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Letters of credit, also known as a Documentary Credit or LC in abbreviation,
are often used in international transactions to ensure that payment will
be received. Due to the nature of international dealings including factors
such as distance, differing laws in each country and difficulty in knowing
each party personally, the use of letters of credit has become a very important
aspect of international trade. The bank also acts on behalf of the buyer,
i.e., the holder of letter of credit by ensuring that the supplier will
not be paid until the bank receives a confirmation that the goods have been
shipped.
When drafting a letter of credit, a series of the standardized terms and
definitions must be used, among which the buyer or import is the "Applicant"
and the seller or exporter is the "Beneficiary"; the bank that issues the
LC is referred to as the "Issuing Bank" which is generally in the country
of the buyer or importer, whereas the bank that advises the LC to the seller
is called the "Advising Bank" which is generally in the country of the seller
or exporter.
In fact, a Letter of Credit is a bank-to-bank commitment of payment in favor
of an exporter or supplier, the Beneficiary, guaranteeing that payment will
be made against certain documents that, on presentation, are found to be
in compliance with terms set by the buyer or importer, the Applicant.
On the other hand, the letter of credit also provides strong protection
for the buyer or importer. Like Bills for Collections, Letters of Credit
are governed by a set of rules from the
International Chamber of Commerce. In this case, the document is called
"Uniform Customs and Practice" and the latest version is document number
600. In short, it is known as UCP600 and over 90% of the world's banks adhere
to this document. There are several types of the letters of credit, incorporating
different specific terms and conditions for a particular transaction.
Click here for a
sample "Irrevocable Letter of Credit" >
The exporter or supplier and importer and buyer can agree detailed terms,
as part of the commercial contract. This can include exactly what documents
need to be produced and precisely what detail such documents should quote.
Letters of Credit, as well as offering a bank's commitment to pay, also
offer benefits in terms of finance. Speak to your bank, or the Advising/Confirming
Bank to see how they can help. Additionally, commercial insurers now offer
an insurance-backed product that covers the same basic risks as confirmations.
Please speak to your insurer for details.
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Typical Documents Requested in a Letter of Credit
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Commercial invoice with packing slip, itemizing content of the shipment,
prices of the goods and amount.
Transport or shipping documents such as a ocean Bill of lading or Airway
bill, typically in five duplicates.
Insurance document if such is prearranged to be seller's duty and agreed
upon by both the seller and the purchaser.
Inspection Certificate, typically provided by a third party inspection
agent jointly selected by the both parties.
Certificate of Origin
<link>, stating from what country the shipped goods originate,
but "originate" in a "certificates of
Origin"
do not mean the country the goods are shipped from, but the country where
there goods are actually made.
Other documents deemed necessary by the importer or buyer and agreed upon
by exporter or seller.
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Types and Terms of the "Letters of Credit"
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Irrevocable Letters of Credit vs. Revocable Letters of Credit
The terms and conditions within a L/C cannot be changed without the express
agreement of the Beneficiary. Under UCP600, revocable L/Cs are no longer
acceptable under any circumstances.
Unconfirmed Letters of Credit vs. Confirmed Letters of Credit
For the unconfirmed letters of Credit, the payment commitment within the
L/C is simply provided by the importer's or Applicant's issuing bank. However,
the "Confirmed Letters of Credit" is much more complicated. If an exporter
or potential beneficiary has any concerns about the circumstances which
may prevent payment being made from either the Issuing Bank or buyer's Country,
the adding of "Confirmation" moves the bank/country risk issues to the bank
which adds its confirmation and notifies the Documentary Credit (DC) to
the exporter or supplier. This middle bank is called " the confirming bank"
or "advising bank". The costs of such a confirmation will obviously depend
upon the level of perceived risks to be covered. Banks can often provide
indicative pricing for confirmations prior to the arrival of the DC so that
costs associated with the "confirmation" procedure can be estimated.
Fully Funded Documentary Letter Of Credit - FFDLC
A written promise of payment provided by a buyer to a seller that is guaranteed
to clear by a particular bank. Once an FFDLC document is presented by the
seller to the involved bank, the bank is obliged to remit full payment to
the seller. The seller may be required to fulfill certain conditions, such
as providing proof of shipment of the goods sold to the buyer, before collecting
payment from the bank. This method of payment provides assurance to the
seller that the buyer has the necessary funds for the transaction and ready
for remittance to the seller upon completion of the sale. For example, an
American consumer electronics distributor may be purchasing $500,000 worth
of stereo equipment from a Chinese manufacturer. Since the two companies
are so geographically distant from each other, each wants surety of the
deal's completion before performing their part of it. So, the seller can
be assured the buyer has payment by receiving notice of an FFDLC, as the
document proves that the buyer has transferred the $500,000 in cash to the
bank involved, who then holds the funds for immediate release to the seller
once the deal is complete and the FFDLC document is presented to the bank.
