Letter of credit (Documentary Letter Of Credit (L/C, DLC)
is the bank’s obligation to pay the seller of goods or services a
certain amount of money in the timely submission of documents confirming
shipment of goods or performance of contractual services.
Documentary Letter Of Credit is one of the most important means of
financing in the international trade, as the letter of credit is a tool
that removes most of risks as from the buyer (importer) and from the
seller (exporter).
Documentary Letter Of Credit is very flexible and convenient tool of
calculations, which have the widest recognition and acceptance in the
world because of the following advantages:
- For the seller, the letter of credit is convenient because it
removes the risk of insolvency of the buyer, because the letter of
credit is the unconditional obligation of the bank to pay, regardless of
the presence or absence of the bank of the applicant credit. Thus, the
letter of credit provides a higher degree of protection of the seller’s
interests with payment upon delivery or by collection.
For the seller of credit is convenient because it removes the risk of
insolvency of the buyer, because the letter of credit – the
unconditional obligation of the bank to pay, regardless of the presence
or absence of the bank of the applicant credit. Thus, the letter of
credit provides a higher degree of protection than the interests of the
seller with payment upon delivery or by collection.
- For the customer the letter of credit is convenient because it
provides greater protection of the buyer’s interests compared to the
down payment, and eliminates the risk of unscrupulous sellers, because
the letter of credit may be required, among other documents, the
documents, issued by independent third parties (Chamber of Commerce, the
insurance company, the independent inspector).
- Availability of “Uniform Rules and Practice for Documentary Letter
of Credit”, which are internationally recognized, clearly defining and
delimiting the obligations of the parties of the letter of credit,
allows advancing the interests of the applicant or beneficiary. Thus,
the letter of credit is the bank’s obligation as an independent
arbitrator who shall be subject to payment of the letter of credit,
regardless of the possible litigation between the parties to the
contract.
The principle of autonomy and independence of the letter of credit from the contract is fundamental.
What should be important during choosing a letter of credit:
It is important to define clearly the conditions of the letter of
credit: type of the letter of credit, payment conditions of the letter
of credit, a list and description of the documents submitted by the
payee and the requirements for such documents, the closing date of the
letter of credit and the period of submission of documents.
There are the following forms of letter of credit:
Revocable Letters of Credit, which can be changed or
canceled by the issuing bank without prior notice to the recipient of
funds. Revoke of letter of credit does not create any obligation of the
issuing bank to the payee (Article 1094 Civil Code). Nominated bank is
obligated to make a payment or other operations on a revocable letter of
credit, if at the time of their commission they have not received
notice of the change of conditions or canceling credit. A letter of
credit is revocable if its text does not explicitly state otherwise.
Irrevocable letter of credit is a firm obligation of
the issuing bank to pay money in order and the terms defined by the
conditions of the letter of credit, if the documents provided for by it,
submitted to the bank specified in the credit, or the issuing bank, and
observe the terms and conditions of the letter of credit.
Irrevocable letter of credit guarantees that the exporter will make
payment to the performance of its obligations, even if an importer wants
to abandon the deal. Therefore, exporter, performing a special order,
for which most likely will not be another buyer, chooses exactly this
kind of letter of credit.
Irrevocable unconfirmed letter of credit. When
making an unconfirmed letter of credit issuing bank, providing a letter
of credit, is only party that is responsible for the disbursement to
seller. Nominated bank has to pay only after receiving the money from
the issuing bank. Nominated bank simply acts on behalf of the bank
providing credit, so it does not take any risk.
Irrevocable confirmed letter of credit – the
obligation of the issuing bank is confirmed by another bank.
Confirmation is an additional guarantee of payment from another bank
(Bank of the exporter or prime bank).
Bank, confirming letter of credit is committed to pay for documents
according to the conditions of the letter of credit if the issuing bank
fails to make the payment.
According to the method of payment letters of credit can be divided into the following types of letters of credit:
1.Transferable Letter of Credit (Transferable LC) is
a letter of credit, the beneficiary of which is entitled to instruct
the advising bank to transfer the letter in full or in part to another
person with the preservation of the conditions of the letter of credit.
Transferable letter of credit may be transferred only once (if in the
Credit otherwise is stated). Prohibition on transfer of letter of credit
is not a prohibition on assignment of revenue on it. Letter of credit
can be transferred only if it is clearly defined by the issuing bank as a
transferable. The term “divisible”, “fractional”, “assignable”,
“passed” and others do not give the right to consider the letter of
credit as transferable. This type of letter of credit is applied when in
the transaction between the seller and buyer the intermediary
participates who has a letter of credit opened in his favor and
transferred into its own provider. The letter of credit can be
transferred only under the conditions specified in the original letter
of credit, with the exception of the amount of the credit, the unit
price, which can be reduced, as well as the expiry date, the last date
for submission of documents after the date of shipment, shipment period,
which may be reduced. During transferable letter of credit the
documents should be requested so that they could be used for the initial
credit. The use of this type of credit requires caution and a good
knowledge of technology.
