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LETTER OF CREDIT

A letter of credit, or “credit letter” is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
Types of Letter of Credit

There are various types of letters of credit in trade transactions. Some of these are classified by their purpose. The following are the different types of letters of credit:

Commercial Letter of Credit

A standard LC also called as a documentary credit.

A commercial letter of credit is the most common type of letter of credit in usage. In fact, it is commonly known as a regular letter of credit.

Global trade is on a rise and brings its own difficulties for all the parties involved. The major difficulties include each country’s different laws, different custom rules, and different languages. Also, a major problem is not being able to know a foreign buyer or a seller personally. Therefore, it becomes difficult to judge credibility. It has become essential to have a common tool that gives security to both the buyer and the seller. This is where the letter of credit comes into the picture.

Letter of credit is a payment term used for international trade. By availing a letter of credit the buyer knows that he will receive the goods that he is paying for and the seller is sure that he will receive the payment against his supply.

There are many types of letters of credit, in today’s post, we are going to discuss the commercial letter of credit:

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Commercial Letter of Credit – Definition

A commercial letter of credit is a legal document from a bank or a financial institution, it represents a promise to pay the holder if the holder fulfills his obligation. Sellers in international transactions often require a guarantee of payment. This guarantee comes from the bank in the form of a letter of credit. If the buyer fails to make payment against his purchases, the bank will cover the full or remaining amount of purchase.

Commercial Letter of Credit Process with Example

Let us understand the process flow of letter of credit with an example.

There are four parties involved in a commercial letter of credit as follows –

• Buyer – Tom residing in the USA
• Issuing Bank – Bank of America, the USA
• Correspondent Bank – Bank of India, India
• Beneficiary/Seller – Ram residing in India

Step 1: Sales Agreement

On 1^st January 2018, Mr. Tom from the USA agrees to buy goods worth USD 10,000.00 from Mr. Ram in India. During the negotiations, it was agreed that payment would be done in a commercial letter of credit.

Step 2: Opening Instructions

Mr. Tom requests Bank of America to open a letter of credit of USD 10,000.00 in favor of Mr. Ram. The Bank of America checks Mr. Tom’s creditworthiness and completes the required formality to issue a letter of credit for this transaction.

Step 3: Issuing Letter of Credit

On 8^th January 2018, The Bank of America issues the requested letter of credit that expires 90 days from the date of issue and forwards it to the corresponding bank i.e. Bank of India. The corresponding bank is usually located in the country in which the seller resides, in our example, it is in India. Bank of India will authenticate the letter of credit and send it to Mr. Ram.

It is necessary that Mr. Ram exports the goods and submits the required documents before the expiry of the letter of credit. If not then the bank of America is not obliged to pay if Mr. Tom doesn’t.

Export/Import Letter of Credit

The Same LC becomes an export or import LC depending on who uses it.
The exporter will term it as an exporter letter of credit whereas an importer will term it is an importer letter of credit.

A letter of credit is a vital tool for facilitating international trade. It benefits both the importers and exporters. An import letter of credit enhances the credit worthiness of the importer while an export letter of credit mitigates the credit risk for the exporter and helps improve his cash flow.

Import Letter of Credit

Import letter of credit is issued by the importer’s bank on behanf of the importer with the exporter being the beneficiary. It is a guaranteed by the importer’s or buyer’s bank that the payment will be giver to the exporter or seller. The credit capacity of the importers is substituted by the credit capacity of the issuing bank. This improves credibility and reduces the risk of fraud. There are terms and conditions regarding the type, quantity, place of delivery and time of delivery mentioned in the import letterof credit.
It also mentions the documents to submitted as proof os shipment. The exporter has to submit some specified documents fulfilling the conditions before the payment can be released to him.

Import Letter of Credit

Advantages of Import Letter of Credit

The biggest advantage of import letter of credit is fraud risk mitigation. The exporter has to submit valid documents as proof of shipment of agreed upon goods before the payment can be made. The terms and conditions under import letter of credit cannot be changed unless all the parties agree, so it’s legally binding. An import letter of credit increases the credit-worthiness of the importer because credit capacity is transferred to the issuing bank. This enables importer to get a better bargain on the prices of imported goods and also access extra funding for expanding his business. Since an import letter of credit is of immense help in less established trade relationships, it provides a safe way to expand sourcing into new geographies for getting lower prices and hence increasing importer’s business margins.

Disadvantages of Import Letter of Credit

The issuing bank is required to pay the exporter as and when he presents the documents covered in terms and conditions of the import letter of credit. There is a risk of receiving bad or damaged goods even if the documents are satisfactory. An importer can mitigate this risk by verifying the exporter’s reputation and checking a sample of goods beforehand. He can also hire an independent third party to do the physical inspection of goods before they are shipped. Issuing a letter of credit adds to the cost of doing business.

Transferable Letter Of Credit

A letter of credit that allows a beneficiary to further transfer all or a part of the payment to another supplier in the chain or any other beneficiary. This generally happens when the beneficiary is just an intermediary for the actual supplier. Such LC allows the beneficiary to provide its own documents but transfer the money further. Transferable Letter of Credit

Definition of Transferable Letter of Credit

Transferable Letter of Credit is a credit facility in which the first beneficiary has the right to pass on the available credit to another party i.e. secondary beneficiary. This is possible only when the Letter of Credit is marked as transferable by the issuing bank upon the instructions of the buyer or the importer of goods.  

