Letter of Credit and International Business

LC-What does it mean?

A letter of credit (LC) is a document issued by a bank, used primarily in trade finance which usually provides an unalterable payment undertaking.

It is an obligatory document that a buyer can request from his

bank in order to guarantee that the payment for goods will be transferred to the seller.

LC – what it supposed for:

The letter of credit is a source of payment for a transaction

redeeming the letter of credit will pay an exporter.

LC – what it supposed for:

Letters of credit are mostly used in international trade transactions for deals between a supplier in one country and a customer in another.

the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits (UCPDC) applies in such cases.

Parties involved in LC transactionApplicant - is the party that arranges for

the letter of credit to be issued.

Beneficiary - is the party named in the letter

of credit in whose favor the letter of credit is

issued.

Parties involved in LC transactionIssuing or Opening Bank - opens a letter of credit (L/C) in favor of the beneficiary, at the request and on the instructions of the applicant. The issuing bank usually is located in the applicant's country

Parties involved in LC transaction

Advising Bank - advises the beneficiary that a letter of credit (L/C) opened by the issuing bank

is available to him/her and informs the beneficiary

about the terms and conditions of the L/C. The advising

bank is not necessarily responsible for the payment of

the credit which it advises.

Parties involved in LC transaction

Correspondent bank - correspondent bank used in

international trade refers to another bank in another

country with which the first bank maintains a banking

service agreement.

Negotiating bank - negotiates the draft(s) and/or

documents presented by the beneficiary or bona fide

holder is known as negotiating bank.

Parties involved in LC transaction

The Confirming Bank - the advising bank which

adds its confirmation to the credit, that is, adds

its own promise to pay, upon authorization or

request of the issuing bank is known as the

confirming bank.

Parties involved in LC transaction

Paying Bank - is the bank nominated in the letter of credit that makes payment to

the beneficiary, after determining that

documents conform, and upon receipt of funds from

the issuing.

Importance

It is often used in international trade to eliminate risk of unfamiliarity with the foreign country, customs, or political instability.

Basically, a Letter of Credit gives the seller reassurance that he will receivethe payment for the goods.

Importance

The seller has to present the bank with the

necessary shipping documents that the shipment of goods completed within a

given time frame.

Most common criteria for LC

Almost all letters of credit are irrevocable, that cannot be amended or canceled

without prior agreement of the beneficiary, the

issuing bank and the confirming bank.

Documents provide by the beneficiary

The documents a beneficiary has to present

in order to receive payment Includes:

•a commercial invoice, •bill of lading, and •other related documents proving the

shipment was insured against loss or damage in transit.

Documents Called for under a Letter of Credit

Bill of Exchange: A non-interest-bearing written

order used primarily in international trade that

binds one party to pay a fixed sum of money to

another party at a predetermined future date.

Commercial Documents: Invoice, Packing list

Documents Called for under a Letter of Credit

Shipping DocumentsInsurance Certificate, Commercial, Official or

Legal Documents

Official Documents:License, Embassy legalization, Origin Certificate, Inspection Certificate, phytosanitary (free from

pests and pathogens) Certificate

Documents Called for under a Letter of Credit

Transport DocumentsBill of Lading: Airway bill, Lorry/truck

receipt, railway receipt, Forwarder Cargo Receipt, Delivery Challan...etc

Insurance documentsInsurance policy, or Certificate but not a

cover note.

L/C is a non-negotiable instrument but may be transferable with the consent of the applicant. the two most basic L/Cs are: (1)Revocable - letter of credit, and (2) Irrevocable - letter of credit

(a) Confirmed irrevocable letter of credit, and (b) Not-confirmed irrevocable letter of credit.

INCOTERMS

International Commercial Terms

GROUP TERM Stands for

EEXW Ex Works

FFCA Free Carrier

FAS Free Alongside Ship

FOB Free On Board CCFR Cost and Freight

CIF Cost, Insurance and Freight

CPT Carriage Paid To

CIP Carriage and Insurance Paid To

DDAF Delivered At Frontier

DES Delivered Ex Ship

DEQ Delivered Ex Quay

DDU Delivered Duty Unpaid

DDP Delivered Duty Paid

Types of LC

•Revocable Letter of Credit • Irrevocable Letter of Credit •Confirmed Letter of Credit•Unconfirmed Letter of Credit•Standby Letter of Credit•Revolving Letter of Credit•Transferable Letter of Credit •Back-to-Back Letter of Credit

Revocable Letter of Credit

•A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification.  It is rarely used in international trade and not considered satisfactory for the exporters.

An irrevocable letter of credit

An irrevocable letter of credit can neither

be amended nor cancelled without the agreement of all parties to the credit.

Under UCPDC 600 all letters of credit are

deemed to be irrevocable unless otherwise stated.