- Red clause Letter of credit. The essence of red
clause letter of credit is that letter of credit requires the terms and
conditions of a special clause, according to which the issuing bank
authorizes the nominated bank to make an advance payment of a specified
amount to the beneficiary before submitting all the documents under the
Credit (prior to shipment of the goods or services). Such clause is
included in the letter of credit at the request of applicant. Down
payment on red clause letter of credit made by the executing bank under a
written obligation of the beneficiary to submit documents in accordance
with the terms of the letter of credit. After the submission of all
documents executed in full. A letter of credit is named in such way
because special clause was done with a red stripe.
3.The letter of credit with Payment at Sight.
Beneficiary receives payment upon presentation and verification of
documents corresponding to all the conditions of the letter of credit.
It is provided a reasonable time for a document check before paying to
the issuing bank, confirming bank or an authorized bank.
4.The letter of credit with Deferred payment.
Letter of credit with Deferred payment is based on an irrevocable
commitment of the issuing bank and / or confirming bank to make payment
against presentation of the relevant documents not at the time of
presentation of the documents and in the corresponding period of
payment, determined by the conditions of the letter of credit. Letters
of credit (with Deferred payment and payment by acceptance) may be a
more attractive financial instruments to customers prior to the date of
payment the buyer can sell the goods and pay the letter of credit,
generated profit.
- Revolving Letter of Credit (Revolving LC) put up
on a certain amount, after which it will be used for some time, again
exposed for the payment of claims of the beneficiary as many times as is
reached set the maximum aggregate limit.
The advantage for the importer is that it can order the product in
quantities greater than it needs at the moment, and thus to secure a
better purchase price. In this case, the delivery of goods will be
divided into certain parties and must be performed at specified
intervals. For exporter to ship on a schedule convenient for the
importer, usually under the revolving credit indicating the dates of the
respective amounts which represent the proportion of the aggregate
limit.
Such statement about the date of the equity amounts forces an
exporter to ship goods in time in accordance with the agreed schedule,
otherwise unused equity amounts simply void, unless otherwise isn’t
stipulated in the letter of credit, that is for a further letter of
credit they will be impossible to use. In this case we are talking about
the “non-cumulative Revolving Letter of Credit.”
If the amounts that were not used in fixed terms for them, however,
are allowed to use in the future, in which case we are dealing with a
“cumulative Revolving Letter of Credit.”
Revolving Letters of Credit are useful only for transactions in which
the same type of product will be delivered at regular intervals to the
same counterparty.
6.Stand-by Letter of Credit (Stand-by LC) was
developed by the American banking system and performs the same functions
as a bank guarantee. Using a Stand-by Letter of Credit is regulated by
the ISP98, and UCP 600.
Stand-by Letter of Credit is a bank’s obligation to make payment in
the event of default on the part of the Applicant, and is a bank
guarantee. Typically, this letter of credit is opened in cases where the
contract provides for payment for goods by bank transfer or otherwise,
not giving an absolute guarantee of payment, and the exporter wants to
protect himself, but the bank guarantee is forbidden, then in the
contract the parties stipulate that as security the letter of credit
will be Stand-by by the importer. Payment under this letter of credit
will be made in the event of non-payment by bank transfer or otherwise,
in unintended ways, on presentation of documents by the beneficiary and
the special statement indicating that the counterparty (applicant for
the credit) has not fulfilled its obligations in respect of payment.
The use of the term “stand-by letter of credit” is explicated in such
way that the law of some states in the U.S. prohibits banks to provide
guarantees, and the International Chamber of Commerce Uniform Rules for
Documentary Credits under the influence of U.S. banks recognizes the
application of these rules for stand-by letters of credit (Article 1).
From this position, their use is preferable to a bank guarantee, which
are subject to national legislation.
In recent years, access to the banks to provide credit guarantee
becomes frequent, which would support the borrower’s obligation to pay
to a third party or a promise to fulfill certain contractual
obligations. This can be done with the help of letter of credit.
Beneficiary under a stand-by letter of credit is drawn firstly to the
applicants for payment and then asks the bank to make a payment. For
commercial letter of credit situation is reversed, “the beneficiary
receives payment from the issuing bank, without resorting to the buyer
for payment.”
Thus, as well as a guarantee, stand-by letter of credit is
irrevocable obligation of the bank to pay a specified amount of stand-by
letters of credit in the first written demand of the beneficiary in the
event of default by a party under the Contract, subject to all
conditions of the credit.
7.Back-to-back letter of credit. The letter of
credit is opened by the issuing bank at the request of the
client-applicant in the event of another open letter of credit in favor
of the client, in which he is a beneficiary. In contrast to the
transferable letter of credit, basic and back-to-back letter of credit
are two legally independent from each other letters of credit, even
though both are designed for the same commodity transactions.
