This article is written by Akarshana S pursuing Certificate Course in Introduction to Legal Drafting: Contracts, Petitions, Opinions & Articles from LawSikho.
Risks are very much common when it comes to international trade. Traders for a long time have been facing problems regarding the lack of common trade currency to make payments abroad and the lack of security while carrying precious items for trade. The practice of the letter of credit made it very much easier for the traders to get well benefited by avoiding risks and shifting the burden of payment on the banks. Letter of credit, which can also be called documentary credit, banker’s documentary letter of credit is one of the well-known old methods in practice for centuries. It has got a wealthy trace line from history which has helped it to reach a point where the letter of credit is considered as the very “lifeblood of commerce”.
Understanding letter of credit
Letter of credit is considered as a saviour to reduce risks in trade by shifting the obligation to pay from the buyer to the bank which acts as a payment guarantee in the transaction in return for the presentation of required documents as mentioned in the letter of credit. In simpler words, A letter of credit can be considered as a document issued by the bank that guarantees the buyer’s payment to the seller, when the buyer is unable to make the payment to the seller.
Parties to a letter of credit
The following parties are involved in the letter of credit:
The buyer on behalf of whom the letter of credit is issued on request.
- Advising bank: The bank operates in the beneficiary’s country and involves instructing the letter of credit, attesting its authenticity to the beneficiary.
- Confirming bank: This bank also generally functions in the beneficiary’s country. On the request or authorization of the issuing bank; the confirming bank comes into the transaction to add its guarantee to the letter of credit by taking responsibility in payment in addition to the bank issuing letter of credit.
- Issuing bank: The bank which issues the letter of credit and takes up the responsibility of payment.
- Nominating bank: The bank generally functions in the seller’s country and is specifically given authorization by the issuing bank to process the request and make the payment to the seller concerning the letter of credit made by the issuing bank.
- Reimbursing bank: The bank in which generally the issuing bank has a nostro account through which the payment is made to the nominated bank and they are allowed to address the reimbursement claim posted.
The seller in whose favour the letter of credit has been issued.
Working method of letter of credit
Step 1: Contract
Buyer to seller
Buyer and seller belonging to different countries enter into a sales contract, with a condition to make payment through letter of credit.
Step 2: Application
Buyer to issuing bank
The buyer then files a letter of credit application to his Issuing Bank and asks to issue the letter of credit against the pledge over documents correlated to the transaction.
Step 3: Letter of credit
Issuing bank to advising/confirming bank
Issuing bank issues letter of credit and forwards it to advising/confirming bank of the seller.
Step 4: Examination
Advising bank to the seller
The seller’s bank scrutinizes the letter of credit issued and sends information obtained to the seller.
Step 5: Shipping
Seller to buyer
The seller after receiving the information dispatches the goods to the buyer.
Step 6: Presentation of documents
Seller to advising bank
The seller then presents all the necessary documents listed under the letter of credit to the advising bank.
Step 7: Processing of documents
Advising bank to the issuing bank
The presented documents are forwarded to the issuing bank for scrutinization.
Step 8: Payment by advising bank
Advising bank to the seller
If the documents needed are presented and in place, then the advising bank initiates payment to the seller.
Step 9: Reimbursement
Issuing bank to the advising bank
After scrutinization and verification of the documents produced, the issuing bank initiates reimbursement for the payment made by the advising bank to the seller.
Step 10: Payment and release of documents
Buyer to the issuing bank
Buyer to make payment to the issuing bank and the issuing bank to release related documents after the payment.
Types of letter of credit
Revocable and irrevocable letter of credit
The issuing bank in its power can cancel or amend the letter of credit without the consent or prior notice to the beneficiary; such type is called a revocable letter of credit. This type of credit is considered very non-reliable as no bank will be ready to act as a confirmation bank in such scenarios and whereas an irrevocable letter of credit cannot be made subject to amendment or cancellation without the consent of the parties.
Transferable letter of credit
In the case of transferable credit, the credit can be transferred by the original beneficiary to others. It is pertinent to note that transfer can be allowed only once and works only on the letter of credit which has a clause that allows the transfer. This type of credit gives sellers their right to instruct the advising bank to give credit to all the beneficiaries involved in the transaction.
