The Mechanism of Letter Of Credit

The Mechanism of Letter Of Credit

THIS WRITE-UP IS INTENDED TO PROVIDE YOU WITH A BASIC OVERVIEW OF LETTER

LETTER OF CREDIT – HISTORY AND MEANING

Letter Of Credit was first used by King John in the year 1210 for purchasing marble from Italy. Letter Of Credit is governed by Uniform Rules which were first published in 1933 and was accepted by over 200 countries world over. These rules are known as Uniform Customs and Practice for Documentary Credits issued by International Chamber of Commerce. Present Publication No. 600 (UCP 600).

It is not an international law but a voluntary customs and practice accepted world over.

Definition of Letter Of Credit (LC)

Letter Of Credit is an instrument for assured payment. It is an undertaking of the ISSUING/OPENING Bank to make payment to beneficiary, against documents stated in LC.

Now before we go back to the definition of Letter Of Credit let us see the 

Mechanism of Letter Of Credit  and Understand it by way an example given below.

Let us understand it by an example:

Suppose M/s ABC India &Co a Indian company who is dealing in decorative lights wants to purchase / Import decorative lights from China. After some search he has zeroed in on one supplier named M/s XYZ China & Co who is willing to supply required quantity and quality at competitive rates.

So M/s ABC India &Co and M/s XYZ China & Co enter into negotiation for supply of goods (decorative lights). While going through the negotiation stages M/s XYZ China & Co asks for full advance payment before supply can be made as they were doing business fist time and had little trust on each other. M/s ABC India &Co replied that he cannot pay in advance but will pay as soon as the goods are received by him (open Account basis, reason lack of trust) as M/s ABC India &Co was also not sure whether M/s  XYZ China & Co is going to fulfil his promise of supply of goods after receiving full payment in advance.

So there was a little impasse and negotiations were about to fail as nobody wanted to be at disadvantage as far as sales contract was concerned.

M/s ABC India &Co narrated this situation to his banker and asked for some help. After discussing the matter with his banker and way out suggested by his banker, M/s ABC India &Co again approached M/s  XYZ China & Co with the following proposal:

M/s ABC India &Co suggested that he can ensure payment to M/s  XYZ China & Co by way of an irrevocable undertaking called Letter Of Credit from his banker in favour of M/s  XYZ China & Co provided goods are supplied as per their contract terms and documents in support of goods having been shipped as per contract terms are presented to M/s ABC India &Co banker within specific time.

M/s  XYZ China & Co immediately agreed to this proposal as now he was sure of this payment which was guaranteed by M/s ABC India &Co banker subject to production of documents and M/s ABC India &Co was also happy as he was also assured of supply of goods before making any payment to M/s  XYZ China & Co.

So they enter into a sales agreement with payment terms clause that settlement of payment of this contract will be by way of Letter Of Credit issued by M/s ABC India &Co banker in favour of M/s  XYZ China & Co.(this is called sales or purchase contract and is basis for issuance of any Letter Of Credit)

So on the basis of above contract we are going to explain Mechanism of LC.

So we have applicant or buyer (M/s ABC India &Co) who can be Importer also here. He has a purchase agreement with the beneficiary (M/s  XYZ China & Co) who is seller of goods and he can be exporter also. They have an agreement for sale purchase of goods, beneficiary is to sell the goods to the applicant but beneficiary wants to be sure about the payment, so to be sure about the payment the Letter Of Credit is used as an instrument of assured payment.

The applicant will make a request to his own bank with whom he has Letter Of Credit (Non-fund) sanction limit or against 100% cash margin for issuance Letter Of Credit.

So the bank which issues Letter Of Credit will be called Issuing bank or Opening Bank in this case M/s ABC India &Co banker.

Letter Of Credit issued by the Issuing bank will be send to another bank called advising bank for the purpose of advising it to beneficiary (in this case M/s XYZ China & Co)

The advising bank will verify the authenticity of the Letter Of Credit and forward it / advise it to the beneficiary.

So once Beneficiary received this Letter Of Credit he will check it and if the conditions mentioned in the Letter Of Credit are as per purchase agreement he will start manufacturing the goods and make shipment of the goods. After shipments he will prepare the documents, because he has to get the payment against the documents stated in Letter Of Credit. So he prepares and sends those documents to the nominated bank or negotiating Bank.

Nominated bank or negotiating bank after making sure that these documents received by him from the beneficiary of the Letter Of Credit are the documents which are stated in Letter Of Credit, will make payment to the beneficiary and negotiating Bank(M/s XYZ China & Co  banker) will send the documents to opening/ issuing bank and claim payment from  opening bank/issuing bank.

Opening bank in turn will get the documents accepted by the applicant /buyer / impoter and once these documents are accepted by the applicant it means that the documents are in order.

Depending upon the nature of the Letter Of Credit it is possible that the documents are delivered to the applicant before payment (Usance LC) or after making payment (Sight LC) and applicant/buyer/importer makes the payment to the issuing/opening bank and the issuing bank/opening bank in turn makes the payment to the negotiating bank. Negotiating bank has already made the payment to the beneficiary.

