How letter of credit works
The function of the letter of credit is to substitute the credit of the bank for the customers’ credit to facilitate trade. Letters of credit are either one of two types: documentary or standby. The documentary letter of credit is the traditional payment method used in an international transaction, whereas the standby letter of credit is often obtained as a guaranty of payment.Documentary Letter of Credit
Documentary letters of credit have been used for centuries to facilitate payment in international trade. These letters of credit are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and definitions of the International Chamber of Commerce are binding on all parties.
A documentary letter of credit is a contractual agreement between banks, known as the issuing bank, on behalf of its customer, authorizing another bank, known as the advising or confirming bank, to make payment to the seller (beneficiary). The issuing bank, at the request of its customer, opens the letter of credit. In doing so, the issuing bank makes a commitment to honor drawings made against the credit. The beneficiary is normally the provider of goods and/or services.
Elements of a Letter of Credit
A payment undertaking by a bank (issuing bank)
On behalf of a buyer (bank customer)
To pay a seller (beneficiary) a specified amount of money
On presentation of specified documents representing the supply of goods
Within specified time limits
Documents must conform to terms and conditions set out in the letter of credit
Documents to be presented at a specified place
The beneficiary is entitled to payment as long as they can provide the documentation required in the letter of credit. The letter of credit is a separate transaction from any other written agreements. All parties to the letter of credit are only concerned with and deal in the required documents and not in the goods and/or services for which the letter is provided. The issuing bank is not liable for any performance of the underlying contract between the buyer and seller. The issuing bank's obligation to the buyer is to examine all documents to insure that they meet all the terms and conditions of the letter of credit. Upon requesting demand for payment the seller warrants that all conditions of the letter of credit have been complied with. If the seller (beneficiary) conforms to the letter of credit, they must be paid by the bank.
The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable amount of time after receipt of the documents to honor the draft.
The issuing banks' role is to provide a guarantee to the seller that if required documents are presented, the bank, upon examination, will pay the seller the amount due and only pay if these documents comply with the terms and conditions set out in the letter of credit.
Typically the documents requested will include an invoice, a bill of lading or airway bill and an insurance document. However, additional documents may be required.
Advising Bank vs. Confirming Bank
An advising bank, usually a foreign correspondent bank of the issuing bank will advise the seller. Generally, the seller will use a local bank to insure the letter of credit is valid. In addition, the advising bank is responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. If the issuing bank does not pay the seller (beneficiary), the advising bank is not obligated to pay.
A correspondent bank may also confirm the letter of credit for the seller (beneficiary). At the request of the issuing bank, the correspondent bank obligates itself to insure payment under the letter of credit. The confirming bank normally would not confirm the letter of credit until it evaluated the country and bank where the letter of credit originates. The confirming bank often is the advising bank.
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; and without notice of any claims against it. A holder in due course is treated favorably under the Uniform Commercial Code.
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. Whether revocable or irrevocable, it will state on the face of the document what type of credit is being presented. 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 only 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 commonly used. It is generally used to provide guidelines for shipment.
The most commonly used irrevocable letter of credit may not be revoked or amended without the agreement of the issuing bank; the confirming bank; and the seller (beneficiary). An irrevocable letter of credit from the issuing bank insures the seller that if the required documents are presented and the terms and conditions are complied with, payment will be made.
Transfer and Assignment
The seller has the right to transfer or assign the right to draw, under a letter of credit only when the letter of credit states that it is transferable or assignable. Letters of credit 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 non-assignable, the seller may transfer their rights prior to performance.
Sight and Time Drafts
All letters of credit require the seller to present a draft and specified documents in order to receive payment. A draft is a written order by which the party creating it, orders another party to pay money to a third party. A draft is sometimes referred to as a bill of exchange.
The two types of drafts used in letters of credit are sight and time. A sight draft is payable as soon
as it is presented for payment although the issuing bank is allowed a reasonable time to review the documents before making payment.
A time draft is not payable until the lapse of a particular time period stated on the draft (often 90 days). The issuing bank is required to accept the draft as soon as the documents comply with the letter of credit terms. The issuing bank is then obligated to pay the draft at maturity.
Standby Letter of Credit (Domestic)
The Standby or domestic letters of credit serve a different function than the documentary letter of credit. The standby letter of credit serves as a guaranty by the issuing bank rather then a source for payment. A bank will issue a standby letter of credit on behalf of its’ customer to provide assurances of payment to the seller in the event the buyer does not or is unable to pay for goods and/or services in accordance with the sellers’ ordinary terms of sale. The parties involved in the transaction never intend for the letter of credit to be drawn upon.The standby letter of credit is issued by the bank and held by the supplier. The buyer is provided open account terms. If payments are made in accordance with the suppliers' terms, the letter of credit would not be drawn on. The seller pursues the customer for payment directly. If the customer is unable to pay, the seller presents a draft and copies of invoices to the bank for payment.
