Letters of Credit - An Introduction

This guide is an introduction to letters of credit (L/C) - also referred to by banks and other Financial institutions as documentary credits. The guide tells you what a letter of credit is, the types of letter of credit available and the internationally agreed rules that govern their operation. You should read this guide together with the guide Letters Of Credit - Best Practice and SITPRO's set of three Letters of Credit Checklists and Guides for Importers, Exporters and Export Sales Representatives. The checklist designed for importers is to be used by purchasing when applying to local banks for letters of credit. The one for exporters is intended primarily for use in export sales and shipping departments. The export sales representative's guide advises on credits and some of the other responsibilities assumed on overseas visits. To ensure a letter of credit is workable, trouble-free and provides the security of payment for which the credit was requested in the first place, it is essential to take simple yet effective at the start. Working through the checkpoints set out in the various sections of the guide will help precautions reduce discrepancies and associated unplanned costs. Successive surveys by SITPRO and others have shown that well in excess of fifty percent of documents presented by exporters to banks for payment under letters of credit are rejected on first presentation. This can cause expensive delays for both the exporter and the importer and may even result in a lesser payment or no payment at all. A great many of those rejections could be avoided if more care was taken to ensure that the documents called for in the credit are properly completed. The SITPRO Letters of Credit Checklists and Guides are designed to minimise unnecessary costs and risk when trading on the basis of letters of credit. They are aligned with and based on interpretation of Uniform Customs & Practice for Documentary Credits (UCP), produced by the International Chamber of Commerce (ICC). The current revision, UCP 600, is available from ICC UK Definition In simple terms, a letter of credit is an undertaking by a bank to make a payment to a named Beneficiary within a specified time, against the presentation of documents which comply strictly with the terms of the letter of credit. Its main advantage is providing security to both the exporter and the importer, but the security offered however, comes at a price and must be weighed against the additional costs resulting 2 SITPRO Financial Guide: Letters of Credit - An Introduction from bank charges. The exporter must understand the conditional nature of the letter of credit and the fact that payment will not be made unless the terms of the credit are met precisely. An importer/buyer (Applicant) may open a letter of credit if they wish to ensure that the exporter/seller (Beneficiary) has performed those requirements as per the underlying sales contract, by making the documentation requested conditions of the credit. (N.B. The sales contract is not an inherent part of the letter of credit, although the letter of credit may contain a reference to such contract). When an exporter asks for payment by letter of credit, he is transferring the risk of non-payment by the buyer to the Issuing Bank -and the Confirming Bank if the letter of credit is confirmed-, providing the exporter presents the required documents in strict compliance with the credit, with the exception of cash in advance. For the exporter a letter of credit is the most secure method of payment in international trade provided the terms of the credit are met.

The following diagram shows those involved in a letter of credit transaction: All parties in the letter of credit transaction deal with documents, not goods. Should letter of credit be chosen as the payment method? An importer should only be thinking of opening a letter of credit if his country's exchange control regulations require it or if the exporter insists upon it. Otherwise, the procedure ought to be avoided because it can quite often cause problems for both parties. ADVISING/ CONFIRMING BANK IMPORTER (Applicant) EXPORTER Underlying Contract (Beneficiary) ISSUING BANK Exporters will need to be certain that it is necessary to use a letter of credit. Typical considerations include: Is it a legal requirement in the importing country? What is the country risk of the importing country Would a confirmed letter of credit be more suitable? What is the usual practice in trading with that country and in that particular commodity? What is the value of the order? Will the bank charges be out of proportion to the value? What is the importer's credit rating? Are they a new customer or has a trading relationship already been established? What is the standing of the Issuing bank? Would a confirmed letter of credit be more suitable? Recommendation by banks who may advise that the best method of payment is a "confirmed irrevocable letter of credit" irrespective of the country, strength of issuing bank and without much regard to the value of the consignment Insistence by a Credit Insurer to trade on letter of credit terms with buyers in certain markets. Are there any other measures that could be taken to protect the exporter - e.g. credit insurance? Strategic decision made by the exporter - this strategy should be flexible to adapt to the changing risk profile of both the country and the buyer "Always traded this way" The reasons for requesting this method of payment should be periodically re-assessed Types of Letters of Credit Irrevocable It can be neither amended nor cancelled without the agreement of all the parties to the credit The Issuing bank gives a binding undertaking to the Beneficiary provided all the credit terms and conditions are fulfiled Under UCP 600 all letters of credit are irrevocable Unconfirmed A letter of credit forwarded by the Advising bank directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity

Confirmed Where a bank usually in the Beneficiary's country, adds its own undertaking confirming that payment will be made as long as compliant documents are presented This commitment holds even if the Issuing bank or the Applicant fails to make payment Confirmation gives the exporter added security, particularly if the standing of the Issuing bank is unknown or the current political and economic state of the importer's country is uncertain Note: Banks may not wish to confirm letters of credit issued in certain countries A bank will make an additional charge for confirming a letter of credit Confirmation costs will vary according to the country involved, but for many countries considered a high risk it will be between 2%-8% Standby letter of credit A secondary payment mechanism used as support where an alternative, less secure, method of payment has been agreed The parties involved with the transaction do not expect that the letter of credit will ever be drawn upon They are also used in the United States of America in place of bank guarantees Often used to guarantee performance or to strengthen the credit-worthiness of a customer Should the exporter fail to receive payment from the importer he may claim under the standby letter of credit Certain documents are likely to be required to obtain payment including: The standby letter of credit itself; Sight draft for the amount due; Copy of the unpaid invoice; Proof of dispatch; and A signed declaration from the Beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit The International Chamber of Commerce rules for operating standby letters of credit are UCP600 and ISP98 International Standby Practices Revolving letter of credit Used for regular shipments of the same commodity between the same exporter and importer The credit must state that it is a revolving letter of credit It may revolve either automatically or subject to certain provisions Avoids the need for repetitious arrangements for opening or amending letters of credit can revolve in relation to time or value If the credit is time revolving once utilised it is re-instated for further regular shipments until the credit is fully drawn If the credit revolves in relation to value once utilised and paid the value can be reinstated for further drawings SITPRO Financial Guide: Letters of Credit - An Introduction 5 Transferable letter of credit The exporter has the right to request the paying or negotiating bank to make part (or all) of the credit value available to third parties Useful for those acting as middlemen, especially where there is a need to finance purchases from third party

suppliers At the request of the (first) Beneficiary, it may be made available in whole or in part to another (second) Beneficiary A credit may be transferred in part to more than one second Beneficiary Back to back letter of credit Can be used as an alternative to the transferable letter of credit A letter of credit is used as security to establish a second letter of credit issued by the Advising Bank in favour of the exporters merchandise supplier rather than transferring the original letter of credit to the supplier Many banks are reluctant to issue back to back letters of credit due to the level of risk to which they are exposed, whereas a transferable credit will not expose them to risk higher than that under the original credit Uniform Customs and Practice for Documentary Credits (UCP) Most letters of credit are subject to UCP: the universally recognised set of rules governing the use of the documentary credits in international trade. UCP was originally formulated in 1933 by the International Chamber of Commerce (ICC) and the current revision (UCP 600) came into effect on 1st July 2007. All definitions and general documentary requirements referred to in this briefing are in accordance with UCP 600 unless otherwise stated (it should be remembered that in some instances this may differ from national law). SITPRO would recommend using letters of credit that are subject to UCP 600. It is important to negotiate, as soon as possible, which party will bear the bank charges. It is worth remembering that on a small transaction these may be out of proportion and if these costs are not included in the pricing any profit may be completely eroded. SITPRO Guides Financial ddAn definiation KingsgA standard, commercial letter of credit (LC[1]) is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking. The letter of credit can also be payment for a transaction, meaning that redeeming the letter of credit pays an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. In such cases, the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies (UCP 600 being the latest version).[2] They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will

be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheques. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and documents proving the shipment was insured against loss or damage in transit. ate Hous Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. There are basically two types: commercial and standby. The commercial letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit is a secondary payment mechanism. Commercial Letter of Credit Commercial letters of credit have been used for centuries to facilitate payment in international trade. Their use will continue to increase as the global economy evolves. Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and definitions of the International Chamber of Commerce are binding on all parties. Domestic collections in the United States are governed by the Uniform Commercial Code. A commercial letter of credit is a contractual agreement between a bank, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank's customer as the payor. Elements of a Letter of Credit