Let us under the concept in simple words:

Concept of Transferable Letter of Credit

There are four parties involved in it. The parties are first beneficiary, secondary beneficiary, final buyer and the bank. The middlemen/exporter i.e. the first beneficiary is one who receives an order from the final buyer. The middlemen is always in shortage of money. So, he requests the final buyer for Transferable Letter of Credit. If the final buyer finds it valuable to engage in the foreign transaction, he will request his bank to issue Irrevocable Transferable Letter of Credit. Now the first beneficiary can purchase the raw materials from the supplier to manufacture goods. Instead of making a cash payment, the middlemen can pay his supplier by giving him the Transferable Letter of Credit. Here the supplier becomes the secondary beneficiary.

Let us understand it with the help of an example.

Example of Transferable Letter of Credit

Kira Ltd, a German company places an order to Sim Ltd., an American company. Sim Ltd. requests Kira Ltd to issue a Transferable Letter of Credit so that it can avail credit facility from its supplier on the basis of such letter of credit. Kira Ltd. requests its bank to issue Transferable Letter of Credit. In this scenario, if the bank refuses to issue Transferable Letter of Credit, Sim Ltd. cannot further avail credit facilities. However, if the bank agrees to the request of Kira Ltd., Sim Ltd. can issue the Transferable Letter of Credit to its supplier i.e. the secondary beneficiary.

Un-transferable LC

A letter of credit that doesn’t allow the transfer of money to any third parties. The beneficiary is the only recipient of the money and cannot further use the letter of credit to pay anyone.

Revocable Letter of Credit

An LC that Issuing bank or the buyer can alter any time without any notification to the seller/beneficiary. Such types of letters are not used frequently as the beneficiary is not provided any protection.

Revocable Letter of Credit – Meaning

A revocable letter of credit is a type of letter of credit in which the issuing bank can amend the terms of the letter of credit or cancel the letter of credit completely without giving prior notice to the beneficiary.

Reasons due to Which a Bank Revokes a Letter of Credit

There are many reasons due to which the issuing bank decides to revoke the revocable letter of credit.

Firstly, there are adverse circumstances such as political tension, deteriorated market conditions, etc. due to which the bank is incapable to honor the terms of the letter of credit. There are high chances of the letter of credit being revoked by a bomb hit bank in Afghanistan.

Secondly, there is a possibility that the issuing bank doesn’t have sufficient funds to honor the letter of credit in which case it cancels the letter of credit. For example after the 2008 financial crisis, Merrill Lynch filed for bankruptcy. In such a condition, it may revoke all its revocable letter of credit.

Irrevocable LC

An LC that does not allow the issuing bank to make any changes without the approval of all the parties.

Standby Letter of Credit

A letter of credit that assures the payment if the buyer does not pay. After fulfiling all the terms under SBLC, if the seller proves that the promised payment was not made. In this situation, the bank will pay to the seller,\.
In a nutshell, it does not facilitate a transaction but guarantees the payment. It is quite similar to a bank guarantee.

Definition of Standby Letter of Credit

A Standby Letter of Credit is a document that provides a guarantee to the beneficiary that, if due to any circumstances, the importer is unable to pay, then the bank will make the payment to the beneficiary, i.e., the exporter.

Let’s try to understand the concept of Standby Letter of Credit with the help of the following example.

Example of Standby Letter of Credit

Niya Ltd., an exporter from India, received an order to supply goods to John Ltd., an American company. Niya Ltd. wants an assurance from John Ltd. that it will make timely payment for the goods. Obliging to the request of Niya Ltd., John Ltd. issued a Standby Letter of Credit in favor of Niya Ltd. In this case, if due to any circumstances John Ltd. fails to make the payment to Niya Ltd., the Indian company can claim the credit on the Standby Letter of Credit. Thus, the Standby Letter of Credit acts as an assurance to the exporter that he will be paid for the export of goods.

The concept of a Standby Letter of Credit is often confused with a Letter of Credit. However, there are some differences between the two:

Standby Letter of Credit vs. Letter of Credit

A Letter of Credit is a credit document used to make payment to the beneficiary upon the fulfillment of contractual obligations. However, a Standby Letter of Credit is a standby payment mode that can only be used by the beneficiary when the purchaser fails to make the payment for any reason.

For a detailed explanation of the differences, please read: Standby Letter of Credit vs Letter of Credit

LC Vs. SBLC

Both the regular letter of credit and standby letter of credit are payment instruments used in international trade. However, there are some basic differences in the product which we will discuss in the following post –

Meaning

A letter of credit is a promise from the bank that the buyer i.e. importer will fulfill his payment obligation and pay the full invoice amount on time. The role of the issuing bank is to make sure that the buyer pays. In case the buyer is unable to fulfill his obligation, the bank will pay to the seller i.e. the exporter, but the funds come from the buyer.

On the other hand, a standby letter of credit is a secondary payment method where bank guarantees the payment when terms of the letter of credit are fulfilled by the seller. It is a kind of additional safety net for the seller. The buyer may not pay the seller due to multiple reasons such as cash flow crunch, dishonesty, bankruptcy, etc. But as long as the seller meet’s the requirement of a standby letter of credit, the bank will pay.

Features within the Instrument

A letter of credit does not have any specific features that the buyer must adhere to for completion of a transaction. It does have basic requirements such as documentation, packing, etc. But all in all, it’s a plain vanilla payment instrument.

