CHAPTER 6

Documentary Letters
of Credit

There is always an underlying agreement between the principal parties to a

trade transaction, often a buyer and a seller. The agreement may be verbal
or written in a formal or informal language. Its terms may be simple or
complex, as the parties may feel necessary. Such an underlying agreement
is referred to as a “sale contract”.
A bank may grant a credit facility against a tangible security or with-
out it. It depends on various factors. Sometimes banks may fix limits on
various types of uses, such as, term loan, overdrafts, letters of guarantee
etc. It helps the banks to monitor the use of each type of facility utilized
by the customer. A letter of credit is also a credit facility like a loan or
overdraft but its nature operation is different from a loan or overdraft
facility.

Genesis: It is the safest and probably the fastest method of obtaining pay-
ment for goods exported. The documentary credit achieves a commercially
acceptable compromise between the conflicting interests of buyer and seller
by matching time of payment for the goods with the time of their delivery.
It does this, however, by making payment against documents representing
the goods rather than against the goods themselves.
A letter of credit is not only a method of obtaining payment but it also
assures buyers of receiving documents relating to goods through their bank,
provided they ask for the required type of documents.

Definition of Letter of Credit: (UCP 600 Articles 1 & 2) “For the purposes
of the Article, the expressions “Documentary Credit(s)” and “Standby
Letter(s) of Credit” (hereafter referred to as “Credit(s)”), mean any arrange-
ment, however named or described, whereby a bank (the “Issuing Bank”)
acting at the request and on the instructions of a customer (“the Applicant”)
or on its own behalf,

40

T. S. Bhogal et al., International Trade Finance

© Tarsem Singh Bhogal and Arun Kumar Trivedi 2008
 DOCUMENTARY LETTERS OF CREDIT 41

(i) is to make a payment to or to the order of a third party (“the

Beneficiary”), or is to accept and pay bills of exchange (Draft(s))
drawn by the Beneficiary,
or
(ii) authorizes another bank to effect such payment, or to accept and pay
such bills of exchange (draft(s)),
or
(iii) authorizes another bank to negotiate, against stipulated document(s),
provided that the terms and conditions of the Credit are complied
with.

For the purposes of these articles, branches of a bank in different

countries are considered another bank”.
An irrevocable documentary credit (especially a confirmed one) is, there-
fore, an excellent instrument of payment. Also, if appropriate documents
are called for and provided reliance can be placed on the integrity of the
seller – it is an effective means of obtaining delivery of the goods.
It is nevertheless, a precision instrument, and must be properly handled
by all concerned. Thus, both buyer and seller should observe certain rules of
commonsense and understand their responsibilities.
It is an important instrument for the exporter to secure payment.

Parties to a letter of credit and

their responsibilities
(a) Applicant’s/Buyer’s Responsibilities: Applicant to a letter of credit is a
buyer or importer of goods. The applicant makes a request in writing to their
bank to issue a letter of credit in favour of the seller/exporter of the goods or
beneficiary. Their instructions to the issuing bank must be clear and precise
and free from excessive detail. The bank cannot be expected to guess what is
wanted: nor can it check complicated, and often technical, specifications, etc.
The purpose of the credit is to pay for the purchase not to “police” the
commercial transaction. Its terms and conditions, and the documents called
for, should, therefore, be in agreement with the sales contract on which it
may be based.
Any examination of the goods prior to, or at the time of shipment must be
evidenced by a document. The precise nature and issuer of such document
must be stated in the credit.
The credit should not call for documents that the seller cannot provide,
nor set out conditions that cannot be met. (This is particularly important
with changes in traditional documentation resulting from trade facilitation
developments and changes in transport technology.)
 42 INTERNATIONAL TRADE FINANCE

