Understanding and Using Letters of Credit

Letters of credit accomplish their purpose by substituting the credit of the

bank for that of the customer, for the purpose of facilitating trade. There
are basically two types: commercial and standby. The commercial letter of
credit is the primary payment mechanism for a transaction, whereas the
standby letter of credit is a secondary payment mechanism.

Commercial Letter of Credit

Commercial letters of credit have been used for centuries to facilitate pay-
ment in international trade. Their use will continue to increase as the glob-
al economy evolves.

Letters of credit used in international transactions are governed by the In-

ternational Chamber of Commerce Uniform Customs and Practice for Doc-
umentary Credits. The general provisions and definitions of the Interna-
tional Chamber of Commerce are binding on all parties. Domestic collec-
tions in the United States are governed by the Uniform Commercial Code.

A commercial letter of credit is a contractual agreement between a bank,

known as the issuing bank, on behalf of one of its customers, authorizing
another bank, known as the advising or confirming bank, to make pay-
ment to the beneficiary. The issuing bank, on the request of its customer,
opens the letter of credit. The issuing bank makes a commitment to honor
drawings made under the credit. The beneficiary is normally the provider
of goods and/or services. Essentially, the issuing bank replaces the bank's
customer as the payee.

Elements of a Letter of Credit

• A payment undertaking given by a bank (issuing bank)

• On behalf of a buyer (applicant)

• To pay a seller (beneficiary) for a given amount of money

• On presentation of specified documents representing the supply of

goods

• Within specified time limits

• Documents must conform to terms and conditions set out in the let-
ter of credit

• Documents to be presented at a specified place

Beneficiary
The beneficiary is entitled to payment as long as he can provide the docu-
mentary evidence required by the letter of credit. The letter of credit is a
distinct and separate transaction from the contract on which it is based.
All parties deal in documents and not in goods. The issuing bank is not li-
able for performance of the underlying contract between the customer
and beneficiary. The issuing bank's obligation to the buyer, is to examine
all documents to insure that they meet all the terms and conditions of the
credit. Upon requesting demand for payment the beneficiary warrants that
all conditions of the agreement have been complied with. If the benefi-
ciary (seller) conforms to the letter of credit, the seller must be paid by
the bank.

Issuing Bank
The issuing bank's liability to pay and to be reimbursed from its customer
becomes absolute upon the completion of the terms and conditions of the
letter of credit. Under the provisions of the Uniform Customs and Practice
for Documentary Credits, the bank is given a reasonable amount of time
after receipt of the documents to honor the draft.

The issuing banks' role is to provide a guarantee to the seller that if com-
pliant documents are presented, the bank will pay the seller the amount
due and to examine the documents, and only pay if these documents
comply with the terms and conditions set out in the letter of credit.

Typically the documents requested will include a commercial invoice, a

transport document such as a bill of lading or airway bill and an insurance
document; but there are many others. Letters of credit deal in documents,
not goods.

Advising Bank
An advising bank, usually a foreign correspondent bank of the issuing
bank will advise the beneficiary. Generally, the beneficiary would want to
use a local bank to insure that the letter of credit is valid. In addition, the
advising bank would be responsible for sending the documents to the issu-
ing bank. The advising bank has no other obligation under the letter of
credit. If the issuing bank does not pay the beneficiary, the advising bank
is not obligated to pay.

Confirming Bank
The correspondent bank may confirm the letter of credit for the benefi-
ciary. At the request of the issuing bank, the correspondent obligates itself
to insure payment under the letter of credit. The confirming bank would
not confirm the credit until it evaluated the country and bank where the
letter of credit originates. The confirming bank is usually the advising
bank.

Letter of Credit Characteristics

Negotiability
Letters of credit are usually negotiable. The issuing bank is obligated to
pay not only the beneficiary, but also any bank nominated by the benefi-
ciary. Negotiable instruments are passed freely from one party to another
almost in the same way as money. To be negotiable, the letter of credit
must include an unconditional promise to pay, on demand or at a definite
time. The nominated bank becomes a holder in due course. As a holder in
due course, the holder takes the letter of credit for value, in good faith,
without notice of any claims against it. A holder in due course is treated
favorably under the UCC.

The transaction is considered a straight negotiation if the issuing bank's

payment obligation extends only to the beneficiary of the credit. If a letter
of credit is a straight negotiation it is referenced on its face by "we engage
with you" or "available with ourselves". Under these conditions the prom-
ise does not pass to a purchaser of the draft as a holder in due course.

Revocability
Letters of credit may be either revocable or irrevocable. A revocable letter
of credit may be revoked or modified for any reason, at any time by the is-
suing bank without notification. A revocable letter of credit cannot be con-
firmed. If a correspondent bank is engaged in a transaction that involves a
revocable letter of credit, it serves as the advising bank.