A payment undertaking given by a bank (issuing bank) On behalf of a buyer (applicant) To pay a seller (beneficiary) for a given amount of money On presentation of specified documents representing the supply of goods Within specified time limits Documents must conform to terms and conditions set out in the letter of credit Documents to be presented at a specified place

Beneficiary The beneficiary is entitled to payment as long as he can provide the documentary evidence required by the letter of credit. The letter of credit is a distinct and separate transaction from the contract on which it is based. All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the customer and beneficiary. The

issuing bank's obligation to the buyer, is to examine all documents to insure that they meet all the terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants that all conditions of the agreement have been complied with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the bank. Issuing Bank The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable amount of time after receipt of the documents to honor the draft. The issuing banks' role is to provide a guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due and to examine the documents, and only pay if these documents comply with the terms and conditions set out in the letter of credit. Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill and an insurance document; but there are many others. Letters of credit deal in documents, not goods. Advising Bank An advising bank, usually a foreign correspondent bank of the issuing bank will advise the beneficiary. Generally, the beneficiary would want to use a local bank to insure that the letter of credit is valid. In addition, the advising bank would be responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. If the issuing bank does not pay the beneficiary, the advising bank is not obligated to pay. Confirming Bank The correspondent bank may confirm the letter of credit for the beneficiary. At the request of the issuing bank, the correspondent obligates itself to insure payment under the letter of credit. The confirming bank would not confirm the credit until it evaluated the country and bank where the letter of credit originates. The confirming bank is usually the advising bank. Letter of Credit Characteristics Negotiability Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed freely from one party to another almost in the same way as money. To be negotiable, the letter of credit must include an unconditional promise to pay, on demand or at a definite time. The nominated bank becomes a holder in due course. As a holder in due course, the holder takes the letter of credit for value, in good faith, without notice of any claims against it. A holder in due course is treated favorably under the UCC. The transaction is considered a straight negotiation if the issuing bank's payment obligation extends only to the beneficiary of the credit. If a letter of credit is a straight negotiation it is

referenced on its face by "we engage with you" or "available with ourselves". Under these conditions the promise does not pass to a purchaser of the draft as a holder in due course. Revocability Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction that involves a revocable letter of credit, it serves as the advising bank. Once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honored, the letter of credit cannot be revoked. The revocable letter of credit is not a commonly used instrument. It is generally used to provide guidelines for shipment. If a letter of credit is revocable it would be referenced on its face. The irrevocable letter of credit may not be revoked or amended without the agreement of the issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and the terms and conditions are complied with, payment will be made. If a letter of credit is irrevocable it is referenced on its face. Transfer and Assignment The beneficiary has the right to transfer or assign the right to draw, under a credit only when the credit states that it is transferable or assignable. Credits governed by the Uniform Commercial Code (Domestic) maybe transferred an unlimited number of times. Under the Uniform Customs Practice for Documentary Credits (International) the credit may be transferred only once. However, even if the credit specifies that it is nontransferable or nonassignable, the beneficiary may transfer their rights prior to performance of conditions of the credit. Sight and Time Drafts All letters of credit require the beneficiary to present a draft and specified documents in order to receive payment. A draft is a written order by which the party creating it, orders another party to pay money to a third party. A draft is also called a bill of exchange. There are two types of drafts: sight and time. A sight draft is payable as soon as it is presented for payment. The bank is allowed a reasonable time to review the documents before making payment. A time draft is not payable until the lapse of a particular time period stated on the draft. The bank is required to accept the draft as soon as the documents comply with credit terms. The issuing bank has a reasonable time to examine those documents. The issuing bank is obligated to accept drafts and pay them at maturity. Standby Letter of Credit The standby letter of credit serves a different function than the commercial letter of credit. The commercial letter of credit is the primary payment mechanism for a transaction. The standby letter of credit serves as a secondary payment mechanism. A bank will issue a standby letter of