The domestic standby letter of credit is governed by Article Five of the Uniform Commercial Code. Under its’ general provisions, the bank is given until the close of the third banking day after receipt of the documents to honor the draft. Note however that every state that has adopted Article Five has the right to amend the language of the Article including the time period. It is important to verify the time period of the state whose law governs the letter of credit.It is also possible to use a standby letter of credit in an international transaction. When doing so the issuing bank should always reside within the borders of the continental United States.
The following procedures illustrate the flow of events that follow the decision to execute a standby letter of credit and are not as rigorous as a documentary letter of credit. The standby letter of credit is normally a domestic transaction although it can be implemented in international transactions. It does not require a correspondent bank (advising or confirming).
Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment.
Buyer applies to his bank for a letter of credit in favor of the seller.
Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to the seller.
Seller ships the goods and bills the buyer under normal terms of sale.
Buyer pays invoice at maturity.
If buyer fails to pay and after waiting period (normally 30 days after maturity) Seller sends past due invoice along with draft and letter of credit for payment to issuing bank.
Issuing bank pays.
Common Defects in Documentation
About half of all drawings presented contain discrepancies. A discrepancy is an irregularity in the documents that causes them to be in non-compliance to the letter of credit. Requirements set forth in the letter of credit cannot be waived or altered by the issuing bank without the express consent of the customer. The seller (beneficiary) should always prepare and examine all documents carefully before presentation to the issuing bank to avoid any delay in receipt of payment. Commonly found discrepancies between the letter of credit and supporting documents include:
Letter of Credit has expired prior to presentation of draft.
Bill of Lading evidences delivery prior to or after the date range stated in the credit.
Stale dated documents.
Changes included in the invoice not authorized in the letter of credit.
Insurance document contains errors.
Invoice amount not equal to draft amount.
Place of loading and destination are not the same as specified in the credit.
Description of merchandise is not the same as stated in letter of credit.
A document required in the letter of credit is not presented.
Documents are inconsistent as to general information such as volume, quality, etc.
Names of documents are not exact as described in the letter of credit. (Beneficiary information must be exact.)
Invoice or statement is not signed as stipulated in the letter of credit.
When a discrepancy is detected by the negotiating bank, a correction to the document may be allowed if it can be done quickly while remaining in the control of the bank. If time is not a factor, the seller should request that the negotiating bank return the documents for corrections.
If there is not enough time to make corrections, the seller should request that the negotiating bank send the documents to the issuing bank on an “approval basis” or notify the issuing bank by wire, outline the discrepancies, and request authority to pay. Payment cannot be made until all parties have agreed to jointly waive the discrepancy.Summary
The use of letters of credit as a tool to reduce risk has been in use for decades. Letters of credit accomplish their purpose by substituting the credit of the bank for the customers’. The underlying purpose of the letter of credit is to facilitate trade both internationally and domestic.Every credit professional should be familiar with the two types of letters of credit: documentary and domestic (standby). Documentary letters of credit are used primarily to facilitate foreign trade. The documentary letter of credit is the primary source for payment.
The domestic (standby) letter of credit is used as a guaranty of payment. The bank issues the standby letter of credit on behalf of its’ customer to provide assurances of the customers’ ability to perform under the sellers’ normal terms of sale.Upon receipt of any letter of credit, the credit professional should review all requirements carefully to insure that what is expected of the seller is fully understood and that the seller can comply with all the letter of credit terms and conditions. Whenever compliance is in question, the buyer should be requested to amend the letter of credit.
There is no requirement that the seller has to accept a letter of credit. The seller should never accept the letter of credit until the seller is satisfied with all of the terms and conditions contained in the letter of credit. Always keep in mind that the letter of credit substitutes the issuing banks credit for the customers. Therefore, it is especially important that the banks’ character, capacity and capital be verified just as we did initially with our customer.If the issuing bank is unknown to us or we have concerns we should not accept the letter of credit and request the customer to obtain a letter of credit from a bank we are comfortable with and have confidence in.
I wish you well.
The information provided above is for educational purposes only and not provided as legal advice. Legal advice should be obtained from a licensed attorney in good standing with the Bar Association and preferably Board Certified in either Creditor Rights or Bankruptcy.
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