Letter of credit

From Wikipedia, the free encyclopedia

Jump to:navigation, search

After a contract is concluded between buyer and seller, buyer's bank supplies a letter of
credit to seller.

Seller consigns the goods to a carrier in exchange for a bill of lading.

Seller provides bill of lading to bank in exchange for payment. Seller's bank exchanges bill of
lading for payment from buyer's bank. Buyer's bank exchanges bill of lading for payment from
the buyer.

Buyer provides bill of lading to carrier and takes delivery of goods.

A standard, commercial letter of credit is a document issued mostly by a financial institution,

used primarily in trade finance, which usually provides an irrevocable payment undertaking.

The letter of credit can also be source of payment for a transaction, meaning that redeeming the
letter of credit will pay an exporter. Letters of credit are used primarily in international trade
transactions of significant value, for deals between a supplier in one country and a customer in
another. They are also used in the land development process to ensure that approved public
facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit
are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant
is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit
are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary,
the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit
incorporate functions common to giros and Traveler's cheques. Typically, the documents a
beneficiary has to present in order to receive payment include a commercial invoice, bill of
lading, and documents proving the shipment was insured against loss or damage in transit.
However, the list and form of documents is open to imagination and negotiation and might
contain requirements to present documents issued by a neutral third party evidencing the quality
of the goods shipped, or their place of origin.

Contents
[hide]

 1 Terminology
 2 How it works
 3 Availability
 4 Some of the Documents Called for under a Letter of Credit
 5 Legal principles governing documentary credits
  6 The price of letters of credit
 7 Legal Basis for Letters of Credit
 8 International Trade Payment methods
 9 Risk situations in letter-of-credit transactions
 10 See also
 11 References

[edit] Terminology
The English name “letter of credit” derives from the French word “accreditation”, a power to do
something, which in turn is derivative of the Latin word “accreditivus”, meaning trust. The
Application any defense relating to the underlying contract of sale. This is as long as the seller
performs their duties to an extent that meets the requirements contained in the letter of credit.

[edit] How it works

A business called the InCosmetika from time to time imports goods from a business called
ACME, which banks with the ABC Bank. InCosmetika holds an account at the Commonwealth
Bank. InCosmetika wants to buy $500,000 worth of merchandise from ACME, who agrees to
sell the goods and give InCosmetika 60 days to pay for them, on the condition that they are
provided with a 90-day letter of credit for the full amount. The steps to get the letter of credit
would be as follows:

 InCosmetika goes to The Commonwealth Bank and requests a $500,000 letter of credit,
with ACME as the beneficiary.
 The Commonwealth Bank can issue a letter of credit either on approval of a standard loan
underwriting process or by InCosmetika funding it directly with a deposit of $500,000
plus fees which are typically between 1% and 8% of the face value of the letter of credit.
 The Commonwealth Bank sends a copy of the letter of credit to the ABC Bank, which
notifies ACME that payment is available and they can ship the merchandise InCosmetika
has ordered with the full assurance of payment to them.
 On presentation of the stipulated documents in the letter of credit and compliance with
the terms and conditions of the letter of credit, the Commonwealth Bank transfers the
$500,000 to the ABC Bank, which then credits the account of ACME for that amount.
 Note that banks deal only with documents required in the letter of credit and not the
underlying transaction.
 Many exporters have mistakenly assumed that the payment is guaranteed after receiving
the letter of credit. The issuing bank is obligated to pay under the letter of credit only
when the stipulated documents are presented and the terms and conditions of the letter of
credit have been met.

