Letters of Credit: The Basics

Definition

A documentary credit is a (conditional) bank undertaking of payment. It is a written undertaking by a bank (issuing bank) given to the seller (beneficiary) at the request, and on the instructions of the buyer (applicant) to pay at sight or at a determinable future date up to a stated sum of money, within a prescribed time limit and against stipulated documents or other conditions. The issuing bank is putting out its credit and good name for the sake of the buyer.

Buyer

Because the documentary credit is a conditional undertaking, payment is made on behalf of the buyer against documents, which may represent the goods and give the buyer rights to them.

Seller

Because the documentary credit is a bank undertaking, the seller can look to the bank for payment, instead of relying upon the ability or willingness of the buyer to pay.

Summary

Documentary credits therefore:

• Are an arrangement by banks for settling international commercial transactions.
• Provide a form of security for the parties involved.
• Ensure payment, provided that the terms and conditions of the letter of credit have been fulfilled.
• Mean that payment by such means is based on documents only, and not on merchandise or services involved.

Types of Letters of Credit

Documentary; Merchandise, Commercial, Trade

The majority of LCs issued are in payment for goods in shipment or current services performed. Payment is normally made against documents for goods shipped. (Article 2 UCP 600)

Standby

Normally, this type of LC functions like a guarantee. This type of credit can be drawn against only upon performance of service or financial obligation default. It is a definite undertaking of the issuing bank. The standby letters of credit from CIB and GEBS both state that they are governed by UCP 600. If that is the case, should we mention ISP98.

Revocable

Under UCP 600 a letter of credit is revocable even if there is no indication to that effect (article 3).

Unconfirmed:

Bears only the obligation of the issuing bank. The beneficiary should look to the credit worthiness of only the issuing bank, and not to any intermediary (Article 7 UCP 600)

Confirmed:

Is a credit in which a second obligation is added to the letter of credit by another bank (Article 8 UCP 600)

Sight:

Payment is at sight, which means that the drafts and documents are honored, if in order, by making payment without delay.

Time, Usance:

The draft honored by accepting it for payment at a future date. Payment is delayed until the maturity of the draft.

Transferable credit:

Can be transferred by the original beneficiary to one or more other parties. It is normally used when the first beneficiary does not supply the merchandise himself, but is a middleman and wants to transfer all or part of his rights to the actual supplier (Article 38 UCP 600)

Comparison of various methods of payment

Method	Goods Available	~Time of Payment	Risk to Exporter	Risk to Importer
Cash in Advance	After Payment	Before Shipment	Very Low	Maximum - Relies on exporter to ship goods as ordered
Letter of credit *Confirmed *Unconfirmed (Advised)	After Payment	When documents are available at shipment	Very Low	Assured of quantity and quality of shipment if inspection report is required
Documentary Collection Sight Draft Documents against Payment	After Payment	On presentation or draft to importer	If draft unpaid, goods must be returned or disposed of, usually at loss	Assured of quantity, also quality, if goods are inspected before shipment
Documentary Collection Time Draft Documents against Acceptance	Before Payment	On maturity of draft	Relies on importer to pay draft	Minimal - Can check shipment for quantity and quality before payment
Cosignment	Before payment, exporter retains title until goods are sold or used	After use; inventory and warehousing cost to exporter	Substantial risk unless through foreign branch of subsidiary	Very Low
Open Account	Before payment	As agreed	Relies on importer to pay account as agreed -- complete risk	Very Low

Letters of credit are used for the following reasons:
	To protect against buyer risk. If the buyer is of unknown creditworthiness, then the seller has the security of the bank's payment undertaking.
	To protect against country risk. The buyer may be willing and able to pay; but economic or political conditions in the buyer's country may prevent or delay payment. This is a real concern when dealing with less developed countries and/or countries with foreign exchange shortages. To protect against these risks, a confirmed letter of credit will be necessary - a bank in the seller's country will (for a fee) add its own payment undertaking to that of the Issuing bank.
	Letters of credit are also used as part of exchange control or import control regimes operating in the buyer's country. In such cases the use of a letter of credit is mandatory, even if not required by the seller for security reasons.

What is a letter of credit? A letter of credit is a banking mechanism which allows importers to offer secure terms to exporters All letters of credit contain these elements:
	a payment undertaking given by a bank (Issuing bank) on behalf of a buyer (applicant)
	to pay a seller (beneficiary) a given amount of money.
	on presentation of documents specified in the letter of credit, representing the supply of goods
	within specified time limits
	these documents conforming to the terms and conditions set out in the letter of credit
	the documents to be presented at a specified place
Put simply, banks who issue letters of credit (Issuing banks) have two main roles:
	To give a binding undertaking to the seller that if compliant documents are presented, the bank will pay the seller the amount due. This offers security to the seller - the bank says in effect "We will pay you if you present these documents (XYZ)"
	To examine the documents, and only pay if these comply with the terms and conditions set out in the letter of credit. This protects the buyer's interests - the bank says "We will only pay your supplier on your behalf if they present the documents (XYZ) that you have asked for"
Note that letters of credit refer to documents representing the goods, not the goods themselves! Banks are not in the business of examining goods on behalf of their customers. Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill, and an insurance document, but there are many others. Letters of credit deal in documents, not goods.

	Buyer and seller agree terms, including means of transport, period of credit offered (if any), latest date of shipment, Incoterm to be used.
	Buyer applies to bank for issue of letter of credit. Bank will evaluate buyer's credit standing, and may require cash cover and/or reduction of other lending limits.
	Issuing bank issues L/C, sending it to the Advising bank by airmail or (more commonly) electronic means such as telex or SWIFT.
	Advising bank establishes authenticity of the letter of credit using signature books or test codes, then informs seller (beneficiary). Advising bank MAY confirm L/C, i.e. add its own payment undertaking.
	Seller should now check that L/C matches commercial agreement, and that all its terms and conditions can be satisfied, (e.g. all documents can be obtained in good time.) If there is anything that may cause a problem, an AMENDMENT must be requested.
	Seller ships the goods, then assembles the documents called for in the L/C (invoice, transport document etc.) Before presenting the documents to the bank, the seller should check them for discrepancies with the L/C, and correct the documents where necessary.
	The documents are presented to a bank, often the Advising bank. The Advising bank checks the documents against the L/C. If the documents are compliant, the bank pays the seller and forwards the documents to the Issuing bank.
	The Issuing bank now checks the documents itself. If they are in order (and it is a sight L/C), it reimburses the seller's bank immediately.
	The Issuing bank debits the buyer and releases the documents (including transport document), so that the buyer can claim the goods from the carrier.

For troublefree letter of credit transactions:
	Communicate with your customers in detail before they apply for letters of credit. The letter of credit is part of the sales process, not the shipping process!
	Consider whether a confirmed letter of credit is needed - if in doubt, seek advice.
	Ask for a copy of the application to be faxed to you, so you can check for terms or conditions that may cause you problems in compliance.
	Upon first advice of the letter of credit, check that all its terms and conditions can be complied with within the prescribed time limits.
	Many presentations of documents run into problems with time-limits. You must be aware of up to three time constraints - the expiry date of the credit, the latest shipping date and the presentation period - maximum time allowed between despatch and presentation of documents.
	If the letter of credit calls for documents supplied by third parties, make reasonable allowance for the time this may take to organise.
	After despatch of the goods, check all the documents both against the terms of the credit and against each other for internal consistency.

glossary of import