A standby letter of credit may have specific clauses that the buyer must fulfill so he can use this instrument. For example, Mr. Harry who resides in the UK agrees to buy 5000 pairs of socks from Mr. Chang who resides in China. Mr. Chang does not want to take the risk so he asks Mr. Harry to get a standby letter of credit. Mr. Harry obtains a standby letter of credit from HSBC bank and he adds following clauses –

1. The material of the socks should be – 80% cotton 20% polyester
2. Each pair should be packed in a clear plastic bag having a logo tag
3. There can be only 1% defect margin i.e. only one pair of defective socks in a hundred pairs is acceptable

Mr. Chang should fulfill all the above-mentioned performance criteria to be eligible for payment through a standby letter of credit. A regular letter of credit cannot have such performance criteria

The Requirement of Issuing Bank

When issuing a letter of credit the bank checks the buyer’s credibility and credit score. Furthermore, it is usually the case that a buyer asks his banker for a letter of credit, i.e. the buyer is usually dealing with the said bank for a long time. So the letters of credit are usually unsecured.

Conversely, a standby letter of credit creates an obligation for the bank, therefore the bank will require a collateral in the form of security to issue a standby letter of credit.

Goal

The letter of credit is a primary instrument of payment, so the goal is to use the letter of credit to complete the transaction.

In contrast, a standby letter of credit is a secondary instrument of payment. If a seller is paid by a standby letter of credit, it means that something went wrong. The goal here for all the parties involved is to avoid using standby letter of payment.

Time Period

A letter of credit is a short-term instrument, where the expiry is usually 90 days.

A standby letter of credit is a long-term instrument, in which the validity is usually one year or so.

Purpose

A letter of credit is used to provide security for a transaction such as a sale agreement.

A standby letter of credit is often used to provide security for a long-term obligation such as a long-term construction project.

Geographical Scope

A letter of credit is usually used in an international transaction where the buyer is the importer and the seller is the exporter.

A standby letter of credit is used in an international transaction but it is also frequently used in domestic transactions as well. Its scope is not limited to any geographical area.

Cost

A standby letter of credit is more expensive than a regular letter of credit. While the fees of a regular letter of credit range from 0.75% to 1.50% of the amount covered, a bank may charge anywhere between 1% to 10% to cover the same amount under a standby letter of credit.

Confirmed LC

Which the seller or exporter acquires the guarantee of payment from a confirming bank (also called the second bank). This is primarily to avoid the risk of non-payment from the first bank. 

Confirmed Letter of Credit

Confirmed Letter of Credit – Meaning

A confirmed letter of credit is a letter of credit in which the seller or exporter has payment guarantee from a second bank or a confirming bank i.e. in case the first bank fails to pay then the payment will be done by the second bank. This is a trade payment method used for international trade.

Why Confirmed Letter of Credit?

The underlying intention of obtaining any type of letter of credit is the sense of security, especially for the seller. In an international transaction, the holder of a letter of credit i.e. the seller must be assured that he will get the payment from the issuing bank if he complies with the terms of payment, but this is not always the case. Sometimes, the seller is not sure whether he will receive the payment against his goods or not. This uncertainty can arise from numerous factors such as questionable creditworthiness of issuing bank or political or economic vulnerability associated with the geographical location of the issuing bank. For example, payment of a regular letter of credit from a bank in Syria is questionable as the country has disturbances. In such cases taking a second guarantee i.e. obtaining a confirmed letter of credit is a wise decision.

The buyer has to go through the same procedure to obtain a second letter of credit. The buyer has to find a second bank who can give confirmation. In general cases, the second bank is the correspondent bank in the seller’s country.

Unconfirmed LC

A letter of credit that is assured only by the issuing bank and does not need a guarantee from the second bank. Mostly the letters of credit are an unconfirmed letter of credit.

Revolving Letter of Credit

When a single LC is issued for covering multiple transactions in place of
issuing separate LC for each tranaction is called Revolving LC. They can
be further classified into Time Based ( Could be Cumulative or Non-Cumulative and Valued-Based.

Meaning

A revolving letter of credit is a single letter of credit that covers multiple transactions over a long period of time. It is very specific in a way that it is used for regular shipments of the same commodity between the same buyer (importer) and the seller (exporter). This letter of credit is issued only once for a certain period of time or a certain number of transactions.  It avoids the need for repetitive arrangements to open a new letter of credit for every transaction.

Types of Revolving Letter of Credit

The revolving letter of credit can be further divided into two subcategories. One is based on time, the other is based on value. Let’s understand each in detail. Following are the two types of revolving letter of credit:

Revolving Letter of Credit Based on Time

In the revolving letter of credit that is based on time, a specific amount (payment) is allowed to be drawn within a defined period of time. Let’s understand with an example.

Example – Mr. Cho from China is a manufacturer of ball pens and is a regular supplier to Mr. Will who is based in the UK. They decide to have a transaction with a revolving letter of credit. On January 1, 2018, Mr. Will obtains a revolving letter of credit of USD 60,000.00 to be drawn each month by USD 10,000.00 for the next 6 months in the name of Mr. Cho.