Once the documents have been presented and meet the terms and condi-
tions in the letter of credit, and the draft is honored, the letter of credit
cannot be revoked. The revocable letter of credit is not a commonly used
instrument. It is generally used to provide guidelines for shipment. If a let-
ter of credit is revocable it would be referenced on its face.

The irrevocable letter of credit may not be revoked or amended without

the agreement of the issuing bank, the confirming bank, and the benefi-
ciary. An irrevocable letter of credit from the issuing bank insures the be-
neficiary that if the required documents are presented and the terms and
conditions are complied with, payment will be made. If a letter of credit is
irrevocable it is referenced on its face.

Transfer and Assignment

The beneficiary has the right to transfer or assign the right to draw, under
a credit only when the credit states that it is transferable or assignable.
Credits governed by the Uniform Commercial Code (Domestic) maybe
transferred an unlimited number of times. Under the Uniform Customs
Practice for Documentary Credits (International) the credit may be trans-
ferred only once. However, even if the credit specifies that it is nontrans-
ferable or nonassignable, the beneficiary may transfer their rights prior to
performance of conditions of the credit.

Sight and Time Drafts

All letters of credit require the beneficiary to present a draft and specified
documents in order to receive payment. A draft is a written order by which
the party creating it, orders another party to pay money to a third party. A
draft is also called a bill of exchange.

There are two types of drafts: sight and time. A sight draft is payable as
soon as it is presented for payment. The bank is allowed a reasonable
time to review the documents before making payment.

A time draft is not payable until the lapse of a particular time period
stated on the draft. The bank is required to accept the draft as soon as the
documents comply with credit terms. The issuing bank has a reasonable
time to examine those documents. The issuing bank is obligated to accept
drafts and pay them at maturity.

Standby Letter of Credit

The standby letter of credit serves a different function than the commer-
cial letter of credit. The commercial letter of credit is the primary payment
mechanism for a transaction. The standby letter of credit serves as a sec-
ondary payment mechanism. A bank will issue a standby letter of credit
on behalf of a customer to provide assurances of his ability to perform un-
der the terms of a contract between the beneficiary. The parties involved
with the transaction do not expect that the letter of credit will ever be
drawn upon.

The standby letter of credit assures the beneficiary of the performance of

the customer's obligation. The beneficiary is able to draw under the credit
by presenting a draft, copies of invoices, with evidence that the customer
has not performed its obligation. The bank is obligated to make payment if
the documents presented comply with the terms of the letter of credit.

Standby letters of credit are issued by banks to stand behind monetary

obligations, to insure the refund of advance payment, to support perform-
ance and bid obligations, and to insure the completion of a sales contract.
The credit has an expiration date.

The standby letter of credit is often used to guarantee performance or to

strengthen the credit worthiness of a customer. In the above example, the
letter of credit is issued by the bank and held by the supplier. The custom-
er is provided open account terms. If payments are made in accordance
with the suppliers' terms, the letter of credit would not be drawn on. The
seller pursues the customer for payment directly. If the customer is unable
to pay, the seller presents a draft and copies of invoices to the bank for
payment.

The domestic standby letter of credit is governed by the Uniform Commer-

cial Code. Under these provisions, the bank is given until the close of the
third banking day after receipt of the documents to honor the draft.

Procedures for Using the Tool

The following procedures include a flow of events that follow the decision
to use a Commercial Letter of Credit. Procedures required to execute a
Standby Letter of Credit are less rigorous. The standby credit is a domestic
transaction. It does not require a correspondent bank (advising or confirm-
ing). The documentation requirements are also less tedious.

Step-by-step process:
• Buyer and seller agree to conduct business. The seller wants a letter
of credit to guarantee payment.

• Buyer applies to his bank for a letter of credit in favor of the seller.
 • Buyer's bank approves the credit risk of the buyer, issues and for-
wards the credit to its correspondent bank (advising or confirming).
The correspondent bank is usually located in the same geographical
location as the seller (beneficiary).

• Advising bank will authenticate the credit and forward the original
credit to the seller (beneficiary).

• Seller (beneficiary) ships the goods, then verifies and develops the
documentary requirements to support the letter of credit. Docu-
mentary requirements may vary greatly depending on the perceived
risk involved in dealing with a particular company.

• Seller presents the required documents to the advising or confirm-

ing bank to be processed for payment.

• Advising or confirming bank examines the documents for compli-

ance with the terms and conditions of the letter of credit.

• If the documents are correct, the advising or confirming bank will

claim the funds by:

o Debiting the account of the issuing bank.

o Waiting until the issuing bank remits, after receiving the docu-
ments.

o Reimburse on another bank as required in the credit.

• Advising or confirming bank will forward the documents to the issu-

ing bank.

