Introduction to Letter of Credit (प्रतीतपत्र)
What is letter of credit?
A letter of credit (LC), also known as a documentary credit or bankers commercial credit, or letter of undertaking (LoU), is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exporter of goods. Letters of credit are used extensively in the financing of international trade, where the reliability of contracting parties cannot be readily and easily determined. Its economic effect is to introduce a bank as an underwriter, where it assumes the counterparty risk of the buyer paying the seller for goods. LC is a form of Documentary Credit.
A technical definition for letter of credit
Letter of credit is an instrument in writing signed by a promisor (Importer’s Bank/Issuing Bank/Opening Bank), containing an unconditional undertaking towards promisee (the Seller/Beneficiary), to pay a certain sum of money to promisee/holder, at a certain time after date or at demand.
Main things to note here:
- Letter of Credit is a form of Promissory Note
Relevant Act: Negotiable Instruments Act 2034
Relevant International Practice: Uniform Customs and Practice for Documentary Credits (UCP) - The promissory note is issued by Buyer’s Bank (promisor) in favor of the Seller (promisee)
- Does it have to be an instrument in writing, signed by the promisor and provided in hard copy to the promisee?
Although letters of credit first existed only as paper documents, they were regularly issued by telegraph in the late 19th century, and by telex in the latter half of the 20th century. Beginning in 1973 with the creation of SWIFT, banks began to migrate to electronic data interchange as a means of controlling costs, and in 1983 the UCP was amended to allow “teletransmission” of letters of credit. By the 21st century, the vast majority of LCs were issued in electronic form and entirely “paperless” LCs are becoming more common. - What is the meaning of unconditional undertaking? Isn’t it that the payment under the promissory note (i.e Letter of Credit) should be made only after the completion of the transaction between seller and buyer?
There might be some confusion here. Yes, it is understood that if you describe something as “unconditional”, you mean that the person doing or giving it does not require anything to be done by other people in exchange other than making a demand based on the promise.
In case of letter of credit, it being essentially a promissory note, the promisor is required to pay a certain sum of money to promisee, at a certain time after date or at demand. The only thing that the issuing bank (i.e. promisor) reviews is the demand and complying presentation against the demand. - What are the complying presentation to be made against the demand?
A Complying Presentation is a set of documents that meet with the requirements of the letter of credit and all of the rules relating to letters of credit. This is not an obstruction to the “unconditional promise” but a part of presenting an authentic demand. Typically the letter of credit will request to include- Financial documents: bill of exchange, co-accepted draft
- Commercial documents: invoice, packing list
- Shipping documents: bill of lading (ocean or multi-modal or charter party), airway bill, lorry/truck receipt, railway receipt, CMC other than mate receipt, forwarder cargo receipt
- Official documents: license, embassy legalization, origin certificate, inspection certificate, phytosanitary certificate
- Insurance documents: insurance policy or certificate
Protection to both Seller and Buyer in International Trade
A letter of credit is a document from a bank that guarantees payment. There are several types of letters of credit, and they can provide security when buying and selling products or services.
- Seller protection: If a buyer fails to pay a seller, the bank that issued a letter of credit must pay the seller as long as the seller meets all of the requirements in the letter. This provides security when the buyer and seller are in different countries.
- Buyer protection: Letters of credit can also protect buyers. If the buyer is concerned about a dishonest seller, there are additional options available for the buyer’s protection. For example, somebody can inspect the shipment before the payment is released. The inspection report can be a component of the “complying presentation” while making the demand.
Sample of Letter of Credit
Just to get the context of what we were taking about in the paragraphs above, here is a sample of letter of credit.
Letter of Credit Sample
Letter of Credit Characteristics
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed freely from one party to another almost in the same way as money. To be negotiable, the letter of credit must include an unconditional promise to pay, on demand or at a definite time. The nominated bank becomes a holder in due course. As a holder in due course, the holder takes the letter of credit for value, in good faith, without notice of any claims against it. A holder in due course is treated favorably under the UCC. The Uniform Commercial Code (UCC) is a standardized set of laws and regulations for transacting business. The transaction is considered a straight negotiation if the issuing bank’s payment obligation extends only to the beneficiary of the credit. If a letter of credit is a straight negotiation it is referenced on its face by “we engage with you” or “available with ourselves”. Under these conditions the promise does not pass to a purchaser of the draft as a holder in due course.
Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction that involves a revocable letter of credit, it serves as the advising bank. Once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honored, the letter of credit cannot be revoked. The revocable letter of credit is not a commonly used instrument. It is generally used to provide guidelines for shipment. If a letter of credit is revocable it would be referenced on its face. The irrevocable letter of credit may not be revoked or amended without the agreement of the issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and the terms and conditions are complied with, payment will be made. If a letter of credit is irrevocable it is referenced on its face.
The beneficiary has the right to transfer or assign the right to draw, under a credit only when the credit states that it is transferable or assignable. Credits governed by the Uniform Commercial Code (Domestic) maybe transferred an unlimited number of times. Under the Uniform Customs Practice for Documentary Credits (International) the credit may be transferred only once. However, even if the credit specifies that it is nontransferable or nonassignable, the beneficiary may transfer their rights prior to performance of conditions of the credit.
A letter of credit that assures the payment if the buyer does not pay. After fulfilling all the terms under SBLC, if the seller proves that the promised payment was not made. In this situation, the bank will pay to the seller. In a nutshell, it does not facilitate a transaction but guarantees the payment. It is quite similar to a bank guarantee. For more information click on Standby LC.
A confirmed letter of credit is a letter of credit in which the seller or exporter has payment guarantee from a second bank or a confirming bank i.e. in case the first bank fails to pay then the payment will be done by the second bank. This is a trade payment method used for international trade. Sometimes, the seller is not sure whether he will receive the payment against his goods or not. This uncertainty can arise from numerous factors such as questionable creditworthiness of issuing bank or political or economic vulnerability associated with the geographical location of the issuing bank.
A revolving letter of credit is a single letter of credit that covers multiple transactions over a long period of time. It is very specific in a way that it is used for regular shipments of the same commodity between the same buyer (importer) and the seller (exporter). This letter of credit is issued only once for a certain period of time or a certain number of transactions. It avoids the need for repetitive arrangements to open a new letter of credit for every transaction.
It can either be
- Time based revolving LC:
In the revolving letter of credit that is based on time, a specific amount (payment) is allowed to be drawn within a defined period of time. It can be either cumulative or non cumulative. In a revolving LC based on time, if it is the cumulative type, the previous unused L/C limits can be used in future months. In a revolving letter of credit based on time, if it is the non-cumulative type, then the previous unused L/C limits cannot be used in future months. The unused limit of LC becomes void.
- Value based revolving LC
In the revolving letter of credit that is based on time, a specific amount (payment) is allowed to be drawn within a defined period of time. Let’s understand with an example.
Back-to-Back Letter of Credit is a negotiable instrument in which the seller gets a Letter of Credit from the buyer and the seller further transfers the Letter of Credit to its supplier. In simple words, the seller first gets the Letter of Credit from the buyer to ensure timely payment and further the same seller hands over the Letter of Credit to someone from whom he buys goods or materials. There are various advantages and disadvantages of Letter of Credit. Let us take an example to under the concept of Back-to-Back Letter Of Credit.
For example, assume that Company A is in the U.S. and sells heavy machinery. Broker B, a trading firm based in London, has learned that Company C, which is located in China, wants to purchase heavy machinery and has managed to broker a deal between the two companies. Company A is eager to sell but does not want to take on the risk of default of payment by Company C. Broker B wants to ensure that the trade is made and that it receives its commission. Back to back LCs can be used to make sure the transaction goes through. Company C will go to a well-known financial institution in China and get it to issue an LC with Broker B as beneficiary. In turn, Broker B will use that LC to go to its own well-known financial institution in Germany and have it issue an LC to Company A. Company A can now ship its heavy machinery knowing that once the transaction is complete, it will be paid by the German bank. The broker is also assured of being paid. The credit risk has been removed from the transaction.
A red clause letter of credit is a specific type of letter of credit in which the buyer can extend the facility of advance payment to the seller against a certain documentary requirement. In other words, under the red clause letter of credit, the issuing bank will make an advance payment to the exporter i.e. the seller before the seller ships the goods to the importer i.e. buyer. This is usually done to provide aid to the seller in the form of working capital to purchase raw material, processing and packaging of goods, etc. The advance payment is done against documentary requirement which includes written undertaking and receipts.