[edit] Availability
A letter of credit being an irrevocable undertaking of the issuing bank makes available the
Proceeds, to the Beneficiary of the Credit provided, stipulated documents strictly complying with
the provisions of the letter of credit, UCP 600 and other international standard banking practices,
are presented to the issuing bank, then:

 i.if the Credit provides for sight payment – by payment at sight against compliant
presentation
 ii.if the Credit provides for deferred payment – by payment on the maturity date(s)
determinable in accordance with the stipulations of the Credit; and of course undertaking
to pay on due date and confirming maturity date at the time of compliant presentation
 iii.a.if the Credit provides for acceptance by the Issuing Bank – by acceptance of
Draft(s) drawn by the Beneficiary on the Issuing Bank and payment at maturity of such
tenor draft, or
 iii.b. if the Credit provides for acceptance by another drawee bank – by acceptance and
payment at maturity Draft(s)drawn by the Beneficiary on the Issuing Bank in the event
the drawee bank stipulated in the Credit does not accept Draft(s) drawn on it,

or by payment of Draft(s) accepted but not paid by such drawee bank at maturity;

 iv. if the Credit provides for negotiation by another bank – by payment without recourse
to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary and/or
document(s) presented under the Credit, (and so negotiated by the nominated bank )

 Negotiation means the giving of value for Draft(s) and/or document(s) by the bank
authorized to negotiate, viz the nominated bank. Mere examination of the documents and
forwarding the same to the letter of credit issuing bank for reimbursement, without giving
of value / agreed to give, does not constitute a negotiation.

[edit] Some of the Documents Called for under a Letter of

Credit
 Financial Documents

Bill of Exchange, Co-accepted Draft

 Commercial Documents

Invoice, Packing list

 Shipping Documents

Transport Document, Insurance Certificate, Commercial, Official or Legal Documents

 Official Documents
 License, Embassy legalization, Origin Certificate, Inspection Certificate, Phytosanitary
certificate

 Transport Documents

Bill of Lading (ocean or multi-modal or Charter party), Airway bill, Lorry/truck receipt,
railway receipt, CMC Other than Mate Receipt, Forwarder Cargo Receipt, Deliver
Challan...etc

 Insurance documents

Insurance policy, or Certificate but not a cover note.

[edit] Legal principles governing documentary credits

One of the primary peculiarities of the documentary credit is that the payment obligation is
abstract and independent from the underlying contract of sale or any other contract in the
transaction. Thus the bank’s obligation is defined by the terms of the credit alone, and the sale
contract is irrelevant. The defences of the buyer arising out of the sale contract do not concern
the bank and in no way affect its liability.[1] Article 4(a) UCP states this principle clearly. Article
5 the UCP further states that banks deal with documents only, they are not concerned with the
goods (facts). Accordingly, if the documents tendered by the beneficiary, or his or her agent,
appear to be in order, then in general the bank is obliged to pay without further qualifications.

The policies behind adopting the abstraction principle are purely commercial and reflect a
party’s expectations: firstly, if the responsibility for the validity of documents was thrown onto
banks, they would be burdened with investigating the underlying facts of each transaction and
would thus be less inclined to issue documentary credits as the transaction would involve great
risk and inconvenience. Secondly, documents required under the credit could in certain
circumstances be different from those required under the sale transaction; banks would then be
placed in a dilemma in deciding which terms to follow if required to look behind the credit
agreement. Thirdly, the fact that the basic function of the credit is to provide the seller with the
certainty of receiving payment, as long as he performs his documentary duties, suggests that
banks should honour their obligation notwithstanding allegations of misfeasance by the buyer. [2]
Finally, courts have emphasised that buyers always have a remedy for an action upon the
contract of sale, and that it would be a calamity for the business world if, for every breach of
contract between the seller and buyer, a bank were required to investigate said breach.

The “principle of strict compliance” also aims to make the bank’s duty of effecting payment
against documents easy, efficient and quick. Hence, if the documents tendered under the credit
deviate from the language of the credit the bank is entitled to withhold payment even if the
deviation is purely terminological.[3] The general legal maxim de minimis non curat lex has no
place in the field of documentary credits.

[edit] The price of letters of credit

All the charges for issuance of Letter of Credit, negotiation of documents, reimbursements and
other charges like courier are to the account of applicant or as per the terms and conditions of the
Letter of credit. If the letter of credit is silent on charges, then they are to the account of the
Applicant. The description of charges and who would be bearing them would be indicated in the
field 71B in the Letter of Credit.