credit on behalf of a customer to provide assurances of his ability to perform under the terms of a contract between the beneficiary. The parties involved with the transaction do not expect that the letter of credit will ever be drawn upon. The standby letter of credit assures the beneficiary of the performance of the customer's obligation. The beneficiary is able to draw under the credit by presenting a draft, copies of invoices, with evidence that the customer has not performed its obligation. The bank is obligated to make payment if the documents presented comply with the terms of the letter of credit. Standby letters of credit are issued by banks to stand behind monetary obligations, to insure the refund of advance payment, to support performance and bid obligations, and to insure the completion of a sales contract. The credit has an expiration date. The standby letter of credit is often used to guarantee performance or to strengthen the credit worthiness of a customer. In the above example, the letter of credit is issued by the bank and held by the supplier. The customer is provided open account terms. If payments are made in accordance with the suppliers' terms, the letter of credit would not be drawn on. The seller pursues the customer for payment directly. If the customer is unable to pay, the seller presents a draft and copies of invoices to the bank for payment. The domestic standby letter of credit is governed by the Uniform Commercial Code. Under these provisions, the bank is given until the close of the third banking day after receipt of the documents to honor the draft. Procedures for Using the Tool The following procedures include a flow of events that follow the decision to use a Commercial Letter of Credit. Procedures required to execute a Standby Letter of Credit are less rigorous. The standby credit is a domestic transaction. It does not require a correspondent bank (advising or confirming). The documentation requirements are also less tedious. Step-by-step process:

Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment. Buyer applies to his bank for a letter of credit in favor of the seller. Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming). The correspondent bank is usually located in the same geographical location as the seller (beneficiary). Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary). Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a particular company. Seller presents the required documents to the advising or confirming bank to be processed for payment.

Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit. If the documents are correct, the advising or confirming bank will claim the funds by: o Debiting the account of the issuing bank. o Waiting until the issuing bank remits, after receiving the documents. o Reimburse on another bank as required in the credit. Advising or confirming bank will forward the documents to the issuing bank. Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer's account. Issuing bank then forwards the documents to the buyer.

Standard Forms of Documentation When making payment for product on behalf of its customer, the issuing bank must verify that all documents and drafts conform precisely to the terms and conditions of the letter of credit. Although the credit can require an array of documents, the most common documents that must accompany the draft include: Commercial Invoice The billing for the goods and services. It includes a description of merchandise, price, FOB origin, and name and address of buyer and seller. The buyer and seller information must correspond exactly to the description in the letter of credit. Unless the letter of credit specifically states otherwise, a generic description of the merchandise is usually acceptable in the other accompanying documents. Bill of Lading A document evidencing the receipt of goods for shipment and issued by a freight carrier engaged in the business of forwarding or transporting goods. The documents evidence control of goods. They also serve as a receipt for the merchandise shipped and as evidence of the carrier's obligation to transport the goods to their proper destination. Warranty of Title A warranty given by a seller to a buyer of goods that states that the title being conveyed is good and that the transfer is rightful. This is a method of certifying clear title to product transfer. It is generally issued to the purchaser and issuing bank expressing an agreement to indemnify and hold both parties harmless. Letter of Indemnity Specifically indemnifies the purchaser against a certain stated circumstance. Indemnification is generally used to guaranty that shipping documents will be provided in good order when available. Common Defects in Documentation About half of all drawings presented contain discrepancies. A discrepancy is an irregularity in the documents that causes them to be in non-compliance to the letter of credit. Requirements set forth in the letter of credit cannot be waived or altered by the issuing bank without the express consent of the customer. The beneficiary should prepare and examine all documents carefully

before presentation to the paying bank to avoid any delay in receipt of payment. Commonly found discrepancies between the letter of credit and supporting documents include:

Letter of Credit has expired prior to presentation of draft. Bill of Lading evidences delivery prior to or after the date range stated in the credit. Stale dated documents. Changes included in the invoice not authorized in the credit. Inconsistent description of goods. Insurance document errors. Invoice amount not equal to draft amount. Ports of loading and destination not as specified in the credit. Description of merchandise is not as stated in credit. A document required by the credit is not presented. Documents are inconsistent as to general information such as volume, quality, etc. Names of documents not exact as described in the credit. Beneficiary information must be exact. Invoice or statement is not signed as stipulated in the letter of credit.