Green clause letter of credit is an extension of red clause letter of credit. Which means it provides the advance not only for the purchase of raw materials, processing, and packaging of goods, etc. but also for pre-shipment warehousing at the port of origin and insurance expense. In usual cases, the advance under this letter of credit is granted only after the purchased goods are stored in bonded warehouses. This type of letter of credit is usually used in transactions related to commodity market such as wheat, rice, gold, etc.
As mentioned in previous paragraphs, the defining difference between a green clause and a red clause letter of credit is its documentary requirement. While advance can be transferred in red clause letter of credit by presenting written undertaking and receipts, an additional document of title is required in green clause letter of credit for transfer of advance. In red clause letter of credit, usually, the percentage of advance available is 20% to 25% of the face value of the letter of credit. In contrast, the availability of advance can be expanded to 75% to 80% of the face value of the letter of credit under the green clause letter of credit.
A letter of credit that demands payment on the submission of the required documents. The bank reviews the documents and pays the beneficiary if the documents meet the conditions of the letter.
An LC that ensures payment after a certain period. The bank may review the documents early but the payment to the beneficiary is made after the agreed-to time passes. This allows a predetermined credit period to the buyer i.e. the importer.
A letter of credit where the issuing bank directly pays the beneficiary and then asks the buyer to repay the amount. The beneficiary may not interact with the buyer.
LC Lingo(s)
The Applicant is the person or company who has requested the letter of credit to be issued; this will normally be the buyer.
The Beneficiary is the person or company who will be paid under the letter of credit; this will normally be the seller (UCP 600 Art.2 defines the beneficiary as “the party in whose favour a credit is issued”).
The Issuing Bank is the bank that issues the credit, usually following a request from an Applicant.
The Nominated Bank is a bank mentioned within the letter of credit at which the credit is available (in this respect, UCP600 Art.2 reads: “Nominated bank means the bank with which the credit is available or any bank in the case of a credit available with any bank”).
The Advising Bank is the bank that will inform the Beneficiary or their Nominated Bank of the credit, send the original credit to the Beneficiary or their Nominated Bank, and provide the Beneficiary or their Nominated Bank with any amendments to the letter of credit.
Confirmation is an undertaking from a bank other than the issuing bank to pay the Beneficiary for a Complying Presentation, allowing the Beneficiary to further reduce payment risk, although Confirmation is usually at an extra cost.
Confirming Bank is a bank other than the issuing bank that adds its confirmation to credit upon the issuing bank’s authorization or request thus providing more security to the beneficiary.
A Complying Presentation is a set of documents that meet with the requirements of the letter of credit and all of the rules relating to letters of credit.
Step by Step process for importing goods through LC
Step 1: Obtaining EXIM Code (if necessary)
For the purpose of minimizing the documentation/administration of the documents and procedures of the import and export, unauthorized business activities, the system for obtaining Export Import (EXIM) Code has been introduced in Nepal from Fiscal Year 2073/2074. The EXIM code has been introduced as a identification, recordal and providing approval for all the commercial export import transaction in Nepal.
To understand in detail about the process of obtaining EXIM Code, its rationality and other legal provisions click this link to another blog.
Step 2: Execute a Contract with the Seller
This step is a no brainer. How would you import goods from Seller without executing a Sales Contract. Basically a sales contract for international sales contract would cover the following:
- Details of the Contracting Parties
- Goods and Quantity
- Invoicing, Price and Payment: Agreed Price, LC and Other Forms of Payment
- Destination, Insurance, Period & Port of Shipment: The Incoterms Rules (INternational COmmerce TERMS)
- Brokerage: Only that accrues irrespective of the final acceptance/closure of the contract
- Quality: Warranties, Guaranties, Independent Certificate of Inspection, Sample Inspections, Shipment warranties for quality delivery
- Vessel: Delivery Vessel, Appropriation
- Discharge, Weighing, Deficiency, Fumigation
- Default, Insolvency, Domicile, Arbitration
Beginner’s guide to INCOTERMS: Click here to view a beginner’s guide to INCOTERMS
Step 3: Apply to your bank for issuing LC in favour of Seller
The seller will want LC issued in his favor to be guaranteed for the payment. Buyer applies to his bank for a letter of credit in favor of the seller. To obtain the LOC, the buyer contacts her bank. That bank operates in the buyer’s home country, and is most likely a bank that the buyer currently does business with. The buyer provides information required for the bank to issue the LOC, including:
- How much is the payment?
- What is the name and address of the seller (known as the beneficiary)?
- When will the seller ship goods?
- How will the seller ship the product?
