Letters of Credit – An Introduction

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This guide is an introduction to letters of credit (L/C) -also referred to by banks and other financial institutions as documentary credits. The guide tells you what a letter of credit is, the types of letter of credit available and the internationally agreed rules that govern their operation.

You should read this guide together with the guide Letters Of Credit – Best Practice and SITPRO’s set of three Letters of Credit Checklists and Guides for ImportersExporters and Export Sales Representatives. The checklist designed for importers is to be used by purchasing staff when applying to local banks for letters of credit. The one for exporters is intended primarily for use in export sales and shipping departments. The export sales representative’s guide advises on credits and some of the other responsibilities assumed on overseas visits.

To ensure a letter of credit is workable, trouble-free and provides the security of payment for which the credit was requested in the first place, it is essential to take simple yet effective precautions at the start. Working through the checkpoints set out in the various sections of the guide will help reduce discrepancies and associated unplanned costs.

Successive surveys by SITPRO and others have shown that well in excess of fifty percent of documents presented by exporters to banks for payment under letters of credit are rejected on first presentation. This can cause expensive delays for both the exporter and the importer and may even result in a lesser payment or no payment at all. A great many of those rejections could be avoided if more care was taken to ensure that the documents called for in the credit are properly completed.

The SITPRO Letters of Credit Checklists and Guides are designed to minimise unnecessary costs and risk when trading on the basis of letters of credit. They are aligned with and based on interpretation of Uniform Customs & Practice for Documentary Credits (UCP), produced by the International Chamber of Commerce (ICC). The current revision, UCP 600, is available from ICC UK (www.iccuk.net).

Definition

In simple terms, a letter of credit is an undertaking by a bank to make a payment to a named Beneficiary within a specified time, against the presentation of documents which comply strictly with the terms of the letter of credit.

Its main advantage is providing security to both the exporter and the importer, but the security offered however, comes at a price and must be weighed against the additional costs resulting from bank charges. The exporter must understand the conditional nature of the letter of credit and the fact that payment will not be made unless the terms of the credit are met precisely.

An importer/buyer (Applicant) may open a letter of credit if they wish to ensure that the exporter/seller (Beneficiary) has performed those requirements as per the underlying sales contract, by making the documentation requested conditions of the credit. (N.B. The sales contract is not an inherent part of the letter of credit, although the letter of credit may contain a reference to such contract).

When an exporter asks for payment by letter of credit, he is transferring the risk of non-payment by the buyer to the Issuing Bank -and the Confirming Bank if the letter of credit is confirmed-, providing the exporter presents the required documents in strict compliance with the credit, with the exception of cash in advance. For the exporter a letter of credit is the most secure method of payment in international trade provided the terms of the credit are met.

The following diagram shows those involved in a letter of credit transaction:

Issuing Bank Arrow Pointing Right Advising / Confirming Bank
Arrow Pointing Up Arrow Pointing Down
Importer
(Applicant)
Arrow Pointing Left
Underlying contract
Arrow Pointing Right
Exporter
(Beneficiary)

All parties in the letter of credit transaction deal with documents, not goods.

Should letter of credit be chosen as the payment method?

An importer should only be thinking of opening a letter of credit if his country’s exchange control regulations require it or if the exporter insists upon it. Otherwise, the procedure ought to be avoided because it can quite often cause problems for both parties.

Exporters will need to be certain that it is necessary to use a letter of credit. Typical considerations include:

Types of Letters of Credit

Irrevocable

Unconfirmed

Confirmed

Standby letter of credit

Revolving letter of credit

Transferable letter of credit

Back to back letter of credit

Uniform Customs and Practice for Documentary Credits (UCP)

Most letters of credit are subject to UCP: the universally recognised set of rules governing the use of the documentary credits in international trade. UCP was originally formulated in 1933 by the International Chamber of Commerce (ICC) and the current revision (UCP 600) came into effect on 1st July 2007. All definitions and general documentary requirements referred to in this briefing are in accordance with UCP 600 unless otherwise stated (it should be remembered that in some instances this may differ from national law). SITPRO would recommend using letters of credit that are subject to UCP 600. It is important to negotiate, as soon as possible, which party will bear the bank charges. It is worth remembering that on a small transaction these may be out of proportion and if these costs are not included in the pricing any profit may be completely eroded.

Disclaimer

Whilst every effort is made to ensure that the information given herein is accurate, SITPRO Ltd. accepts no legal responsibility for any views expressed or implied or for any errors, omissions or misleading statements in that information caused by negligence or otherwise.

UCP600 contains the rules for the use of letters of credit. Where there are any inconsistencies with this guide, UCP600 will prevail.