When a discrepancy is detected by the negotiating bank, a correction to the document may be allowed if it can be done quickly while remaining in the control of the bank. If time is not a factor, the exporter should request that the negotiating bank return the documents for corrections. If there is not enough time to make corrections, the exporter should request that the negotiating bank send the documents to the issuing bank on an approval basis or notify the issuing bank by wire, outline the discrepancies, and request authority to pay. Payment cannot be made until all parties have agreed to jointly waive the discrepancy. Tips for Exporters

Communicate with your customers in detail before they apply for letters of credit. Consider whether a confirmed letter of credit is needed. Ask for a copy of the application to be fax to you, so you can check for terms or conditions that may cause you problems in compliance. Upon first advice of the letter of credit, check that all its terms and conditions can be complied with within the prescribed time limits. Many presentations of documents run into problems with time-limits. You must be aware of at least three time constraints - the expiration date of the credit, the latest shipping date and the maximum time allowed between dispatch and presentation. If the letter of credit calls for documents supplied by third parties, make reasonable allowance for the time this may take to complete. After dispatch of the goods, check all the documents both against the terms of the credit and against each other for internal consistency.

Summary The use of the letters of credit as a tool to reduce risk has grown substantially over the past

decade. Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. The credit professional should be familiar with two types of letters of credit: commercial and standby. Commercial letters of credit are used primarily to facilitate foreign trade. The commercial letter of credit is the primary payment mechanism for a transaction. The standby letter of credit serves a different function. The standby letter of credit serves as a secondary payment mechanism. The bank will issue the credit on behalf of a customer to provide assurances of his ability to perform under the terms of a contract. Upon receipt of the letter of credit, the credit professional should review all items carefully to insure that what is expected of the seller is fully understood and that he can comply with all the terms and conditions. When compliance is in question, the buyer should be requested to amend the credit.

ter of Credit, Standard Example:

sitpro.org.uk SITPRO Ltd. is a company limited by guarantee Registered in England & Wales No: 4188890 Copyright SITPRO Ltd. 2007 This guide may not be republished, in full or in part, without SITPROs prior permission UCP600 contains the rules for the use of letters of credit. Where there are any inconsistencies with this guide, UCP600 wi Steps in the Letter of Credit Process I. Buyer and seller agree to terms including means of transport, period of credit offered (if any), and latest date of shipment acceptable. Buyer applies to bank for issue of letter of credit. Bank will evaluate buyer's credit standing, and may require cash cover and/or reduction of other lending limits. Issuing bank issues LC, sending it to the Advising bank by airmail or electronic means such as telex or SWIFT. Advising bank establishes authenticity of the letter of credit using signature books or test codes, then informs seller (beneficiary). Seller should now check that LC matches commercial agreement and that all its terms and conditions can be satisfied. Seller ships the goods, then assembles the documents called for in the LC (invoice, transport document, etc.). The Advising bank checks the documents against the LC. If the documents are compliant, the bank pays the seller and forwards the documents to the Issuing bank. The Issuing bank now checks the documents itself. If they are in order, it reimburses the seller's bank immediately. The Issuing bank debits the buyer and releases the documents (including transport document), so the buyer can claim the goods

II.

III. IV.

V. VI. VII.

VIII. IX.

from the carrier.

What is a Letter of Credit? A letter of credit is a banking mechanism which allows importers to offer secure terms to exporters. All letters of credit contain these elements:

a payment undertaking given by the bank (issuing bank) on behalf of the buyer (applicant) to pay a seller (beneficiary) a given amount of money on presentation of specified documents representing the supply of goods within specific time limits these documents conforming to terms and conditions set out in the letter of credit documents to be presented at a specified place.

Put simply, the issuing banks role is twofold:

to guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due. This offers security to the seller the bank says in effect We will pay you if you present documents (XYZ) to examine the documents, and only pay if these comply with the terms and conditions set out in the letter of credit. This protects the buyers interests the bank says We will only pay your supplier on your behalf if they present documents (XYZ) that you have asked for

Note that the letter of credit refers to documents representing the goods not the goods themselves! Banks are not in the business of examining goods on behalf of their customers Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill, an insurance document; but there are many others. Letters of credit deal in documents, not goods.

