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Types of Letter of Credit

Types of Letter of Credit

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Published by Vasant Kothari

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Published by: Vasant Kothari on Jul 14, 2011
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Letter of Credit
Vasant R. Kothari talks about the different types of Letters of Credit, which are integral to international business and trade.

Types of

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here are two types of Letters of Credit: Revocable and Irrevocable. A Revocable Letter of Credit can be revoked without the consent of the Exporter, meaning that it may be cancelled or changed up to the time the documents are presented. A Revocable Letter of Credit affords the exporter little protection; therefore, it is rarely used. An Irrevocable Letter of Credit cannot be cancelled or changed without the consent of all parties, including the exporter. Unless otherwise stipulated, all Letters of Credit are irrevocable. A further differentiation is made between Letters of Credit, depending on the payment terms. If payment is to be made at the time documents are presented, this is referred to as a Sight Letter of Credit. Alternatively, if payment is to be made at a future fixed time from presentation of documents (e.g. 60 days after sight) this is referred to as a Term or Usance or Deferred Payment Letter of Credit.

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Standby Letters of Credit is an assurance from a bank that an importer is able to pay an exporter. The exporter doesn’t expect to have to draw on the letter of credit to get paid.

AdvAntAges to the Importer
• Importer is assured that the exporter will be paid only if all terms and conditions of the Letter of Credit have been met. • Importer is able to negotiate more favourable trade terms with the exporter when payment by Letter of Credit is offered. • If the exporter is willing to grant extended terms to importer, importer may arrange for a Letter of Credit which is payable at a future date (i.e., 60 or 90 days after presentation of complying documents). • Through the use of Banker’s Acceptances, importer may finance the goods until they are marketed • By the documents called for, the importer can seek to minimize the risks in not receiving the goods ordered.

For extra security, the exporter may require the letter oF credit to be ‘conFirmed’ by the bank that checks it.
Confirmed and unconfirmed letters of credit come in the picture when an importer arranges a letter of credit with his/her own bank, known as the issuing bank. The exporter will usually want a bank in their country to check that the letter of credit is valid. For extra security, the exporter may require the letter of credit to be ‘confirmed’ by the bank that checks it. By confirming the letter of credit, the second bank agrees to guarantee payment even if the issuing bank fails to make it. So a confirmed letter of credit provides more security than an unconfirmed one. Back-to-Back Letter of Credit is a new letter of credit opened based on an already existing, nontransferable credit used as collateral. Traders often use back-to-back arrangements to pay the ultimate supplier. A trader receives a letter of credit from the importer and then opens another letter of credit in favour of the supplier. The first letter of credit serves as collateral for the second credit. Red Clause Letter of Credit provides the exporter with cash before shipment to finance production of the goods. The importer’s issuing bank may advance some or all of the funds. The importer, in essence, extends financing to the exporter and incurs the risk for all advanced credits. In Revolving Letter of Credit, the issuing bank restores the credit to its original amount once it has been used or drawn down. A single revolving letter of credit can cover several transactions between the same importer and exporter. Usually, these arrangements limit the number of times the importer may draw down its line over a predetermined period. Transferable Letter of Credit allows the exporter to transfer all or part of the proceeds of the original letter of credit to a second beneficiary, usually the ultimate supplier of the goods. The letter of credit must clearly state that it is transferable for it’s to be considered as such. This is a common financing tactic for middlemen and is common in East Asia.

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dIsAdvAntAges to the Importer
• A Letter of Credit does not offer protection to the importer against the exporter shipping inferior quality goods and/or a lesser quantity of goods. • It is necessary for the importer to have a line of credit with a bank before the bank is able to issue a Letter of Credit. The amount outstanding under each Letter of Credit issued is applied against this line of credit from the date of issuance until final payment.

AdvAntAges to the exporter
• The risk of payment relies upon the creditworthiness of the Issuing Bank and the political risk of the Issuing Bank’s domicile, and not the creditworthiness of the importer. • Exporter agrees in advance to all requirements for payment under the Letter of Credit. If the Letter of Credit is not issued as agreed, the exporter is not obligated to ship against it.

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• Exporter can further reduce foreign political and bank credit risk by requesting confirmation of the Letter of Credit by a bank. • The exporter may be able to obtain financing for the purchase or manufacture of goods that will be shipped under the Letter of Credit. • Under Banker’s Acceptance financing, the exporter may receive funds shortly after shipment, despite having granted credit terms to importer, or exporter may receive funds prior to export. The decision is typically based on the exporter’s cash flow position.

either the importer or the exporter is unable to comply with the terms of the sale agreement or the agreement has been changed. For example, an exporter will ask for an amendment to extend the expiry date and the latest shipping date if they are unable to manufacture the merchandise according to the agreed upon time. An importer may request an amendment to increase the value of the Letter of Credit if they subsequently decide to purchase a higher quantity of merchandise. Any amendments to the Letter of Credit must be accepted by the exporter and where more than one change is included in an amendment, they must be accepted as a whole as opposed to accepting or rejecting individual items within the amendment.

dIsAdvAntAges to the exporter
• Documents must be prepared and presented in strict compliance with the requirements stipulated in the Letter of Credit. • Some importers may not be able to open Letters of Credit due to the lack of credit facilities with their bank which consequently inhibits export growth. • Exporter is exposed to the commercial risk that the bank providing its undertaking is willing and able to perform.

