulfilled the contract. It is basically a guarantee issued by a bank in a letter of credit format. Normally it calls for one or two documents, which can be issued by the beneficiary to be presented against payment. Normally these may be a copy of in voice and a declaration by the beneficiary that the said invoice has not been paid.
It would be observed that the various types of letters of credit give the financing support to the buyer of goods. The financing is done to buyer on the basis of usance/ deferred letter of credit, etc.