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Introduction
A Letter of Credit in layman terms is essentially a letter from a competent authority vouching for the creditworthiness of a person or a business organization. This is a very useful tool of negotiation especially in international trade.
A letter of credit is a guarantee given by the bank on behalf of the purchaser for the goods and services purchased from the seller. This bank guarantee ensures the payment of dues to the seller in the event of a default from the purchaser. It is also used as a negotiable instrument in the normal course of business.
As mentioned earlier, a letter of credit is of great importance for international trades where the importer and the exporter are not acquainted with each other and in many cases do not even have a single physical contact. A letter of credit issued by the bank in such a case assures the seller of the safety and the viability of the transaction. The bank is required to honour this guarantee for the full amount of the transaction or the balance amount due or pending to the seller as the case may be.
Such a letter of credit is a very vital aspect of international trade where it is governed by the rules of the International Chamber of Commerce.
The details regarding the parties to such trade as well as types of the letter of credit and the documents required for such trade are discussed below.
Parties to Trade via Letter of Credit
When a trade or transaction is carried out between two parties on the basis of a letter of credit issued by a bank, the following entities are involved.
- Purchaser (Importer)
- Seller (Exporter)
- Bank Issuing the Letter of Credit
- Advising Bank (in certain cases where the seller is a client).
The purchaser is usually a client of the bank which issues the letter of credit on behalf of the purchaser. Such a letter of credit is issued when the buyer has a long standing healthy relationship with the bank which enables it to vouch for the buyer.
In similar cases, the advising bank has a relationship with the seller and thus can receive credit on behalf of the seller for his/her dues and eventually credit the same to the seller.
In many cases, the issuing bank directly credits the dues to the seller instead of having an advising bank as an intermediary.
Documents required for a Letter of Credit
The letter of credit usually mentions the required set of documents to be presented by the seller to the issuing bank for claiming the dues. These documents required by the issuing bank to complete the transaction are mentioned below.
- Bill of exchange
- Bill of lading
- Packaging list
- Legalized Commercial Invoices
- Shipping documents and transport documents (bill of lading, etc)
- Government licenses
- Certificate of origin
- Phytosanitary or Health certification of the products
- Inspection certificates
- Insurance documents
Upon receiving all the necessary documents, the issuing bank will release the payment of the seller (part of full as the case may be) in the event of a default from the purchaser or as per the agreed terms of the trade.
Types of Letter of Credit
There are many types of letter of credit that can be accepted as part of the trade. The nature of the letter of credit depends on the agreed terms between the buyer and the seller. Some of the types of letter of credit available in the normal course of business are mentioned hereunder.
Importer/Exporter Letter of Credit
This is the most basic and common form of letter of credit issued in any international trade. The importer is usually the buyer and exporter the seller or the beneficiary. When the LC is issued by the importer it is known as the Importer LC and similarly, an LC issued by the exporter is known as Exporter LC.
Standby LC
This is a letter of credit issued by the bank of the buyer which provides a standing guarantee of payment to the seller or the beneficiary only in the event of non-payment or default by the buyer.
Revocable LC
This is an uncommon form of LC issued between the trading parties. Under this tyoe of LC, the buyer or the issuing bank can revoke or alter the terms of the LC without any prior intimation to the seller. Due to its high risk nature, this form of LC is less preferred by the sellers/exporters.
Irrevocable LC
In contrast to the above form of LC, this type of LC safeguards the seller’s/exporter’s interests. The issuing bank or any party for that matter cannot make any changes to the issued letter of credit without the prior consent of the seller.
Transferable LC
This type of letter of credit can be transferred down the supply chain and the original seller or beneficiary acts as only an intermediary to the ultimate seller.
Non-Transferable LC
As suggested by the name of this type of LC, this document is a non-transferable letter of credit which cannot be passed on to any other party or to satisfy any other financial obligations.
Confirmed LC
This type of LC involves an intermediary bank or the advising bank also assuring the payment to the seller or the beneficiary. Only an irrevocable LC can be treated as a confirmed LC.
Unconfirmed LC
This type of LC is in contrast to the type of LC above. The guarantee is provided only by the issuing bank and no other bank is involved.
Back to Back LC
This type of LC is where one letter of credit is issued by the bank of buyer to the intermediary and another letter of credit is issued by the bank of the intermediary party to the ultimate seller or the ultimate beneficiary.
Revolving LC
This is also known as a blanket LC in common parlance where the letter of credit is issued for more than one payment or multiple payments instead of issuing them for every single one or for each transaction.
Sight LC
Under this type of LC, payment is made to the beneficiary upon presenting the necessary documents. The funds can be disbursed right away to the beneficiary and thus this form of LC is more immediate or prompt as compared to any other forms of LC.
Risks involved in LC
The transactions involving the use of letter of credit are not free of risks. There are many inherent risks that are part of such trade. Some of such risks are mentioned below.
- Risk of fraud where the documents obtained or presented are forged for a non-existent or lesser value of products.
- Legal risk where the transaction cannot be executed on account of any legal implications or barriers.
- Government Risk where any action or inaction of the government of one or more parties involved causes disruptions in the execution of the transaction
- Risks of failure due to any natural or uncontrollable acts like natural calamities or war
- Risk of insolvency on part of the buyer or the issuing bank
- Non-delivery or incomplete delivery of desired goods
- Quality issues of the goods received
- Damage during transit
- Late or delayed shipment
FAQs – Letter of Credit
1. Who issues the LC?
A letter of credit (more commonly known as LC) is issued by the buyer’s bank on behalf of the buyer to the seller’s or beneficiary’s bank, authorizing the payment of dues to the seller or the ultimate beneficiary for the amount of the transaction.
2. What are the payment terms or due date for LC?
The due date for realizing a LC depends upon the agreement between the buyer and the seller and is usually for the period of 30 days, 60 days or 90 days as the case may be.
3. What is a Confirmed LC?
A confirmed LC is where the intermediary bank or the advising bank guarantees the payment of dues to the seller in the event of non-payment by the issuing bank or the buyer.
4. How long does it take to receive an LC?
The issuing bank usually issues the LC within 2 to 3 business days of application by the buyer.
5. Are LCs issued for free?
No. Letter of credit is issued by the issuing bank or the advising bank upon payment of stipulated fees which is usually calculated as a percentage of the amount of the transaction involved.