The stages of the letter of credit 1. Buyer and seller agree terms, including means of transport, period of credit offered (if any), latest date of shipment, In co term to be used 2. Buyer applies to bank for issue of letter of credit. Bank will evaluate buyers credit standing, and may require cash cover and/or reduction of other lending limits 3. Issuing bank issues L/C, sending it to the Advising bank by airmail or (more commonly) electronic means such as telex or SWIFT 4. Advising bank establishes authenticity of the letter of credit using signature books or test codes, then informs seller (beneficiary). Advising bank MAY confirm L/C, i.e. add its own payment undertaking 5. Seller should now check that L/C matches commercial agreement, and that all its terms and conditions can be satisfied, (e.g. all documents can be obtained in good time.) If there is anything that may cause a problem, an AMENDMENT must be requested. 6. Seller ships the goods, and then assembles the documents called for the L/C (invoice, transport document etc.) Before presenting the documents to the bank, the seller should check them for discrepancies with the L/C, and correct the documents where necessary. 7. The documents are presented to a bank, often the Advising bank. The Advising bank checks the documents against the L/C. If the documents are compliant, the bank pays the seller and forwards the documents to the Issuing bank 8. The Issuing bank now checks the documents itself. If they are in order (and it is a sight L/C), it reimburses the sellers bank immediately 9. The Issuing bank debits the buyer and releases the documents (including transport document), so that the buyer can claim the goods from the carrier.

ll prevail.

Commercial Letter of Credit Flow Applicant approaches Issuing/ Opening Bank with LC application form duly filled and requests Issuing Bank to issue a Letter of Credit in favour of Beneficiary. 1. Issuing Bank issues a Letter of Credit as per the application submitted by an Applicant and sends it to the Advising Bank, which is located in Beneficiarys country, to formally advise the LC to the beneficiary. 2. Advising Bank advises the LC to the Beneficiary. 3. Once Beneficiary receives the LC and if it suits his/ her requirements, he/ she prepares the goods and hands over them to the carrier for dispatching to the Applicant. 4. He/ She then hands over the documents along with the Transport Document as per LC to the Negotiating Bank to be forwarded to the Issuing Bank. 5. Issuing Bank reimburses the Negotiating Bank with the amount of the LC post Negotiating Banks confirmation that they have negotiated the documents in strict conformity of the LC terms. Negotiating Bank makes the payment to the Beneficiary. 6. Simultaneously, the Negotiating Bank forwards the documents to the Issuing Bank to be released to the Applicant to claim the goods from the carrier. 7. Applicant reimburses the Issuing Bank for the amount, which it had paid to the Negotiating Bank. 8. Issuing Bank releases all documents along with the titled Transport Documents to the Applicant. Settlements Under a Letter of Credit

All commercial letters of credit must clearly indicate whether they are payable by sight payment, by deferred payment, by acceptance, or by negotiation. These are noted as formal demands under the terms of the commercial letter of credit. In a sight payment, the commercial letter of credit is payable when the beneficiary presents the complying documents and if the presentation takes place on or before the expiration of the commercial letter of credit. In a deferred payment, the commercial letter of credit is payable on a specified future date. The beneficiary may present the complying documents at an earlier date, but the commercial letter of credit is payable only on the specified future date. An acceptance is a time draft drawn on, and accepted by, a banking institution, which promises to honor the draft at a specified future date. The act of acceptance is without recourse as it is a commitment to pay the face amount of the accepted draft. Under negotiation, the negotiating bank, a third party negotiator, expedites payment to the beneficiary upon the beneficiarys presentation of the complying documents to the negotiating bank. The bank pays the beneficiary, normally at a discount of the face amount of the value of the documents, and then presents the complying documents, including a sight or time draft, to the issuing bank to receive full payment at sight or at a specified future date. Types of Letter of Credit Irrevocable An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all parties to the credit. Under UCP500 all letters of credit are deemed to be irrevocable unless otherwise stated. Here, the importer's bank gives a binding undertaking to the supplier provided all the terms and conditions of the credit are fulfilled. Unconfirmed The advising bank forwards an unconfirmed letter of credit directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity. Confirmed A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This commitment holds even if the issuing bank or the buyer fails to make payment. The added security to the exporter of confirmation needs to be considered in the context of the standing of the issuing bank and the current political and economic state of the importer's country. A bank will make an additional charge for confirming a letter of credit. In many cases, the confirming bank is located in Beneficiarys country. Confirmation costs will vary according to the country involved, but for many countries