If certain non-correctable discrepancies are noted, such as late shipment or presentation of documents past the expiry date, the exporter can send the documents to the Issuing Bank with the belief that the importer will approve the discrepancies. When the documents are received by the issuing bank, they will be checked and the discrepancies referred to the importer for acceptance. Meanwhile, the documents will not be released to the importer until the issuing bank receives the importer’s approval of the discrepancies. Upon receipt of the approval, payment will be made under the Letter of Credit. It is advantageous for the exporter to advise the importer directly of the discrepancies to ensure a quick response when the importer is contacted by the issuing bank. Discrepancies could be misspellings, missing dates of issue and expiration (maturity), incorrect naming of ICC publication numbers, or unfamiliarity with the name of the bank issuing the instrument.

deALIng wIth dIsCrepAnCIes
Any inconsistency found in the documents presented or failure to comply with the terms and conditions of the Letter of Credit is deemed a “discrepancy.” Certain discrepancies may be corrected by the exporter either by amending the original documents or by replacing them with new ones. If discrepancies are noted in the Bill of Lading, insurance document or consularised invoice, exporter must get the corrected document(s) from the issuing party.

Common probLems wIth Letters of CredIt
Statistics show that in as many as 50% of transactions using letters of credit, the exporter’s documents will be rejected by the banks at presentation. Most problems result from the exporter’s inability to fulfill obligations stated in the letter of credit. At the heart of the problem is the very limited discretion available to

Amendments to A Letter of CredIt
After issuance of a Letter of Credit, changes can be done through amendments subject to acceptance by the exporter. Amendments to the Letter of Credit will be required when

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banks in the matching of the terms and conditions of the credit against the documents presented. They must do this in a literal way, with no room for the exercise of judgment. For example, if a Letter of Credit calls for goods described as “100% Cotton, 40s x 40s, 132 x 72”. However the exporter presents a commercial invoice referring to the goods as “100% Cotton, 40s x 40s, 121 x 64”. The exporter may find these terms difficult or impossible to fulfill and, either tries to fulfill them and fails, or asks the importer to amend to the letter of credit. As most letters of credit are irrevocable, amendments may at times be difficult since both the importer and the exporter must agree.

arise late in the process. When this occurs, the importer’s and exporter’s banks will try to negotiate any differences. In some cases, the exporter can correct the documents and present them within the time specified in the letter of credit. If the documents cannot be corrected, the advising bank will ask the issuing bank to accept the documents despite the discrepancies found. It is important to note that, if the documents are not in accord with the specifications of the letter of credit, the importer’s issuing bank is no longer obligated to pay.

• •

when to use A Letter of CredIt
Although letters of credit can be useful,

justify the bank charges and extra costs involved, and who pays these costs? The customer’s creditworthiness: Do they have a track record? Risks associated with the country of import: Is it politically stable with a good reputation as an international trading partner? Normal trading practices: Is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity? Available advice and guidance: banks may recommend using of a letter of credit in certain trading situations regardless of other factors, while credit insurers sometimes insist on it.

If, letter of credit is the best option left

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exporters mAy hAve one or more of the foLLowIng probLems
• The shipment schedule cannot be met on time; • The stipulations concerning freight costs are unacceptable; • The price becomes too low due to exchange rates fluctuations; • The quantity of product ordered is not the expected amount; • The description of product is either insufficient or too detailed; and, • The stipulated documents are difficult or impossible to obtain. Even when exporters accept the terms of a letter of credit, problems often

it’s often best to avoid using one for a transaction. They can sometimes result in expensive delays, bureaucracy and unexpected costs. As a general rule one should probably only consider opening a letter of credit as an importer if: • Exporter insists on it, or • National exchange controls require it Exporters - deciding whether to ask for a letter of credit Think carefully about whether or not exporter needs to ask an overseas customer for a letter of credit. Some important things to consider include: • Legal matters: Does the exporting country require one? • Costs: Does the value of the order

for the exporter, then exporter needs to consider which type of letter to use. A ‘confirmed and irrevocable’ letter of credit is the most secure type.

ConCLusIon
Letters of Credit are a time-tested instrument of international trade. They have been used effectively to expand markets for goods and services and to facilitate a variety of financial transactions, either as a method of payment or as a credit enhancement, within as well as across the borders of sovereign states. Letters of Credit efficiently reduce payment risk, making the task of the corporate treasury staff less difficult.
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