Similarly, the buyer does not risk sending payment to the seller without
knowing whether or not the goods have actually been shipped.
Sight Letter of Credit
This is a letter of credit made payable to a beneficiary upon presentation
to the opener of conforming documents.
Revolving Letters of Credit
Revolving Letter of Credit is a 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 replenished when exhausted) or in time (an amount
is available in fixed installments over a period such as week, month, or
year). L/Cs revolving in time are of two types: in the cumulative type,
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.
Standby Letter of Credit - SLOC
This is a type of guarantee of payment issued by a bank on behalf of a
buyer or importer 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. The bank issuing the SLOC will perform
brief underwriting duties to ensure the credit quality of the party seeking
the letter of credit, then send notification to the bank of the party requesting
the letter of credit, which typically is a seller or creditor. Also known as a "non-performing
letter of credit", a standby letter of credit will typically be in force
for about one year, allowing for enough time for payment to be made through
standard contractual guidelines. The seller will ask for a standby letter of credit, which
can be cashed on demand if the buyer fails to make payment by the date specified
in the contract. The cost to obtain a standby letter of credit is typically
1-8% of the face amount annually, but the letter can be canceled as soon
as the terms of the contract have been met by the purchaser or borrower.
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Most Common Causes for Letter of Credit Failures
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Failures of the letters of credit are not uncommon in cross-border global
trades. Many issues could contribute to the failures. The following are
three most common causes for the letter of credit to fail.
Time Lines are improperly addressed
The letter of credit should have an expiration date that gives sufficient
time to the seller to get all the tasks specified and the documents required
in the LC. If the letter of credit expires, the seller is left with no
protection. Most letters of credit fail because Sellers/Exporters/Beneficiaries
were unable to perform within the specified time frame stipulated in the
letter of credit. Three dates are of importance in a letter of credit:
a) The date by when shipment should have occurred. The date the the "Bill
of Lading" is generated. b) The date by when documents have to be presented
to the Bank; c) The expiry date of the LC itself. A good source
to give you an idea of the timelines would be your freight forwarding
agent. As a seller check with your freight forwarding agent to see if
you would be in a position to comply.
Discrepancy within the Letter of Credit
Failed letters of credit often contain discrepancies in clauses. A discrepancy
as small as a missing period or comma could render the document invalid
in the end. Thus, the earlier in the process the letter of credit is examined,
the more time is available to identify and fix the problem. Consistency
is critical in drafting a letter of credit.
Problems in compliance of the documents and conditions within the
Letter of Credit
Letters of credit are all about documents and not facts or merchandise.
The inabilities of producing any given documents at the prescribed time
will nullify the letter of credit. A seller, exporter or beneficiary should
try and run the compliance issues with the various department or individuals
involved within the organization to see if the compliance would be a problem
and if so, the letter of credit should be amended before shipping the
goods. As a buyer, importer or applicant, you should also take a step
to confirm with the supplier or beneficial and make sure they will be
able to comply all the terms as included in the draft of the L/C before
having the bank issue the final version of the letter of credit.
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Legal Aspects of the Letters of Credit
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Essential Principles Governing Law Within the United States, Article 5 of
the Uniform Commercial Code or UCC in abbreviation, governs the Letters
of Credit. Article 5 is founded on two principles: first, the L/C's independence
from the underlying business transaction, and second, strict compliance
with documentary requirements.
Strict Compliance
You may be interested in knowing how strict are compliance requirements.
It is to certain extent depending on how the courts explain the Articles.
Some courts insist upon literal compliance so that a misspelled name or
typographical error voids the exporter's/beneficiary's/seller's demand for
payment. Other courts require payment upon substantial compliance with documentary
requirements. However, the bank may insist upon strict compliance with the
requirements of the L/C to avoid their potential liabilities. As a matter
of fact, in the absence of conformity with the L/C, the seller cannot force
payment and the bank pays at its own risk. Sellers should be careful and
remember that the bank may insist upon strict compliance with all documentary
requirements in the LC. If the documents do not conform, the bank should
give the seller prompt, detailed notice, specifying all discrepancies and
shortfalls.
The
Independence Doctrine
Again, letters of credit deal in documents, not goods. L/Cs are purely documentary
transactions, separate and independent from the underlying contract between
the buyer and the seller. The bank honoring the L/C is concerned only to
see that the documents conform with the requirements in the L/C. If the
documents conform, the bank will pay, and obtain reimbursement from the
buyer, importer or Applicant. The bank need not look past the documents
to examine the underlying sale of merchandise or the product itself. The
letter of credit is independent from the underlying transaction and, except
in rare cases of fraud or forgery, the issuing bank must honor conforming
documents. Therefore, sellers are given protections that the issuing bank
must honor its demand for payment which complies with the terms of the L/C
regardless of whether the goods conform with the underlying sale contract.
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