considered a high risk will be between 2%-8%. There also may be countries issuing letters of credit, which banks do not wish to confirm - they may already have enough exposure in that market or not wish to expose themselves to that particular risk at all. Standby Letters of Credit A standby letter of credit is used as support where an alternative, less secure, method of payment has been agreed. They are also used in the United States of America in place of bank guarantees. Should the exporter fail to receive payment from the importer he may claim under the standby letter of credit. Certain documents are likely to be required to obtain payment including: the standby letter of credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce publishes rules for operating standby letters of credit ISP98 International Standby Practices. Revolving Letter of Credit The revolving credit is used for regular shipments of the same commodity to the same importer. It can revolve in relation to time or value. If the credit is time revolving once utilised it is reinstated for further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once utilised and paid the value can be reinstated for further drawings. The credit must state that it is a revolving letter of credit and it may revolve either automatically or subject to certain provisions. Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit. Transferable Letter of Credit A transferable letter of credit is one in which the exporter has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers. Back-to-Back Letter of Credit A back-to-back letter of credit can be used as an alternative to the transferable letter of credit. Rather than transferring the original letter of credit to the supplier, once the letter of credit is received by the exporter from the opening bank, that letter of credit is used as security to establish a second letter of credit drawn on the exporter in favour of his importer. Many banks are reluctant to issue back-to-back letters of credit due to the level of risk to which they are exposed, whereas a transferable credit will not expose them to higher risk than under the original credit.

Advantages of Letter of Credit: 1. The beneficiary is assured of payment as long as it complies with the terms and conditions of the letter of credit. The letter of credit identifies which documents must be presented and the data content of those documents. The credit risk is transferred from the applicant to the issuing bank. 2. The beneficiary can enjoy the advantage of mitigating the issuing banks country risk by requiring that a bank in its own country confirm the letter of credit. That bank then takes on the country and commercial risk of the issuing bank and protects the beneficiary. 3. The beneficiary minimizes collection time as the letter of credit accelerates payment of the receivables. 4. The beneficiarys foreign exchange risk is eliminated with a letter of credit issued in the currency of the beneficiarys country. Risks involved in Letter of Credit. 1. Since all the parties involved in Letter of Credit deal with the documents and not with the goods, the risk of Beneficiary not shipping goods as mentioned in the LC is still persists. 2. The Letter of Credit as a payment method is costlier than other methods of payment such as Open Account or Collection 3. The Beneficiarys documents must comply with the terms and conditions of the Letter of Credit for Issuing Bank to make the payment. 4. The Beneficiary is exposed to the Commercial risk on Issuing Bank, Political risk on the Issuing Banks country and Foreign Exchange Risk in case of Usance Letter of Credits. Applicant

The applicant is the party who requests and instructs the issuing bank to open a letter of credit (L/C) in favor of the beneficiary. The applicant usually is the importer or the buyer of goods and/or services. The applicant in the sample letter of credit is DEF Imports. The applicant can also be another party acting on behalf of the importer, such as a confirming house. The confirming house is equivalent to a buying office, it acts as an intermediary between importer and exporter, and it can be located in a third country or in the exporter's country. The confirming house negotiates and books the order on behalf of the importer and guarantees payment to the exporter, and often finances the importer. When dealing with importers in a country with a foreign exchange shortage, for example Nigeria, the exporter may deal with the confirming house in the United Kingdom (U.K.) or in other areas to ensure payment.

Beneficiary

The beneficiary is the party in whose favor a letter of credit (L/C) is opened by the issuing bank. The beneficiary usually is the exporter or the seller of goods and/or services. The beneficiary in the sample letter of credit is UVW Exports.

Issuing Bank

The issuing bank---opening bank---opens a letter of credit (L/C) in favor of the beneficiary, at the request and on the instructions of the applicant. The issuing bank usually is located in the applicant's country. The issuing bank in the sample letter of credit is The Sun Bank.

Advising Bank

The advising bank---notifying bank---advises the beneficiary that a letter of credit (L/C) opened by the issuing bank is available to him/her and informs the beneficiary about the terms and conditions of the L/C. The advising bank is not necessarily responsible for the payment of the credit which it advises. The advising bank can be a branch office of the issuing bank or a correspondent bank, which usually is located in the beneficiary's country. The advising bank in the sample letter of credit is The Moon Bank. The issuing bank most often sends the L/C through its branch office or correspondent bank to avoid fraud. The branch office or the correspondent bank maintains specimen signature(s) on file where it may counter-check the signature(s) on the L/C, and it has a coding system---secret test key---to distinguish a genuine L/C from a fraudulent one. The exporter can request the importer to specify his/her bank (the exporter's bank) as the advising bank in an L/C application. The exporter's bank may not be the issuing bank's correspondent bank, thus the issuing bank may use other bank as the advising bank.