(b) The Issuing Bank: The issuing bank is the opening bank of a letter of
credit on behalf and at the request of the applicant, the buyer/importer of the
goods. Letter of credit is a legal contract between the seller/ beneficiary and
the issuing bank. It is an independent undertaking of the issuing bank to pay
or accept the bill of exchange and make payment, on presentation of the
documents according to the terms and conditions stated in the letter of
credit. If the documents do not satisfy the requirements of the letter of credit
the issuing bank is not liable to act in any way i.e. to pay or accept the bill
of exchange and make payment.
Letters of credit may be issued by mail, telex, cable or by SWIFT
(Society for Worldwide Inter-bank Financial Telecommunication) in accor-
dance with the requirements of the applicant and the beneficiary. Using
SWIFT system is becoming more popular these days. Authentication of the
letter is the responsibility of the advising bank by verifying authorised
signatures on the letter, in case of mail, test key number in case of telex and
cable etc.
(c) The Advising Bank: The advising bank is an agent bank of the issuing
bank in the country of the exporter. The advising bank forwards the letter of
credit to the beneficiary in accordance with the instructions of the issuing
bank. Being an agent of the issuing bank, it has a list of signatories of the
issuing bank. Therefore, it is advising bank’s responsibility to ensure that
the letter of credit is signed by the authorised signatories of the issuing bank
before forwarding it to the beneficiary.
If the advising bank forwards the letter without any undertaking on its
part it must say clearly when advising the letter of credit to the beneficiary,
i.e. it (the advising bank) is under no obligations to make payment or incur
any liability to make deferred payment etc.
(d) The Seller’s/Beneficiary’s Responsibilities: Although considerable
time may elapse between the receipt of a credit and its utilization, the seller
should not delay studying it and requesting any necessary changes, if
required.
The seller should satisfy him that the terms, conditions and docu-
ments called for are in agreement with the sales contract. (Banks are not
concerned with such contracts. Their examination of the documents will
take into consideration only the terms of the credit and any amendments
to it.)
When it is time to present the documents the beneficiary should:

(i) present the required documents exactly as called for by the credit.
The documents must be in accordance with the terms and condi-
tions of the credit and not on their face inconsistent with one
another.
 DOCUMENTARY LETTERS OF CREDIT 43

(ii) present the documents to the bank as quickly as possible and in

any case within the validity of the credit and within the period of
time after the date of issuance of the document specified in the
credit or as applicable under Article No.14 (c) U.C.P. 600.
(iii) must remember that non-compliance with the terms stipulated in
the credit or irregularities in the documents, oblige the bank to
refuse settlement.

(e) A confirming bank: A confirming bank is the one, which adds its independ-
ent guarantee to the letter of credit. It undertakes the responsibility to make pay-
ment/acceptance of bills of exchange and pay on maturity or negotiate under the
letter of credit in addition to the issuing bank. A confirming bank is usually the
advising bank. If the issuing bank requests the advising bank to add its confir-
mation to the credit the advising bank does so. If the advising bank does not
wish to do so, it must advise the issuing bank immediately of its intention of not
doing so. Once the advising bank adds it confirmation, it is known as confirm-
ing bank. The confirmation is an independent undertaking between the con-
firming bank and the beneficiary.
(f) Nominated Bank: A nominated bank is the bank authorised by the
issuing bank to pay, incur deferred payment liability, to accept bill of
exchange and pay on maturity, or to negotiate the letter of credit.
(g) Reimbursing Bank: A reimbursing bank is a bank authorised by the issuing
bank to honour the reimbursement claim made by the negotiating/ paying bank
in settlement of negotiation/payment under a letter of credit. This is the bank
with which the issuing bank has agency/accounting arrangements.
(h) The Carrier: The carrier is the company who take possession of the
cargo with an undertaking to transport and deliver it safely at a place of des-
tination agreed by the buyer and the seller. The cargo carrier is a shipping
company, an airline or another type of transporter by road i.e. lorries etc.
The cargo carrier supplies a transport document indicating receipt of goods
and the terms of carriage of the goods.
(i) The Insurer: The insurer is an insurance company with prime responsibility
for insuring the cargo as required under the terms and conditions of the letter of
credit. The insurer indemnifies the holder of the insurance document i.e. insur-
ance policy or insurance certificate against any loss or damage to the cargo.

W H O D O E S W H AT ?

The buyer and the seller conclude a sales contract for payment by docu-
mentary credit. The buyer requests his bank, the “issuing bank” to issue a
 44 INTERNATIONAL TRADE FINANCE

letter of credit in favour of the seller/beneficiary specifying the instructions

according to the agreed terms and conditions with the seller.
The issuing bank issues a letter of credit incorporating the terms and
conditions agreed with the seller and asks another bank, usually the bank
of the seller or another bank who is the correspondent of the issuing
bank, to advise and/or confirm the credit, if so requested by the buyer/
applicant.
The advising or confirming bank checks the authenticity of the letter
of credit and informs the seller that the credit has been issued in their
favour.
As soon as the seller receives the credit and is satisfied that he can
meet its terms and conditions, he is in a position to load the goods and
dispatch them. The seller then sends the documents evidencing the
shipment to the bank where the credit is available (the bank). It may be
the issuing bank, or the confirming bank, or any bank named (nomi-
nated bank) in the credit as the paying, accepting or negotiating bank, or
it may be the advising bank or a bank willing to negotiate under the
credit.
The advising bank/confirming bank scrutinises carefully the documents
received under a credit. If the documents are in conformity with the terms of
the credit it will process them accordingly. Any other bank, including the
advising bank if it has not confirmed the credit, may negotiate, but with
recourse to the beneficiary.
The bank, if other than the issuing bank, sends the documents to the
issuing bank.
The issuing bank also scrutinises the documents and, if the documents
are found as per terms of letter of credit it:

