Life Cycle and Types of Documentary Credit / Letter of Credit

DOCUMENTARY CREDIT/Letter of Credit is an undertaking by a bank to the Beneficiary (Exporter/ seller) that it would make payment to him against presentation of documents drawn in terms of the credit. The Documentary Credit (DC) would be issued at the request of the customer (Importer /buyer) of the bank.

DC is a widely prevalent mechanism for settlement of trade in international trade. It assures the exporter of payment. Also, he is assured that the importer is bonafide and that the formalities in the importer’s country regarding the import have been complied with. As far as the importer is concerned, he will pay for the import only on receipt of the documents conforming to the terms and conditions of the credit.

The process of a Documentary Credit:

1. The contract is made between the importer and the exporter.

2.    The importer asks its bank to issue a documentary credit to the exporter.

3.    The importer's bank sends the documentary credit to the exporter's bank (advising bank).

4.    The exporter's bank advises the exporter of the issue of the documentary credit.

5.  After dispatch of the goods, the exporter delivers the required documents to its bank. The documents are examined against the terms and conditions stipulated in the documentary credit. If the requirements have been complied with, the exporter will be able to obtain payment.

6.    The exporter's bank sends the documents to the importer's bank and receives payment either at sight or term. 

7. The importer's bank delivers the documents to the importer upon reimbursement, after which the goods may be handed over.

PARTIES INVOLVED:

1. Beneficiary:  The seller of goods or services to whom the Documentary credit is addressed. The party entitled to its benefits.

2. Applicant or Account Party: The buyer of goods or services who requested the Documentary credit to be issued.

3. Issuing Bank: The primary financial institution that initiates and writes the Documentary credit extending their guarantee and liability to pay if the terms and conditions are fulfilled.

4. Advising Bank: The bank, usually in the beneficiary's country, whose primary job is to pass on the Documentary credit to the beneficiary. The advising bank is principally a correspondent bank of the issuing bank which means that the two parties have exchanged authenticating procedures, and may have also established accounts with each other. An important part of passing on a Documentary credit to a beneficiary is verifying its authenticity. When the advising bank authenticates the credit, they are saying it is a genuine instrument from the named issuing bank. They are not commenting on the creditworthiness of the bank or its country. This procedure gives the seller some protection against fraudulent instruments. That is why it is common practice to have letters of credit advised to a seller through a correspondent bank.

5. Confirming Bank: A separate financial institution requested by the issuing bank to add their guarantee of payment or acceptance to the credit instrument. It is necessary for this bank to establish a credit line or facility for the issuing bank in order to agree with this request. The confirming bank is usually but not necessarily the advising or drawee bank. The beneficiary cannot request on its own for a bank to confirm a Documentary credit. The request must come through the issuing bank. Therefore, a seller should ask the buyer to authorize the issuing bank to request confirmation.

6. Reimbursing Bank: Sometimes the issuing bank names a bank where it keeps funds in the currency of the Documentary credit to pay drawee or negotiating banks on its behalf. This bank is known as a reimbursing bank, and is usually named under the special instructions portion of the Documentary credit.

7. Negotiating Bank: A bank either nominated by the beneficiary under a freely negotiable Documentary credit or designated as a restricted negotiating bank by the issuing bank. Allows more flexibility in making payment, and enables beneficiaries to present documents for payment to their local international bank.

Types of Documentary Credit

1. Irrevocable: The opening introduction referred to a written undertaking given by an issuing bank. Such an undertaking is considered as irrevocable. In essence, this means that documentary credits can only be amended or cancelled with the agreement of the beneficiary and, if one is in place, the confirming bank. Although the overwhelming majority of credits used in global trade are irrevocable, revocable credits do occasionally surface.

2.    Revocable:  The opening introduction referred to a written undertaking given by an issuing bank. Such an undertaking is considered as revocable. In this extreme care should be taken with such instruments as they can be cancelled at any time without the consent of the beneficiary, and do not provide any satisfactory degree of security. It should be noted that banks would never confirm a revocable credit. 

3. Confirmed: Confirmation is a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying presentation. Confirmation is normally requested by a beneficiary (seller) at the time of agreeing the sale of goods, or agreeing to provide services or performance, and is usually a pre-condition inserted in the proforma invoice or sale contract. 

4. Unconfirmed: A letter of credit that is assured only by the issuing bank and does not need a guarantee from the second bank. Mostly the letters of credit are an unconfirmed letter of credit.

5. Revolving: In normal circumstances, an amendment is required in order to increase the value of a credit that has already been partially or fully utilised. However, a useful way around this is to utilise a revolving credit, which provides for the value of the credit to be restored.

6. Red & Green Clause: Such credits contain a special clause that allows the seller to draw on the credit prior to shipment of goods and presentation of documents. Historically, this clause was written in red or green ink.

a)    Unsecured or Clean Red Clause: Required documents do not include evidence of goods.

b)    Secured or Documentary Red Clause: Advances are made against presentation of warehouse receipts, or similar documents, together with seller’s undertaking to deliver the bill of lading and/or other required documents upon shipment.

c)    Green Clause: Allow for advance payment but provide for storage of the goods in the name of the bank as security.

7. Transferable: This type of credit allows the seller (‘first beneficiary’) to transfer the credit, fully or partially, to one or more third parties (‘second beneficiary’). In order for this practice to be effective, the credit must clearly state that it is transferable. It should be noted that a bank is under no obligation to transfer a credit except to the extent and in the manner expressly consented to by that bank. Unless otherwise agreed at the time of transfer, all charges incurred in respect of a transfer (such as commissions, fees, costs or expenses) must be paid by the first beneficiary.

8. Back-to Back: Such credits are commonly used by traders who act as ‘middlemen’ between the source supplier and the final buyer. In this process, two separate Credits are issued:

a)    A Master Credit in favour of the ‘middleman’, and

b)    A Back-to-Back Credit in favour of the source supplier

9. Standby Letter of Credit: Standby credits are very similar to demand guarantees (sometimes referred to as bank guarantees), the prime variation being in terminology and practice. Whilst used globally, they are more commonplace in the United States. Such a credit represents a secondary obligation covering default only, and provides security against non-performance as opposed to performance (as is the case with a normal documentary credit). In other words, if an expected action does not take place as covered by the standby, then a claim can be made. With documentary credits, claims are made against actual actions, e.g. shipment of goods.

10. Sight LC: A letter of credit that demands payment on the submission of the required documents. The bank reviews the documents and pays the beneficiary if the documents meet the conditions of the letter. 

11. Deferred Payment LC: An LC that ensures payment after a certain period. The bank may review the documents early but the payment to the beneficiary is made after the agreed-to time passes. It is also known as Usance LC. 

Hope this information will help you. Any other doubt, please ping me, I will try to respond asap.

- Sachin Gupta