There is one more bank which comes into the picture in this process in case beneficiary is not satisfied with credit rating of the issuing/opening bank. In that situation beneficiary seeks guarantee for payment and that guarantee is given by another bank acceptable to beneficiary and is called confirming bank.(this additional guarantee is given on the request of issuing/opening bank).

So this confirming bank is the bank which gives guarantee on behalf of issuing bank /opening bank to make the payment in case the opening bank fails to the payment.

Now we hope from the above explanation you can easily understand the definition of Letter of Credit Given below

 We will again read the definition of Letter Of Credit “ LC IS AN INSTRUMENT FOR ASSURED PAYMENTS. IT IS AN UNDERTAKING GIVEN BY THE ISSUING BANK/OPENING BANK TO THE BENEFICIARY FOR MAKING PAYMENT AGAINST THE DOCUMENTS STIPULATED IN LETTER OF CREDIT”

Now we can discuss other aspects of Letter Of Credit:-

All Letter Of Credits are governed by the rules framed under UCPDC and we have to mention that while issuing Letter Of Credit itself.

As per UCPDC in LC’s, all parties deal in documents and not in goods and services. So the subject matter in the Letter Of Credit is the documents and not the goods and services. This has a very serious implication for all the parties involved in the Letter Of Credit. i.e applicant that is Buyer and the opening bank they  cannot refuse payment simply on the basis that there is  defective goods and services. Even if goods and services are defective but the documents are as per Letter Of Credit opening bank has obligation to make payment because all parties in LC deal in documents and not in goods and services. So that is an important element of Letter Of Credit transaction.

 

Now let us discuss parties in Letter Of Credit transaction:-

Let us see which the parties are:

 1^st party is  Applicant:

LC Applicant is normally the buyer under the sales contract and the party that initiates the request to the Issuing Bank to issue an LC on its behalf. The LC Applicant normally maintains banking facilities with the Issuing Bank.

2^nd party is Beneficiary:

LC Beneficiary is normally the seller under the sales contract and the party who will receive payment under the LC if it can fulfil all the terms and conditions of the credit.

3^rd one is the Opening/Issuing Bank:

An Issuing Bank (or LC opening bank) is the bank that issues the LC in favour of a seller at the request of the LC applicant. The Issuing Bank is normally located in the applicant’s country with established banking relationship with the applicant.

By issuing an LC, the Issuing Bank undertakes to pay the seller/beneficiary the value of the draft and/or other documents if all the terms and conditions of the LC are complied with.

4^th is the Advising Bank:

An Advising Bank (or sometimes known as notifying bank) is the bank that advises the LC beneficiary that there is an LC issued in his favour. Advising Bank is normally located in the seller’s country and is either appointed by the Issuing Bank or LC applicant. Its primary responsibility is to authenticate the LC to ensure that the LC comes from genuine source.

5^th is the Nominated Bank:

A Nominated Bank is a bank authorised by the Issuing bank in the credit to pay, negotiate, issue a deferred payment undertaking or accept drafts under the LC. If the LC does not specify a Nominated Bank, the LC is deemed as freely negotiable and any banks that receive documents from the LC beneficiary are qualified to be a Nominated Bank.

A Nominated Bank is not responsible to pay under the credit unless it has added its confirmation to the credit. In such a case, it will become a Confirming Bank.

6^th is the Negotiating Bank:

A Negotiating Bank is the bank that examines the drafts and/or documents presented by the LC beneficiary and gives values to such drafts and/or documents. Negotiation could be in the form of purchasing or agreeing to purchase the drafts and/or documents presented.

7^th is the Confirming Bank:

A Confirming Bank (normally also the Advising Bank) is the bank that adds its own undertaking to pay the LC beneficiary if all terms and conditions of the credit are complied with. Such undertaking is in addition to that given by the Issuing Bank at the request of the Issuing Bank.

The Confirming Bank will only confirm an LC upon satisfactory evaluation on the conditions of the Issuing Bank and its domicile country.

Then there are other banks like Reimbursing Bank, Paying Bank etc

LC is usually subject to the Uniform Customs and Practice for Documentary Credits, International Chamber of Commerce Publication No. 600 (UCP 600).

Availability of Letter Of Credit;

 Under UCP 600, an LC can be made available with:

        1.  Payment – Payment at sight against compliant documents.

   2. Negotiation – Payment with or without recourse to the beneficiary or bona fide holder against compliant documents presented under the credit.

  3.Acceptance by a Drawee Bank – Payment at a future determinable date against compliant documents. A tenor draft is normally required for presentation under an acceptance credit and is drawn on the acceptance bank rather than the issuing bank.

Usance Credit –

Payment at a future determinable date against compliant documents. A tenor draft is normally required (but not mandatory) for presentation under a usance credit and is drawn on the Issuing Bank. Usance credit is available by Negotiation, Acceptance and Deferred Payment. A tenor draft is not required for presentation under a deferred payment credit.

Letter Of Credit is now a widely used instrument both for International and Domestic Trade for ensuring payment and also very useful product for the banks for generating other income without deployment of Funds.

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