Following is the line of transactions –

Month	Transactions on the part of Mr. Cho	Payment through revolving letter of credit
January 2018	Goods worth USD 10,000.00 manufactured and shipped	Payment received USD 10,000.00
February 2018	Goods worth USD 3,000.00 manufactured and shipped	Payment received USD 3,000.00
March 2018	Goods worth USD 4,000.00 manufactured and shipped	Payment received USD 4,000.00
April 2018	Goods worth USD 12,000.00 manufactured but shipping of only USD 10,000.00 allowed. So goods of USD 10,000.00 shipped and remaining goods kept in stock	Payment received USD 10,000.00
May 2018	Goods worth USD 8,000.00 manufactured and goods worth USD 10,000.00 shipped (USD 8000.00 of May + USD 2000.00 of April)	Payment received USD 10,000.00
June 2018	Goods worth USD 10,000.00 manufactured and shipped	Payment received USD 10,000.00
End of June 2018	Revolving letter of credit expired

Further, a revolving letter of credit based on time can be of two types as follows –

Cumulative

In a revolving LC based on time, if it is the cumulative type, the previous unused L/C limits can be used in future months. In the previous example, if Mr. Cho doesn’t ship any good in the month of May 2018, then he can ship goods worth USD 20,000.00 in the month of June 2018.

Non-Cumulative

In a revolving letter of credit based on time, if it is the non-cumulative type, then the previous unused L/C limits cannot be used in future months. In the previous example, if Mr. Cho doesn’t ship any good in the month of May 2018, still he is allowed to ship only goods worth USD 10,000.00 in the month of June 2018. The USD 10,000.00 unused limit of May 2018 becomes void.

Revolving Letter of Credit Based on Value

The second type of revolving letter of credit is based on value. In this, an amount and a validity for the letter of credit is set, and the seller has to work on these criteria.

Let’s extend our previous example and make it revolving letter of credit in relation to value. Other things same on January 1, 2018, Mr. Will obtains a revolving letter of credit of USD 60,000.00 to be drawn each month by USD 10,000.00 for the next 6 months in the name of Mr. Cho.

Back-To-Back Letter of Credit

Back to Back Letter of Credit is an LC wich commonly involves an intermediary in a transaction. There are two letters of credit, the first issued by the bank of the buyer tothe intermediary and the second issued by the bank of an intermediary to the seller.

Back-to-Back Letter of Credit Definition

Back-to-Back Letter of Credit is a negotiable instrument in which the seller gets a Letter of Credit from the buyer and the seller further transfers the Letter of Credit to its supplier. In simple words, the seller first gets the Letter of Credit from the buyer to ensure timely payment and further the same seller hands over the Letter of Credit to someone from whom he buys goods or materials. There are various advantages and disadvantages of Letter of Credit. Let us take an example to under the concept of Back-to-Back Letter Of Credit.

Example of Back-to-Back Letter of Credit

Suppose a garment manufacturer Xion Ltd. sells its product to Harry. In return, Harry did not make the payment. Instead, he gave Xion Ltd. a Letter of Credit. This Letter of Credit is an assurance to Xion Ltd. that if Harry fails to make timely payment, Xion Ltd can use the negotiable instrument to get its claim from the bank. To process the order of Harry, Xion Ltd. purchases raw material from its supplier, Noble Ltd. Xion Ltd. does not make any payment to it. Instead, it hands over the original Letter of Credit received from Harry after changing the beneficiary name with its intermediary bank. Now Noble Ltd. is assured that it will receive the payment for the material purchased by Xion Ltd. This transfer of Letter of Credit from one seller to another seller is Back-to-Back Letter of Credit (BBLC).

Parties to BBLC

• Issuing Bank
• Confirming Bank
• Beneficiary
• Transferring Bank
• Applicant
• Advising Bank
• Accepting Bank

Procedure for Back-to-Back Letter of Credit

The issuing bank upon getting the instructions from the customer agrees to issue Letter of Credit, which is transferable to the first beneficiary. This means that the first beneficiary can transfer the letter of credit to its customer or third party or secondary beneficiary. The transferring bank i.e. the bank issuing the letter of credit shall issue a “Transferred Letter of Credit”. The “Transferred Letter of Credit” looks identical to the original Letter of Credit. The first beneficiary holding the original Letter of Credit gives the “Transferred Letter of Credit” to the secondary beneficiary.

Essential Documents Required for Letter of Credit

Payment Clause in Back-to-Back Letter of Credit

When the first beneficiary transfers the original LC to the secondary beneficiary, it is assumed that the payment has been made to the first beneficiary of the transaction when LC is presented at the bank. However, if partial payment is made to the secondary beneficiary, in such case the original beneficiary has the right to present the invoice and draft to the bank after the secondary beneficiary has presented the documents.

Example of Payment in Back-to-Back Letter of Credit

Suppose Xion Ltd. has handed over Noble Ltd. a Back-to-Back LC. Noble Ltd. approaches the bank to claim its payment that was due from Xion Ltd. The original LC was issued for $ 15,000, but the payment due to Noble Ltd was only $ 10,000. Here the bank will require not only the original LC but also a written request to hand over the specified amount. Bank requires original LC to endorse it further by writing the amount due and the name of the party. LC being a negotiable instrument can be endorsed further. After making the payment to Noble Ltd, the bank shall issue a document suggesting the payment made to the party of the original LC and the amount due on it.

Red Close Letter of Credit

A letter of crefit that partially pays the beneficiary before the goods
are shipped or the services are performed. The advance is paid against
the written confirmation from the seller and the receipt.

Meaning

A red clause letter of credit is a specific type of letter of credit in which the buyer can extend the facility of advance payment to the seller against a certain documentary requirement. In other words, under the red clause letter of credit, the issuing bank will make an advance payment to the exporter i.e. the seller before the seller ships the goods to the importer i.e. buyer. This is usually done to provide aid to the seller in the form of working capital to purchase raw material, processing and packaging of goods, etc. The advance payment is done against documentary requirement which includes written undertaking and receipts.

