Letter of Credit

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Russian: Аккредитив


Contents

General Provisions

A Letter of Credit is a document in which the importer's bank essentially promises to pay the exporter if the importer does not pay. The creditworthiness of the bank is substituted for the creditworthiness of the importer. However, the concept is substantially more complex than this. The promise is not made upon the exporter meeting certain conditions (or the importer not meeting certain conditions), but it is made on the documents of the transaction: This is the reason why a Letter of Credit is often called a Documentary Letter of Credit. The bank is under no obligation to pay even though delivery has been made and the importer has obtained control of the merchandise; similarly, the bank has to pay even though the merchandise may be shoddy or not fit for sale. The bank is obligated to pay only if the documents are in order. The Letter of Credit is therefore a contractual agreement between the Issuing Bank and the beneficiary, independent of the underlying relationship between the exporter and the importer; only the documents relating to the exporter-importer transaction matter. This obviously means that extreme care must be taken in handling the documents related to a Letter of Credit; otherwise, it triggers a very time-consuming and expensive process of amendments and corrections to the Letter of Credit.[1]

The Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 ("UCP") are rules that apply to any documentary credit ("credit") (including, to the extent to which they may be applicable, any standby letter of credit) when the text of the credit expressly indicates that it is subject to these rules. They are binding on all parties thereto unless expressly modified or excluded by the credit[2]

There are two types of Letters of Credit[3].

  • 1 - A revocable Letter of Credit can be revoked without the consent of the Exporter, meaning that it may be cancelled or changed up to the time the documents are presented. A revocable Letter of Credit affords the Exporter little protection; therefore, it is rarely used.
  • 2 - An irrevocable Letter of Credit cannot be cancelled or changed without the consent of all parties, including the Exporter. Unless otherwise stipulated, all Letters of Credit are irrevocable. A further differentiation is made between Letters of Credit, depending on the payment terms[4]. If payment is to be made at the time documents are presented, this is referred to as a sight Letter of Credit. Alternatively, if payment is to be made at a future fixed time from presentation of documents (e.g. 60 days after sight), this is referred to as a term, usance or deferred payment Letter of Credit.


Diagram of Typical Simplified L/C Transaction Flow

L C EC.jpeg


LEGEND FOR THE DIAGRAM ABOVE

0 Seller and Buyer [0] conclude a sales contract, with method of payment, for the first time, usually by Letter of Credit (documentary credit).

1 Buyer [1] applies to his issuing bank, usually in Buyer's country, for Letter of Credit in favor of Seller (beneficiary).

2 Issuing bank [2.1] requests another bank, usually a correspondent bank in Seller's country, to [2.2] confirm the Letter of Credit.

3 Issuing bank [3] requests another bank (sometimes a correspondent bank in Seller's country) to advise the credit.

4 Advising bank, usually in Seller's country, [4] forwards Letter of Credit to Seller informing about the terms and conditions of the Letter of Credit.

5 If credit terms and conditions conform to sales contract, Seller prepares [5.1] goods and documentation, and arranges delivery of goods to carrier, having received a clean Bill of Lading [5.2].

6 Seller presents [6] listed in the Letter of Credit documents (bill of lading, invoice, packing list, certificate of origin, etc.) evidencing the shipment (Bill of Lading) and by Letter of Credit to paying bank named in the Letter of Credit (the advising bank usually), or any bank willing to negotiate under the terms of the Letter of Credit.

7 Advising bank [7.1] examines the documents for compliance with terms of the Letter of Credit. If complied with, bank [7.2] will pay to Seller’s account according to terms of the Letter of Credit.

8 Advising bank [8] sends the documents to the issuing bank.

9 Issuing bank [9] examines the documents for compliance with terms of the Letter of Credit.

10 Documents [11] release to Buyer after [10] payment or on other terms agreed between the bank and Buyer.

11 Buyer [12] surrenders Bill of Lading to carrier (in case of ocean freight) in exchange for the [13] goods or the Delivery Order.


Advantages and Disadvantages of Using a Letter of Credit

| EXPORTER IMPORTER
Ячейка 1*2 Ячейка 2*2 Ячейка 3*2 Ячейка 3*1
Ячейка 1*3 Ячейка 2*3 Ячейка 3*3 Ячейка 3*1
Ячейка 1*3 Ячейка 2*3 Ячейка 3*3 Ячейка 3*1

References

  1. Additional useful data concerning Letter of credit (terminology, sample documents, etc.) could be revealed at http://www.export911.com/e911/export/docLC.htm
  2. ICC Uniform Customs and Practice for Documentary Credits (UCP 600) - http://shippingandfreightresource.com/wp-content/uploads/2013/05/ucp-600.pdf
  3. A Guide to Letters of Credit - http://www.tradev.net/Downloads/Tools/guide2lc.pdf
  4. ibid
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