Business English Department, College of Foreign Languages,
Hunan University
Chapter Six
Letter of Credit
By Yiping Wang
Revision of the payment methods
• Advance payment
• Open account
• Documentary collection
They are all based on commercial credit
Letter of credit
Contents of this chapter
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The definition of letter of credit
Parties of a credit
Features
Benefits
Procedures of a credit transaction
Case study
sample credit
Types of credit
Summary
Assignment
Objectives
In this period, students are required to
have an understanding of the concept of
letter of credit, including its:
definition
features
contractual relationship
benefits
parties and
the procedures
6.1 Definition
• The Documentary Credit or letter of credit is
an undertaking issued by a bank for the
account of the buyer (the applicant) or for its
own account, to pay the beneficiary the
value of the draft and/or documents
provided that the terms and conditions of the
documentary credit are complied with.
6.2 Parties involved in a
documentary credit
• Applicant/importer/buyer
• Issuing /opening bank /buyer’s bank
• Advising bank/exporter’s /seller’s
bank
• Beneficiary/exporter/seller
•
•
•
•
•
•
Confirming bank
Negotiating bank
Paying bank/drawee bank
Accepting bank
Reimbursing bank
Transferring bank
6.3 Features of a letter of credit
A letter of credit places a bank’s credit
instead of a commercial credit. It is
guaranteed by the issuing bank’s
creditworthiness. Its main characteristics
are as follows:
1. The issuing bank undertakes primary
obligation to effect payment.
2. L/C stands independent of the sales
contract.
3. Banks deal with documents and not
with
goods,
services
or
other
performances to which the documents
may relate.
4. Banks assumes no responsibility for
the
form,
sufficiency,
accuracy,
genuineness, falsification or legal effect of
any documents presented.
Three independent contracts under a credit
Beneficiary
Sales contract
Applicant
Credit
Security agreement
Issuing Bank
6. 4 Benefits of L/C
The documentary credit provides a high level of
protection and security to both buyer and seller
engaged in international trade. The seller is
assured that payment will be made by a party
independent of the buyer so long as the terms and
conditions of the credit are complied with. The
buyer is assured that payment will be made to the
seller only after the bank has received the
required documents called for in the credit.
1. Facilitates financing
• Provides a specific transaction with an
independent credit backing and clear-cut
promise of payment.
• Satisfies the financing needs of the seller and
buyer by placing the bank’s credit standing,
distinguished from the bank’s funds, at the
disposal of both parties.
• Reduces or eliminates the commercial
credit risk. The seller no longer needs to
rely on the willingness and capability of
the buyer to make payment.
• Reduces certain exchange and political
risks.
• May not require actual segregation of cash.
• Expands sources of supply for the buyer.
2. Provides legal protection
•
•
•
•
Documentary credits are supported by a
wide variety of laws and regulations :
Legislative and semi-legislative law
Codified law — in most countries, the law
for documentary credit has been codified
Contractual law
Documentary credits are usually governed
by the ICC rules. These rules are
universally recognized. The current version
is UCP600.
3. Assures expert examination of
documents
• The buyer is assured that the documents
must be presented in compliance with the
terms and conditions of the documentary
credit and the UCP rules.
• The buyer is assured that the documents
presented will be examined by banking
personnel
knowledgeable
in
the
documentary operations, and
• The buyer is confident that payment will
only be made to the seller after the
terms
and
conditions
of
the
documentary credit and the UCP rules
are complied with.
6.4 Basic documentary credit
procedures
• Issuance
Issuance is the process of the
buyer’s applying for the opening of a
documentary credit at the issuing
bank and the issuing bank’s formal
notification of the seller through the
advising bank.
1.Sales Contract
Applicant
(Buyer)
2.Application
Beneficiary
(Seller)
3. Security
agreement
Issuing
Bank
5. Advise
4. Credit
Advising
Bank
Issuance
1. The buyer and seller agree on
the terms of the sales contract:
a. Specifying a documentary
credit as the means of payment,
b. Naming an advising bank
c. Listing the required documents
2. The buyer applies to his bank for
the opening of the credit
3. He signs the security agreement
with the issuing bank.
4. The issuing bank issues and sends
the documentary credit to the
advising bank named in the credit.
5. The advising bank informs the
seller of the documentary credit.
Amendment
Amendment is the process
whereby
the
terms
and
conditions of a documentary
credit may be modified after the
credit has been issued.
1. Contact
Applicant
(Buyer)
Beneficiary
(Seller)
2.Order of
Amendment
4. Amendment
Notification
Issuing
Bank
3.Amendment
Notification
Advising
Bank
Upon receipt of the documentary credit, the
beneficiary should review it closely to see that
the terms and conditions
n reflect the contract between the buyer
and the seller
n can be met within the time stipulated
n does not contain any conditions which
are unacceptable or impossible to comply
with
Utilization
Utilization is the process for the
seller’s shipping of the goods, the
transmission of documents from the
seller to the buyer through the banks,
and the transfer of payment from the
buyer to the beneficiary through the
banks.