Thus we can say that a red clause letter of credit facilitates pre-shipment finance for the beneficiary. Originally these letters of credit were written in red ink, so they are called red clause letter of credit.

Advantages of Red Clause Letter of Credit

Interest-Free Unsecured Working Capital Finance for the Seller

The most defining and major benefit of a red clause letter of credit is that the beneficiary i.e. the seller has easy availability of working capital. If the seller avails a regular means of finance, he may have to pay anywhere between 7% to 15% interest for the financing facility. The seller can save on interest expense with red clause letter of credit.

Advantage to the Buyer

When the seller saves interest expense on working capital, he can pass on this benefit to the buyer. Thus the buyer will have an advantage of lower cost product. This is a competitive advantage for the buyer. Thus red clause letter of credit creates a win-win situation for both the buyer and the seller.

Disadvantages in Red Clause Letter of Credit

Beneficiary may not Use the Advance for Right Purpose

The main intent of red clause letter of credit is to provide finance to the seller for his working capital needs. This way he can have enough liquidity to pay for raw material, production costs, labor, etc. It also acts as a surety to the buyer that the order placed will be manufactured on time and without any hitches. However, it may happen that the seller will not use the advance payment for its intended purpose. In many cases, it has happened that the seller used the money to pay off his past debt. This actually nullifies the purpose of red clause letter of credit.

Risk of Bad Debt

In any transaction when one party gives an advance payment to another party, there is always a risk that the receiver may simply take the money and run off. This risk intensifies when the seller (receiver of the advance) is from another country. This is an intrinsic risk that a red clause letter of credit carries.

The mechanism of the red clause letter of credit is such that the issuing bank extends an advance to the seller on instructions of the buyer. After the seller fulfills his obligation, the buyer pays to the bank. If the seller doesn’t oblige to his side of the promise, then the issuing bank will ask for the money it has advanced from the buyer. Thus it is very important for the buyer to have trust in the seller, else this arrangement can actually backfire on the buyer.

Interest, Fees and Other Expenses

The red clause letter of credit is quite an expensive tool. It carries a fixed fee which is higher than the regular letter of credit. Also, the advance payment that issuing bank gives to the seller carries an interest rate. At the time of final payment, the buyer has to pay this interest rate plus the letter of credit amount. Furthermore, the issuing bank may ask for a collateral from the buyer against this letter of credit. It will also check the buyer’s credibility and past records.

Therefore, it is necessary that the buyer does a proper cost-benefit analysis before applying for the red clause letter of credit.

Green Clause L

An LC that pays advance to the seller just not against the written undertaking and a receipt, but also a proof of warehousing the goods. 
Green Clause Letter of CreditGreen clause letter of credit is a type of letter of credit that is available for international trade. It is called green clause letter of credit because originally these were written in green ink.

Understanding Green Clause Letter of Credit

To understand the green clause letter of credit, it is first important to understand the red clause letter of credit.

Red Clause Letter of Credit

In the simplest words, we can say that red clause letter of credit is an advance payment letter of credit. Under the red clause letter of credit, the issuing bank will make an advance payment to the exporter i.e. the seller before the seller ships the goods to the importer i.e. buyer. This is usually done to provide aid to the seller in the form of working capital to purchase raw material, processing and packaging of goods, etc. The advance payment will be done against documentary requirement under the red clause letter of credit. Generally, documents required are written undertaking and receipts.

Now let’s move on to green clause letter of credit.

Green Clause Letter of Credit

Green clause letter of credit is an extension of red clause letter of credit. Which means it provides the advance not only for the purchase of raw materials, processing, and packaging of goods, etc. but also for pre-shipment warehousing at the port of origin and insurance expense. In usual cases, the advance under this letter of credit is granted only after the purchased goods are stored in bonded warehouses. This type of letter of credit is usually used in transactions related to commodity market such as wheat, rice, gold, etc.

The documentary requirement for green clause letter of credit is more than the red clause letter of credit. In addition to written undertaking and receipts, the issuing bank requires documents of title to transfer advance under green clause letter of credit. The document of title just proves that the goods to be shipped are already warehoused.

Let us now understand the difference between the green clause letter of credit and red clause letter of credit.

Difference between Green Clause Letter of Credit and Red Clause Letter of Credit

Documentation Requirement

As mentioned in previous paragraphs, the defining difference between a green clause and a red clause letter of credit is its documentary requirement. While advance can be transferred in red clause letter of credit by presenting written undertaking and receipts, an additional document of title is required in green clause letter of credit for transfer of advance.

Proportion of Advance

In red clause letter of credit, usually, the percentage of advance available is 20% to 25% of the face value of the letter of credit. In contrast, the availability of advance can be expanded to 75% to 80% of the face value of the letter of credit under the green clause letter of credit.

Security

In such international transactions, the buyer is always concerned about his safety as he is paying advance money to the seller. The buyer i.e. the importer is more secured in green clause letter of credit than the red clause letter of credit. This is because the buyer is extending the advance against the document of title. Which means the buyer knows that the goods in question are already warehoused and only the shipment procedure is remaining. On the other hand, in the red clause letter of credit, the advance can be extended even before the production begins this makes it more risky for the buyer.

Green Clause Letter of Credit Process with an Example

Let’s now understand the green clause letter of credit process with an example.