Unconfirmed

The advising bank forwards an unconfirmed

letter of credit directly to the exporter without

adding its own undertaking to make payment or

accept responsibility for payment at a future

date, but confirming its authenticity

Confirmed

A confirmed letter of credit is one in which the advising bank, on the instructions of

the issuing bank, has added a confirmation

that payment will be made as long as

compliant documents are presented. This

commitment holds even if the issuing bank or the

buyer fails to make payment.

Sight and Deferred Letter of Credit 

Sight L/C states that the payments would be made by the

issuing bank at sight, on demand or on presentation.

In case of Deferred/Usance letter of credit, draft are drawn

on the issuing bank or the correspondent bank at specified

usance Period.

The credit will indicate whether the usance draft are to be

drawn on the issuing bank or in the case of confirmed

credit on the confirming bank.

Revolving Letter of Credit

Single L/C that covers multiple-shipments over a long period. Instead of arranging a new L/C for each separate shipment, the buyer establishes a L/C that revolves either in value (a fixed amount is available which is refilled when exhausted) or in time (an amount is available in fixed installments over a period). L/Cs revolving in time are of two types: in the cumulative, the sum unutilized in a period is carried over to be utilized in the next period; whereas in the non-cumulative type, it is not carried over.

Revolving Letter of Credit

The revolving credit is used for regular shipments of the same commodity to the same importer. It can revolve in relation to time or value.

If the credit is time revolving once utilized it is re-instated for further regular shipments until the credit is fully drawn.

If the credit revolves in relation to value once utilized and paid the value can be reinstated for further drawings.

The credit must state that it is a revolving letter of credit and it may revolve either automatically or subject to certain provisions.

Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit.

Standby Letters of Credit

A guarantee of payment issued by a bank on behalf of a

client that is used as "payment of last resort" should the

client fail to fulfill a contractual commitment with a

third party. Standby letters of credit are created as a sign

of good faith in business transactions, and are proof of a

buyer's credit quality and repayment abilities.

Transferable Letter of Credit

A transferable letter of credit is one in which the exporter has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties.

This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers.

Back-to-Back Letter of Credit

Arrangement in which one irrevocable one letter of credit serves as

the collateral for another; the advising bank of the first letter of

credit becomes the issuing bank of the second letter of credit.

Two letters of credit (LCs) used together to help a seller finance the

purchase of equipment or services from a subcontractor. With the

original LC from the buyer's bank in place, the seller goes to his

own bank and has a second LC issued, with the subcontractor as

beneficiary. The subcontractor is thus ensured of payment upon

fulfilling the terms of the contract. 

Back-to-Back Letter of Credit

Two letters of credit, one in favor of the buyer's agent and one financing the seller. A back-to-back credit is created when an exporter holding an irrevocable Letter of Credit persuades the buyer's bank (the advising bank) to open a second credit in favor of the merchandise supplier. The two credits are identical in all respects, except that the supplier becomes the Beneficiary of the back-to-back credit, and the amount of the second credit is less than the original export credit. The difference is the import agent's commission.

A back-to-back letter of credit can be used as an alternative to the

transferable letter of credit. Rather than transferring the original letter of

credit to the supplier, once the letter of credit is received by the exporter

from the opening bank, that letter of credit is used as security to establish a

second letter of credit drawn on the exporter in favor of his importer.

Back to Back Letter of Credit

The parties to a Back to Back Letter of Credit are:

    1.  The buyer and his bank as the issuer of the original Letter of Credit.

    2.  The seller/manufacturer and his bank,

    3.  The manufacturer's subcontractor and his bank.

Advantages of Letter of Credit•The beneficiary is assured of payment

as long as it complies with the terms and conditions of the letter of credit.

•The letter of credit identifies which documents must be presented and the data content of those documents.

•The credit risk is transferred from the applicant to the issuing bank.

Advantages of Letter of CreditThe beneficiary can enjoy the advantage of

mitigating the issuing bank’s country risk by requiring that a bank in its own country confirm the letter of credit.

The beneficiary minimizes collection time as the letter of credit accelerates payment of the receivables.

The beneficiary’s foreign exchange risk is eliminated with a letter of credit issued in the currency of the beneficiary’s country.

Risks involved in Letter of CreditSince all the parties involved in Letter of

Credit deal with the documents and not with the goods, the risk of Beneficiary not shipping goods as mentioned in the LC is still persists.

The Letter of Credit as a payment method is costlier than other methods of payment such as Open Account or Collection

Risks involved in Letter of CreditThe Beneficiary’s documents must

comply with the terms and conditions of the Letter of Credit for Issuing Bank to make the payment.

The Beneficiary is exposed to the Commercial risk on Issuing Bank, Political risk on the Issuing Bank’s country and Foreign Exchange Risk in case of Usance Letter of Credits.

The process of opening LCs

• After a contract is concluded between buyer and seller, buyer's bank supplies a letter of credit to seller.

