Meaning  of Letter of Credit (LC)

Modern trade is confined to the global trading of goods and services. This means the trade takes place between buyer and seller of two different countries or even continents. While doing so there is no chance of face-to-face interaction between the buyer and the seller. Thus, there exists a risk of payment, delivery, and trust between the parties of the trade being undertaken. To cover or minimize such risks of international trade, different documentary credits are issued through the banking system. One such documentary form of credit is the Letter of Credit (LC).

A letter of credit is a document issued by a bank guaranteeing the seller of the payment in full as long as a certain delivery condition has been met. It is a documentary promise that if the buyer fails to pay the seller, the bank will cover or pay the outstanding amount. In other words, a letter of credit is a letter written by one bank or financial institution to another to accept a cheque, draft, hundi, or bill of exchange of any specified person within the limit of the amount specified therein the letter. LC is mostly used in international trade where buyer and seller are not known to each other whereby the payment from the buyer’s side is assured to the seller. In precise, the letter of credit acts as the financing instrument for the purchase of foreign goods by assisting the importer (buyer) through the creation of credit. It brings confidence and trust between parties involved along with the security of payment to the exporter (seller) under mentioned clauses.

Who is involved in the Letter of Credit?

Buyer – The applicant or opener of the LC

Issuing Bank – The bank opening LC for buyer

Seller – The beneficiary who will be paid through LC

Confirming Bank – The bank guarantees the payment even if the issuing bank refuses to do so

Advising Bank – The seller’s bank that advises on LC

Negotiating Bank – The bank verifying documents and confirms the terms and conditions under LC on behalf of the beneficiary to avoid discrepancies

Reimbursing Bank – The bank who authorize to honor the reimbursement claim of negotiation/payment acceptance

Features of Letter of Credit

A letter of credit facilitates easy and risk-reduced international trade. It has a benefit for both buyer and seller. The different features of the letter of credit have been outlined below:

It is an agreed condition undertaken for payment

It is issued by the buyer’s bank to the seller’s bank atthe request of the buyer

Its payment can be made at the sight or determinable data in the future as agreed upon by the buyer and seller

The documents for its performance are stipulated in the letter of credit

The credit amount and dispatch time is fixed

Types of Letter of Credit

A letter of credit is mostly used in international trade. Depending upon its components, conditions, and nature, there are different types of letters of credit. The different types of letters of credit have been mentioned below:

Commercial Letter of Credit: It is the most common form of a letter of credit used in regular import-export transactions of international trade. The majority of commercial letter of credit is issued subject to the latest version of UCP (Uniform Customs and Practice for Documentary Credits)  The ICC (International Chamber of Commerce) issues the UCP which are the set of rules that governs the entire procedure of commercial letter of credit.

Revocable Letter of Credit: This is a type of letter of credit the issuer can amend or cancel the credit anytime without prior notice to the beneficiary. Since the revocable letter of credit does not provide any protection to the beneficiary, they are not used frequently. In addition, UCP 600 has no reference to the revocable letter of credit. All credits issued subject to UCP 600 are irrevocable unless otherwise agreed between the parties.

Irrevocable  Letter of Credit: Such a letter of credit cannot be amended or canceled without the agreement of the credit parties. An unconfirmed irrevocable letter of credit cannot be modified or altered without the written consent of issuing bank and the beneficiary. A confirmed irrevocable letter of credit needs also confirms banks’ written consent to make modifications or cancellations to be effective.

Confirmed Letter of Credit: If a letter of credit’s payment undertaking is guaranteed by a second bank, in addition to the issuing bank, this kind of credit is called a confirmed letter of credit. The confirming bank agrees to pay or accept drafts against the credit even if the issuer refuses to do so. Only irrevocable LC can be confirmed.

Unconfirmed Letter of Credit: A letter of credit that has been guaranteed only by its issuing bank is called an unconfirmed letter of credit. No other bank has guaranteed such a letter of credit other than its original issuer. This means the only bank that undertakes to honor a complying presentation is the issuing bank under such an unconfirmed letter of credit.

Transferable Letter of Credit: This is a specific type of letter of credit which can be transferred from one party to another. A transferable letter of credit is issued with the option to allow a trader to transfer its rights and obligations to the supplier.

