Letters of credit are a payment mechanism, particularly used in international trade. The Seller gets paid, not after the Buyer has inspected the goods and approved them, but when the Seller presents certain documents (typically a bill of lading evidencing shipment of the goods, an insurance policy for the goods, commercial invoice, etc.) to his bank. The bank does not verify that the documents presented are true, but only whether they “on their face” appear to be consistent with each other and comply with the terms of the credit. After examination the bank will pay the Seller (or in LC terms the beneficiary of the letter of credit).
Letter of Credit, Standard Example:
1) Buyer and Seller sign a purchase contract that stipulates payment by letter of credit. It is good practice to agree already in the purchase contract which documents the Seller/Beneficiary has to present.
2) The Buyer/Applicant goes to his bank (so called issuing bank) opening the credit to the benefit of the Seller, in particular the Buyer tells his bank which documents the Beneficiary has to present, where and how, and the amount of the credit and details of payment (by sight, deferred sight paymnet, against acceptance or negotiation of drafts).
3) The Issuing Bank, which is normally located in a foreign country, advises the Beneficiary through a correspondence bank located in the country of the Beneficiary of the credit. So in step # 3, the Issuing Bank issues the L/C and forwards it to the Advising Bank.
4. The Advising Bank checks the apparent authenticity of the L/C and advises the L/C to the Beneficiary
5) The Seller/Beneficiary checks if the L/C complies with the commercial agreements and if all terms and conditions specified in the L/C can be satisfied, then the Seller ships the goods
6) The Beneficiary assembles the documents specified in the L/C, checks the documents for discrepancies with the L/C, draws the draft and presents the draft and the documents to the Advising Bank
and presents the necessary documents to his local bank which pays him after examining them.
7. The Advising Bank bears the draft and the documents against terms and conditions of the L/C and forwards them to the Issuing Bank
8. The Issuing Bank checks if the documents comply with the L/C and makes a payment immediately (if the L/C is available by sight) or on a certain date (if L/C is available by deferred payment).
Confirmed Letter of Credit
Confirmed Letters of Credit have the advantage that the payment obligation of the confirming bank is independent of the issuing bank. Buyers may obtain injunctions against the issuing bank in their home country to prevent the bank from honouring the LC. Obtaining an injunction in a foreign country is more difficult.
Standby Letter of Credit
A standby letter of credit is basically a bank guarantee. Previously US banks were not allowed to issue guarantees and circumvented this limitation by issuing standby letters of credit where the beneficiary basically has to present his face to get paid. Most letters of credit, particularly in international transactions, are subject to the Uniform Customs and Practices (UCP) issued and published by the International Chamber of Commerce (ICC). The current revision UCP 600 is publication No. 600 of the ICC and takes effect as of July 1, 2007. Since the ICC lacks legislative authority, meaning it is not the arm of or authorized by any government but rather a trade association, the UCP are no laws and have to be explicitly incorporated into individual transaction. Some countries and states have enacted statutes regarding letters of credit (see eg Article 5 US Uniform Commercial Code). In international trade however, most parties choose to use the UCP.
[use of the graphics with kind permission of SACHIN BHATIA ]