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LETTERS OF CREDIT

NEED AND SCOPE

Risks in Foreign Exchange Transactions.

Exchange risk. Failure of foreign banks. Sudden changes in policies. Country risk. Interest risk. Liquidity risk.

Need for LC

Under International Maritime Law, when goods leave a country, the title for the goods pass on to the buyer. The seller may therefore insist on 100% advance payment. The alternative is to provide LC of a bank acceptable to him.

What is a Letter of Credit. (LC)?

It is an arrangement wherein a Bank guarantees on behalf of the buyer to make payment to the seller, upon presentation of documents specified in the LC. It is an undertaking by a Bank to pay on acceptance of the bills provided the beneficiary of the credit, (the seller), fulfils the terms and conditions set out in the LC.

Parties to the LC

Opener-Buyer Importer. Opening Bank- bank issuing the LC as per the Buyers request. Advising Bank-the bank through which the LC is advised. LC will be sent to the beneficiary through their agents (correspondent banks) abroad. The duty of the advising bank is to authenticate the message by (verifying the signature or

testing the cable message), so that the seller can act on it without any fear of forgery etc. Beneficiary- Seller-Exporter in whose favour the LC is opened. Negotiating Bank-The bank which is authorised to handle (purchase) the documents under the LC in the exporting country.

LC will stipulate whether a notified bank, is to negotiate (restricted LC) or any bank is, to negotiate in the sellers country. (unrestricted LC) Reimbursing bank. The bank which is authorised ( by the LC issuing bank) to effect reimbursements. SBI Mumbai designates Chemical Bank New York,

(reimbursing bank) to debit its account with them and honour the commitments under the LC. Confirming Bank. In some cases, the seller may insist that a bank known or acceptable to him in his country should add its guarantee (confirmation) on the LC issued by the buyers bank.

Types of LCs

Revocable: can be cancelled, revoked or amended without prior consent of the seller. This type is most uncommon. Irrevocable is the most commonly used LC. Confirmed/Unconfirmed LC. Confirmed LC will contain an additional guarantee/ confirmation of a bank in the sellers

Chosen by the seller. In a confirmed LC, the Seller has the assurance /guarantee of two banks (1) issuing bank and (2) confirming bank. Transferable LC. The LC can be easily transferred to other beneficiaries by the original beneficiary. Generally an LC will be nontransferable. Words like assignable/divisible will not be treated as transferable.

Back-to-Back LC. This is an inland LC opened on the basis of an export LC received by an exporter. For example a Mumbai exporter has received an LC for export of prawns worth $10,000 . He has to procure prawns from Cochin. In such a case he will open an inland LC which will be in conformity with the export LC received.

If an import LC is opened to fulfill an export LC requirement, it will also be called back-to-back LC. Acceptance LC. This LC permits drawing of usance bills (instead of sight bills which are drawn normally) that will be duly honoured on maturity dates.

Revolving LC. The amount of LC becomes automatically available for further drawing once the original amount is used. Let us say, the original amount of the LC is $20,000. Under ordinary LC, as soon as this amount is drawn the LC is dead. If it is a revolving LC, this amount or any other specified amount is again available for further draw by the seller subject to the conditions specified in the LC

Revolving LC is suitable when payments are made in installments on staggered supplies or upon the progress of work as in the case of building a ship or a custom built machinery. Red clause LC. In this LC, a special clause is incorporated/printed in RED that the beneficiary can be given pre-shipment advance of a specified value of the LC.

Green Clause LC. Here a clause is printed in GREEN to indicate that advances of the specified amounts in the LC can be given to the Exporter towards storage charges at the port of shipment. This helps the exporter to save himself from the risk of incurring huge storage charges due to delay in taking delivery of goods, say for want of shipping space.

INCOTERMS

INCOTERMS specifies up to what point in the trade transaction the Seller has fulfilled his obligations so that the goods can be considered to be legally delivered to the buyer. After the risks have been transferred from the seller to the buyer , at this critical point, the seller is assured of his rights of payment , even if, for instance, the goods are subsequently lost en-route.

The INCOTERMS and their abbreviations have been defined by the International Chamber of Commerce (ICC), so as to avoid any misinterpretations. These are terms like FOB, CIF, Ex-Works, FOA, FAS (Free alongside ship) etc. ICC has laid down the Sellers and Buyers primary duties under each of these terms.

These abbreviated terms are freely used in LCs, Export contracts, Proforma invoices etc. These terms of trade should be known to all engaged in export import business.

Uniform Customs and Practice for Documentary Credits.

The rules and regulations relating documentary credits is defined by ICC in their publication N0:500 This clearly defines the liabilities and responsibilities of each of the parties to documentary credits.

Check List for an LC


Ensure it is issued by a reputed bank. LC and all subsequent messages issued relevant to the LC are authenticated. If it is checked by an advising bank, ensure the advising banks stamp appears on the LC. There should be no ambiguity in the conditions of the LC. For example you cannot have part shipments when you are importing one equipment.

It does not contain any clause that violates any law in force in the Sellers/ Buyers country. It must carry a Notation to the effect that it is subject to Uniform Customs and Practices for Documentary Credits. Ensure the LC is operative. Specify the documents that must be enclosed with the LC.

These will include all conditions relating to the contract particularly, clauses relating to payment terms, pre-shipment inspection, delivery schedules, port of destination, payment of expenses incurred in the exporters country, customs clearance, Insurance certificates etc.