(a) effects payment in accordance with the terms of the credit, either to
the seller if he has sent the documents directly to the issuing bank or
to the bank that has made funds available to the beneficiary in
anticipation, or

(b) reimburses in the pre-agreed manner the confirming bank or any bank
that has paid, accepted or negotiated documents under the credit.

When the documents have been scrutinised by the issuing bank and
found to meet the credit requirements, they are released to the buyer upon
payment of the amount due, or upon other terms agreed between the buyer
and the issuing bank.
The buyer will present the transport document to the carrier who will
then release the goods.
 DOCUMENTARY LETTERS OF CREDIT 45

A D VA N TA G E S A N D D I S A D VA N TA G E S O F
LETTERS OF CREDIT

Advantages to exporter
Assurance of Payment: The beneficiary is assured of payment as the issu-
ing bank is bound to honour the documents drawn under the letter of
credit.
Ready Negotiability: The exporter, if he needs money immediately can
secure payment by having the documents, drawn under the letter of credit,
discounted (post shipment advance).
Compliance With Regulations: Letter of credit is evidence that the exchange
control regulations, if applicable in the country of the importer, have been
complied with.

Pre-Shipment Facility: The exporter can secure an advance from his bank
against a letter of credit received for export of goods (pre-shipment
advance).

Advantages to importer
Credit facility from the Issuing Bank: The issuing bank lends its own credit
facility to the importer against a letter of credit, if the importer cannot avail
any credit facility from the exporter.

Assured delivery of goods: The issuing bank honours the documents

drawn under a letter of credit only when all the terms and conditions of the
credit have been complied with. Therefore the importer is assured not
only of obtaining the goods, but also, if proper care is taken, obtaining the
specified goods in time. In this respect the buyer and seller should negoti-
ate the date of shipment of the goods from named ports of shipment and
destination.

Disadvantages to applicant/importer
Fraudulent Documents: The beneficiary wants to sell goods against a letter
of credit and lays down the terms and conditions, regarding payment for
the goods, suitable to him. He is going to supply certain documents as an
evidence of shipment of goods and, if bent upon defrauding, he may suc-
ceed in obtaining payment by supplying poor quality goods or falsifying
the documents.
 46 INTERNATIONAL TRADE FINANCE

Expensive: Issuing banks charge fees for issuing a letter of credit and such
fees are not required to be paid in case of an open account system. The
charges recovered by banks under an open account system are much less
than under a letter of credit.
Credit Line: A certain amount/portion of the buyer’s/applicant’s credit line
with their bank gets tied up in an outstanding letter of credit. It will not be
available for any more pressing credit needs, which may develop in the
applicant’s business operations.
Cash flow: The applicant may have to tie up his cash as collateral security
against the letter of credit, which will cause deficit in his cash flow.
Documents Delayed: It often happens that the documents of title to goods
do not reach the importer on time because those are processed by different
banks in different countries.
Goods Delayed: Sometimes the goods are delayed in transit because of var-
ious reasons. If the importer had committed him or herself with another
party to supply those goods on or before a pre-determined date delay may
cause damage to his reputation and/or financial loss.

Disadvantages to the beneficiary

Discrepancies in documents: If the exporter is not familiar with the proper
procedures for processing documents, the documents may be presented
with discrepancies and the bank will send those on collection basis.