Applicant
(Buyer)
Beneficiary
1. Goods
(Seller)
7. Documents
6. Payment
Issuing
Bank
2. Documents
4. Documents
5.Payment
3. Payment
Negotiation
Acceptance
Advising
Bank
1.The seller ships the goods to the buyer
and obtains the title documents from the
shipping line.
2.The seller prepares and presents all the
documents as required by the credit to the
nominated bank.
3.The advising/confirming bank reviews the
document package making certain the
documents are in conformity with the terms
and conditions of the credit and pays the
seller according to the terms of the credit.
4. The advising/confirming bank sends the
documents to the issuing bank.
5. The issuing bank
n Reviews the documents making certain
that they are in conformity with the terms of
the credit.
n
Pays the advising/confirming bank
according to their reimbursement agreement.
n Advises the buyer that the documents
have been received
6.The buyer reviews the documents
making certain that they are in
conformity with the terms of the credit
and makes payment to the issuing
bank.
7.The issuing bank sends the
documents to the buyer who then takes
possession of the shipment.
Some commonsense rules about L/C
An irrevocable documentary credit is, an
excellent instrument of payment. Also, if
appropriate documents are called for, and
provided reliance can be placed on the
integrity of the seller, it is an effective means
of obtaining delivery of the goods. It is,
nevertheless, a precision instrument, and
must be properly handled by all concerned.
First Rule
• Buyer: His instructions to the issuing bank
must be clear, correct and precise, and free
from excessive details.
• Seller: Although considerable time may
elapse between the receipt of a credit and
its utilization, he should not delay examining
it
and
requesting
any
necessary
amendments.
Second Rule
• Buyer: The purpose of the credit is to pay for
his purchase, not to “police” the commercial
transaction.
• Seller: He should satisfy himself that the terms,
conditions and documents called for are in
agreement with the sales contract. The
examination of the documents will take into
consideration only the terms of the credit and any
amendments to it.
Third Rule
• Buyer: Any examination of the goods
prior to, or at the time of, shipment,
must be evidenced by a document.
The precise nature — and issuer —
of such documents must be stated in
the credit.
• Seller: When it is time to present the
documents, he should:
*Present the required documents exactly
as called for by the credit.
*Present the documents to the bank as
quickly as possible, and in any case within
the validity of the credit and within the period
of time after issuance of the transport
document specified in the credit or
applicable under UCP600.
Fourth Rule
• Buyer: The credit should not call for
documents that the seller cannot provide, nor
set out conditions that he cannot meet.
• Seller: He must remember that noncompliance with the terms stipulated in the
credit, or irregularities in the documents,
obliges the bank to refuse settlement.
Case Study
Case 1: Bank of China as the issuing bank
received documents under a letter of credit.
The documents are in compliance with the
requirements of the credit, but the
applicant got the news from its business
partner that this shipment of goods are
faulty products, should the bank make
payment?
Case 2
You received documents under the
credit you issued. The presentation
includes a document not required by
the credit, and which is not consistent
with other documents presented.
Would you reject the documents
under UCP600?
Key to the case
No. You would not examine the document
per UCP600 Article -- Article14(g) banks
examine “all documents stipulated in the
credit” and “Documents not stipulated in
the credit will be disregarded by banks. If
they received such documents, they shall
return them to the presenter or pass them
on without responsibility”.
Summary
Assignment
• Preview P113 to P151 Types of Credit
• Read UCP 600. I’ve send it to your public
e-mail.
Thank
You!
Advance Payment
The buyer pays the seller prior to shipment
of the goods or provision of services.
Characteristics:
• It provides greatest security for the seller
and involves the highest risk for the buyer.
• Under this payment method, the buyer
must have a high level of confidence in the
ability and willingness of the seller to
deliver the goods as ordered.
Open Account
An arrangement between the buyer and
seller whereby the goods are delivered to
the buyer before payment is required.
Characteristics:
• It provides the least risk for the buyer, and
the greatest risk for the seller.
• The seller must have absolute trust that he
will be paid at the agreed date.
Documentary Collection
• A compromised method between open
account and advance payment.
• For the seller, there is the possibility of the
buyer refusing to honor the draft and take
up the documents.
• For the importer. He has the risk that the
goods shipped may not be as ordered.
Types of credit
• 1.
• 2.
• 3.
•4
• 5.
• 6.
• 7.
• 8.
Revocable vs. irrevocable
Confirmed vs. unconfirmed
Sight credit vs. time/usance credit
Transferable credit
Mode of availability
Special function clause
Back-to-Back documentary credit
Reciprocal credit
• Letter of credit may be classified
from different angles such as
time of payment, commitment of
banks, special purpose of credit.