[edit] Legal Basis for Letters of Credit

Although documentary credits are enforceable once communicated to the beneficiary, it is
difficult to show any consideration given by the beneficiary to the banker prior to the tender of
documents. In such transactions the undertaking by the beneficiary to deliver the goods to the
applicant is not sufficient consideration for the bank’s promise because the contract of sale is
made before the issuance of the credit, thus consideration in these circumstances is past. In
addition, the performance of an existing duty under a contract cannot be a valid consideration for
a new promise made by the bank: the delivery of the goods is consideration for enforcing the
underlying contract of sale and cannot be used, as it were, a second time to establish the
enforceability of the bank-beneficiary relation.

Legal writers have analyzed failed to satisfactorily reconcile the bank’s undertaking with any
contractual analysis. The theories include: the implied promise, assignment theory, the novation
theory, reliance theory, agency theories, estoppels and trust theories, anticipatory theory, and the
guarantee theory. [4] Davis, Treitel, Goode, Finkelstein and Ellinger have all accepted the view
that documentary credits should be analyzed outside the legal framework of contractual
principles, which require the presence of consideration. Accordingly, whether the documentary
credit is referred to as a promise, an undertaking, a chose in action, an engagement or a contract,
it is acceptable in English jurisprudence to treat it as contractual in nature, despite the fact that it
possesses distinctive features, which make it sui generis.

A few countries including the US (see Article 5 of the Uniform Commercial Code) have created
statutes in relation to the operation of letters of credit. These statutes are designed to work with
the rules of practice including the UCP and the ISP98. These rules are practice are incorporated
into the transaction by agreement of the parties. The latest version of the UCP is the UCP600
effective July 1, 2007[5]. The previous revision was the UCP500 and became effective on 1
January 1994. Since the UCP are not laws, parties have to include them into their arrangements
as normal contractual provisions.

[edit] International Trade Payment methods

 Advance payment (most secure for seller)

Where the buyer parts with money first and waits for the seller to forward the goods

 Documentary Credit (more secure for seller as well as buyer)

Subject to ICC's UCP 600, where the bank gives an undertaking (on behalf of buyer and at the
request of applicant ) to pay the shipper ( beneficiary ) the value of the goods shipped if certain
documents are submitted and if the stipulated terms and conditions are strictly complied.

Here the buyer can be confident that the goods he is expecting only will be received since it will
be evidenced in the form of certain documents called for meeting the specified terms and
conditions while the supplier can be confident that if he meets the stipulations his payment for
the shipment is guaranteed by bank, who is independent of the parties to the contract.

 Documentary collection (more secure for buyer and to a certain extent to seller)

Also called "Cash Against Documents". Subject to ICC's URC 525, sight and usance, for
delivery of shipping documents against payment or acceptances of draft, where shipment
happens first, then the title documents are sent to the [collecting bank] buyer's bank by seller's
bank [remitting bank], for delivering documents against collection of payment/acceptance

 Direct payment (most secure for buyer)

Where the supplier ships the goods and waits for the buyer to remit the bill proceeds, on open
account terms.

[edit] Risk situations in letter-of-credit transactions

Fraud Risks

 The payment will be obtained for nonexistent or worthless merchandise against

presentation by the beneficiary of forged or falsified documents.
 Credit itself may be forged.

Sovereign and Regulatory Risks

 Performance of the Documentary Credit may be prevented by government action outside

the control of the parties.

Legal Risks

 Possibility that performance of a Documentary Credit may be disturbed by legal action

relating directly to the parties and their rights and obligations under the Documentary
Credit

Force Majeure and Frustration of Contract

 Performance of a contract – including an obligation under a Documentary Credit

relationship – is prevented by external factors such as natural disasters or armed conflicts
Risks to the Applicant

 Non-delivery of Goods
 Short Shipment
 Inferior Quality
 Early /Late Shipment
 Damaged in transit
 Foreign exchange
 Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

 Insolvency of the Applicant

 Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

 no obligation to reimburse the Claiming Bank unless it has issued a reimbursement

undertaking.

