Letter of Credit: Meaning, Importance and Parties involved

 

 A letter of credit (L/C) is a combination of:

• A guarantee issued by the buyer/importer’s bank in favor of the seller/exporter.

• A payment method at sight or at future date provided the exporters submit necessary documents that comply with the terms and conditions set out in the L/C

An LC is also known as documentary credit or simply a credit. These terms are used in UCP 600, which is the internationally agreed set of rules and regulations that govern LC.

UCP 600, the set of rules that covers nearly all L/Cs issued, defines a [letter of] credit as

…any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honor a complying presentation.

The term "honor" in the context of UCP 600 means:

• To pay at sight if the credit is available by sight payment.

• To incur a deferred payment undertaking and pay at maturity if the credit is available by deferred payment.

• To accept a draft/bill of exchange and pay at maturity if the credit is available by acceptance.

Given their structure and the need to comply with an L/C's terms and conditions before payment is made, letters of credit are a relatively secure form of payment mechanism that provides a reasonable level of protection to both buyers and sellers.

Parties to an L/C

Technically, there are only two parties to an L/C – the issuing bank and the beneficiary. But there are other parties involved throughout the lifecycle of an L/C, including at least some and maybe even all of those described below.

Issuing Bank: The issuing bank is the party that issues, or opens, an L/C. By issuing the L/C, the issuing bank guarantees payment to the beneficiary, provided the beneficiary presents documents that comply with the terms and conditions.

In essence, an L/C is a legal contract between the issuing bank and the beneficiary that crystallizes once the beneficiary submits those documents.

Beneficiary: The beneficiary (seller/exporter) is the party in whose favor an L/C is issued. On presenting documents that comply with the stipulated terms and conditions, the beneficiary is entitled to receive payment.

Applicant: The applicant (buyer/importer) is the party that requests an L/C to be issued by its bank. The applicant must provide all the information required to issue the L/C, such as the terms and conditions of payment and the documents that must be presented by the beneficiary. Such terms need to be fully aligned with the previously agreed contract of sale between the buyer and seller.

If the issuing bank is not satisfied with the creditworthiness of the applicant or with the terms of the request, it may refuse to issue the L/C or only do so after risk mitigation is provided. The applicant is usually responsible for the costs associated with issuing an L/C as well as any subsequent amendments to it.

Advising Bank: The advising bank is responsible for checking the authenticity of an L/C and advising it to the beneficiary at the request of the issuing bank. The advising bank is usually a correspondent of the issuing bank located in the seller's country, but may be a branch or subsidiary of the same bank.

In some cases, the beneficiary may request that an L/C be advised through its own bank, in which case there may be a second advising bank.

Confirming Bank

While the advising bank checks the authenticity of the L/C instructions before advising it, this does not guarantee that the beneficiary will be paid even if documents are submitted that comply with the L/C terms. This is because the issuing bank may not honor its commitment or a country event may prevent it from doing so. As a result, the seller may request that the L/C is confirmed.

To address this, the issuing bank, on instruction from the applicant, might request the advising bank to add its confirmation. If the bank is satisfied with regard to the credit risk of the issuing bank and the associated country risks, then it will confirm the L/C. This ensures that the beneficiary is paid even if the issuing bank does not pay.

Sometimes, confirmation is provided at the request of the beneficiary without the knowledge of the issuing bank. This is known as a silent confirmation.

Negotiating Bank

This is the bank that receives and checks the documents submitted by the beneficiary and takes action in accordance with the terms of the L/C. This may involve:

• Making immediate payment for sight L/Cs (where documents are in order).

• Making deferred payment for usance L/Cs.

• Requesting instructions from the issuing bank where there are discrepancies with regard to the documents presented.

Nominated Bank

The issuing bank may authorize a specific bank other than the advising bank, such as a local branch of the same bank, to accept a draft/bill or negotiate an L/C. This bank is referred to as the nominated bank.

A nominated bank that:

• Makes payment to the beneficiary is also known as the paying bank.

• Accepts a term draft drawn by the beneficiary is referred to as the accepting bank.

• Negotiates a term draft and/or documents presented by the beneficiary is known as the negotiating bank.

A nominated bank that claims reimbursement from the issuing bank is sometimes referred to as the claiming bank.

In practice, it is possible for a single bank to act in one or more of the roles of advising, confirming, negotiating, or nominated bank.

Reimbursing Bank

A final party commonly involved once a negotiation is completed is a reimbursing bank. In situations where a negotiating bank makes payment prior to receipt of funds from the issuing bank, it will claim reimbursement. It may do so from the issuing bank, but where it does so from a third-party bank authorized by the issuing bank then that bank is known as the reimbursing bank.