Letters of Credit (LC): Basic Concepts – Part I

CS Deepak Pratap Singh

A Trade is defined as activity of buying and selling or exchanging goods and /or services between people and countries.

Every country does not have all-natural resources, technology etc., and no one can trade with himself to earn profit. There should be two separate people and countries for trade. When traders buy or sell their goods and /or services within territory of their own country, this is called domestic trade. The domestic sale happens within territorial waters of the country and regulatory laws applicable will be laws as enforceable within the country. The traders have no risk of doing business in their country, because of they are aware of Rules and Regulations, Government Policies and Taxation Statutes of their own country.

Now after globalization and from ancient ear, India is dream destination of various foreign traders. India has world largest skilled manpower as well as natural resources. The Indian corporates have developed themselves and are giving competition to world leaders. The demand of Indian goods and / or services is soaring in foreign market. The Indian entrepreneurs have already made impact in the International Market.

Read- Letters of Credit (LC): Basic Concepts – Part II

Foreign Trade, also referred as International trade, it is the exchange money (capital), men (people) material(goods) and services between countries. Foreign Trade has serious implications on the economy of every country.

The main feature of an International Trade is the goods, people or money (capital) crosses the international borders of Country, possessing various types of risks.

Since foreign trade is necessity of every country, specially when the world is turning just like a global village due to modern technology and ease of doing business.

As defined by ADAM SMITH; “It is the maxim of every prudent master of a family, never attempt to make at home what it will cost him more to make than to buy.

It means that if a foreign country supplies us some products at a rate, which is cheaper than the cost of production of that product in our country, then it is better to buy such product from foreign market.

Though international trade is riskier than domestic trade, but the advantages are said to be outweigh the risk associated with it.

THERE ARE VARIOUS TYPES OF PAYMENT METHODS TO SETTLE AN INTERNATIONAL TRADE; LETTERS OF CREDIT (LCs) IS ONE OF THEM.

A” LETTERS OF CREDIT: is an irrevocable, written undertaking by a commercial bank, issued at the request of the buyer (applicant) in favor of seller(beneficiary), to the effect that payment for certain goods or services will be made against a complying presentation of documents.

INVESTOPEDIA: A letter of credit is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.

WIKIPEDIA:  letter of credit (LC), also known as a documentary credit, bankers commercial credit, is a payment mechanism used in international trade to perform the same economic function as a guarantee, by allocating risk undertaken by contracting parties. At law, a letter of credit is categorized within Financial law as a form of a Simple position, which alongside guarantees, derivatives, and insurance allocate risk as a form of a promise from one party to another.

A letter of credit primarily achieves this by creating a written commitment from a bank on behalf of one party that payment be made to a third-party, provided that the terms and conditions stated therein have been met. Any documents tendered which are outlined in the letter of credit, the third party will be paid by the bank.^[1][2] A letter of credit is extremely common within international trade and goods delivery, where the reliability of contracting parties cannot be readily and easily determined. Its economic effect is to introduce a bank as underwriting the credit risk of the buyer paying the seller for goods.

Article 2 of UCP 600(Uniform Customs and Practice for Documentary Credits) promulgated by International Chamber of Commerce defines: “Any arrangement however named or described, that is irrevocable and thereby constitutes a defined undertaking of the issuing bank to honour a complying presentation.”

Now while going through above definition of UCP 600, we know that Letters of Credit is an irrevocable instrument from its inception and it need not to be written on the face of the instrument.

NEED TO ISSUE LETTERS OF CREDIT; We know that the creditworthiness of a buyer though very good in international market but not absolute. There are various circumstances beyond his control, which will hamper his creditworthiness. Through LCs the issuing bank replaces the buyer’s assurance of payment with its own undertaking to pay against complying presentation of documents, irrespective of whether the buyer or importer pays or not. The Letters of Credits also mitigate some of the other risks, which are related to international trade.

LCs offers better security to both buyer and seller, since the assurance of payment is offered by an independent, third party, specially institutions such as internationally reputed banks.

The payment will be release when seller presents documents exactly as specified in the terms of issue of LCs.

