Letter of Credit (L C)
The technical term for letter of credit is documentary credit. At the very outset one must understand that letters of credit deal with documents, not goods. The idea in an international trade transaction is to shift the risk from the actual buyer to a bank. Thus an L/C (as its commonly referred to) is a payment undertaking given by a bank to the seller and is issued on behalf of the applicant, that is, the buyer.
- The buyer is the applicant
- the seller is the beneficially.
- The bank that issues the LC is referred to as the issuing bank, which is generally in the country of the buyer.
- The bank that advises the L/C to the seller is called the advising bank, which is generally in the country of the seller.
The specific bank makes the payment upon the successful presentation of the required documents by the seller within the specified time frame. Note that the bank scrutinizes the “documents” and not the ‘goods’ for making payment.
Typically the documents requested in a letter of credit are the following:-
- Commercial invoice
- Transport document such as bill of lading or airway bill
- Insurance document
- Inspection Certificate
- Certificate of Origin
But there could be others too.
TYPES OF LETTERS OF CREDIT
Revocable- This is not a binding undertaking. It can be cancelled or amended without notice to the exporter and therefore not an acceptable security.
Irrevocable- The importers bank undertakes to honour this provided all terms and conditions are complied with. It cannot be cancelled or amended without the agreement of all parties concerned.
Unconfirmed- The advising bank (exporters bank) has no responsibility but will negotiate documents with recourse to the seller.
Confirmed- The exporters bank adds its confirmation and will honour documents provided they are in compliance with the letter of credit.
Transferable- One under which the first beneficiary has the right to request the paying bank to make credit available in whole or part to one or more other parties.
Divisible– The letter of credit can be divided between two or more parties.
Revolving-– The value of the credit revolves over a certain period.
DETAILS INCLUDED IN A LETTER OF CREDIT.
- Type of credit.
- The name and address of the opener(a buyer)
- Name and address of the beneficiary (the seller)
- Amount of credit in foreign currency.
- The name of the party on whom the bills of exchange are to be drawn and whether they are to be sight or term bills.
- Terms of contract and shipment e.g. FOB, C.I.F.
- Precise instructions as to the documents against which payment is to be made.
- Brief description of goods.
- Shipping details – e.g. the latest date for shipment, Names of ports of shipment and point of discharge.
- Whether credit is available for one or several shipments.
Reasons why letters of credit fail
The letter of credit should have an expiry date that gives sufficient time to the seller to get all the tasks specified and the documents required in the Letter of Credit. Most LC’s fail because seller/exporters /beneficiaries were unable to perform within the specified time frame in the LC. Three dates are of importance in an LC
- The date by when shipment should have occurred. The date on the bill of lading.
- The date by when documents have to be presented to the bank.
- The expiry date of the Letter of Credit itself.
Discrepancy within the letter of credit
Letters of credit could also have discrepancies. Even a discrepancy as small as a missing point or comma can render the document invalid
Compliance with the documents and conditions within the letter of credit
Letters of credit are about documents and not facts; the inability to produce a given document at the right time will nullify the letter of credit.
Bills of exchange
(Refer to payment methods ‑trade and consumer, for meaning of bills of exchange)
‘Documentary’ means that certain documents accompany the bill and enable the seller to retain control over the goods.
- Sight draft‑ documents against payment
This is a collection arrangement whereby a full set of shipping documents (together with the bill of exchange) is passed to the bank to collect money from the overseas buyer.
- Cash against documents
This method requires shipping documents to be handed over by the bank in exchange for payment. It is similar to sight draft, but without the inclusion of a bill of exchange.
- Term draft
This is similar to the sight draft method of collecting payment but the buyer obtains the documents by accepting the draft (usually by endorsing it). An accepted bill is proof of the existence of a debt, which cannot then be disputed as to amount for any other reason.
- Open account
Open account is the main alternative to documentary terms and should only be used where the buyer is judged credit worthy and the market free of political risks. Unlike documentary terms, documents of title are sent straight to the buyer either with the goods or under separate cover. The options for open account payment:
- Bank transfers
- Promissory notes