Article explains What is a Letter of credit, Parties involved in letter of credit, Step by Step procedure for issuance of a letter of credit, What are the different types of letter of credit, Difference between Letter of Understanding(LOU) and LOC, What was PNB scam? Why LOU was banned by the RBI and How a letter of credit is useful in trade.

History

The roots of the phrase ‘Letter of credit can be found in the ancient history of Europe. In ancient times, when a person wants to travel to another country, he needs to carry a ‘Circular Letter’ of credit from his home bank. This Circular letter helps him to withdraw cash easily from other banks during his journey. The person dealing in the Commercial International trades made the methods and techniques to handle letter of credit worldwide. It was identified by the International Chamber of Commerce (ICC), which publishes the Uniform Customs and Practice for Documentary Credits (UCP) in 1933. UCP is the set of standardized and unified rules to control the issuance of the letter of credit worldwide. In the late 19th and 20th century, Letter of credit was mainly issued by the Telegraph and Telex respectively in paper documents. But In 1983 UCP was amended and it allows to issue and use the letter of credit in the electronic form (paperless).

A. What is a Letter of credit?

Letter of Credit is an important tool for international trade. Letter of credit is the letter issued by the bank which signifies the creditworthiness of the buyer. In this, the Bank of buyer gives a guarantee to the seller that the buyer will pay the amount in proper time. If there is a default or buyer is unable to pay the amount, the whole or due amount is paid by the bank. In other words, there is a contract between the buyer’s bank and the seller to perform promise or discharge the liability of the buyer in case of his default. Bank need collateral or security for the issuance of the letter of credit. Bank will charge a fee for his services.  Letter of credit mostly helps in the business of imports and exports. Letter of credit is issued by the Bank of importer on the condition that if goods and documents are with the compliance of the purchase agreement, then bank will issue the letter of credit to exporter which states that, if importer is unable to pay the required sum, then the obligation to pay the amount will be transferred to the Bank.

B. Parties involved in letter of credit

1. Applicant/ Buyer – It is the person who applies for the letter of credit to the Bank for eg. It can be buyer or importer who requests the bank to issue the Letter of credit

2. Beneficiary/seller/ Exporter – It is the person who gets the benefits of the letter of credit. If there is default by the buyer, the bank will pay the amount to the seller or exporter.

3. Issuing bank – Issuing Bank is the Bank who issue a letter of credit at the request of the buyer or applicant. Issuing Bank also charges fees for his services.

4. Negotiating or Confirming bank – It is the bank situated in the home country of the seller. Letter of credit is issued by issuing bank but if the seller prefers his home bank for the payment then he can submit the document to the negotiating bank. Negotiating or confirming bank can be used as a means of communication between the seller and the issuing bank.

5. Intermediary – It is the company which helps sellers and buyers  to trade.

6. Shipper – It is a Company which ships the good from one country to another.

C. Step by Step procedure for issuance of a letter of credit

Step 1 – Seller and buyer will enter into the contract and will decide on terms and conditions of the contract, modes of payment & delivery.

Step 2 – Buyer will approach the issuing bank to open letter of credit in the favor of the seller.

Step 3 – Issuing bank will start making a letter of credit in favor of seller and will also require the following documents from the buyer:

  • Bill of lading
  • Insurance Document
  • Insurance Certificate
  • Airway Bill
  • Commercial Invoice
  • Certificate of Origin
  • Transport Bill
  • Any other document required under the contract

Step 4 – Issuing bank after completing whole formalities transfers the letter of credit to Advising bank of the supplier in his home country.

Step 5 -Advising Bank transfers the letter of credit to the seller. Seller reviews the document and if there is any amendment required, he will notify it to the buyer.

Step 6 – After agreeing with the terms of the contracts, seller ready the goods for the shipment. During shipment, the seller takes the bill of lading and other documents required for the transportation.

Step 7 – Seller need to produce a document before the Negotiating bank. The negotiating bank will review the documents and check whether documents are in accordance with the letter of credit or not. And after reviewing, Negotiating Bank will transfer the documents to issuing bank.

Step 8 – Issuing bank will receive documents from Negotiating bank. After payment to the bank, Issuing bank will give documents to the buyer. These documents will help him to take possession of the goods.