• Issuing bank will examine the documents for compliance. If they are
in order, the issuing bank will debit the buyer's account.

• Issuing bank then forwards the documents to the buyer.

Standard Forms of Documentation

When making payment for product on behalf of its customer, the issuing
bank must verify that all documents and drafts conform precisely to the
terms and conditions of the letter of credit. Although the credit can require
an array of documents, the most common documents that must accom-
pany the draft include:

Commercial Invoice
The billing for the goods and services. It includes a description of mer-
chandise, price, FOB origin, and name and address of buyer and seller.
The buyer and seller information must correspond exactly to the descrip-
tion in the letter of credit. Unless the letter of credit specifically states oth-
erwise, a generic description of the merchandise is usually acceptable in
the other accompanying documents.
Bill of Lading
A document evidencing the receipt of goods for shipment and issued by a
freight carrier engaged in the business of forwarding or transporting
goods. The documents evidence control of goods. They also serve as a re-
ceipt for the merchandise shipped and as evidence of the carrier's obliga-
tion to transport the goods to their proper destination.

Warranty of Title
A warranty given by a seller to a buyer of goods that states that the title
being conveyed is good and that the transfer is rightful. This is a method
of certifying clear title to product transfer. It is generally issued to the pur-
chaser and issuing bank expressing an agreement to indemnify and hold
both parties harmless.

Letter of Indemnity
Specifically indemnifies the purchaser against a certain stated circum-
stance. Indemnification is generally used to guaranty that shipping docu-
ments will be provided in good order when available.

Common Defects in Documentation

About half of all drawings presented contain discrepancies. A discrepancy
is an irregularity in the documents that causes them to be in non-compli-
ance to the letter of credit. Requirements set forth in the letter of credit
cannot be waived or altered by the issuing bank without the express con-
sent of the customer. The beneficiary should prepare and examine all doc-
uments carefully before presentation to the paying bank to avoid any
delay in receipt of payment. Commonly found discrepancies between the
letter of credit and supporting documents include:

• Letter of Credit has expired prior to presentation of draft.

• Bill of Lading evidences delivery prior to or after the date range

stated in the credit.

• Stale dated documents.

• Changes included in the invoice not authorized in the credit.

• Inconsistent description of goods.

• Insurance document errors.

• Invoice amount not equal to draft amount.

• Ports of loading and destination not as specified in the credit.

• Description of merchandise is not as stated in credit.

• A document required by the credit is not presented.

• Documents are inconsistent as to general information such as

volume, quality, etc.
 • Names of documents not exact as described in the credit. Benefi-
ciary information must be exact.

• Invoice or statement is not signed as stipulated in the letter of cred-

it.

When a discrepancy is detected by the negotiating bank, a correction to

the document may be allowed if it can be done quickly while remaining in
the control of the bank. If time is not a factor, the exporter should request
that the negotiating bank return the documents for corrections.

If there is not enough time to make corrections, the exporter should re-
quest that the negotiating bank send the documents to the issuing bank
on an approval basis or notify the issuing bank by wire, outline the dis-
crepancies, and request authority to pay. Payment cannot be made until
all parties have agreed to jointly waive the discrepancy.

Tips for Exporters

• Communicate with your customers in detail before they apply for
letters of credit.

• Consider whether a confirmed letter of credit is needed.

• Ask for a copy of the application to be fax to you, so you can check
for terms or conditions that may cause you problems in compliance.

• Upon first advice of the letter of credit, check that all its terms and
conditions can be complied with within the prescribed time limits.

• Many presentations of documents run into problems with time-lim-

its. You must be aware of at least three time constraints - the expira-
tion date of the credit, the latest shipping date and the maximum
time allowed between dispatch and presentation.

• If the letter of credit calls for documents supplied by third parties,

make reasonable allowance for the time this may take to complete.

• After dispatch of the goods, check all the documents both against
the terms of the credit and against each other for internal consist-
ency.

Summary
The use of the letters of credit as a tool to reduce risk has grown substan-
tially over the past decade. Letters of credit accomplish their purpose by
substituting the credit of the bank for that of the customer, for the pur-
pose of facilitating trade.

The credit professional should be familiar with two types of letters of cred-
it: commercial and standby. Commercial letters of credit are used primar-
ily to facilitate foreign trade. The commercial letter of credit is the primary
payment mechanism for a transaction.
The standby letter of credit serves a different function. The standby letter
of credit serves as a secondary payment mechanism. The bank will issue
the credit on behalf of a customer to provide assurances of his ability to
perform under the terms of a contract.

Upon receipt of the letter of credit, the credit professional should review
all items carefully to insure that what is expected of the seller is fully un-
derstood and that he can comply with all the terms and conditions. When
compliance is in question, the buyer should be requested to amend the
credit.