Letter Of Credit - LC Payment - The Safetest Payment Way

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.

A standard, commercial letter of credit is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking.

The letter of credit can also be source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheques. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and documents proving the shipment was insured against loss or damage in transit. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin.

How it works

A business called the InCosmetika from time to time imports goods from a business called ACME, which banks with the ABC Bank. InCosmetika holds an account at the Commonwealth Bank. InCosmetika wants to buy $500,000 worth of merchandise from ACME, who agrees to sell the goods and give InCosmetika 60 days to pay for them, on the condition that they are provided with a 90-day letter of credit for the full amount. The steps to get the letter of credit would be as follows:

• InCosmetika goes to The Commonwealth Bank and requests a $500,000 letter of credit, with ACME as the beneficiary.
• The Commonwealth Bank can issue a letter of credit either on approval of a standard loan underwriting process or by InCosmetika funding it directly with a deposit of $500,000 plus fees which are typically between 1% and 8% of the face value of the letter of credit.
• The Commonwealth Bank sends a copy of the letter of credit to the ABC Bank, which notifies ACME that payment is available and they can ship the merchandise InCosmetika has ordered with the full assurance of payment to them.
• On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of the letter of credit, the Commonwealth Bank transfers the $500,000 to the ABC Bank, which then credits the account of ACME for that amount.
• Note that banks deal only with documents required in the letter of credit and not the underlying transaction.
• Many exporters have mistakenly assumed that the payment is guaranteed after receiving the letter of credit. The issuing bank is obligated to pay under the letter of credit only when the stipulated documents are presented and the terms and conditions of the letter of credit have been met.

Elements of a Letter of Credit

Beneficiary

The beneficiary is entitled to payment as long as he can provide the documentary evidence required by the letter of credit. The letter of credit is a distinct and separate transaction from the contract on which it is based. All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the customer and beneficiary. The issuing bank's obligation to the buyer, is to examine all documents to insure that they meet all the terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants that all conditions of the agreement have been complied with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the bank.

Issuing Bank

The issuing bank's liability 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 provisions of the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable amount of time after receipt of the documents to honor the draft.

The issuing banks' role is to provide a guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due and to examine the documents, and only pay if these documents comply with the terms and conditions set out in the letter of credit.

Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill and an insurance document; but there are many others. Letters of credit deal in documents, not goods.

Advising Bank

An advising bank, usually a foreign correspondent bank of the issuing bank will advise the beneficiary. Generally, the beneficiary would want to use a local bank to insure that the letter of credit is valid. In addition, the advising bank would be responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. If the issuing bank does not pay the beneficiary, the advising bank is not obligated to pay.

Confirming Bank

The correspondent bank may confirm the letter of credit for the beneficiary. At the request of the issuing bank, the correspondent obligates itself to insure payment under the letter of credit. The confirming bank would not confirm the credit until it evaluated the country and bank where the letter of credit originates. The confirming bank is usually the advising bank.

Some of the Documents Called for under a Letter of Credit

• Financial Documents: Bill of Exchange, Co-accepted Draft
• Commercial Documents: Invoice, Packing list
• Shipping Documents: Transport Document, Insurance Certificate, Commercial, Official or Legal Documents
• Official Documents: License, Embassy legalization, Origin Certificate, Inspection Certificate, Phytosanitary certificate
• Transport Documents: Bill of Lading (ocean or multi-modal or Charter party), Airway bill, Lorry/truck receipt, railway receipt, CMC Other than Mate Receipt, Forwarder Cargo Receipt, Deliver Challan...etc
• Insurance documents: Insurance policy, or Certificate but not a cover note.

Various Kinds of LC

Confirmed Letter of Credit

A letter of credit, issued by a foreign bank, which has been verified and guaranteed by a domestic bank in the event of default by the foreign bank or buyer. Typically, this form of letter of credit will be sought when a domestic exporter seeks assurance of payment from a foreign importer.

Commercial Letter of Credit

A commercial letter of credit assures the seller that the bank will provide payment for any goods or merchandise shipped to the bank's customer, assuming the seller provides any required documentation of the transaction and its shipment of the purchased goods.

