Documentary Letter of Credit LC - Trade Payments Instrument

Need for Documentary Letter of Credit LC

Normally, in international trade, the exporter may not be ready to take the risk of selling his abroad unless he is sure of getting his payment. Likewise, the buyer may not buy goods in international market from an unknown party due to risk of not meeting his requirements. Both these risks are quiet high, which may sometime result into major financial loss. This perception is not congenial to development of international trade.

The seller, therefore, needs an assurance of payment on behalf of the buyer; similarly, a buyer would want somebody to ensure due performance by the seller as per the contract.

Both the parties can feel satisfied, if a professional intermediator like bank lends his support by issuing Documentary Credit on behalf of the buyer (importer) in favour of the seller (exporter).

What is a Documentary Credit ? Meaning, Definition

A Documentary Credit is an instrument, which can be used for settling the trade payments. It may be defined as follows

"Credit means any arrangement, however, named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour* a complying presentation."

Honour means :-

1. To pay at sight if the credit is availableby Sight payment.
2. To incur a deferred payment undertaking and pay at maturity if the credit is available by deferred payment.
3. To accept a bill of exchange ('draft') drawn by the beneficiary and pay at maturity if the credit is available by acceptance.

In common parlance, documentary credit is like a bank guarantee except that the bank guarantee covers a situation of non-performance of the contract (payment is made when a customer does not perform as per the contract). A documentary credit covers a situation where payment is made on performance of contract.

From the above definition, we can derive five important features of documentary credits, viz. :-

• It is an irrevocable undertaking in writing,
• Given by a Bank called the Opening Bank,
• On behalf of its customer who is the importer or buyer,
• to honour bills drawn by a third party who may be the beneficiary or the transferee under the credit,
• subject to compliance with terms and conditions of the credit.

Parties To The Letter of Credit (LC)

1. Opener (Importer/Buyer) : The party on whose request the credit is issued.
2. Issuing Bank : The bank that issues a credit at the request of an applicant or on its own behalf.
3. Advising Bank : A bank that advises the credit at the request of the issuing bank.
4. Beneficiary (seller/ exporter) : The party in whose favour the credit is issued.
5. Nominated Bank : The bank with which the credit is available or any bank in the case of a credit available with any bank.
6. Confirming Bank : The bank which guarantees honouring of bills by the Opening Bank under the credit i.e. if the Opening Bank fails for any reason to honour the Confirming Bank honours, wherever available.
7. Reimbursing Bank : The bank which pays claims made by the nominated bank after negotiating bills drawn by the exporter under the credit.

Types of Letter of Credit (LC)

1. Irrevocable Letter of Credit : It carries a definite undertaking ;of the issuing bank to honour the documents drawn strictly in conformity with the terms and conditions of the credit. It cannot be amended nor cancelled without the consent of all parties concerned. Any Credit issued will be an irrevocable credit.
2. Revocable Letter of Credit : This credit can be amended / modified / cancelled any time by the opening bank without the consent of the beneficiary. Hence, this credit is not a safe credit from the point of view of the beneficiary. However, in practice, this type of credit is seldom issued. Even though the credit can be cancelled any time, but the opening bank would be liable to the beneficiary for the shipments made by him prior to receipt of notice by him about the cancellation of credit by the issuing bank.
3. Confirmed Letter of Credit :
   • means the bank that adds its confirmation* to a credit upon the issuing bank's authorisation or request.
   • * Confirmation means a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying presentation.
4. Anticipatory Letter of Credit :
   1. Red Clause Letter of Credit : In this credit, the issuing bank authorizes nominated bank, which is in beneficiary's country, to give pre-shipment credit to the beneficiary. This advance is given to the beneficiary for purchase of rawmaterial / processing / packing of the goods to be exported. It is given at the risk and responsibility of the issuing bank and is unsecured. The pre-shipment advance given in this way would be adjusted against the documents tendered by the exporter for negotiation. This type of L/C is known as 'Red Clause Letter of Credit'.
   2. Green Clause Letter of Credit : This credit is an extended version of red clause credit. In addition to whatever has been given in red clause credit, it covers charges for warehousing of goods at the port of shipment, when waiting for ship or space and insurance therefor. Generally, the advance under this credit is given to the exporter after the goods are lodged in bonded warehouse and would be adjusted once they are shipped on board. Under this credit, warehouse warrants are given as a security for the advance.
5. Transferable Letter of Credit :
   • means a credit that specifically states it is "transferable". A transferable credit may be made available in whole or in part to another beneficiary ("second beneficiary") at the request of the beneficiary ("first beneficiary").
   • Transferring bank means a nominated bank that transfers the credit or, in a credit available with any bank, a bank that is specifically authorised by the issuing bank to transfer and that transfers the credit.
   • A credit may be transferred in part to more than one second beneficiary provided partial shipments are allowed.
6. Back-to-back Letter of Credit : The beneficiary of the export credit, who is not the manufacturer of the goods, may approach a bank to open a letter of credit in favour of the manufacturer who is ready to supply the goods. Such a letter of credit is opened on the strength of the export letter of credit and hence called back-to-back letter of credit. Such a documentary credit should be opened on behalf of the good exporters and suppliers.
7. Revolving Letter of Credit :
   • When a buyer wants a regular supply of goods from the foreign / domestic supplier, he may approach his banker to open a revolving letter of credit in supplier's favour.
   • When the shipment is made and the documents are drawn on the opener as per the terms of credit, the documents are negotiated and forwarded to the drawee for payment.
   • When the payment is made, the credit is reinstated and made available to the beneficiary on receipt of the advice from the issuing bank.
   • Further negotiations will take place after the advice of reinstatement is received.
   • Revolving letter of credit should stipulate maximum drawings under the credit and should have reinstatement clause.
8. Stand-by or Backup Letter of Credit : The very name of this credit suggests that it is not a regular letter of credit, but a sort of stand-by or back-up credit. These types of credits can be issued in India, but are very much in vogue in Western Countries, especially in U.S.A in place of guarantee. These credits are generally used as substitutes for performance guarantee or for securing loans. As per FEMA, now they can be issued in India for imports of certain category as per FEDAI guidelines. Our exporters can freely receive standby letter of credit to cover their exports of goods.