Example –

Mr. Mac from Canada is buying wheat worth USD 10,000.00 from Mr. Shiv from India. Mr. Shiv requests Mr. Mac to issue a green clause letter of credit with an advance payment of USD 5000.00 (i.e. 50%). Mr. Mac agrees and applies for green clause letter of credit with his bank – Bank of Canada

Importer/Buyer – Mr. Mac from Canada
Exporter/Seller – Mr. Shiv from India
Green clause letter of credit issuing bank – Bank of Canada
Advising bank – Bank of India

Following is the detailed process for the above example –

1. The sale transaction in agreed upon.
2. On request of Mr. Mac, Bank of Canada issues Green Clause Letter of Credit of USD 10,000.00 in the name of Mr. Shiv (beneficiary)
3. Bank of India advises the Green Clause Letter of Credit received from Bank of Canada to Mr. Shiv
4. Mr. Shiv collects warehouses the wheat that is to be shipped on Mundra Port (Port of origin) of India
5. Mr. Shiv submits the advance payment document, i.e. written undertaking, receipt and document of title to the Bank of India
6. Bank of India checks these documents and sends it to Bank of Canada
7. Bank of Canada checks the advance payment documents and informs Mr. Mac that the documents have arrived
8. Mr. Mac provides an undertaking to Bank of Canada that he will pay the 50% advance i.e. USD 5000.00 to the Bank of Canada in future.
9. Bank of Canada pays USD 5000.00 to the Mr. Shiv through Bank of India. Which means Bank of India receives the payment from the Bank of Canada and notifies Mr. Shiv.
10. Upon receiving the advance payment, Mr. Shiv starts shipment procedure and ships the goods to Mr. Mac.
11. Mr. Shiv submits the shipping documents such as invoice, packing list, bill of lading, etc. to Bank of India
12. Bank of India checks the shipping documents and forwards it to Bank of Canada
13. Bank of Canada checks the documents and informs Mr. Mac that they have received the shipping documents.
14. Mr. Mac makes the payment of USD 10,000.00 to the Bank of Canada (100%) + plus pays interest for the 50% advance payment that has been paid by Bank of Canada earlier.
15. Bank of Canada remits the remaining unpaid portion of USD 5000.00 (50%) to the Mr. Shiv through Bank of India.
16. Bank of India receives the payment of USD 5000.00 and further remits this payment to Mr. Shiv’s account
17. Using the shipping documents, Mr. Mac clears the goods from the shipping line.

This is the entire process of green clause letter of credit.

Sight LC

A letter of credit that demands payment on the submission of the required
documents. The bank reviewsthe documents amd pays the beneficiary if
the documents meet the conditions of the letter.
sight Letter of Credit

A sight letter of credit is a special type of letter of credit in which a payment term “sight” is used in a letter of credit. It basically means “payment at sight”. It is also known as letter of credit at sight.

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Meaning

In a sight letter of credit, the payment for the transactions is released immediately after the seller presents the required documents to the advising bank. The documents required as per the terms of a letter of credit is usually the proof of shipment. This includes invoice, packing list, bill of lading, insurance, etc.

A regular letter of credit is a document that guarantees payment to the seller if the conditions of the letter of credit are confirmed by both the buyer and the seller. However, the time by which buyer releases payment to the seller depends on the type of the letter of credit. For example, a red clause or a green clause letter of credit gives an option of advance payment before the shipment of goods, whereas the usance letter of credit gives an option of differed payment. In case of sight letter of credit, the payment is released immediately after the required documents are presented to the advising bank.

Here when we say payment is released immediately it usually means in five to ten business days. This is because the advising bank needs time to review the documents submitted by the seller. In most cases, the advising bank sends the documents to the bank that has issued the sight letter of credit. Thereafter, once the documents get confirmation from the issuing bank, it will release the payment.

Deferred Payment LC

An LC that ensures payment after a certain period. The bank may review the documents early but the payment to the beneficiary is made after the agreed-to time passes. It is also known as Usance LC. For more information click on Differed payment LC

Direct Pay LC

A letter of credit where the issuing bank directly pays the beneficiary and then asks the buyer to repay the amount. The beneficiary may not interact with the buyer.

Why use Sight Letter of Credit?

The letter of credit by itself is used as a payment tool to ensure the safety of both the parties involved in the international trade. However, the sight letter of credit is very specific in its usage.

A sight letter of credit helps manage the seller’s working capital cycle. It is a boon especially for small companies who are working on tight bootstrapping principles. Such companies may insist on sight letter of credit from their buyers.

Furthermore, a sight letter of credit may prove to be a very useful tool when the seller is doubtful of receiving payment. This can be due to numerous reasons such as the buyer may be located in a volatile region where there is political or economic tension or buyer himself may be in some financial turmoil. In this case, the seller prefers that he gets paid as quickly as possible, so he asks for sight letter of credit.

Conclusion

Letter of Credit has become an important tool for reducing the risk of business and to speed up the cash flow cycle. It facilitates business to trade at ease. Being a negotiable instrument, it can be endorsed multiple times making it the most flexible payment tool. Back-to-Back Letter of Credit facilitates payments to subcontractors. The first beneficiary can transfer the LC in the favor of the secondary beneficiary, assuring payment to the supplier. This helps the business to continue its functions smoothly.

A Letter of Credit is also known as ‘Documentary Credit’. Nestled in the word ‘documentary’ is the word ‘document’. This is because, in a letter of credit transaction, documents are its driving force. The performance of the seller/exporter is tied to the documents requested in the letter of credit. What that means is that in a LC transaction, the payment from a bank to the seller/exporter is conditional upon the ability of the seller to generate the documents that are requested by the buyer/importer in the letter of credit. In order to pay the seller, once the bank receives the documents from the seller, the bank examines the submitted documents to see if they comply with the documentary credit terms that were set by the buyer and the governing rules of the LC. The

bank also checks the instructions to ensure that the documents submitted by the seller contain no errors. Since these complying documents submitted by the seller to the bank are the trigger for the seller to get paid, it makes them the most important component of a letter of credit transaction in international trade.

