A letter of credit is a promise by a bank on behalf of the buyer (customer/importer) to pay the seller (beneficiary/exporter) a specified sum in the agreed currency, provided that the seller submits the required documents by a predetermined deadline. Advantage for the seller: The security that the supply of goods will be paid. Advantage for the buyer: The security that payment will be effected only against delivery of the agreed documents.
Procedure for a Letter of Credit
Upon opening a letter of credit the bank undertakes an obligation on behalf of the buyer to pay the seller. To this end the buyer must have sufficient assets/credit with the issuing bank. Axios Credit Bank provides a special order form to facilitate the formulation of the order for the letter of credit.
Upon receipt of the notification the bank sends the letter of credit to the seller without incurring any liability for its part. However, the bank must take reasonable care to check that the credit appears authentic. When confirmation is requested the bank sends the letter of credit to the seller with its own promise to pay.
If the wording of the letter of credit does not reflect the requirements of both parties, the letter of credit can be adjusted by means of an amendment.
Using and Honoring Letters of Credit
Before they can be submitted, all required documents must be available and must comply with the UCP (Uniform Customs and Practice for Documentary Credits) and documentary credit terms and conditions, and be consistent amongst each other. Axios Credit provides a special remittance form (DE) for the seller's convenience to facilitate the submission of the documents. If the document submission is compliant with the letter of credit, it is honored in accordance with the conditions set out in the letter of credit.
Types of Letters of Credit
Under a sight letter of credit, payment is made to the seller immediately after the required documents have been submitted to the authorized bank, provided the conditions in the letter of credit have been met. Banks are, however, allowed a reasonable period of time for checking purposes (not more than five working days after they receive the documents).
In the case of a letter of credit with deferred payment, the payment to the seller is not made when the documents are submitted, but instead at a later time defined in the letter of credit. In the Asia, this kind of documentary credit is also known as a "usance L/C."
In the case of an acceptance credit, the payment to the seller is not made when the documents are submitted, but instead at a later time defined in the letter of credit. The seller can request a discount from the bank that accepted the bill of exchange, or from another bank, and thus draw the amount of the bill minus the discount at any time after the documents have been submitted.
Negotiable Credit Under UCP 600 (Uniform Customs and Practice for Documentary Credits, 2007 revision, article 2) negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank. Unfortunately, the term "negotiable credit" is understood and applied in different ways in different parts of the world.
Transferable letters of credit are particularly well adapted to the requirements of international trade. They allow an intermediary to transfer a letter of credit to a supplier, thus enabling the intermediary to reduce the extent to which it uses its own funds to process business transactions.
If the buyer requests partial deliveries of the ordered goods at specific intervals (contract for delivery by installments), payment can be made under the terms of a revolving letter of credit that covers the value of each consecutive installment. The bank is normally liable for the total value of all agreed partial deliveries. However, the second partial payment is not effective until the first installment has been paid, and so forth.
Red Clause L/C
In the case of a red clause credit (letter of credit with advance payment), the seller can request an advance for an agreed amount (defined in the terms and conditions of the letter of credit) from the correspondent bank. This advance is basically intended to finance the manufacture or purchase of the goods to be delivered under the letter of credit. The advance is normally paid against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires.
Green Clause L/C
Unlike the red clause letter of credit, in the case of a green clause letter of credit, the advance is normally paid not only against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires, but also against receipt of an additional document providing proof that the goods to be shipped have been warehoused.
Forms of Letters of Credit
In the case of an unconfirmed letter of credit, the correspondent bank merely notifies the seller that a letter of credit has been opened. In this case, it makes no promise to pay and is therefore not required to honor documents presented by the seller. As a result, the seller may rely exclusively on the issuing bank (letter of credit bank) and therefore bears the collection risk of the issuing bank and the country risk – according to their domicile – as well as the transfer risk.
If the correspondent bank confirms the letter credit (on behalf of the issuing bank), then it is committing itself towards the seller to honor documents that are in compliance with the documentary credit terms and presented on time. In this case, the seller receives not only an obligation by the issuing bank but also a legally equivalent and independent promise of payment on the part of the correspondent bank. The seller then bears the collection risk of the confirming bank and, if this bank is not domiciled in his country, the corresponding country risk – according to its domicile – as well as the transfer risk.
All letters of credit subject to the current "Uniform Customs and Practice for Documentary Credits" (UCP 600), which is effectively the norm nowadays, are regarded as irrevocable. It is possible in theory to open a revocable letter of credit, but this is no longer done in practice for various reasons (difficult wording/insufficient security [revocation]).
An irrevocable letter of credit is a firm commitment by the issuing bank to make payment if the documentary credit conditions are fulfilled. It may not be amended or canceled without the consent of the seller and all obligated banks. If the seller wishes to amend or cancel individual conditions of the letter of credit, then he must ask the buyer to issue an instruction to the issuing bank in this respect.