D. What are the different types of letter of credit?

  • Revocable and Irrevocable Letter of Credit-

A revocable letter of credit can be altered, amended or canceled by the issuing bank or buyer at any time. Bank and buyer are not bound to give notice to the seller for such letter of credit. It cannot be altered, amended or canceled after the seller had submitted the document to the issuing bank. It does not protect the interest of the seller.

Irrevocable Letter of credit is the letter which can be altered, amended or canceled only with permission of buyer, seller and issuing bank.

  • Confirmed and Unconfirmed Letter of Credit

Confirmed letter of credit provides more protection to the seller than the unconfirmed letter of credit. Confirmed letter of credit is the letter in which Confirming bank (bank of the seller) takes the undertaking of payment to the seller. Seller feels more secure in dealing with confirming bank rather than issuing bank. He confirms the letter of credit from his home bank. If issuing bank is unable to pay the required sum than he can recover from the confirming bank.

Unconfirmed letter of credit is a letter in which only issuing bank is liable to pay the seller on the breach of the buyer. It is riskier than the confirmed letter of credit.

  • Transferable and Non Transferable letter of credit 

When the letter of credit can be transferred to the third party (2nd beneficiary) than it is called the transferable letter of credit. The third party cannot transfer further.

When the letter of credit cannot be transferred to the third party (2nd beneficiary) than it is called non-transferable letter of credit. In this sole and ultimate beneficiary is the seller only.

  • Restricted and Unrestricted letter of credit

In the restricted letter of credit, seller nominates specific bank for the payment. The issuing bank on the default of buyer makes the payment to only to the specific bank nominated by the seller.

In the unrestricted letter of credit payment can be made to any bank negotiated by the seller

  • Straight and Negotiable Letter of credit

In straight letter of credit payment is made to the person whose name is written in the documents.
In Negotiable letter of credit payment can be made to any person nominated by the seller.

  • Sight and Deferred Letter of credit

When the payment to the seller is made immediately after the verification of the documents then it is called Sight Letter of credit.
When the payment to the seller is not made on verification of document but within the period prescribed by the letter of credit than it is called Deferred letter of credit. It gives protection to the buyer as he can inspect and suspect the goods before the payment.

  • Back to Back letter of credit

In Back to back letter of credit 2 Letter of credit are issued. In this buyer’s bank issue letter of credit in favor of the broker (intermediary) or seller and broker’s bank or seller on the basis of such letter of credit issues a new letter of credit in the favor of seller or manufacturer. It is used by the broker who gets a commission on this or by the seller who purchases the goods from the manufacturer on a credit basis.

  • Standby letter of credit

Standby letter of credit describes the creditworthiness of the buyer. It is a formal document in which issuing bank gives guarantee and assurance to the seller that in case of default, the bank will repay the amount. It is a document which defines the duties and obligations of the bank and seller. The standby letter of credit provides more protection to the seller.

  • Revolving Letter of credit

In Revolving letter of credit , a single letter of credit is issued to transfer same goods several times. When buyer and seller is dealing with the same goods from time to time than they can issue a revolutionary letter of credit which helps them to do business on single letter of credit.

  • Red Clause and Green letter of credit

Red Clause letter of credit is document in the red colour which signifies ‘advance payment’. In this type of letter of credit buyer’s bank pays advance before the delivery of the good and documents.
Green clause letter of credit is the document in the green ink which signifies ‘advance payment and storage’. In this type of letter of credit in addition to advance payment, bank also provides storage facility to seller at the port to store the goods.

E. Difference between Letter of Understanding(LOU) and LOC

1. Letter of Understanding is the letter of comfort or bank guarantee in which a bank of the customer allows him to raise money from another Indian bank’s foreign branch for short-term credit. In a letter of credit, Bank of buyer gives a guarantee to the seller that the buyer will pay the amount in proper time. If there is default or buyer is unable to pay the amount, the whole or due amount is paid by the bank.

2. Letter of credit is more secure than the letter of Understanding because it contains details of purchase by the buyer, date of issue, goods purchase, expiry date and all other documents.

3. In Letter of Undertaking message of the consent of the  buyer’s Bank is transferred from a channel called Society for Worldwide Interbank Financial Telecommunication (SWIFT) system to the overseas Bank.  Such SWIFT message should be recorded in Bank’s banking system. If it is not recorded in banking System It cannot be traced.

