Letters of credit

Everything about Letters of credit

A Letter of Credit is issued by a bank at the request of its customer (importer) in favour of the beneficiary (exporter).
It is an undertaking/ commitment by the bank, advising/informing the beneficiary that the documents under a LC
would be honoured, if the beneficiary (exporter) submits all the required documents as per the terms and conditions
of the LC.

Importance of letter of credit in trade activities

The trade can be classified into Inland and International. Due to the geographical proximities of the importers and
the exporters, banks are involved in LC transactions to avoid default in payment (credit risks). To facilitate trade
and also to enable the exporter and importer to receive and pay for the goods sold and bought, letter of credit is
used as a tool. Letter of credit mechanism that the payment and receipts (across the globe) are carried out in an
effective manner

Letters of Credit – Parties

1. Applicant (importer) requests the bank to issue the LC
2. Issuing bank (importer’s bank which issues the LC [also known as Opening banker of LC])
3. Beneficiary (exporter)

Different types of banks:
– Opening bank (a bank which issues the LC at the request of its customer [importer])
– Advising bank (the issuing banker’s correspondent who advices the LC to beneficiary’s banker and/ or
beneficiary)
– Negotiating bank (the exporter’s bank, which handles the documents submitted by the exporter. The
bank also finances the exporter against the documents submitted under a LC)
– Confirming bank (the bank that confirms the credit)
– Reimbursing bank (reimburses the LC amount to the negotiating/ confirming bank)

Types of Letters of credit

(a) Sight Credit – Under this LC, documents are payable at sight/ upon presentation
(b) Acceptance Credit/ Time Credit – The Bills of Exchange which are drawn, payable after a period, are called usance bills. Under acceptance credit usance bills are accepted upon presentation and eventually honoured on due dates.
(c) Revocable and Irrevocable Credit – A revocable LC is a credit, the terms and conditions of the credit can
be amended/ cancelled by the Issuing bank, without prior notice to the beneficiaries. An irrevocable credit is a credit, the terms and conditions of which can neither be amended nor cancelled without the consent of the beneficiary. Hence, the opening bank is bound by the commitments given in the LC.
(d) Confirmed Credit – Only Irrevocable LC can be confirmed. A confirmed LC is one when a banker other
than the Issuing bank, adds its own confirmation to the credit. In case of confirmed LCs, the beneficiary’s
bank would submit the documents to the confirming banker.
(e) Back-to-Back credit – In a back to back credit, the exporter (the beneficiary) requests his banker to issue
a LC in favour of his supplier to procure raw materials, goods on the basis of the export LC received by
him. This type of LC is known as Back-to-Back credit.
Example: An Indian exporter receives an export LC from his overseas client in Netherlands. The Indian
exporter approaches his banker with a request to issue a LC in favour of his local supplier of raw materials.
The bank issues a LC backed by the export LC.
(f) Transferable Credit – While a LC is not a negotiable instrument, the Bills of Exchange drawn under it are
negotiable. A Transferable Credit is one in which a beneficiary can transfer his rights to third parties. Such
LC should clearly indicate that it is a ‘Transferable’ LC

(g) “Red Clause” Credit & “Green Clause” Credit – In a LC a special clause allows the beneficiary (exporter) to
avail of a pre-shipment advance (a type of export finance granted to an exporter, prior to the export of goods). This special clause used to be printed (highlighted in red colour, hence it is called “Red Clause” Credit. The issuing bank undertakes to repay such advances, even if shipment does not take place.
In case of a ‘Green clause’ credit, the exporter is entitled for an advance for storage (warehouse) facilities
of goods. The advance would be granted only when the goods to be shipped have been warehoused,
and against an undertaking by the exporter that the transportation documents would be delivered by an
agreement date.
(h) Standby LC: In certain countries there are restrictions to issue guarantees, as a substitute these countries
use standby credit. In case the guaranteed service is not provided, the beneficiary can claim under the
terms of the standby credit. In case of Standby LCs, the documents required are proof of non- performance
or a simple claim form.

(g) “Red Clause” Credit & “Green Clause” Credit – In a LC a special clause allows the beneficiary (exporter) to avail of a pre-shipment advance (a type of export finance granted to an exporter, prior to the export of goods). This special clause used to be printed (highlighted in red colour, hence it is called “Red Clause” Credit. The issuing bank undertakes to repay such advances, even if shipment does not take place.
In case of a ‘Green clause’ credit, the exporter is entitled for an advance for storage (warehouse) facilities of goods. The advance would be granted only when the goods to be shipped have been warehoused, and against an undertaking by the exporter that the transportation documents would be delivered by an agreement date.
(h) Standby LC: In certain countries there are restrictions to issue guarantees, as a substitute these countries
use standby credit. In case the guaranteed service is not provided, the beneficiary can claim under the
terms of the standby credit. In case of Standby LCs, the documents required are proof of non- performance
or a simple claim form.