In many countries, it is beneficial to the exporter when the advising bank is the exporter's bank, where the exporter may avail the reduced bank charges and fees because of special relationships with the bank. In addition, it is more convenient to deal with the exporter's own bank over a bank with which the exporter does not maintain a business account.

Correspondent Bank

The term correspondent bank or correspondent used in international trade refers to another bank in another country with which the first bank maintains a banking service agreement. In the sample letter of credit the correspondent bank of The Sun Bank is The Moon Bank, and vice versa.

Confirming Bank

The advising bank which adds its confirmation to the credit, that is, adds its own promise to pay, upon authorization or request of the issuing bank is known as the confirming bank. The confirming bank in the sample letter of credit is The Moon Bank.

Nominated Bank

A bank designated by the issuing bank which is authorized to pay, to accept draft(s), to incur a deferred payment undertaking, or to negotiate the letter of credit (L/C) is known as the nominated bank. The nominated bank can be a party other than the advising bank. The nominated bank in the sample letter of credit is The Moon Bank.

Paying, Accepting or Negotiating Bank

The nominated bank which:

makes payment to the sight draft(s) drawn by the beneficiary is known as paying bank, accepts the term draft(s) drawn by the beneficiary is known as accepting bank, negotiates the draft(s) and/or documents presented by the beneficiary or bona fide holder is known as negotiating bank.

When the bank negotiates the draft(s) and/or documents, that is, the negotiation, it gives value to such draft(s) and/or documents, not just examination of the documents.

Transferring Bank

The paying, accepting or negotiating bank that makes the credit available in whole or in part to one or more second beneficiaries at the request of the first beneficiary is known as the transferring bank.

Claiming Bank and Reimbursing Bank

The claiming bank is a paying, accepting or negotiating bank which claims for reimbursement on another party called the reimbursing bank. The reimbursing bank can be a party other than the issuing bank authorized (by the issuing bank) to reimburse the claiming bank.

Checking the Incoming Letters of Credit

If the exporter receives a letter of credit (L/C) directly from an issuing bank in the importing country, he/she must be very careful if the integrity of the issuing bank is unknown and the authenticity of the credit is in question. Errors in the terms and conditions of a letter of credit may occur as a result of the applicant's error in preparing the L/C application and/or the issuing bank's error in preparing the L/C. The exporter must check the L/C immediately and thoroughly upon receipt from the bank, to ensure that the terms and conditions stipulated in the L/C are correct and conform to the sales contract, and that he/she can comply exactly to the L/C requirements. Otherwise, the exporter must immediately ask the importer to amend the L/C (please see Amendments of Letters of Credit). If any terms and conditions of the letter of credit are not complied with, no matter how small, a discrepancy is said to occur and it can delay or prevent the payment. The exporter should check the details of letter of credit, including the following:

The names and addresses are complete and spelled correctly. The L/C is irrevocable and confirmed by the advising bank, conforming to sales contract. The amount is sufficient to cover the consignment. The description of goods is correct. The quantity is correct. The unit price of goods, if stated in the L/C, conforms to the contract price. The latest date for shipment or the shipping date is sufficient to dispatch the consignment. The latest date for negotiation or the expiry date is sufficient to present the documents and draft(s) to the bank. The port (or point) of shipment and the port (or point) of destination are correct. The partial shipment/drawing is permitted or prohibited. The transhipment is permitted or prohibited. The L/C is transferable or non-transferable. The type of risk and the amount of insurance coverage, if required. The documents required are obtainable. The following words, or similar, are present in the L/C: "Unless otherwise expressly stated, this Credit is subject to the Uniform Customs and Practice for Documentary Credits, 1993 Revision, International Chamber of Commerce Publication No. 500."

The ICC (International Chamber of Commerce) Publication No. 500---Uniform Customs and Practice for Documentary Credits, 1993 Revision---operates from January 1, 1994. It is an update of the ICC Publication No. 400. Some banks may still use the ICC Publication No. 400. The publication is issued by the International Chamber of Commerce (ICC) in Paris, France. The ICC Publication No. 500 and other ICC publications are available at your local Chamber of Commerce affiliated with the ICC.