Letter of Credit (LC) is also known as “Documentary Credit”. It is called so in view of credit available to the supplier (seller) immediately against submission of documents to his bank for negotiation.
Definition of Letter of Credit: Letter of credit (LC) is an undertaking letter issued by the importer’s (buyer’s) bank wherein the seller is assured of full payment of goods/service sold by him on a condition that the supplier fulfills his part of the sale contract embodied in Letter of Credit.
Complications in international trade
The role of commercial banks in opening and negotiating the LCs is crucial to sort out the transaction complications of exporter (seller) as well as that of importer (buyer). Let us take an example of a seller (exporter) who wants to sell his products to a buyer of another country. The seller (exporter) may not know the credentials of the buyer (importer). Naturally, he carries the risk of non-payment or delayed payment of goods sold by him, if he does the transaction directly with the buyer. He may also come across problems associated with international trade like exchange control regulations of importer’s country. In the above circumstances, he looks for intermediary like a bank of good reputation, who could guarantee him of the payment on behalf of the buyer, in relations to goods/service sold by him. In a similar situation, the buyer, on the other hand is also at risk of not receiving the goods or services as per contract entered with the seller, if he has made the advance payment to the seller without any intermediary help. Therefore for making payment to the seller before the delivery of goods/service ordered by him, he also needs someone like a bank of good reputation, who could guarantee him that the invoice payment will be made to supplier only after supplier evidencing the documents to the bank that the supplier complied all the conditions of contract between the buyer and seller.
How LC transactions take place?
The buyer approaches his bank to open (issue) a LC on his behalf. The LC issued by the bank assures the beneficiary that the bank would give the guarantee of payment provided he fulfills all the conditions precisely embodied in Letter of Credit. Thus the supplier (seller) is assured of full payment for goods/service sold by him as per contract terms. The buyer is also equally happy that the payment will be made to the supplier, only after the supplier complies all the terms of contract which are precisely embodied in LC.
It is to be noted that bank is dealing only with the documents and not with the goods/service delivered to the buyer. LC issuing bank bound to reimburse the payment of documents, negotiated by the negotiating bank, which are in conformity with the conditions embedded in the LC. Therefore there is no scope for buyer disputing with regard to quality of goods or otherwise.
LC on Sight Payment and LC on Usance terms
‘LC on Sight Payment’ means the payment should be made on receipt of the document by LC issuing Bank. The other type of LC is ‘LC on Usance terms’. LC Bills under Usance terms are the bills payable by the buyer/importer at a specified period ‘after date’ or ‘after sight ’of the bill. The term ‘after date’ means the due date will be calculated from the date of the bill. The term ‘after sight’ means the due date will be calculated from the date of presentation of bill. In both the cases, the exporter would get immediate payment from negotiating bank. However for negotiation of LC under usance terms, the beneficiary /seller/exporter has to pay interest/discount charged by the negotiating bank for usance period.
LC (Inland) and LC (Foreign)
If a LC is issued to a beneficiary (seller) in the same country, such LC is called ‘Inland LC’ and if the LC is issued to a beneficiary of foreign country such LC is called ‘LC (foreign)’.
Freely negotiable and Restricted Letters of Credit
Letter of credit which is marked ‘freely negotiable’ indicates that it may be negotiated by any bank chosen by the beneficiary. It is possible to open a letter of credit marked to designated bank to negotiate the LC. Such LC where negotiation is restricted to designated bank is called ‘Restricted Letter of Credit’.
Uniform Customs and Practice (UCP) for Documentary Credits
Uniform Customs and Practice (UCP) for Documentary Credits is a set of uniform rules established and published by International Chamber of Commerce on issuance of Letter of credit and method of handling letter of credit in international trade finance. The voluntary codes of UCP are applied by the banks and commercial parties in more than 175 countries all over the world. Though drawn-up rules of UCP do not have the binding of law, they have gained almost universal acceptance and are incorporated as a reference in all documentary credits. The International Chamber of commerce with their headquarters in Paris first published Uniform Customs and Practice for Documentary Credits in 1933 and same was periodically revised 1951, 1962, 1974, 1983, 1993 & 2007. The latest UCP revision is done in July 2007 under publication No.UCP 600 of ICC. UCP is a voluntary code applied by the banks all over the world.
Related articles: (i) Know who are the eight parties involved in Letter of credit transaction (ii) Dissecting different types of LCs (Letters of credit) (iii) Meaning of Standby LCs of different types.