Irrevocable Letter of Credit

An irrevocable letter of credit includes a guarantee by the issuing bank that if all of the terms and conditions set forth in the letter are satisfied by the beneficiary, the letter of credit will be honored.

Revocable Letter of Credit

An revocable letter of credit may be cancelled or modified after its date of issue, by the issuing bank.

Standby Letter of Credit

In the event that the bank's customer defaults on a payment to the beneficiary, and the beneficiary documents proof of its loss consistent with any terms set forth in the letter, a standby letter of credit may be used by the beneficiary to secure payment from the issuing bank.

Procedures for Using the Tool

The following procedures include a flow of events that follow the decision to use a Commercial Letter of Credit. Procedures required to execute a Standby Letter of Credit are less rigorous. The standby credit is a domestic transaction. It does not require a correspondent bank (advising or confirming). The documentation requirements are also less tedious.

Step-by-step process:

• Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment.
• Buyer applies to his bank for a letter of credit in favor of the seller.
• 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).
• Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary).
• 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.
• Seller presents the required documents to the advising or confirming bank to be processed for payment.
• Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit.
• If the documents are correct, the advising or confirming bank will claim the funds by: Debiting the account of the issuing bank; Waiting until the issuing bank remits, after receiving the documents; Reimburse on another bank as required in the credit.
• Advising or confirming bank will forward the documents to the issuing bank.
• Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer's account.
• Issuing bank then forwards the documents to the buyer.

Tips for Exporters

• Communicate with your customers in detail before they apply for letters of credit.
• Consider whether a confirmed letter of credit is needed.
• Ask for a copy of the application to be fax to you, so you can check for terms or conditions that may cause you problems in compliance.
• Upon first advice of the letter of credit, check that all its terms and conditions can be complied with within the prescribed time limits.
• Many presentations of documents run into problems with time-limits. You must be aware of at least three time constraints - the expiration date of the credit, the latest shipping date and the maximum time allowed between dispatch and presentation.
• If the letter of credit calls for documents supplied by third parties, make reasonable allowance for the time this may take to complete.
• After dispatch of the goods, check all the documents both against the terms of the credit and against each other for internal consistency.

Risk situations in letter-of-credit transactions

Fraud Risks

• The payment will be obtained for nonexistent or worthless merchandise against presentation by the beneficiary of forged or falsified documents.
• Credit itself may be forged.

Sovereign and Regulatory Risks

• Performance of the Documentary Credit may be prevented by government action outside the control of the parties.

Legal Risks

• Possibility that performance of a Documentary Credit may be disturbed by legal action relating directly to the parties and their rights and obligations under the Documentary Credit

Force Majeure and Frustration of Contract

• Performance of a contract – including an obligation under a Documentary Credit relationship – is prevented by external factors such as natural disasters or armed conflicts

Risks to the Applicant

• Non-delivery of Goods
• Short Shipment
• Inferior Quality
• Early /Late Shipment
• Damaged in transit
• Foreign exchange
• Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

• Insolvency of the Applicant
• Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

• No obligation to reimburse the Claiming Bank unless it has issued a reimbursement undertaking.

Risks to the Beneficiary

• Failure to Comply with Credit Conditions
• Failure of, or Delays in Payment from, the Issuing Bank
• Credit Issued by Party other than Bank

Risks to the Advising Bank

• The Advising Bank’s only obligation – if it accepts the Issuing Bank’s instructions – is to check the apparent authenticity of the Credit and advising it to the Beneficiary

Risks to the Nominated Bank

• Nominated Bank has made a payment to the Beneficiary against documents that comply with the terms and conditions of the Credit and is unable to obtain reimbursement from the Issuing Bank

Risks to the Confirming Bank

• If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may not be able to obtain reimbursement from the Issuing Bank because of insolvency of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a dispute as to whether or not payment should have been made under the Credit

Other Risks in International Trade

• A Credit risk risk from change in the credit of an opposing business.
• An Exchange risk is a risk from a change in the foreign exchange rate.
• A Force majeure risk is 1. a risk in trade incapability caused by a change in a country's policy, and 2. a risk caused by a natural disaster.
• Other risks are mainly risks caused by a difference in law, language or culture. In these cases, the cargo might be found late because of a dispute in import and export dealings.