Letter of Credit

Letters of credit essentially substituting the credit of the bank for that of the customer, in order to facilitate trade. There are basically two types: Documentary and Standby. The documentaryl letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit is a secondary payment mechanism. Purchase order financing deals only with documentary letters of credit.

Documentary Letter of Credit
Documentary letters of credit have been used for centuries to facilitate payment in international trade.Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. Theses rules govern transactions.

A domestic 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 will open the letter of credit in favor of the seller to induce the seller to bring the goods to port. Essentially, the issuing bank replaces the bank's customer as the payee.

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 (Seller) 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 is to examine all documents to insure that they meet all the terms and conditions of the credit. If the documents are in order the (seller) will be paid by the bank.

Issuing Bank
The issuing bank has created an accounts payable liability on behalf of its customer (buyer) to pay under the letter of credit. The issuing bank is basically guaranteeing payment if the documents presented are in order.

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 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. Trade finance only deals in irrevocable letters of credit.

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.

 

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