Letter of Credit

A letter of credit is a written commitment to pay, by a buyer's or importer's bank (called the
issuing bank) to the seller's or exporter's bank (called the accepting bank, negotiating bank, or
paying bank).

A letter of credit guarantees payment of a specified sum in a specified currency, provided the
seller meets precisely-defined conditions and submits the prescribed documents within a fixed
timeframe. These documents almost always include a clean bill of lading or airway bill,
commercial invoice, and certificate of origin. To establish a letter of credit in favor of the seller
or exporter (called the beneficiary) the buyer (called the applicant or account party) either pays
the specified sum (plus service charges) up front to the issuing bank, or negotiates credit.

Letters of credit are formal trade instruments and are used usually where the seller is unwilling to
extend credit to the buyer. In effect, a letter of credit substitutes the creditworthiness of a bank
for the creditworthiness of the buyer. Thus, the international banking system acts as an
intermediary between far flung exporters and importers. However, the banking system does not
take on any responsibility for the quality of goods, genuineness of documents, or any other
provision in the contract of sale. Since the unambiguity of the terminology used in writing a
letter of credit is of vital importance, the International Chamber Of Commerce (ICC) has
suggested specific terms (called Incoterms) that are now almost universally accepted and used.
Unlike a bill of exchange, a letter of credit is a nonnegotiable instrument but may be transferable
with the consent of the applicant.

In simpler terms, Letter of credit – is a written promise send by the bank of an importer (buyer)
to the bank of the exporter (supplier) which acts as a guarantee that the importer will pay the
mentioned agreed amount of money to the exporter as specified in the letter of credit. The LC
acts as a guarantee for payment. Also, it can be termed as a condition undertaking given by a
bank to the exporter at the importer’s request to effect payment up to a certain amount within the
stated time against presentation of specified documents. It also must comply with the terms of
the letter of credit. The letter of credit is governed by International Chamber of Commerce.
(ICC).
The seller avails the bill of lading to his bank in exchange for payment. Then the seller’s bank
provides the bill of lading to the buyer’s bank who also proceeds and hands over the bill of
lading to the importer then the importer provides the original bill of lading to carrier (shipping
line and is authorized to take delivery of the goods).

Letter of Credit is of 7 types:

Revocable Letter of Credit: Revocable Letter of Credit, which can be revoked, that is, amended
or cancelled by the bank issuing the credit, without the notice of other parties.

Confirmed Letter of Credit: This LC is issued after guarantee or confirmation by another bank
other than Issuing Bank.

Irrevocable Letter of Credit: This type of LC can’t be amended or cancelled by the Issuing Bank
without the consent of parties to LC, particularly the Beneficiary.

Sight Credit & Usance Credit: in the Sight Letter of Credit, Issuing Bank has to made payment at
the sight, on demand or on presentation.

Back-to-Back Letter of Credit: Back-to-Back Letter of Credit is a main type of letter of credit in
which LC opens against the security of another LC with corresponding terms. It is also called as
Countervailing Credit.

Standby Letter of Credit: The Standby Letter of Credit is used as a substitute for performance
guarantee or for securing loans.
Transferable Letter of Credit: This type of LC can be transferred by the Original Beneficiary to
second beneficiary or several second beneficiaries.

The process of flow of letter of credit involves the following parties:

1) Buyer(Importer)
2) Buyer’s bank
3) Seller( Exporter)
4) Seller’s bank
5) Carrier (Shipping line)

Process of Letter of Credit (LC):

Step 1: The importer and exporter agree on the sale terms and come into the contract
encompassing the type of products, delivery schedule, mode of payment etc. After this, buyer
arranges for his bank (Issuing Bank) to open a Letter of Credit in favor of the seller. The buyer’s
bank is liable to prepare the issuing letter of credit as per buyer’s instructions to the supplier and
required Letter of Credit documents including – Bill of Lading, Commercial Invoice, Transport
Document such as Bill of Lading, Airway Bill, etc., Insurance Document, Inspection Certificate,
Certificate of Origin and any other document as per the sale contract.

Step 2: The buyer’s bank transfers the letter of credit to the advising bank in the seller’s country.

Step 3: After checking authenticity of the letter of credit, the advising bank forwards it to the
exporter. The seller now reviews the terms & conditions mentioned in LC and notify any
required amendment to the buyer.

Step 4: Once terms & conditions of trade are finalized and agreed, the seller makes merchandise
ready for shipment to the appropriate destination. The seller obtains required transport
documents like Bill of Lading, while shipping the goods.

Step 5: Now seller presents the shipping documents to the Negotiating Bank, indicating complete
compliance with the terms of the letter of credit. The job of Negotiating Bank is to review these
documents and dispatch these to the Issuing Bank. The Negotiating Bank also raises a
reimbursement claim to the Reimbursing Bank.

Step 6: Once Issuing Bank receives all documents, importer has to make the payment to bank
and will receive the documents, which will make him to take the shipment into possession.

