Letter Of Credit

The forms of payment in business transactions are payment by cash or by cheques, drafts etc. All these modes of payment require proximity between buyer and seller and the element of trust between them. If we go across international trade, buyer and seller are miles apart, having different legal structures and each one is not having knowledge of other’s financial position. In such cases, it is preferred to deal through their bankers. In this method, seller should have the confidence that the buyer would pay for the goods either immediately or after the agreed period of credit. And in case seller is not satisfied, banks would be approached to provide element of trust between buyer and seller and by this the terms of trade are complied with and interests of each party are protected. LC transaction is based on the principle of strict compliance. And it is a promise to pay

The method of achieving this element of trust in international trade is done through the system of letter of credit. A seller only gets paid after performing specific actions that the buyer and seller agree to.

“An LC can be compared to a guarantee given by a bank on behalf of its customer to the effect that the bank would make payment to the beneficiary when the beneficiary presents the documents required in the LC. They are not negotiable instruments.”

To understand it better, let us consider a practical example.

ABC Company in India wants to import certain machinery which is manufactured by XYZ Company in England. They enter into system of LC to make and receive payments. Since neither party knows the other, they are not sure whether the other will fulfil his part of obligation or not. ABC Company will approach its banker, bank of India and make a request by an application for opening a letter of credit (LC) in favour of XYZ Company. Bank of India, after opening a letter of credit in favour of XYZ Company, informs another bank in England, the Barclays bank (Assumed name) with whom bank of India has an arrangement, to forward the letter of credit to XYZ Company. The Barclays bank after verifying the authenticity of the LC forwards the same to XYZ Company. After verifying that the LC complied with the terms of sales contract, XYZ Company ships the machinery to ABC Company. Now XYZ Company collects the bills of lading handed over by the shipping company and the other documents required as per the LC ad Draws a bill of exchange under the LC and presents it to its bankers, the Barclays bank, for negotiating the bill and obtain the payment. Barclays bank, on their part, receives the bill and documents from XYZ Company and verifies them as per terms of LC. After checking the authenticity of documents, Barclays negotiates the bill and makes the payment to XYZ Company. After it Barclays bank sends the bill and documents to Bank of India. Bank of India verifies its authenticity. If documents are found in order then Bank of India sends the bill to ABC Company for payment. ABC Company checks the documents on receiving them and pays the bill. On ABC Company making payment, Bank of India releases the shipping document so that ABC Company can collect the goods from the shipping company.

Parties to LC

1. Applicant-buyer-Importer – person who applies to the bank to open a LC. In the above example – ABC Company

2. Issuing Bank – Bank which opens the LC on the request of applicant/importer. In the above example – Bank of India

3. Beneficiary-Exporter-Seller – person who is entitled to get the benefit under LC i.e. getting payments or drawing bills and receive payments. In example it was XYZ Company

4. Advising Bank – the bank in the exporter/beneficiary country through which LC is advised to the beneficiary. The advising bank only forwards the LC to beneficiary.

5. Negotiating Bank – The bank in the beneficiary country who negotiates the bills i.e. makes payment on the bills drawn by the seller and accepts the documents. In example it was Barclays Bank. But if the LC specifies the bank then that bank will be the negotiating bank or also called Nominated bank.

Types of Letter of Credit

• Acceptance Credit
• Irrevocable Credit
• Confirmed credit
• Transferrable Credit
• Back to Back Credit
• Revolving LC
• With Recourse and without Recourse Credits

Documents required under a LC

- Bill of Exchange: Payment is made on this document. In LC the right to draw a bill is conferred only on beneficiary. The bill amount should be within the limit specified in LC.

- Invoice

- Transport Documents

- Bills of Lading: is a document to title to goods i.e. they are representatives of the goods and holder of the same is entitled to get the possession of the goods.

- Airway Bill

- Insurance documents

- Other documents