Everything You Should Know About Letter of Credit
Most of the trade in the world is done internationally. In order to facilitate this, a business needs to have trade agreements with its partners and counterparts. Regarding this, suppose a simple situation (certainly not fictional);
Ms. “A” (as an Iranian exporter) has a contract with Mr. “B” (an importer from UAE) for sending a shipment of goods. In this scenario, both parties do not know each other and as you are aware, trust and getting paid in full and on time is important. With any new foreign buyer, Mr. “B” should first check the new foreign buyer’s credit. If Mr. “B” is unable to find reliable credit information, there is a trade finance tool available that provides a high level of certainty of payment to exporters called the Letter of Credit or LC or LoC.
A Letter of Credit as the most commonly accepted instrument of settling international trade payments is less risky and in the following parts of this blog, it will be clear why LCs are less risky.
A Letter of Credit; The “lifeblood” of international trade
A letter of credit is an instrument that is commonly used to facilitate payments in business transactions between buyers and sellers and can be used either locally or across borders.
In fact, it is a letter usually issued by a bank or other financial institution guaranteeing that a buyer, or in other words your customer will pay a seller (you) on schedule and for the accurate amount. Now, if the buyer cannot pay, then the issuing bank will be required to cover the full or remaining amount of the purchase.
Moreover, letters of credit are often used in international trade and can be considered as an effective and reliable financial instrument for securing payments in international trade.
If we consider international regulation governing LC, the UCP 600 are the latest rules that govern LC transactions worldwide. Uniform Customs and Practice for Documentary Credits (UCP) is prepared by the International Chamber of Commerce (ICC). Currently, the majority of letters of credit issued every day are subject to the latest version of the UCP. Finally, it can be regarded as a promise to pay in a contractual commitment context. LCs make it possible to do business worldwide. To this end, it must be noted that Letters of Credit are considered the “lifeblood” of international trade. This term comes from the case of The Bhoja Trader.
How does the Letter of Credit work?
The exporter and their bank must be satisfied with the creditworthiness of the importer’s bank. Once the sales agreement is completed, the importer applies to their bank to open a Letter of Credit in favor of the exporter. The importer’s bank drafts the Letter of Credit using the Sales Agreement terms and conditions and transmits it to the exporter’s bank.
The exporter’s bank reviews and approves the Letter of Credit and sends it to the exporter. Then, the exporter ships the goods in the manner provided in the letter of credit and submits the required documents to their bank. The exporter’s bank checks the documents for compliance with the letter of credit terms and conditions. Any document errors must be amended and resubmitted. Once approved, the exporter’s bank submits the complying documents to the importer’s bank. The importer’s bank releases payment to the exporter’s bank. The importer’s account is debited and their bank releases the documents to the importer to claim the goods and clear customs.
Main parties to a Letter of Credit
The Letter of Credit transactions normally involves the following main parties:
- Applicant/Opener: The buyer of the goods or services (Importer) on whose behalf of the credit is issued.
- Issuing Bank: The bank which issues the credit and undertakes to make the payment on behalf of the applicant as per terms of the LC.
- Beneficiary: The seller of goods or services (Exporter) in whose favor the credit is issued.
- Advising Bank: The advising bank is responsible for the transfer of documents to the issuing bank on behalf of the exporter and is generally located in the country of the exporter.
Main types of the Letter of Credit
In this part, I would like to draw a distinction among four types of LC which are recognized as main:
- Irrevocable letter of credit: An irrevocable letter of credit is one that cannot be canceled or amended without the consent of all parties concerned. LCs are typically irrevocable, which means that once the LC is established it cannot be changed without the consent of both parties.
- Revolving letter of credit: A revolving Letter of Credit is one where, under terms and conditions thereof, the amount is renewed or reinstated without specific amendments to the credit being needed. It can revolve in relation to time and value. This type of credit is generally used in local trade and sometimes for import also.
- A standby letter of credit: The standby credit is a documentary credit or similar arrangement however named or described which represents an obligation to the beneficiary on the part of the issuing bank to make payments on account of any indebtedness undertaken by the applicant, money borrowed, or for any default by the applicant in the performance of an obligation.
- Revocable letter of credit: A revocable letter of credit is one that can be canceled or amended by the issuing bank at any time and without prior notice to or consent of the beneficiary. From the exporter’s point of view, such LCs are not safe.
Advantages of Letter of Credit
To sum up, making use of LCs has a lot of fruit for both parties to the contract. In fact, the process both works in favor of the buyer and seller. The first thing that should be considered is that it helps in expanding businesses quickly into new geographies; and finally, reduces the production risk, if the buyer cancels or changes his order.
Remember, while you are trading with other countries, or if you are investing, never forgot to check how risky it is to Trade with or Invest in. Recently, one of the parameters is the situation of that country on FATF.
You can also ask for advice from our Lawyers specializing in commercial matters.