Letter of Credit

This method of payment, frequently found in international trade, is a very good compromise between the needs of both buyer and seller and was discussed at the beginning of this lesson. It is a fairly flexible form of payment were gives security to both buyer and seller and is one of the safest methods of payment. It is also a method of payment the successful completion of which depends on the carrier or his agent fulfilling his role with the utmost efficiency. A Documentary Letter of Credit is a document given by a bank by which it undertakes to pay the seller against presentation of a draft. For example a Bill of Exchange and other documents specified in the Letter of Credit provided such documents are in order and presented within a specified period. That is, a bank, known as the issuing bank, acting on the instruction of the buyer, undertakes to make available a predetermined amount to the seller, who is known as the beneficiary. The opening of a Letter of Credit is normally done through the intermediary of another bank in the country of residence of the beneficiary. This is a general rule but there are exceptions. It is not unusual for a Letter of Credit to be opened or established in the country of the applicant, that is the buyer, and payable there. The applicant needs to state where the credit is to be paid, if it is not stated then it will be paid in the buyer’s country. Some countries may restrict where a Letter of Credit is established and paid because of foreign exchange problems or restrictions. The intermediary through whom the letter of credit is established is known as the advising/confirming or paying bank.

There are, therefore, four parties who are involved in documentary credit:

  1. The buyer – applicant for credit.
  2. The seller – the beneficiary.
  3. The buyers bank – the issuing bank.
  4. The advising/confirming or paying bank.

It is very important to understand that a bank may not re-interpret the terms of the Documentary Credit in any way. They must be adhered to exactly. To ensure, as far as is possible, uniformity of interpretation by banks in respect of Documentary Credits the International Chamber of Commerce, in conjunction with other interested parties, has produced guidelines entitled ‘Uniform Customs and Practice for Documentary Credits’, usually abbreviated to “UCP”. Documentary credits are normally described as “Irrevocable”, meaning that they cannot be revoked once they have been opened, but will lapse if the documents are not presented within the stipulated time. On the buyer’s instruction the issuing bank irrevocably commits itself to pay the beneficiary on the correct presentation of the requirement documents. If a seller is uncertain of the financial status of the buyer he will require the credit to be confirmed. This means that the bank in the buyer’s country notifying the letter of credit gives an undertaking to pay without recourse to the seller (unless it is otherwise stipulated). The seller is certain of receiving payment providing he presents the right documents. The correspondent bank may be willing to add their confirmation at the seller’s request and expense, if requested and/or authorized by the opening bank to do so. When the buyer instructs his bank to open a letter of credit he will state explicitly the type of Credit and the conditions under which the bank will pay the seller. In the example the buyer has elected to pay his sight draft providing it is accompanied by certain documents which will ensure the correct delivery of the goods where and when he wants them. In the section covering the method of dispatch you will note that part-shipment is prohibited, but transshipment is allowed and that the documents must be presented for payment within 15 days from the date of shipment. The expiry date is given as August 31st and this would be the latest date for the presentation of documents by the seller. It is vital that the required documents are presented to the bank by the seller within the time limit set. It is also essential the documents comply fully with the instructions in the credit and are correctly completed in every detail. For example in a recent survey it was found that 57% of documents are rejected by the bank on first presentation and this may delay payment by anything from a few days to many months and prevent the buyer taking delivery of his goods on time.