The process of opening LCs

•Seller consigns the goods to a carrier in exchange for a bill of lading

The process of opening LCs

Seller place bill of lading for payment from buyer's bank. Buyer's bank exchanges bill of lading for payment from the buyer.

Buyer provides bill of lading to carrier and takes delivery of goods.

Methods of Trade Payment

Advance payment - This method of payment is the most secure for seller. The buyer parts with money first and waits for the seller to forward the goods.

Documentary Credit - This method of payment is more secure for seller as well as buyer. The bank gives an undertaking on behalf of buyer and at the request of applicant to pay the shipper the value of the goods shipped.

Trade Payment methods

Documentary collection - This method of payment is more secure for buyer and to a certain extent to seller. where shipment happens first, then the title documents are sent to the buyer's bank by seller's bank, for delivering documents against collection of payment/acceptance.

Direct payment - This method of payment is the most secure for buyer. The supplier ships the goods and waits for the buyer to remit the bill proceeds, on open account terms.

Process of settlement of LCs

Settlements Under a Letter of Credit

All commercial letters of credit must clearly indicate whether they are payable by sight payment, by

deferred payment, by acceptance, or by negotiation. These are noted as formal demands under the terms of the commercial letter of credit.

In a sight payment, the commercial letter of credit is payable

when the beneficiary presents the complying documents and if

the presentation takes place on or before the expiration of the

commercial letter of credit.

Settlements Under a Letter of Credit

In a deferred payment, the commercial

letter of credit is payable on a specified future

date. The beneficiary may present the complying documents at an earlier

date, but the commercial letter of credit is

payable only on the specified future date.

Settlement•An acceptance is a time draft drawn on,

and accepted by, a banking institution, which promises to honor the draft at a specified future date. The act of acceptance is without recourse as it is a commitment to pay the face amount of the accepted draft.

Settlement

Under negotiation, the negotiating bank, a third party negotiator, expedites payment to the beneficiary upon the beneficiary’s presentation of the complying documents to the negotiating bank.

The bank pays the beneficiary, normally at a discount of the face amount of the value of the documents, and then presents the complying documents, including a sight or time draft, to the issuing bank to receive full payment at sight or at a specified future date.

Opening of LCs and payments for imports – Bangladesh aspect

•payments for imports into Bangladesh should be made through an AD (Authorized Dealer) in the area where the holder of the LCAF is resident

• In case the importer is a new customer, the AD should obtain certificate from the AD through which the applicant imported earlier to the effect that no bill of entry is due/overdue for submission by the importer.

Opening of LCs – Bangladesh aspect

ADs are authorized to issue 'Letter of Credit Authorization Forms' (LCAFs) in conformity with the Import Policy Order (IPO) allowing imports into Bangladesh.

Opening of LCs – Bangladesh aspect

Import permits or clearance permits are not required for imports by the Ministries and government Departments against specific allocation given to them by the government.

But all Ministries and Government Departments except the Ministry of Defense shall duly submit LCAF to their nominated banks before opening LC for the purpose of import.

Opening of LCs – Bangladesh aspect

LCAFs remain valid for remittances for one year

subsequent to the month of issuance. In terms of

the Importers, Exporters and Indentors (Registration) Order, 1981 no person can

import goods into Bangladesh unless he is

registered with the CCI&E or exempted from the

provisions of the said Order.

Opening of LCs – Bangladesh aspect

Before Letter of Credit Authorization Form (LCAF) is issued or Letter of credit (LC) is opened or remittance is made the AD

should verify that the importer is registered with

the CCI&E or otherwise exempted from such registration.

Opening of LCs – Bangladesh aspect

The AD should ensure that the registration number of the importer is invariably

furnished on the IMP form. Where the importer is exempted from such registration, a suitable mention of this fact should be made on the IMP form.

Opening of LCs

Appropriate Inco terms should be incorporated in the letter of credit/purchase contract in compliance with the IPO in force.

Unless otherwise exempted by the Pre-shipment Inspection Act, 1999, all goods to be imported shall be inspected by an NBR designated Pre-shipment Inspection (PSI) company for quantity, quality, description, classification and price.

When LCs are opened, full particulars thereof must be

endorsed on the back of the exchange monitoring copy of the LCAF under the seal and signature of the AD. The Taka equivalent of the LC opened must be endorsed on the LCAF at the ruling BC selling rate (spot), but if a forward exchange cover is provided

theconversion should be made at the actual forward

rate.

Details of amounts remitted, whether under LC or otherwise, should be endorsed on the back of the exchange monitoring copy of the LCAF together with

the number of the relative IMP form.

•A L/C guarantees payment of a specified sum in a specified currency

•provided the seller meets precisely-defined conditions and submits the prescribed documents within a fixed timeframe.

•Documents include a clean bill of lading, or airway bill, commercial invoice, and certificate of origin.