2. Buyer instructs their bank, the Issuing Bank, to open an LC in favor of the Seller

Application Form

At this stage the Buyer fills in the bank’s Letter of Credit application form with full details to replicate the contract agreed with the Seller. The Buyer must ensure the form avoids ambiguity, fully reflects the commercial contract and is not so complex as to make the transaction unworkable.

Terms of Payment

Documentary credits may be made available in one of four ways.

 

1. Sight Payment

This is where payment is made to the Seller, upon presentation of conforming documents. A sight Bill of Exchange, also called a Draft, is usually called for, though payment can be made against documents alone.

 

2. Deferred Payment

A deferred payment does not require the presentation of a draft. The Paying Bank is authorized to make payment at an agreed future date against presentation of conforming documents. The future date for payment is defined in the Letter of Credit usually as a number of days after the date of dispatch of goods or after the date of presentation of the documents.

 

3. Acceptance

An Acceptance LC requires presentation of a draft drawn on the bank nominated as Accepting Bank. If the terms of the LC are met, the draft is then accepted by the bank and is payable at a determinable future date. This will be detailed in the Letter of Credit as either a fixed future date, or a specific number of days from the date of dispatch of goods, or from the date of presentation of the documents.

 

4. Negotiation

With a Negotiable LC, the Issuing Bank must reimburse the bank, which negotiates drafts or documents drawn under its documentary LC. The credit may be made freely negotiable with any bank, or negotiation may be restricted to a bank nominated by the issuing bank. Under this type of LC, the Seller is responsible for any negotiation interest unless the Buyer specifically authorizes the Negotiating Bank to charge interest to their account.

 

Payment at the counters of the Issuing Bank

In this case the conforming documents have to be received by the Issuing Bank within the presentation period. Payment is only then made to the Beneficiary or Advising Bank.

Special Types of Letters of Credit

Transferable

Transferable Letters of Credit are used when the Seller is acting as an intermediary between the Buyer and Seller in a commercial transaction. In this instance, all of the rights and obligations of the LC are transferred from the intermediary to the ultimate supplier. The intermediary has no liability.

 

The terms of the transferred LC must be the same as the original except for the amount, unit price, expiry date, latest presentation date and period of shipment. All of these may be reduced, or brought forward.

 

The identities of the Buyer and the ultimate supplier may need to be withheld from each other. Careful drafting of the original and transferred Letter of Credit is needed to ensure this occurs.

 

Back-to-Back

In this instance, two LCs are established completely independently of each other. The Buyer establishes theirs in the Seller’s favor. The Seller can then arrange a second LC in favor of the ultimate supplier of the goods or the supplier of raw materials.

 

This type of LC should only become necessary where the underlying contracts are on terms which do not match or where a Transferable LC is unable to maintain secrecy on a particular aspect of the transaction.

 

Revolving

If aSeller makes regular shipments to a particular Buyer under a long-term supply contract, it may be beneficial for a series of shipments to be secured by a single documentary LC.

 

A Revolving LC can achieve this by the LC being reinstated for the original amount after a given period, and allowing the value of the LC to be drawn each time a shipment of goods is undertaken.

 

Be aware that as this is a continuing liability, it will have an impact on banking facilities.

 

Advance Payments

An LC that contains a clause, which authorizes the nominated bank to advance a portion of the value of the LC to the Seller before shipping documents are presented. This enables the Seller to purchase raw materials or to pay other costs before receiving the full payment, once conforming documents have been presented.

 

Advances are made at the risk of the Buyer. Drawings under an LC are made against a simple receipt from the Seller that they will refund the amount if they do not ship the goods as required. The Buyer’s account is debited as soon as an advance has been made.

 

Standby

A Standby Letter of Credit is a type of trade debt guarantee that is only drawn against in the event that the Buyer defaults in some way, eg. fails to pay for a consignment within an agreed period. A standby LC includes an expiry date, but no latest shipment date. Standby LCs will normally call for a statement of default from the Seller and also evidence of default.

 

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