LETTER OF CREDIT: DEFINITION, TYPES AND PARTIES THERE OF
Speaker: Roksana Jaman Munni
AVP,
Social Islami Bank Ltd.,
AVP,
Social Islami Bank Ltd.,
Principal Branch.
HISTORY OF LETTER OF CREDIT
The origins of the documentary credit lay in a ‘LETTER’ provided by a bank to a correspondent or agent. Upon production/presentation of that letter, ‘credit’ was provided to a named client in the form of money.
From the 1840s, documentary credits began to serve as a means of facilitating payment for foreign trade transactions.
It was not until the 18th and 19th centuries that the term ‘letter of credit’ became widely used and recognized. During this period, it was common for merchants to seek out
new markets and to make use of the trading opportunities offered by such
markets. In order to provide their clients with a means of obtaining cash
during their overseas travels, banks in the Western world introduced the
concept of a “TREVELLER’S LETTER OF CREDIT”. This document allowed bank clients to avoid the need to carry large sums of money, which could be lost or stolen.
new markets and to make use of the trading opportunities offered by such
markets. In order to provide their clients with a means of obtaining cash
during their overseas travels, banks in the Western world introduced the
concept of a “TREVELLER’S LETTER OF CREDIT”. This document allowed bank clients to avoid the need to carry large sums of money, which could be lost or stolen.
In addition to the traveler’s letter of credit, it was usual for a formal letter
of introduction to be addressed to the bank’s overseas correspondent or
agent. This letter, usually sent in advance of travel, would indicate that the
client was a valued customer of the bank. It would also request that the
correspondent or agent provide the client with any necessary assistance.
of introduction to be addressed to the bank’s overseas correspondent or
agent. This letter, usually sent in advance of travel, would indicate that the
client was a valued customer of the bank. It would also request that the
correspondent or agent provide the client with any necessary assistance.
A traveler’s letter of credit took the form, literally, of a letter. It indicated
that-
that-
· The issuing bank would honor bills of exchange drawn on it(Issuing bank) by the correspondent or agent in respect of amounts paid to the named traveler, plus any charges incurred by the correspondent or agent.
· There would also be an indication of a maximum amount that could be drawn and
· An expiry date.
Today, a documentary credit can be used for almost any
situation in which goods are being shipped, or services
or performance are being provided.
What is Documentary Credit/Letter of Credit(LC)/Credit ?
A documentary credit is an IRREVOCABLE UNDERTAKING issued by a bank whereby it undertakes to make payment to a named beneficiary, provided that the documents stipulated in the documentary credit are presented, and all of its terms and conditions are complied with.
According to Uniform Customs and Practice of Documentary Credits (UCPDC 600), Article 2-
Credit means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honor a complying presentation.
· Issuer-Although it is a bank that will usually issue a documentary credit, any company or individual may also act in the capacity of issuer. It is often a decision for a beneficiary whether an issuer has the financial means to fulfil the terms of the undertaking given in its documentary credit.
· “ however named or described “-If we review this definition, we can see that any method of settlement (‘however named or described’) that describes itself as being irrevocable, and which is payable upon the presentation of one or more stipulated documents, can be made subject to UCP 600.
· Honor-means a) to pay at sight if the credit is available by sight payment.
b) to incur a deferred payment undertaking and pay at maturity if the
credit is available by deferred payment.
c) to accept a bill of exchange (“draft”) drawn by the beneficiary and pay
at maturity if the credit is available by acceptance
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· Complying Presentation- Complying presentation
means a presentation that is in accordance with the
terms and conditions of the credit, the applicable
provisions of these rules and international standard
banking practice.(Article 15 of UCP-600)
Figure: Flow Chart of Letter of Credit
Who are the Parties in Letter of Credit?
1. Issuing bank- means the bank that issues a credit at the request of an applicant or on its own behalf.
2. Beneficiary-means the party in whose favor a credit is issued.
3. Advising bank-means the bank that advises the credit at the request of the issuing bank.
4. Confirming bank-means the bank that adds its confirmation to a credit upon the issuing bank’s authorization or request.
5. Nominated bank-means the bank with which the credit is available or any bank in the case of a credit available with any bank.
6. Reimbursing bank- UCP 600, sub-article 13(a), describes a ‘reimbursing bank’ as the bank named in a documentary credit upon which the nominated bank (the ‘claiming bank’) may claim in respect of any honor or negotiation that it has effected to the beneficiary.
7. Second advising bank-UCP 600, sub-article 9(c), describes a ‘second advising bank’ as a bank utilized by the advising bank to advise the credit or any amendment to the beneficiary.
8. Transferring bank-UCP 600, sub-article 38(b), defines a ‘transferring bank’ as follows.
Transferring bank means a nominated bank that transfers the credit or, in a credit
available with any bank, a bank that is specifically authorized by the issuing bank to
transfer and that transfers the credit. An issuing bank may be a transferring bank.