- Where should the shipment arrive? And numerous other details
Typically Banks in Nepal require to submit Pro-forma invoice, BBN/FER Form No 3: Details of Opening LC (LC Opening Form), Registration Doc among others.
Details matter: It’s essential that the bank gets all of the details correct. The LC is a legally binding document, and these documents are interpreted exactly as written. Again, the LC is separate from the sales agreement, and it’s based on documents not actions performed. So one can’t assume that everything will work out if there’s an error in the LC. Even a seemingly minor item, like a typographical error, can cause problems. If the document isn’t perfect, it needs to be corrected before anybody moves forward.
Funding: When the bank issues the LC, the bank makes a promise, and the bank is responsible for sending money. That’s what makes a letter of credit so safe for sellers – the fact that the bank takes responsibility for payment. Because of that, the bank needs to be confident that the buyer can fund the payment. Before the bank issues the LC, the buyer may have to deposit funds with the bank, or the bank might arrange financing for the buyer as part of the LC.
LC Margin: The buyer may while applying to the bank to create LC in favor of Seller may need to produce LC margin in form of deposit/credit ranging from 10% to 100% of the LC value as required by the bank. The bank will hold this amount from the bank account of the buyer or release it as a line of LC credit. The bank will also charge LC charge which is usually based on fixed percentage of the LC amount.
Step 4: Approval of the LC and Forwarding it to Seller's Bank
Issuing bank approves the application, and issues and forwards the LC issued in seller’s favor to seller’s bank (Corresponding/Advising Bank). The Seller’s Bank is typically located in the seller’s country and is likely a bank that the seller already has a relationship with. There may be several banks in between acting as intermediaries, but those are left out for simplicity.
Step 5: Seller's Bank will forward the LC to Seller
Seller’s bank will authenticate the LC and forward the original LC to the seller (since it is a promissory note, the seller should have the LC document until payment is received). At that point, the seller must review the LC to ensure that it matches what he agreed to do and that is capable of meeting the requirements of the LC. He should also decide if he is comfortable trusting the issuing bank and any other banks involved. If everything is acceptable, the seller can move to the next step: produce and ship goods.
Step 6: Sending Goods and Documents
To receive payment with a LC, the seller must satisfy the requirements specified in the LC. Among other things, that usually means:
- Shipping the goods by a certain date
- Possibly having the goods inspected before shipment
- Using the shipping method specified in the LC
- Shipping to and from ports specified in the LC
- Gathering documents listed in the LC (specific shipping documents, for example)
- Submitting documents to the bank by a specific date
Seller confidence: The seller knows that she will get paid as long as she meets the requirements of the LC (and assuming the banks involved remain solvent and follow through on their obligations). It doesn’t matter if her customer goes bankrupt or decides not to pay—the bank is on the hook for payment. The end customer’s financial situation is the bank’s problem, not the seller’s problem.
Delivery not required: Depending on the details of the LC, it doesn’t even matter if the goods ever make it to the customer. A storm may damage or destroy products during shipment, but the seller might not be responsible for that loss if they just had to ship goods.
Documentary requirements: The primary challenge for the seller is meeting the requirements of the LC. Again, banks only care about the details written into the LC and the documents you submit to satisfy the LC. If anything is off, the seller won’t get paid. For example, if you ship one day late, it’s a major problem. You might throw in some extra product for free (and your customer might even agree that this makes up for the late shipment), but banks won’t pay unless the LC is amended to account for the later shipping date. It takes extra money and time to revise a LC.
Step 7: Payment and Shipment Arrive
Once documents arrive at the seller’s bank, the bank verifies that the documents meet the requirements of the LC. Again, the bank takes everything literally: If anything doesn’t match—even the spelling or abbreviation of a company name—the bank can refuse payment. Banks take several business days to conduct this review.
If the documents are in good order, the seller’s bank forwards the documents to the buyer’s bank. The buyer’s bank performs the same review of documents against the LOC. If everything checks out, the buyer’s bank sends payment to the seller’s bank.
Next, the buyer’s bank forwards the documents to the buyer, who uses those documents to take possession of the goods when they arrive. When does the seller get paid? The timing of payment depends on the type of LC used. The seller might get paid within a few days of submitting documents to a local bank. In other cases, the seller waits until certain conditions are met. Sometimes the seller gets paid an “advance” (before shipping anything) so she can buy materials needed to produce the customer’s goods.