4. Letter of Undertaking is cheaper and requires less documentation than letter of credit.

F. What was PNB scam? Why LOU was banned by the RBI?

Nirav Modi, a billionaire jeweler defrauded the Punjab National Bank with a massive 1.77 billion (11,400 crore) scam. Nirav Modi with the help of the deputy manager of PNB Gokulnath Shetty and other bank officials of PNB procured Letter of Understanding from PNB for 7 years to pay his diamond suppliers. When LOU is issued,  consent of the bank should pass through a message channel called SWIFT system. Details in the SWIFT should be recorded in the banking system. In this case, with the help of banking officials, SWIFT message for the LOU issued to the Nirav Modi for past 7 years has not been recorded in the banking system. The guarantee by the bank never figured in the Bank’s Financial Statements. Thus this helps Nirav Modi to commit one of the biggest scams in India.

After Punjab National Bank (PNB) scam, letter of undertaking was banned by the RBI but RBI allowed to continue the issue of Letter of credit subject to the compliance of provisions contained in Department of Banking Regulation Master Circular No. DBR. No. Dir. BC.11/13.03.00/2015-16.

G. How a letter of credit is useful in trade

  • Letter of credit is an important instrument for international transactions. Uniform Customs and Practice for Documentary Credits (UCP) are the standardized rules for issuance and use of the letter of credit which facilitates the smooth running of business worldwide. UCP rules protect the parties from international fraud by framing unified rules to use the letter of credit internationally.
  • At present, UCP 600 rules are followed by the traders, bankers, and investors of almost 175 countries. UCP 600 came into effect on 1 July 2007. UCP 600 created clarity and removed vague and ambiguity from the definitions of important terms used in the international trade. UCP 600 provides detailed reorganized rules about how documents will be acknowledged and signed, how payment will be made to seller, means & modes of transport of goods, how communication will be made to parties, insurance of goods etc.
  • Letter of credit protects the interest of the seller. In international trade parties are connected through a distance, it is very difficult to have a mutual trust. The issuing bank will issue a letter of credit after checking the performance of the account of the buyer.  Letter of credit is a mechanism in which issuing bank guarantees creditworthiness of the buyer. The issuing bank will issue the letter of credit after checking the performance of the account of the buyer. The seller on such letter of credit starts trusting the buyer and it leads to the easy & smooth running of the trade.
  • It reduces the risk attached to International trade. for eg Suppose if a buyer makes a default, then the liability will be transferred to the Bank. It is very useful in the business of export and import. As goods are imported and exported from one country to another. Letter of credit gives assurance to the exporter that in case importer is unable to pay the required sum, he can easily recover it from the issuing or confirming bank.
  • Letter of credit ensures that payment and delivery of goods will be in proper time and at the proper place. It reduces the delay in payment and delivery of the goods & services.
  • Letter of credit also protects the interest of the buyer. Bank will pay the seller on the condition that the seller will produce valid documents before the bank. Solvency and the creditworthiness of buyer can also be ensured by the issuance of the letter of credit. It helps the buyer to purchase goods on the credit.
  • Buyer and seller face many challenges in the business. Buyer is afraid of the condition of goods which is to be delivered and the seller is afraid of the creditworthiness of the buyer and letter of credit helps to solve this problem. There is a legal contract between seller and buyer on the guarantee that payment will be made on delivery of the good.
  • Letter of credit is the mechanism from which transactions in the business can be controlled and maintained.
  • After digitalization, letter of credits is issued in electronic form. Thus it reduces the time and efforts for completion of the transaction.

Conclusion

In present times, the letter of credit has become an important tool for the business. It provides security to both the buyer and seller. Mainly letter of credit is issued for international transactions for eg. export and import etc. but it can be issued for domestic transactions also. Letter of credit is governed by the law of contracts. The purpose of forming standardized UCP rules is to avoid unnecessary litigation. Letter of credit protects newly entered company from trade risks. Letter of credit provides flexibility in the business which leads to an easy and smooth transaction. In the future, the letter of credit will become more prevalent for international business & also it will reduce the time & cost of the parties.

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