Standby Letter of Credit: Under a standby letter of credit, payment is made to the beneficiary when there is a breach of the principles of obligation. For instance, a construction company is awarded a contract and the company cannot fulfill the obligation under the contract, the beneficiary of the standby letter of credit under such condition can apply for payment to the nominated bank. In such a situation, the nominated bank considers only the terms and conditions of the standby letter of credit and the rules governing the credit when deciding a complying presentation. The standby letter of credit hasits own rules known as International Standby Practice 1998 (ISP 98) issued by the International Chamber of Commerce (ICC). However, the standby letter of credit can also be issued as per UCP.

Back to Back Letter of Credit: The arrangement in which one irrevocable letter of credit serves as the collateral for another, the advising bank of the first letter of credit becomes the issuing bank of the second letter of credit. Unlike a transferable letter of credit, two separate letters of credit exist in back to back letter of the credit transaction.

Red Clause Letter of Credit: A letter of credit written or typed or printed with red ink is called a red clause letter of credit. Such a letter of credit allows the seller to draw a certain sum from the advising or paying bank, in advance of shipment or before presenting the prescribed document.

Clean Letter of Credit: A letter of credit that does not require any document other than a written demand for payment by its beneficiary is called a clean letter of credit. Clean letters of credit are issued only to the highest credit standing companies on their request. This type of letter of credit is the most suitable commercial situation where no movement of goods is expected. Examples of clean letters of credit include travel letters of credit, direct pay standby letters of credit, etc.

Documents Required for Letter of Credit

To open a letter of credit, the applicant has to submit a different document. These documents are specified in UCP which has been more compliantly addressed by Nepal Rastra Bank in the context of Nepal. Generally, the following documents are required to open a letter of credit for import and export trade:

Firm Registration certificate (duly renewed)

 Attested photocopy of citizenship

Income tax certificate (duly renewed)

Proforma invoice/sales contract (HARMONIC CODE to be mentioned)

Country of origin

Delivery terms

Application form

BlBlNl Form No. 3 (3 copies)

Insurance of required

Account related with the issuing bank

Minute, Article of Association (AOA) and Memorandum of Association (MOA) in case of private limited companies

Risks Associated With Letter of Credit

Though a letter of credit balances the risk of business between the buyer and the seller. Still, some risks prevail in the letter of credit for different parties. Such risks are outlined below:

Country risks such as civil war, political movement, border cease, political bans, boycotts, etc.

Fraud risk in which the payment is received from  the help of false documents or not exportable merchandises

Foreign exchange risk due to fluctuation in convertible currency rates

Regulatory risk such as a change in policy, rules, laws, and acts by the government which directly or indirectly affects the international trade and practice of letter of credit

Failure of issuing or collecting bank

Accidents during the delivery of goods

Difference Between Letter of Credit and Bank Guarantee

Letter of Credit (LC)	Bank Guarantee (BG)
1. It is a commitment of the buyer’s bank to the seller that it will accept the invoice presented by the seller and make payment, subject to a certain condition.	1. It is given by the bank to the beneficiary on behalf of the applicant to effect payment if the applicant defaults on payment
2. In a letter of credit, the primary liability lies with the bank only which collect payment from the client afterward	2. In a bank guarantee, the bank assumes liability when the client fails to make payment
3. The payment is made by the bank as it becomes due such that it does not wait for the applicant’s default and beneficiary to invoke undertaking	3. It becomes effective when the applicant default in making payment to the beneficiary
4. It is most appropriate to import and export business	4. It is suitable for government contracts
5. The letter of credit is riskier for the bank but less risky for merchant t	5. It is riskier for merchants and less risky for the bank
6. It ensures that the amount will be paid as long as the service is performed in a defined manner 0	6. It mitigates loss if the parties to the guarantee do not satisfy the stipulated condition
7. There are five more parties involved in a letter of a credit transaction in applicant, beneficiary, issuing bank, advising bank, negotiating bank, and confirming bank	7. Only three parties are involved in a bank guarantee i.e. Applicant, beneficiary, and the bank