Risks to the Beneficiary

 Failure to Comply with Credit Conditions

 Failure of, or Delays in Payment from, the Issuing Bank
 Credit Issued by Party other than Bank

Risks to the Advising Bank

 The Advising Bank’s only obligation – if it accepts the Issuing Bank’s instructions – is to
check the apparent authenticity of the Credit and advising it to the Beneficiary

Risks to the Nominated Bank

 Nominated Bank has made a payment to the Beneficiary against documents that comply
with the terms and conditions of the Credit and is unable to obtain reimbursement from
the Issuing Bank

Risks to the Confirming Bank

 If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may not be
able to obtain reimbursement from the Issuing Bank because of insolvency of the Issuing
Bank or refusal of the Issuing Bank to reimburse because of a dispute as to whether or
not payment should have been made under the Credit

Other Risks in International Trade

  A Credit risk risk from change in the credit of an opposing business.
 An Exchange risk is a risk from a change in the foreign exchange rate.
 A Force majeure risk is 1. a risk in trade incapability caused by a change in a country's
policy, and 2. a risk caused by a natural disaster.
 Other risks are mainly risks caused by a difference in law, language or culture. In these
cases, the cargo might be found late because of a dispute in import and export dealings.

 Letter of Guarantee
 A letter from a bank to a brokerage firm which states that a customer (who has written a call
option) does indeed own the underlying stock and the bank will guarantee delivery if the call is
assigned. Thus the call can be considered covered. Not all brokerage firms accept letters of
guarantee. Also: letter issued to Option Clearing Corporation by member firms covering a
guarantee of any trades made by one of its customers, (a trader or broker on the exchange
floor).


Hypothecation

Generally, a hypothecation is a contract which pledges or creates a lien on collateral to secure a

debt, where the debtor keeps possession of the collateral. The arrangement is common with
modern mortgages and the financing of business equipment and some consumer goods purchases
- the borrower retains legal ownership of the property but provides the lender with a lien over the
property until the debt is paid off.

Contents
[hide]

 1 Hypothecation of securities in capital markets

 2 No creditor's duty of care
 3 See also
 4 External links
 5 References

[edit] Hypothecation of securities in capital markets

Hypothecation and re-hypothecation, respectively, are commonly used to describe the means by
which securities brokers and dealers first extend credit on margin to their customers using
pledged securities as collateral, and then pledge the client-owned securities held in the client's
margin account as collateral for the brokerage's bank loan. In this example, hypothecation
describes the posting of collateral to secure the customer's obligation to the broker;
rehypothecation is the pledging by the broker of hypothecated client-owned securities in a
margin account to secure a loan to the broker from a bank. This common use of the terms
hypothecation and re-hypothecation is technically inaccurate, since the pledgee of the securities
collateral, in the case of the broker, may be deemed to have possession of it.

While rehypothecation is not permitted in some jurisdictions, it is common practice in the United
States, generally under the terms of a written collateral agreement that explicitly permits it. In
addition to the re-hypothecation of a securities broker-dealer's collateral by re-lending it or
posting it as collateral for one of its own obligations, another means of re-hypothecation is the
repurchase agreement (or repo). In a two-party repurchase agreement, one party sells the other a
security at a specified price with a commitment to buy the security back at a later date for
another specified price. Overnight repurchase agreements, the most commonly used form of this
arrangement, comprise a sale which takes place the first day and a repurchase that reverses the
transaction the next day. Term repurchase agreements, less commonly used, extend for a fixed
period of time that may be as long as several months. Open-ended term repurchase agreements
are also possible. A so-called reverse repo is not actually different than a repo; it merely
describes the opposite side of the transaction. The seller of the security who later repurchases it
is entering into a repurchase agreement; the purchaser who later resells the security enters into a
reverse repurchase agreement. Notwithstanding its nominal form as a sale and subsequent
repurchase of a security, the economic effect of a repurchase agreement is that of a secured loan.
[1]

[edit] No creditor's duty of care

Since under a strict hypothecation, goods remain in the custody of the borrower or third party,
who also enjoys the right to deal with them in the ordinary course of business, the hypothecation
itself does not normally impose upon the creditor a duty of care over the hypothecated property.
Accordingly, a judgment of the Kerala High Court of India[2] held that where hypothecated
property was lost and the banker was not aware of the loss otherwise than in the ordinary course
of business