Letter Of Credit

LETTER OF CREDIT

Project by: Ayush Agarwal

SA/A09/DEIM/0016

What Is LC? 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 LC can also be the 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, stormwater 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 does LC Works? A business called the InCosmetika from time to time imports goods from a business called BLISS, which banks with the ABC Bank. InCosmetika holds an account at the Commonwealth Bank. InCosmetika wants to buy $500,000 worth of merchandise from BLISS, 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: • •

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InCosmetika goes to The Commonwealth Bank and requests a $500,000 letter of credit, with BLISS as the beneficiary. The Commonwealth Bank can issue an LC 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 LC. The Commonwealth Bank sends a copy of the LC to the ABC Bank, which notifies BLISS 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 BLISS for that amount. Note that banks deal only with documents required in the letter of credit and not the underlying transaction.

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Many exporters have mistakenly assumed that the payment is guaranteed after receiving the LC. 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.

Methods Of International Payment •

Advance payment (most secure for seller)

Where the buyer parts with money first and waits for the seller to forward the goods •

Documentary Credit (more secure for seller as well as buyer)

subject to ICC's UCP 600, where the bank gives an undertaking (on behalf of buyer and at the request of applicant ) to pay the shipper ( beneficiary ) the value of the goods shipped if certain docs are submitted and if the stipulated terms and conditions are strictly complied. Here the buyer can be confident that the goods he is expecting only will be received since it will be evidenced in the form of certain docs called for meeting the specified terms and conditions while the supplier can be confident that if he meets the stipulations his payment for the shipment is guaranteed by bank, who is independent of the parties to the contract. •

Documentary collection (more secure for buyer and to a certain extent to seller)

subject to ICC's URC 525, sight and usance, for delivery of shipping documents against payment or acceptances of draft, where shipment happens first, then the title documents are sent to the [collecting bank] buyer's bank by seller's bank [remitting bank], for delivering documents against collection of payment/acceptance •

Direct payment (most secure for buyer)

Where the supplier ships the goods and waits for the buyer to remit the bill proceeds, on open account terms Risk situations in LC transaction

Parties to a LC? •

The Applicant opens the letter of credit. o The buyer, or customer, is the Applicant. o Sometimes the Applicant is called the account party.

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The Opening Bank issues the letter of credit. o The Opening Bank's credit replaces the buyer's credit.

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The Advising Bank is an agent of the Opening Bank. o Verifies the authenticity of the Opening Bank.

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The Confirming Bank is usually the Advising Bank, but it confirms that the credit exists. o It can negotiate the documents, and can accept the letter of credit the Opening Bank will not pay.

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The Paying Bank is also called the drawing bank. o The Paying Bank may act also the Advising Bank, or the Confirming Bank, or the Opening Bank.

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The Beneficiary is often the seller. o It is party to whom the credit is issued.

Cares to be taken while using LC! Pitfalls of Letters of Credit

Letters of credit make it possible to do business worldwide. They are important and helpful tools, but you should be careful when using letters of credit. As a seller, make sure you: • • • • • •

Carefully review all requirements for the letter of credit before moving forward with a deal Understand all the documents required Can get all the documents required for the letter of credit Understand the time limits associated with the letter of credit, and whether they are reasonable Know how quickly your service providers (shippers, etc) will produce documents for you Can get the documents to the bank on time

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Make all documents required by the letter of credit match the letter of credit application exactly

Types Of LC’s. 1.Revocable versus Irrevocable o

You should always insist and carefully check that a letter of credit is irrevocable.  Once an irrevocable letter of credit is open it cannot be changed without the written consent of all parties including the beneficiary.  A revocable letter of credit can be change or withdrawn without notifying the beneficiary.

2.Confirmed versus Advised o o

Confirmed is preferred, as the Confirming Bank promises to pay. Advised does not guarantee the creditworthiness of the Opening Bank.

3.Straight versus Negotiation o o

A negotiation letter of credit can be presented to any bank. A straight letter of credit can only be paid in the country of the Paying Bank.

4.Sight versus Usance o o

At sight means the Beneficiary is paid as soon as the Paying Bank has determined that all necessary documents are in order. Usance time can be between 30 and 180 days after the bill of lading date.  This is a form of delayed payment, and should be avoided.

Common Mistakes that occur while making LC. •

Exporters make the following common mistakes, which cause them to lose the sale or not get paid. o Presenting documents late, after the letter of credit has expired. o Shipping their goods after the specified date. o Making a partial shipment when partial shipment is not allowed. o Not presenting the proper documents. o Not legalizing the documents. o Not obtaining completed bills of lading.

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Not obtaining required insurance. Submitting copies instead of originals. Spelling mistakes. Mathematical mistakes.