Is APPLICANT considered as a party in Letter of Credit ?
- Applicant means the party on whose request the credit is issued.
It should be noted that although an applicant is responsible for completing an application form to issue, or to amend, a documentary credit, it is not a party to that documentary credit.
· the interaction between an applicant and its bank prior to the issuance of a documentary credit is outside the scope of UCP 600; and
· following the issuance of a documentary credit, an applicant may subsequently request an amendment to its terms and conditions, or provide a waiver of discrepancies that have been identified by the issuing bank. An issuing bank is under no obligation to accept or take note of such request or waiver.
Types of Letter of Credit
1. Commercial Letter of Credit: Commercial letters of credit are mainly used as a primary payment tool in international trade such as exporting and importing transactions. Majority of commercial letters of credit are issued subject to the latest version of UCP (Uniform Customs and Practice for Documentary Credits). The ICC publishes UCP, which are the set of rules that governs the commercial letters of credit procedures.
2. Revocable Letters of Credit: Revocable letters of credit give issuer the amendment or cancellation right of the credit any time without prior notice to the beneficiary. Since revocable letters of credit do not provide any protection to the beneficiary, they are not used frequently. In addition, UCP 600 has no reference to revocable letters of credit. All credits issued subject to UCP 600 are irrevocable unless otherwise agreed between the parties.
3. Irrevocable Letters of Credit: Irrevocable Letters of Credit cannot be amended or cancelled without the agreement of the credit parties. Unconfirmed irrevocable letters of credit cannot be modified without the written consent of both the issuing bank and the beneficiary. Confirmed irrevocable letters of credit need also confirming bank's written consent in order any modification or cancellation to be effective.
4. Payment at Sight Letters of Credit: According to this LC, payment is made to the seller immediately after the required documents have been submitted.
5. Deferred Payment Letters of Credit: According to this LC the payment to the seller is not made when the documents are submitted, but instead at a later period/tenor defined in the letter of credit, i.e., payment made on maturity.
6. Unconfirmed Letters of Credit: Unconfirmed Letters of Credit can be described as a letter of credit, which has not been guaranteed or confirmed by any bank other than the bank that opened it. In these types of credits, the only bank that undertakes to honor a complying presentation is the issuing bank.
7. Confirmed Letters of Credit : It would be easier to understand the confirmed letters of credit if we start from the definition of the confirmation.
“Confirmation means a definite undertaking of the confirming bank, in addition to that of
the issuing bank, to honor or negotiate a complying presentation.”
If a letter of credit's payment undertaking is guaranteed by a second bank, in addition to the bank originally issuing the credit this kind of credit is called confirmed letter of credit. The confirming bank agrees to pay or accept drafts against the credit even if the issuer refuses to do so. Only irrevocable credits can be confirmed.
8. Clean Letters of Credit: A letter of credit payable upon presentation of the draft, without any supporting document being required.
Clean letters of credit are issued only by the request of the highest credit standing companies. It is suitable for variety commercial situations where no movement of goods is expected. Historically these types of credits have been used in traveler's letters of credit. Today direct pay standby letter of credit can be given as an example of clean letters of credit.
9. Transferable Letters of Credit: Transferable letter of credit is a documentary credit that is issued with the option to allow a trader to transfer its rights and obligations to the supplier.
To arrange the issuance of a transferable documentary credit, the final buyer (applicant) instructs its bank to issue a documentary credit in favor of the trader from which the goods are to be bought (who will become known as the ‘first beneficiary’), stating that it is transferable. This allows the trader to request the nominated bank with which the documentary credit is available for honor or negotiation to transfer it in whole or in part to the trader’s supplier(s) (who will become known as the ‘second beneficiary’).
10. Back-to-Back Letters of Credit: Arrangement in which one irrevocable letter of credit serves as the collateral for another; the advising bank of the first letter of credit becomes the issuing bank of the second L/C.
11. Advance Payment (Red Clause) Letters of Credit: Letter of credit that carries a provision (traditionally written or typed in red ink) which allows a seller to draw up to a fixed sum from the advising or paying-bank, in advance of the shipment or before presenting the prescribed documents.
12. Green Clause Letters of Credit: A letter of credit that pays advance to the seller just not against the written undertaking and a receipt, but also a proof of warehousing the goods.
13. Revolving Letters of Credit: When a single letter of credit is issued for covering multiple transactions in place of issuing separate LC for each transaction is called revolving LC. They can be further classified into Time Based (Could be Cumulative or Non-Cumulative) and Value Based.
14. Standby Letters of Credit: A standby letter of credit acts as a guarantee if there is a failure to perform a contractual undertaking, such as the obligation of a buyer to pay or that of a seller to deliver. It has the same basic form as a commercial documentary a standby letter of credit is issued, draws only in case of default on the transaction to which the standby letter of credit relates.
However, a standby letter of credit can be issued subject to either the UCP 600 or the ISP 98.
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