The following terminologies should be understood clearly:

Issuing bank – This is a buyer’s or importer’s bank which is establishing a letter of credit(LC in
favor of exporter) but you should note that the issuing bank forwards the letter of credit to
exporter’s bank and commits itself to honor the condition given by the exporter against the
amount specified in the LC. The issuing bank is usually in the importer’s country.

The correspondent bank – This bank is usually in the exporter’s country, it’s the institution
which receives the letter of credit from the issuing bank for authentication and informing the
exporter.

Now let’s see the use of Letter of Credit with an example:

Exporter: A textile company that sells various types of cloths.

Importer: A customer that buys cloths from the textile company.

First, a buyer (importer) and seller (exporter) decide to do business together. They agree on a
price, quantity, and other terms, and they specify how and when the goods will be shipped to the
buyer. As part of the agreement, we’ll assume that the seller wants the buyer to use a letter of
credit (LOC).

Why does the seller demand a letter of credit? The seller wants more confidence that the buyer
will pay. Perhaps this buyer and seller have never worked together, or the order might be large
enough to cause severe financial hardship if something goes wrong (if the seller spends money to
produce and ship goods, and the buyer’s assets are seized for some reason).

It’s important to know that the sales agreement is not part of the letter of credit. The sales
agreement is between the buyer and the seller only, and the LOC uses information in the
agreement, but the LOC is a separate document issued by a bank.
To get a letter of credit (LOC), the buyer contacts her bank. That bank operates in the buyer’s
home country, and is most likely a bank that the buyer currently does business with. The buyer
provides information that is needed for the bank to issue the LOC, including details like:

How much is the payment?

What is the name and address of the seller (known as the beneficiary)?

When will it be shipped?

How will it be shipped?

Where should the shipment arrive?

And numerous other details

It’s essential that the bank gets all of the details correct. The LOC will be a legally binding
document, and these documents are interpreted literally. Again, the LOC is separate from the
sales agreement, and it’s based on documents – not actions – so you can't assume that everything
will work out if there’s an error (even a seemingly minor item like a typographical error); if the
document isn’t perfect, it needs to be redone before anybody moves forward.

When the bank issues the LOC, the bank will have made a promise, and the bank will be
responsible for sending money (that’s what makes a letter of credit so safe for sellers) – so the
bank wants to know that the buyer can actually come up with the money. At this point, the buyer
may have to deposit funds with the bank, or the bank might offer a loan to the buyer as part of
the LOC.

After issuing the LOC, the bank sends it to the seller’s bank. This is typically a bank in the
seller’s country – presumably a bank that the seller already has a relationship with. There may be
several banks in between acting as intermediaries, but we’ve left them out for simplicity.

The seller’s bank will review the LOC and forward it to the seller. At this point, the seller should
review the LOC to ensure that it matches what she agreed to do and that she is capable of
meeting the requirements of the LOC. She should also decide if she is comfortable trusting the
issuing bank and any other banks involved. If everything is acceptable, the seller can move to the
next step: produce and ship goods.

To get paid with a letter of credit (LOC), the seller will need to meet the requirements specified
in the LOC. Among other things, that generally means:

i. Shipping the goods by a certain date

ii. Possibly having the goods inspected before shipment
iii. Using the shipping method specified in the LOC
iv. Shipping to and from ports specified in the LOC
v. Gathering documents specified in the LOC (shipping documents, for example)
vi. Submitting documents to the bank by a certain date
This is where sellers really enjoy the benefits of a letter of credit. The seller knows that she will
get paid (assuming the bank that promised payment is good for the money) as long as she meets
the requirements of the LOC. It doesn’t matter if her customer has gone bankrupt or decides not
to pay – the bank is on the hook for payment; the bank will have to deal with the end customer.

Likewise, depending on how things were arranged, it doesn’t even matter if the goods ever make
it to the customer. A storm may damage or destroy the goods during shipment, and the seller
might not be responsible for that loss.

The main challenge for the seller is meeting the requirements of the LOC. Again, banks only
care about the details written into the LOC and the documents you submit to satisfy the LOC. If
anything is off, the seller won’t get paid.

For example, if you ship one day late, it’s a major problem. You might throw in some extra
product for free (and your customer might even agree that this makes up for the late shipment),
but banks won’t pay unless the LOC is amended to account for the later shipping date. It takes
extra money and time to amend a LOC.
Once documents are submitted to the seller’s bank, the bank will verify that the documents meet
the requirements of the LOC. Again, the bank will take everything literally: if anything is off –
even the spelling or abbreviation of a company name – the bank can refuse payment. Banks take
several business days to conduct this review.

If the documents are good, the seller’s bank will forward the documents to the buyer’s bank. The
buyer’s bank will perform the same review of documents against the LOC. If everything checks
out, the buyer’s bank will send payment to the seller’s bank.

The buyer’s bank will then forward the documents to the buyer, who uses those documents to
take possession of the goods when they arrive.

When does the seller get paid? The timing of payment depends on the type of LOC used. The
seller might get paid within a few days of submitting documents to a local bank. In other cases,
the seller will have to wait until certain conditions are met. Sometimes the seller gets paid an
“advance” (before shipping anything) so she can buy resources that will be used to produce the
customer’s goods.