RULES GOVERNING LETTERS OF CREDIT;

The provisions of “Uniform Customs and Practice for Documentary Credits (UCP)” governs Letters of Credit. The UCP is a universally recognised set of rules governing the use of documentary credits in International Trade. The Banking Associations and individual banks in more than 160 countries have adopted UCP. The ICC (International Chamber of Commerce) has published UCP in 1933 and after it is revised in 1951, 1962, 1974 and recently in 1^st July, 2007(UCP 600).

The provisions of UCP 600 are applicable to both International as well as Domestic Traders, provided that it is written on thee documents that it will govern according to the provisions of UCP, 600.

LEGAL STATUS OF UCP 600: it has no legal status in any country or state. It is simple a set of rules introduced for better practices in International Trade and Finance. It is a codified, standardised best practices or Code of conduct for the operation of Letters of Credit. It creates a bridge in international finance and trusted by various countries. This is widely accepted all over the world in International Trade and Finance.

PARTIES TO LETTERS OF CREDIT;

Article 10(a) of UCP 600 states that “except as otherwise provided in Article 38 a credit can neither been amended nor cancelled without agreement of the issuing bank, the confirming bank if any and the beneficiary.

Now from above Article it is derived that the parties to the Letters of Credit does not includes the “Applicant”.

i) The issuing bank;

ii) The confirming bank; and

iii) The beneficiary.

The “Parties to the Credits” are those that have express obligations under the credit and none others. Since a Letters of Credit is a direct undertaking of the issuing bank to the beneficiary. No third party shares its commitment or involved in it. That is why “The Applicant” has kept out of definition of Parties.

TYPES OF LETTERS OF CREDIT

I) CLEAN LETTERS OF CREDIT; is a Letters of Credit, which does not call either for Financial Document(s) or Commercial Document(s).

II) DOCUMENTRY LETTERS OF CREDIT; When LC is used in conjunction with Financial or Commercial Documents or both is termed as “Documentary Letters of Credit.”

NOTE: We come across also with two terms such as IMPORT LC and EXPORT LC. These are the same instruments but treated in different perspectives. Such as a Letters of Credit for a country in which goods and / or services are exported, the buyer will treat it as IMPORT LC and seller in India will treat it as EXPORT LC.  

PROCESS OF ISSUANCE OF LETTERS OF CREDIT;

I) Agreement between buyer and seller. The agreement must say that the payment should be settled through documentary letters of credit;

II) Buyer applied for issue of Documentary letters of credit and submits its application with bank for issue of LC with a copy of Sale Contract and other documents as required by the bank.

III) The buyers’ bank issues LCs and transmit the same through another bank (advising bank) for being advised to the beneficiary. If LC is to be confirmed, advising bank is requested and authorised by the issuing bank to add its confirmation to the credit, prior to it being advised to the beneficiary.

IV) The issuing bank will furnish a copy Letters of Credit to the buyer. The buyer will check the terms and conditions of LC, whether it is in accordance with Agreement with Seller and if he is not satisfied with them, then he reports the discrepancies to the issuing bank and issuing bank will take appropriate decision to ratify the same. Same opportunity will be given to the seller to look into the terms of issue of LC.

V) Advising bank advises LC to the beneficiary, the advising bank adds confirmation to the LC only if (I) it has been requested by the issuing bank; (ii) it agrees to do comply with such request. The Advising Bank checks the apparent authencity of LC and accordingly advises the Beneficiary;

VI) Beneficiary receives the LC and it is his duty to examine the terms and conditions of issue of LC, whether it is in accordance with the terms and conditions of Agreement/ Contract with buyer as mutually agreed. It beneficiary require any modification then he request the Applicant (Buyer) to amend the same;

VII) The buyer should inform amendment if any suggested by the Seller to the issuing bank and same will be after compliance communicated to the beneficiary through Advising bank;

VIII) The beneficiary has option not to accept the amendment and no amendment is operative till formally accepted by the beneficiary and same will be communicated to the Advising Bank. If not so communicated to the Advising Bank, but if beneficiary acts on the amendments and present the documents confirming to the amendments, it is deemed to have accepted the amendments.

NOTE: IN NEXT ARTICLE WE SHALL DISCUSS THE WAY LETTERS OF CREDIT WORKS AND VARIOUS IMPLICATIONS.