Back-to-back letter of credit
In the event of the buyer unwilling to disclose his identity and unwilling to initiate a transferable letter of credit, back-to-back credit comes into play. In this type of credit, the beneficiary requests his banker to issue a letter of credit in favour of the beneficiary’s supplier to help him with the procurement of raw materials and goods required to fulfill the contract made on the terms of the letter of credit.
Red and green clause letter of credit
In the case of the red clause of the letter of credit, as per the authority given by issuing bank to the nominated bank, the nominated bank verifies the request of the beneficiary and provides pre-shipment credit to the beneficiary. In the course of failure by the beneficiary to pay the given advance amount to the nominated bank, the issuing bank shall be held liable to make the due payment.
The green clause is similar to the red clause with certain additional features like providing advance for the charges incurred in the process of warehousing and insurance by obtaining warehouse receipts as security.
Confirmed letter of credit
Confirmed letter of credit deals with only irrevocable credits. Along with issuing bank, the confirmed banker also adds its own confirmation to the letter of credit and becomes the party to such letter of credit.
In the event of indebtedness, borrowing of money, or any default in performance of a contract suffered by the beneficiary, the issuing bank is put forth in a position to be obligated to step forward to help the beneficiary to perform his obligation.
Payment letter of credit
Payment or sight credit is a type that is more immediate and efficient compared to other types of letter of credit. In this type, upon presentation of the eligible documents to the issuing or nominating banks, they are made available for payment on sight basis.
Deferred payment and acceptance letter of credit
The deferred payment is more like usance credit type, where the issuing bank shall be responsible for the payment on the due date mentioned on the letter of credit without drawing the bill of exchange. Whereas acceptance letter is similar to deferred payment, except for the fact that it mandates drawing of a bill of exchange.
Negotiation letter of credit
The negotiation in negotiation letter of credit can be restricted to a specific bank or may be open to any bank willing to negotiate. Moreover, in the failure of a negotiating bank to negotiate, it is always the responsibility of the issuing bank to make the payments. A negotiating bank becomes the holder in due course if its negotiation was effective.
Uniform customs and practice: The most common code
Uniform Customs and Practices codified by the International Chamber of Commerce. It is the most common, voluntarily applied code by many bankers across the globe issuing letter of credit.
The following are the few important points to be acknowledged about the Uniform Customs and Practice.
If a letter of credit fails to mention whether it is revocable or irrevocable, then it shall be considered as the irrevocable credit.
A credit by its nature itself is a separate transaction from the contract on which it may be based.
Documents are the major essence on which the banks involved deals, not the goods or services to which the presented document relates to.
The issuing bank is obligated to do the following:
- To scrutinize once the documents under the letter of credit are received.
- To inform the beneficiary/nominated bank about the discrepancies in the presented documents.
- To convey the status as to accepted/rejected before the completion of five banking days following the day on which documents were received.
If the issuing bank fails to do this, then it shall lose its power to reject the documents.
The issuing bank is mandated to honour the credit, if the documents presented are in total compliance with the letter of credit.
Even in the recent case during the pandemic, Standard Retail Pvt. Ltd. & Ors. Vs. M/s G.S. Global Corps & Ors, when the applicants approached the court to seek, stay on the honour of letter of credit on the ground that they were unavailable to perform their part of the contract due to the outbreak of coronavirus. The hon’ble court rejected the plea stating that the letter of credit is an independent transaction with the bank and the bank is in no way concerned with the underlying dispute among the parties to the contract.
Unless the letter of credit explicitly instructs otherwise, partial shipments and/or partial drawing are allowable.
Banks shall not be held responsible for interruption in business due to the acts of God, wars, riots, strikes, civil commotions, the lockout of any other reason beyond their control. If the letter of credit expires in such circumstances, the branches shall not pay, accept, negotiate, incur deferred payment on behalf of such expired credit.
If the letter of credit has got no specific mention of it being “transferable” then it shall deem to be considered as non-transferable.
Letter of credit has two significant importance; firstly, International trade strengthens the economic growth of the country, and also it has many risks involved such as transportation/carriage risk, customer risk, country risk, different law barriers, lack of personal dealings, etc. In such a scenario, the invention of ‘letter of credit’ has yielded a good result and promoted a greater number of international trades. Secondly, it reduces the burden on the parties. In general contracts without a letter of credit, the parties are put up in a place to take up burden for everything from entering a contract to payment but in the case of a letter of credit involvement, employing allowing a trusted third party (banks) to play their role by issuing, scrutinizing the presentations and then allowing payments is the safer way to conduct transactions
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