What documents are generally requested in a letter of credit transaction?

It is evident that the buyer generally requests the documents from a seller in a LC transaction.

So think as a buyer/importer when looking for the logic behind the kind of documents that typically get requested in a LC (or documentary credit) transaction.

From a buyers’ perspective, the buyer would absolutely need the following:

1. Proof of value of goods being imported.
2. Proof of Shipment.
3. Proof of Packing.

Furthermore, the buyer may also want the following:

• Proof of Origin of goods. (same as bullet point number 9 given below)
• Proof that the products meet the desired quality
• Proof of Insurance.

Additionally, the buyer’s country may have statutory requirements like:

• Phytosanitary or Health Certification of product that is being imported
• The buying country’s embassy-certified (or legalized) Invoice and/or documents
• Certification and declaration by the seller/exporter that goods in a particular export shipment are wholly obtained, produced, manufactured or processed in a particular country.

So based on the above-listed 10 requirements respectively, let’s generate the document list:

1. Commercial Invoice (Proof of Value)

• Bill of Lading (Proof of Shipment)
• Packing List (Proof of Packing)
• Certificate of Origin (Proof of Origin)
• Inspection Certificate (Proof of Quality)
• Insurance Certificate (Proof of Insurance)
• Health Certificate of Phytosanitary Certification
• Consular Invoice or Legalized Commercial Document(s)
• Certificate of Origin (same as #4 given above)
• Draft or Bill of Exchange (Negotiable Instrument to be given to the bank in order to get paid)

If you notice these documents that are requested in a LC, typically fall in to the following five categories:

• Commercial Documents
• Shipping and Transport Documents
• Insurance documents
• Official Documents required by Buyer/Importer’s country
• Financial Documents

The following is a brief explanation of the above listed documents:

1. Commercial Invoice

In international trade, a Commercial Invoice is a very important document since it is the official bill of sale and a document based on which the importer pays the exporter. It is issued by the seller/exporter and should be on the beneficiary’s (exporter’s) letterhead that matches the beneficiary information on the L/C. A commercial Invoice includes a description of merchandise (with their Harmonized codes), price, terms and name and address of buyer and seller. The buyer and seller information must correspond exactly to the description in the letter of credit. Unless the letter of credit specifically states otherwise, a generic description of the merchandise is usually acceptable in the other accompanying documents. This is also a document that is used for custom clearance and payment of duties. It should have the correct currency designation and made out in the same currency as the letter of credit. As per LC Rules UCP600 Article 18: Commercial Invoice “need not be signed” anymore.

• Transport Documents Bill of Lading (Marine/Ocean/Port-to-Port)

Bill of Lading (B/L) is a contract between a seller and the carrier evidencing delivery of goods into the care and custody of the carrier. When authenticated it becomes a document of title. The B/L can be ‘straight’ or ‘negotiable. A straight B/L states that the goods are consigned to a specified person or entity and it is not negotiable free from. If the B/L is negotiable it can be made to the “order” of blank; bank; shipper; buyer; or seller. The documents evidence control of goods. The B/L also serves as a receipt for the merchandise shipped and as evidence of the carrier’s obligation to transport the goods to their proper destination. (Refer LC Rules UCP600 Article 20 UCP600)

A ‘Clean on Board’ B/L means that goods have been received on board by the carrier in apparent good condition and stowed ready for transport.

Other Transport Documents: Non-negotiable seawaybill; Charter party bill of lading; Multimodal transport document; Air transport document; Road, rail, or inland waterway transport document; Courier and post receipt. (Covered under LC rules UCP600 Articles 21 to 25)

3. Packing List

A packing list is usually requested by the buyer from the seller to assist the buyer in identifying the contents of each package or container that is being exported. It must show the shipping marks and number of each package.

A typical Packing Slip contains the following information:

• Name, Address, Phone of Seller/Exporter (consignor)
• Name, Address, Phone of Buyer/Importer (consignee)
• Description of Goods being Exported
• Quantity (Number)
• Weight
• Package Type
• Total Number of Packages with contents of each package
• Markings used on the Package
• Reference Commercial Invoice, Date and Buyer’s Purchase Order, Delivery Term and Mode of Transport
• Carrier details with a reference to the transport document, vessel name and container number

Though a Packing List is not usually required to be signed, some countries and their customs authorities may want the packing slip to be signed and stamped.

The Packing List should not reveal any financial information (price/value etc.) about the shipment.

4. Certificate of Origin (C/O or Co0)

A certificate of origin is a document that provides evidence of the country-of-origin of the imported goods. It is used in determining any preferential custom tariff, duty on goods and whether or not goods originate in a country against which the importing country has trade restrictions. The certificate should be consistent with and identified with the other shipping documents by shipping marks and numbers, and must be signed by the appropriate authority. If this document is missing, the highest rates may be applied to each consignment, and Customs authority in the buyer’s country may not allow the goods to be imported. Unlike transport and insurance documents, Letter of credit rules (UCP600) do not cover certificate of origin under any specific articles.

• Inspection Certificate

An inspection certificate evidences that goods were inspected and details the result of the inspection. It is a preventative measure against possible fraud and a means of protecting the buyer against receiving substandard or unwanted goods. Inspection is generally carried out by a third party reputable firm which is independent. Clean Report of Findings (CRF) is a type of Inspection Certificate.