Documents handled under Letters of Credit

Documents play a crucial role in trade transactions. Documents are integral part of LCs. The banks involved in LC
transactions deal only with documents and on the evidence of the correct and proper documents only the paying
banks (opening bank/confirming bank) need to make payment. In view of these factors, banks have to be careful
while handling documents/ LCs.
At various stages, different banks (Negotiating bank {beneficiary’s bank}, confirming bank, opening bank) have to
verify whether all the required documents are submitted strictly as per the terms and conditions of credit. The
important documents handled under LCs are broadly classified as

(a) Bill of Exchange:

Bill of exchange, is drawn by the beneficiary (exporter) on the LC issuing bank. When the bill of exchange is not
drawn under a LC, the drawer of the bill of exchange (exporter), draws the bill of exchange on the drawee
(importer). In such a case, the exporter takes credit risk on the importer, whereas, when the Bill of Exchange is
drawn under LC, the credit risk for the exporter is not on the importer but on the LC issuing bank. Banks should
be careful in ensuring that the Bill of Exchange is drawn strictly as per the terms and conditions of the credit.
Some others important aspects are:
(i) It should be drawn by the beneficiary on the opening bank

(ii) It should clearly indicate the amount and other
details

(iii) Depending upon the LC terms a Bill of Exchange may be drawn as a sight bill or an usance bill

(iv) It should clearly indicate the LC number.

(b) Commercial Invoice:

This is another important document. Commercial invoice is prepared by the beneficiary, which contains

(i) relevant details about goods in terms of value, quantity, weights (gross/net), importer’s name and address, LC number

(ii) Commercial invoice should exactly reflect the description of the goods as mentioned in LC. (iii) Another important requirement is that the commercial invoice should indicate the terms of sale contract (Inco terms) like FOB, C&F, CIF, etc

(iv) Other required details like shipping marks, and any specific detail as per the LC terms should also be covered.

(c) Transport Documents:

When goods are shipped from one port to another port the transport document issued is called the bill of lading.
Goods can be transported by means of airways, roadways and railways depending upon the situations. In case
goods are transported by means of water ways, the document is called bill of lading, by airways it is known as
airway bills and by roadways called as lorry receipt and by railways it is known as railway receipt. In case of a
single transaction, when different modes are used to transport the goods from the beneficiary’s country to the
importer’s destination, a single transport document can be used viz., Multi model transport document.

For ease of reference the most commonly used document i.e., Bill of Lading is discussed here.

(d) Bill of Lading (B/ L):

The B/ L is the shipment document, evidencing the movement of goods from the port of acceptance (in exporter’s
country) to the port of destination (in importer’s country). It is a receipt, signed and issued by the shipping company
or authorized agent. It should be issued in sets (as per the terms of credit).
Other important features:
As per the terms and conditions of the credit, a bill of lading should clearly indicate:
(i) the description of goods shipped, as indicated in the invoice
(ii) conditions of goods “Clean” or otherwise (not in good condition/ shortage/damaged)
(iii) drawn to the order of the shipper, blank endorsed or in favour of the opening bank
(iv) the gross and net weight
(v) Freight payable or prepaid
(vi) Port of acceptance and port of destination

Insurance Policy/ Certificate:

This document is classified as a document to cover risk.
(a) It must be issued by the insurance company or their authorized agents
(b) It should be issued in the same currency in which the LC has been issued
(c) It should be issued to cover “All Risks”
(d) The date of issuance of the policy/ certificate should be on or before the date of issuance of the shipment,
and should clearly indicate that the cover is available from the date of shipment
(e) Unless otherwise specified, it should be issued for an amount of 110% of CIF value of goods
(f) The description of the goods in the policy/certificate should be as per the terms of the credit
(g) The other important details like the port of shipment, port of destination etc needs to be clearly indicated Other documents:
As per the terms of LC, all required documents have to be submitted by the beneficiary. Documents like Certificate
of Origin (issued by the Chamber of Commerce), indicates the origin of goods. The origin of goods should not be
from any prohibited nations.
Packing list, required certificates, etc. should be drawn as per the terms and conditions of the credit.
Uniform Customs and Practice for Documentary Credit (UCPDC 600) International Chamber of Commerce (ICC), arranges to issue uniform guidelines to handle documents under Letters of Credit.

These guidelines are used by various parties involved in letters of credit transactions like,
exporters, importers, their bankers, shipping and insurance companies. These guidelines gives clarity for the
persons to draw and handle various documents. The latest guidelines is called as UCPDC 600 and it came into
effect in July 2007. Banks, which are involved in LC transactions need to be familiarized with UCPDC 600.

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