Back-to-back letter of credit is effective in cases where the seller
does not want the proxy provider to know the end customer, and vice
versa. In this case, the terms of a letter of credit opened in the name
of the broker, may be moved to credit, which will open in the name of an
intermediary third party transactions, both credit will be run
independently of each other, and the terms of a letter of credit may
differ if it is necessary.
This type of credit is usually used by middlemen.
In the CIS countries to open such credit, the banks generally require collateral or broker deposits to lower the risks.
Payment mechanism
- Importer (buyer) has a guarantee that the bank will not pay for his
account as long as he doesn’t receive documents in accordance with the
terms of the letter of credit and is satisfied that received documents
by the external signs meet the requirements of the importer.
- Banks will deny payment of documents by the importer, if the
documents on the goods do not meet the letter of credit, thereby
protecting the interests of the importer.
- Customer can be sure of receiving payment as soon as he provides the documents to the bank according with the letter of credit.
- Customer receives against the shipping documents, specified in the
letter of credit, prompt payment (if the letter of credit provides for
payment terms – on demand).
- Required documents usually include shipping documents such as bills
of lading (receipt of shipmaster) goods and transport waybill, duplicate
w / a bill showing that the goods have been shipped in accordance with
the needs and specification of the buyer.
Letter of credit in most cases is as follows:
- Exporter and importer agree to the release of LC (Letter of credit).
- Importer (the buyer) with the consent of the exporter (seller) asks
his bank to issue a letter of credit. The importer’s bank (the issuing
bank) in such case assumes an obligation to pay a fixed amount to the
exporter with the condition that the exporter will provide the documents
that match the letter of credit for a specified period of time.
- Bank issuing informs the bank of the exporter of the credit.
- Bank of the exporter (advising bank informs the exporter that, the letter of credit is issued on his advantage).
- Exporter ships the goods, prepares the necessary documents and send them to the bank for providing in the designated bank.
- Designated bank verifies the documents and if the documents are in
compliance with the terms and conditions of letter of credit, this bank
will pay the amount of the documents, but not exceeding the total amount
of the letter of credit.
- Designated bank sends the documents to the importer’s bank for
onward transmission to the importer, who can use them to get the goods.
General advantages of the letter of credit
1.Letter of credit is very flexible computational tool that can be used for payment transactions on a variety deals of clients.
2.Letter of credit is a tool, the rules of using of which are defined
in the authoritative international organization, are common and are
recognized all around the world. This is beneficial to both customers
and banks, as each party of the transaction has a clear understanding of
rights, responsibilities, and standard requirements to all participants
in the operation.
3.Letter of credit is useful as a tool for short-term financing.
Advantages of the letter of credit for importers
1.Letter of credit may open by own expense of the client, by funds
provided by the bank on credit, as well as by providing support by
customer to fulfill its obligations (mortgage, deposit).
2.Payment is performed after shipment of goods and delivery of documents.
3.Importer determines a list of the documents against which will be issued payment.
4.Limit the period of providing of the documents and shipment of goods.
Advantages of the letter of credit for exporters
1.To the obligation of the buyer to pay, it is added an obligation of
the issuing bank, this liability does not depend on the relationship
between the seller and the buyer.
2.If the letter of credit is confirmed, so there is a guarantee of payment from the second bank.
3.Performance of the letter of credit is a guarantee of payment.
The similarities between the letters of credit and guarantees
1.Letter of credit and guarantee are due to the existence and the need to secure the obligations of partners in a transaction.
2.Letter of credit and guarantee are the bank’s obligation to make payment to the beneficiary against certain documents;
3.Letter of credit and guarantee are paid during the provision to the
bank well-defined and clearly understood terms of those instruments of
documents.
4.Commercial banks offer guarantees and letters of credit on the base
of written confirmation of the presence of obligations in the applicant
that are provided by such guarantees or letters of credit (the
contract, etc.).
The differences between the letters of credit and guarantees
- Letter of credit is opened with the intention of using it, that is,
payment by letter of credit is a phenomenon that occurs during the
normal course of events (method of payment). Guarantee is used as a way
to ensure obligations and is used if in the process of the
implementation of one of the parties of the transaction is not able to
meet its own obligations.
- Letter of credit is used as a method of payment in one form or
another. The guarantee can cover almost any kind of obligations (the
advance payment guarantee, performance of contractual obligations,
tender obligations, repayment, payment of customs duty, payment of a
fine or compensation fixed by the court, the observance of the guarantee
period of equipment, guarantee of the payment of court collateral,
guarantee of payment of the transfer a football player and many others.)
Area of application of guarantee, thus much wider than in credit.
- Letter of credit is a transferable tool, as it allows to optimize
the calculations between the partners. Guarantee in rare cases can be
transferable as all that is required to receive funding under the
guarantee is the requirement of payment, which makes it a ground for
abuse of this tool.
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