Definition of Letter of Credit:
LC is an arrangement whereby the LC opening bank at the request of the opener undertakes to make the payment of a certain sum of money to the beneficiary or his order after shipment of the goods, against the submission of documents which has to be strictly as per the T&C of the LC.
There is various type of LC issued in different countries depending upon the requirements of buyer/seller. The more important are:
1) Irrevocable LC:
It’s a type of LC which can not be canceled or amend by the LC issuing bank without the agreement of the parties of the LC transaction. Here, the beneficiary has 100% payment guarantee if in case the buyer defaults or buyer does not pay.
2) Confirmed LC:
When an LC is issued, the issuing bank may request the advising bank or any other bank (normally in the same country as the exporter) to add its confirmation on the LC. By agreeing to add the confirmation, the confirming bank undertakes to pay to the beneficiary provided stipulated documents are presented & T&C are complied with. Insolvency risk of the issuing bank is eliminated by addition of this second payment guarantee to the LC. Mostly, confirming bank & the beneficiary is located in the same country thus eliminating the country risk factor.
3) With Recourse LC:
With recourse term defines the situation in which the paying bank (exporter bank or nominated bank or confirming bank) will be able to claim refunds from the beneficiary in case the letter of credit documents are not paid by the issuing bank. In general, the nominated bank or the negotiated bank pay the letter of credit amount to the beneficiaries with recourse terms.
4) Transferable LC:
It is a sort of documentary credit which can be used in situations where middlemen are playing a certain role. Usually, middlemen (First Beneficiary) do not have enough capital establishment to buy the goods from their source (Second Beneficiary) before they re-sell them to their final customer (applicant). The beneficiary is entitled to request the paying, accepting, negotiating bank to pay, accept, negotiate bills presented by one or more parties.
A letter of credit can be transferred to the second beneficiary at the request of the first beneficiary only if it expressly states that the letter of credit is “transferable”.
5) Back To Back LC:
The back-to-back LC is actually made up of two distinct LCs, one issued by the buyer’s bank to the intermediary and the other issued by the intermediary’s bank to the seller. With the original LC from the buyer’s bank in place, the broker goes to his own bank and has a second LC issued, with the seller as beneficiary. The seller is thus ensured of payment upon fulfilling the terms of the contract and presenting the appropriate documentation to the intermediary’s bank. In some cases, the seller may not even know who the ultimate buyer of the goods is.
The difference between back-to-back letters of credit and transferable letters of credit is such that in a transferable letter of credit, the rights under the existing letter of credit are transferred. In a back-to-back transaction, different letters of credit are actually issued.
6) Red Clause & Green Clause LC:
Both the clause allow the nominated bank to grant advance to the beneficiary. Red clause advance is possible only aginst the receipt of funds & the undertaking to ship the goods as per the LC terms.
In the Green clause, all must be guaranteed by a bank or deposit of goods-warrant issued by a recognized warehouse.
e.g. Let suppose supplier requires an advance in order to purchase their raw material. In Red Clause case, on the request of supplier only negotiating bank can pass the advance amount. Here, the bank won’t confirm whether the supplier has indeed purchased raw material or used it for any other purpose.
IN Green clause case, the bank in addition to the request of the supplier, have to check whether indeed the raw materials have been procured by the supplier. For this, they may insist on a warehousing receipt or at times even a tax paid transport document should do. These documents that are to be checked for can be specified in the LC itself.
7) Revolving LC:
It is structured in a way so that it revolves either in value or in time covering multiple shipments over a long period of time under a single letter of credit.
e.g. Shipment of textile products monthly basis from India to the USA for a 12 months period of time.
8) Deferred Payment LC:
In this case, the payment to the exporter is not made when the documents are submitted, but instead at a later time defined in the LC. This kind of LC is also known as “USANCE LC”
9) Transit LC:
It is issued in one foreign country with the beneficiary in another but is advised through & usually confirmed by a bank in London.
10) Restricted & Unrestricted LC:
The LC which does not specify any particular bank who is authorized to negotiate etc. is termed as Unrestricted LC or open or general credit.
If a specified bank is designated to pay, accept or negotiate the LC, it is termed as Restricted or Specified LC.
How LC Works?
- Foreign buyers request his banker to open an LC in the favor of the Exporter.
- The buyer’s bank opens the LC.
- The beneficiary ships the order according to the terms and conditions stated in the credit.
- When the goods are loaded, the exporter collects the documents and forwards them to the exporter’s bank.
- Exporter bank makes payment to the exporter.
- The exporter bank posts the documents to the issuing bank on behalf of the beneficiary.
- The buyer’s bank makes the payment to the Exporter’s bank.
- The documents transmit to the applicant. The applicant uses these documents to clear the goods from the customs.