How Letters of
of a Letter of Credit
- A payment undertaking given by a bank (issuing
- 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
The beneficiary 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 to the
buyer, is to examine all documents to insure that they meet all the
terms and conditions of the credit. Upon requesting demand for payment
the beneficiary warrants that all conditions of the agreement have been
complied with. If the beneficiary (seller) conforms to the letter of
credit, the seller must be paid by the bank.
The issuing bank's liability to pay and to be reimbursed from its
customer becomes absolute upon the completion of the terms and
conditions of the letter of credit. Under the provisions of the Uniform
Customs and Practice for Documentary Credits, the bank is given a
reasonable amount of time after receipt of the documents to honor the
The issuing banks' role is to provide a guarantee to the seller that
if compliant documents are presented, the bank will pay the seller the
amount due and to examine the documents, and only pay if these documents
comply with the terms and conditions set out in the letter of credit.
Typically the documents requested will include a commercial invoice,
a transport document such as a bill of lading or airway bill and an
insurance document; but there are many others. Letters of credit deal in
documents, not goods.
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.
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.
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 nominated bank becomes a holder in due course. As a
holder in due course, the holder takes the letter of credit for value,
in good faith, without notice of any claims against it. A holder in due
course is treated favorably under the UCC.
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.
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
Once the documents have been presented and meet the terms and
conditions in the letter of credit, and the draft is honored, the letter
of credit cannot be revoked. The revocable letter of credit is not a
commonly used instrument. It is generally used to provide guidelines for
shipment. If a letter of credit is revocable it would be referenced on
The irrevocable letter of credit may not be revoked or amended
without the agreement of the issuing bank, the confirming bank, and the
beneficiary. An irrevocable letter of credit from the issuing bank
insures the beneficiary that if the required documents are presented and
the terms and conditions are complied with, payment will be made. If a
letter of credit is irrevocable it is referenced on its face.
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.
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.
for Using the Tool
The following procedures include a flow of events that follow the
decision to use a Commercial Letter of Credit. Procedures required to
execute a Standby Letter of Credit are less rigorous. The standby credit
is a domestic transaction. It does not require a correspondent bank
(advising or confirming). The documentation requirements are also less
- Buyer and seller agree to conduct business.
The seller wants a letter of credit to guarantee payment.
- Buyer applies to his bank for a letter of
credit in favor of the seller.
- Buyer's bank approves the credit risk of the
buyer, issues and forwards the credit to its correspondent bank
(advising or confirming). The correspondent bank is usually located
in the same geographical location as the seller (beneficiary).
- Advising bank will authenticate the credit and
forward the original credit to the seller (beneficiary).
- Seller (beneficiary) ships the goods, then
verifies and develops the documentary requirements to support the
letter of credit. Documentary requirements may vary greatly
depending on the perceived risk involved in dealing with a
- Seller presents the required documents to the
advising or confirming bank to be processed for payment.
- Advising or confirming bank examines the
documents for compliance with the terms and conditions of the letter
- If the documents are correct, the advising or
confirming bank will claim the funds by:
- Debiting the account of
the issuing bank.
- Waiting until the issuing
bank remits, after receiving the documents.
- Reimburse on another bank
as required in the credit.
- Advising or confirming bank will forward the
documents to the issuing bank.
- Issuing bank will examine the documents for
compliance. If they are in order, the issuing bank will debit the
- Issuing bank then forwards the documents to
Forms of Documentation
When making payment for product on behalf of its customer, the issuing
bank must verify that all documents and drafts conform precisely to the
terms and conditions of the letter of credit. Although the credit can
require an array of documents, the most common documents that must
accompany the draft include:
The billing for the goods and services. It includes a description of
merchandise, price, FOB origin, and name and address of buyer and
seller. The buyer and seller information must correspond exactly to the
description in the letter of credit. Unless the letter of credit
specifically states otherwise, a generic description of the merchandise
is usually acceptable in the other accompanying documents.
A document evidencing the receipt of goods for shipment and issued by a
freight carrier engaged in the business of forwarding or transporting
goods. The documents evidence control of goods. They also serve as a
receipt for the merchandise shipped and as evidence of the carrier's
obligation to transport the goods to their proper destination.
A warranty given by a seller to a buyer of goods that states that the
title being conveyed is good and that the transfer is rightful. This is
a method of certifying clear title to product transfer. It is generally
issued to the purchaser and issuing bank expressing an agreement to
indemnify and hold both parties harmless.
Specifically indemnifies the purchaser against a certain stated
circumstance. Indemnification is generally used to guaranty that
shipping documents will be provided in good order when available.