• Insurance Certificate

An Insurance Certificate is requested by the buyer/importer when the trade terms specified in the LC is either ‘Cost, Insurance & Freight’ (CIF) or ‘Cost & Insurance Paid to (CIP). As per these trade terms the seller contracts for insurance cover against the buyers risk of loss or damage to the goods during carriage. The insurance document should cover the risk specified in the Documentary Credit. It should be for the CIF or CIP value of the goods. Otherwise the insurance should be for a minimum of 110% of the amount for which payment, negotiation or acceptance is requested in the UC. (LC Rules UCP 600 Article 28 covers Insurance)

• Health Certificate I Certificate of Free Sale I Certificate of Sanitation

Certain countries require that all imports of meat, poultry, fish, seafood, livestock, vegetables, fruits, etc. that are marked for human consumption are attested by the exporting country that they are free from pests and/or diseases; meet the standards and legislation for export and are fit for human consumption. The declaration that is given on a Health Certificate by the exporting country is a government to government affirmation and is generally issued by government-authorized agencies and departments. However, in a LC transaction if there is no mention of who should issue the Health Certificate then it leaves the door open for anyone to issue the certificate and that includes the seller.

The Health Certificate is also known by the following names: Certificate of Free Sale; Certificate of Sanitation and Free Sale; Certificate of Sanitation and Sanitary Certificate.

Phytosanitary Certificate: Similarly, a Phytosanitary Certificate is issued by the exporting country for plants and plant products that are being exported. The certificate is issued by the plant protection government body of the exporting country to the plant protection government body of the importing country certifying that the plants or plant products covered by the certificate have been inspected and are considered to be free from pests and that they conform to the existing phytosanitary requirements of the importing country.

• Consular or Customs Invoice

A consular or customs invoice is prepared by the seller on an official country-specific form. It may be required to be ‘visaed’ (officially stamped) and signed by a consular officer of the importing country that has an office/consulate in the exporting country. The value of goods required must agree with that shown on the commercial invoice.

• Certificate of Origin

See No. 4

1. Bill of Exchange or Draft

A Bill of Exchange (or ‘Draft) is an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed determinable future time a sum of certain money to or to the order of a specified person or bearer. (Read more about this in our Article on Bill of Exchange}

Avoiding Document Discrepancies

Upon receipt of a letter of credit advice from the advising bank the seller should immediately:

• Verify that the LC Type, its amount and the terms and conditions are as per the negotiated sales contract.
• Calculate that the expiry date, the latest shipment date and presentation of the document period is workable.
• Ascertain if the requested documents can be produced and submitted within the above-stated timelines stipulated in the LC
• Check that the documents that are requested in the LC is what was mutually agreed upon and that there are no non-documentary conditions in the LC
• See if Merchandise description in the LC is proper and can be stated correctly on all relevant document like Commercial Invoice and Shipping Document.
• Ensure that all Names and Addresses (Beneficiary’s and Applicant’s) are stated correctly
• see if the LC seeks any ‘special conditions’ that the seller has to fulfil and that it can be accomplished.

Others:

• Make sure that the Shipping document shows the correct Consignee
• Make the Draft (Bill of Exchange) for the correct amount, correct tenor and is drawn upon the correct party.
• Make sure information stated on different documents is consistent and as per the LC requirements.
• See that the currency is properly designated in the Commercial Invoice.(USD, CAD etc.)
• Note if the Bill of Lading (Shipping document) requires to indicate whether freight is ‘prepaid’ or ; ‘collect’ i.e. payable at destination
• Note if the Bill of Lading (Shipping document) requires to mention the port of loading and port of discharge

The seller/exporter should note that the negotiating bank’s (that bank that receives and examines the documents) ability to pay against documents submitted by the seller under a given LC, depends entirely on the strict compliance of these documents with the terms and conditions of the LC and the provisions contained in the rules for LCs which is UCP600.

An Opinion on Documents:

An opinion: The seller should negotiate with the buyer to include only the most essential documents in the LC transaction. (Perhaps just the first four in our list). For any other documents that the buyer requests the seller can deliver them directly to the buyer outside the LC arrangement.

This will hasten up payment considerably and reduce the chances of discrepancies which mostly sprout from documents that have to be submitted to the bank for payment, since they are made part of the LC transaction by the buyer.

Keep in mind that any document that is made a part of the LC transaction has to be submitted to the bank for scrutiny and payment. For this reason you want to keep the list of documents that form part of the LC transaction to a minimum.

Author. Puru Grover @ Credit Guru Inc 1 CreditGuru.com

For this article please note:

A) That the following terms have been used interchangeably in this article:

• Documentary Credit = Letter of Credit = LC = L/C
• Beneficiary = The Seller = The Exporter The party that that derives payment from the letter of credit
• Applicant = The Buyer = The Importer = The party who arranges to open the Letter of Credit with their bank = The party who requests the documents from the seller.

B) In this article there is a reference to UCP600.

UCP stands for Uniform Customs and Practices for Documentary Credits (or UCP or UCPDC)

These are a globally accepted set of LC rules on the issuance and use of letters of credit that are put out by the International Chambers of Commerce (ICC). The current version of these rules is UCP600. (600 is the publication number)

You can find more information and buy a copy of these rules from the International Chambers of Commerce website iccwbo.org

For more informations access: International Chamber of Commerce on
www.iccwbo.org