Difficult terms and conditions of L/C: Terms and conditions relating to cer-
tain documents may not be easy to fulfill or those documents may be diffi-
cult to obtain.
Different Language: Letters of credit may be received in the importing
country’s language and may not be understood by the exporter. It will be
costly to get the documents translated.
Competitive Terms: Letters of credit payment terms are so restrictive that
sellers may lose sales to competitors who quote less restrictive terms.
Documents Delayed: It often happens that the documents of title to goods
do not reach the importer on time because documents have been processed
by different banks in different countries.
Goods Delayed: Sometimes the goods are delayed in transit because of
various reasons. If the exporter has committed by issuing a performance
bond etc in favour of the importer to supply those goods on or before a pre-
determined date, the delay may cause damage to his reputation and also
financial lossif a claim is made by the importer.
 DOCUMENTARY LETTERS OF CREDIT 47

LETTER OF CREDIT – MECHANISM

1. Proforma invoice

2. Firm order placed by importer

3. L/C application

4. Foreign currency forward contract

5. L/C. Advice sent through AB/CB

6. L/C. Confirmation advice to beneficiary

7. L/C. Confirmation advice

8. Exporter hands goods to the carrier

9. The carrier issues bill of lading/transport document

10. Insurance company issues insurance policy

TP TP
Goods
17 9 10
16 8
Insce.
1
11
Importer
2 Beneficiary

4 12
3 6
15 7
18

Issuing bank 13 Advising bank

14

Figure 6.1 Letter of credit – mechanism

 48 INTERNATIONAL TRADE FINANCE

11. Other documents as required

12. Documents forwarded by the beneficiary to AB/CB and documents

checked and/or negotiated by AB/CB/NB

13. Documents forwarded by the AB/CB/NB to the issuing bank in

accordance with reimbursement clause

14. The issuing bank provides reimbursement to the AB/CB/NB

15. Payment/Acceptance of documents/Bills of Exchange and other

documents forwarded to the importer

16. The importer hands transport documents to the carrier

17. The carrier delivers goods to the importer

18. Funds credited to the beneficiary’s account.

LETTER OF CREDIT CONTRACTS AND

R E G U L AT I O N S

Contracts and regulations

1. Sale contract between buyer and seller

2. L/C. Contract between the importer and the issuing bank

3. Foreign currency forward contract between the importer and the issuing
bank

4. L/C. Contract between the issuing bank and the beneficiary

5. L/C. Contract between AB/CB/NB

6. L/C. Contract between the exporter/beneficiary and AB/CB/NB

7. Pre-shipment finance contract between AB/CB/NB and the beneficiary

8. Counter indemnity between AB/CB and the beneficiary – performance

bond
 DOCUMENTARY LETTERS OF CREDIT 49

Insce.Co
Carrier 13
11
16 10 ECGD
12

Importer 1 Exporter

2 14
3 4 7
6
15
8
9

Issuing bank 17 AB/CB bank

Figure 6.2 Letter of credit – contracts and regulations

9. Performance bond between the AB/CB and the importer

10. Contract of freightment – the exporter and the carrier company

11. Contract of insurance – between the beneficiary and the carrier company

12. Risk cover contract – between the exporter and the carrier company

13. Export finance guarantee – NCM and ECGD etc.

14. Seller’s indemnity for negotiation of documents under reserve –

between the beneficiary and the negotiating bank

15. Loan contract for L.I.M. between the importer and the issuing bank

16. Shipping guarantee – between issuing bank and carrier company

17. L/C. confirmation contract between IB & CB.

 50 INTERNATIONAL TRADE FINANCE

SALE CONTRACT

What is a sale contract?

A sale contract is an agreement between the buyer and the seller in which
various terms and conditions of the transaction are specified. One need not
get confused with the terms “sale contract” and “letter of credit”. Credits, by
their nature, are separate transactions from sales or other contract(s) on
which they may be based and banks are in no way concerned with or bound
by such contract(s), even if any reference whatsoever to such contract(s) is
included in the credit (UCP. 600 Art. 4(a)).
The sale contract, in its simplest form, is an accepted order to buy or offer
to sell a certain commodity or service that has been negotiated between the
buyer and the seller.
The agreement between the buyer and the seller may be made orally or in
writing. Although an oral contract is in general legally binding, it may cause
some problems due to different understandings of its provisions by different
parties. Therefore, to avoid misunderstanding, a verbal contract is required
to be confirmed in writing.

Contents of a sale contract

A properly negotiated sale contract should include the following points:

■ Description of goods

■ The price of the goods

■ Payment terms i.e. Sight/Usance (term period)

■ Trade terms

■ Packing and marking

■ Shipping instructions i.e. date shipment

■ Ports of shipment and discharge

■ Insurance of goods

■ Inspection and warranties

 DOCUMENTARY LETTERS OF CREDIT 51

■ Methods of payment

■ Additional documents or conditions

The terms used will determine which party is to bear the costs involved
in shipping the goods abroad, and are subject to international rules for their
interpretation. They are known as “Incoterms” and are published by the
International Chamber of Commerce, commonly known as ICC Publication
“Incoterms 2000”.