Defects in Documentation
About half of all drawings presented contain discrepancies. A
discrepancy is an irregularity in the documents that causes them to be
in non-compliance to the letter of credit. Requirements set forth in the
letter of credit cannot be waived or altered by the issuing bank without
the express consent of the customer. The beneficiary should prepare and
examine all documents carefully before presentation to the paying bank
to avoid any delay in receipt of payment. Commonly found discrepancies
between the letter of credit and supporting documents include:
- Letter of Credit has expired prior to
presentation of draft.
- Bill of Lading evidences delivery prior to or
after the date range stated in the credit.
- Stale dated documents.
- Changes included in the invoice not authorized
in the credit.
- Inconsistent description of goods.
- Insurance document errors.
- Invoice amount not equal to draft amount.
- Ports of loading and destination not as
specified in the credit.
- Description of merchandise is not as stated in
- A document required by the credit is not
- Documents are inconsistent as to general
information such as volume, quality, etc.
- Names of documents not exact as described in
the credit. Beneficiary information must be exact.
- Invoice or statement is not signed as
stipulated in the letter of credit.
When a discrepancy is detected by the negotiating bank, a correction
to the document may be allowed if it can be done quickly while remaining
in the control of the bank. If time is not a factor, the exporter should
request that the negotiating bank return the documents for corrections.
If there is not enough time to make corrections, the exporter should
request that the negotiating bank send the documents to the issuing bank
on an approval basis or notify the issuing bank by wire, outline the
discrepancies, and request authority to pay. Payment cannot be made
until all parties have agreed to jointly waive the discrepancy.
- Communicate with your customers in detail
before they apply for letters of credit.
- Consider whether a confirmed letter of credit
- Ask for a copy of the application to be fax to
you, so you can check for terms or conditions that may cause you
problems in compliance.
- Upon first advice of the letter of credit,
check that all its terms and conditions can be complied with within
the prescribed time limits.
- Many presentations of documents run into
problems with time-limits. You must be aware of at least three time
constraints - the expiration date of the credit, the latest shipping
date and the maximum time allowed between dispatch and presentation.
- If the letter of credit calls for documents
supplied by third parties, make reasonable allowance for the time
this may take to complete.
- After dispatch of the goods, check all the
documents both against the terms of the credit and against each
other for internal consistency.
a Letter of Credit
This scenario describes the
process of exporting goods and receiving payment
using a letter of credit.
The importer requests a quotation for the
You (the exporter) provide a quotation
for the products to the importer.
The importer sends you a purchase order
based on your offer.
You issue a sales order based on the
purchase order and send it along with an invoice
to the importer.
(Optional) You send an advanced shipping
notification to inform the importer of the exact
date and quantities of products to be delivered.
The importer opens a letter of credit
with the opening bank in the country of
destination (import country).
The letter of credit stipulates in detail
which documents are required by customs and by
any other agency regulating your products. These
Bills of lading
Export packing list
Shipper’s Export Declaration (U.S. only)
Single Administrative Document (E.U.
Certificate of origin
Licenses (when necessary)
With the exception of the insurance
certificates, you can create the above documents
using SAP GTS.
The export letter of credit provides you with a
guarantee that you will be paid, provided you
ship the products and present the documents
specified in the letter of credit within a
stipulated time. This reduces any payment
risk to you, the exporter.
It also enables you
as an exporter to request immediate payment
under letter of credit drawings (provided that
the documents are in order), thereby improving
your cash flow.
The opening bank sends the letter of
credit to the advising bank in your country.
The advising bank advises you that a
letter of credit has been opened in your favor.
You ship the merchandise in accordance
with the terms stipulated in the letter of
You give the
documents proving that the shipment was made in
conformance with the letter of credit to the
advising bank in your country.
The advising bank pays you for the
products based on the documents received.
The advising bank transfers the documents
to the opening bank and receives payment from
The importer receives the products, files
an import declaration and pays customs duties to
the responsible authorities.
You file a customs declaration for the
The use of the letters of credit as a tool to reduce risk has grown
substantially over the past decade. Letters of credit accomplish their
purpose by substituting the credit of the bank for that of the customer,
for the purpose of facilitating trade.
The credit professional should be familiar with two types of letters
of credit: commercial and standby. Commercial letters of credit are used
primarily to facilitate foreign trade. The commercial letter of credit
is the primary payment mechanism for a transaction.
The standby letter of credit serves a different function. The standby
letter of credit serves as a secondary payment mechanism. The bank will
issue the credit on behalf of a customer to provide assurances of his
ability to perform under the terms of a contract.
Upon receipt of the letter of credit, the credit professional should
review all items carefully to insure that what is expected of the seller
is fully understood and that he can comply with all the terms and
conditions. When compliance is in question, the buyer should be
requested to amend the credit.
Existing small business owners who want to expand
into new markets will also benefit from this export information.
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