LETTER OF CREDIT

In case of commercial transactions, before the selling of goods take place, buyers are often asked to give Sellers a letter of credit, a legal document which is issued by a financial institution. This happens especially when the parties involved in the transaction do not properly know each other. Now days, it has become very common to give effect to payments in this manner when it comes to the international trade, as bank is an uninterested party in the transaction. Also it proves very helpful in long distances, diverse languages, customs etc as it becomes difficult to infer the guarantee of payment. Letter of credit is altogether a transaction distinct from the contract of goods. It is issued at buyer’s request wherein bank gives payment assurance or promise that seller or the exporter will be getting payment if they did whatever they have agreed for and if all the requirements as given in letter of credit are met.

There are following parties involved in letter of credit transaction:

• Beneficiary – Party to whom the payment is to be made. Beneficiary is entitled for payment if is able to show all the documentary evidence as is required by letter of credit. Beneficiary can request the payment on fulfillment of required conditions.
• Buyer– This is the party that has to purchase the goods or the services and needs letter of credit.
• Issuing Bank– This is the institution that issues letter of credit and is nowhere responsible for performance of contract. All that it is responsible for is examination of documents for insuring the meeting of all required terms and conditions. After this is done, issuing bank is absolutely liable to make the payment. The banks are given reasonable time to honor the draft.
• Advising bank– It’s usually the issuing banks’ foreign correspondent bank and advises beneficiary. The advising bank is responsible merely for sending documents to issuing bank.

Following the signing of contract between the parties, importer applies to issuing bank for opening letter of credit. After this issuing bank forwards the advice of credit to advising bank. Once the shipment is completed, exporter then presents the necessary documents to advising bank for demanding payment. Advising bank does the required checking of submitted documents and payment is given to the seller. Issuing bank sends those documents to importer, and then the amount specified in letter of credit as well as expenses incurred by the financial institution or bank are taken from importer’s account.

At various stages, the banks have to check the submission of all the required documents as per the letter of credit.  Important documents under Letter of credit include bill of exchange drawn on the opening bank by beneficiary and must indicate clearly the relevant details including the number of letter of credit.  Another document required is commercial invoice containing all details regarding goods, Letter of credit number, importer’s information, contract terms, shipping marks etc. Further, it requires transport documents (airway bills, lorry receipt, railway receipt, bill of lading), Certificate of origin, insurance policies etc.

There are various kinds of letter of credit on the basis of the security provided to beneficiary and are as follows:

• Irrevocable Letter of Credit –Revocable letter of credit is one where modification or cancellation can be done at any time by the issuing bank or the buyer without any notice given to the beneficiary. Such type of letter of credit is disadvantageous to seller as it involves a higher risk.To the contrary, an irrevocable letter of credit is one where no party is allowed to make changes in the letter of credit unless there is a mutual agreement between the parties.
• Confirmed Letter of credit – Such Letter of credit is for backing up the issuing banks’ credit standing and thus helps in diminishing the risk of foreign trade. On request of the issuing bank, a second bank agrees for paying letter of credit. The Seller’s bank confirms to take responsibility of negotiation and of payment collection from the buyer’s bank. Whereas in unconfirmed Letter of Credit, seller’s domestic bank acts as issuing bank’s agent but is not responsible to beneficiary.

• Revolving Letter of Credit– It is issued in the regular business transactions between buyer and seller. This letter of credit is issued once and still remains valid for certain period of time for another transaction without any need to issue any other letter of credit.
• Transferrable letter of credit– These are used when the beneficiary is just an intermediary. It allows the transfer of payments to the third parties.
• Red clauseletter of credit– In this type of letter of credit, beneficiary is allowed for partial payment even before shipping of products or performing the services.
• Back-to-back- Letter of credit– It involves two letters of credit one that is issued to intermediary by buyer’s bank and another issued to seller by intermediary’s bank.
• Sight Letter of credit– The buyer’s bank has to make payment at sight that means payment immediately to seller’s bank on fulfillment of required terms and conditions.

Advantage of the Letter of credit includes curtailing the risk of non- performance on the seller’s side and reduces the credit risk assuring payment on time especially at times where determining buyer’s credit worthiness is big task as buyer cannot refuse payment by taking the argument of bad quality of goods. Hence it saves seller from fraudulent buyers who try delaying the payment unnecessarily.