1. Whether or not it can be revoked
1.1 Revocable credit
• Definition: one that may be amended or
cancelled or revoked by the issuing bank
without the beneficiary’s consent and even
without prior notice to the beneficiary up to the
moment of payment by the bank at which the
issuing bank has made the documentary
credit available.
1.1 Revocable credit
Nature:
The revocable credit therefore does
not constitute an undertaking by the
issuing bank to make payment.
Risks under Revocable credit to Beneficiary
• The revocable credit involves risks to the
beneficiary since the documentary credit may
be amended or cancelled while the goods are in
transit and before the documents are presented,
or although documents may have been
presented, before payment has been made, or,
in the case of a deferred payment documentary
credit, before documents have been taken up.
Revocable credit
• Usage: it is normally accepted as
usage between affiliated parties or
subsidiary companies, or as a
usage of a particular trade, or as a
substitute for a promise to pay or a
payment order. At present days,
revocable credits are seldom used.
Function clause of revocable credit
• This credit is subject to cancellation or
amendment at any time without prior notice
to the beneficiary.
• We undertake to honor your drafts drawn and
negotiated in conformity with the terms of this
credit provided such negotiation has been
made prior to receipt by your notice of
cancellation.
Function clause of revocable credit
• This advice, revocable at any time without
notice, is for your guidance only in
preparing drafts and documents and
conveys no engagement or obligation on
our part or on the part of our above
mentioned correspondent.
• This revocable credit may be cancelled by
the issuing bank at any moment without
prior notice.
1.2 Irrevocable credit
• A credit that constitutes a definite
undertaking of the issuing bank, provided
that the stipulated documents are presented
to the nominated bank or to the issuing bank
and that the terms and conditions of the
documentary credit are complied with, to pay,
accept drafts and /or document(s) presented
under the documentary credit.
Irrevocable credit
• It can’t be cancelled/modified without
the express consent of the issuing bank,
the confirming bank (if any) and the
beneficiary. Therefore, it constitutes an
undertaking by the issuing bank to
make payment.
Function clause of Irrevocable credit
• We (The Issuing Bank) hereby issue in your
favor this irrevocable documentary credit
that is available by payment/negotiation of
your draft.
• We hereby engage with you that all drafts
drawn in conformity with the terms of this
credit will be duly honored on presentation.
2. According to
the adding of confirmation
2.1 Confirmed credit
• Definition: A credit that carries the
commitment to pay by both the
issuing bank and the advising bank. It
is advised to the beneficiary with
another bank’s confirmation added
thereto.
Confirmed credit
• It constitutes a definite undertaking of the
confirming bank, in addition to that of the
issuing bank, provided that the stipulated
documents are presented to the confirming
bank on or before the expiry date and the
terms and conditions of the documentary
credit are complied with, to pay, to accept
draft(s) or to negotiate.
Confirmed credit
• Confirmation is only added to an
irrevocable credit at the request of the
issuing bank. It is used when the seller
does not have confidence that the
issuing bank can effectively guarantee
payment.
Confirmed credit
• Therefore, if the issuing bank is
considered to be a first class bank,
there may not be any need to have
its documentary credit confirmed
by another bank.
• If the advising bank confirms the
credit it must pay without recourse to
the seller when the documents are
presented, provided they are in order
and the credit requirements are met.
Advantages of Confirmed credit
• A double assurance of payment
--Assurance of payment by the
issuing bank
--Assurance of payment from the
confirming bank
The issuing bank’s authorization clause
The advising bank is authorized to add
your confirmation.
• Please notify the beneficiary and add
your confirmation.
• Please add your confirmation if the
beneficiary required.
•
The confirming bank’s
engagement clause
• At the request of the correspond
(Issuing Bank) we (Advising Bank)
have been requested to add our
confirmation to this credit and we
hereby undertake that all drafts
drawn by you (Beneficiary) in
accordance with the terms of the
credit will be duly honored by us.
• At the request of the correspondent
bank we confirm their credit and
also engage with you that drafts
drawn in conformity with the terms
of this credit will be paid by us.
• This credit bears our confirmation and we
hereby engage to negotiate or accept on
presentation to us, drafts drawn and
documents presented in conformity with
the terms of this credit.
• We have been requested to add our
confirmation to this credit and we hereby
undertake to honor all drafts drawn in
accordance with the terms of the credit.
2.2 Silent confirmation
• Silent confirmation represents an
agreement between a bank and the
beneficiary for that bank to “add its
confirmation” to the documentary credit
despite not being so authorized by the
issuing bank.
2.3 Unconfirmed credit
A credit that bears no confirmation of
the correspondent bank. It only has
the commitment of the issuing bank.
• Function clause:
• “We advise this credit to you without
engagement on our part.”