Letter of credit, also known as documentary credit, has been a crucial aspect of the export import business. It is said that some form of documentary credit has existed for thousands of years dating back to the Babylonian times in ancient Iraq (Mesopotamia). Historians argue that the letter of documentary credit had played a vital role in establishing Babylon as a key trade center on the ancient trade route between the Mediterranean Sea and China. Now, almost a thousand years later, the letter of documentary credit is still one of the most important payment instruments of the export and import business.
What is Documentary Credit?
A documentary credit is a written understanding given by a bank to pay a stated amount of money on sight or at a future date. This is given by the issuing bank to the seller or beneficiary on the instruction of the buyer. The undertakings are conditional and based upon the beneficiary’s compliance. The process can be satisfied by providing a ‘complying presentation’ (good and trustworthy presentation) of documents.
Essential Players in Documentary Credit Transactions:
• The Applicant: This is the buyer or reporter requesting the letter of documentary credit.
• The Issuing Bank: This is the bank which will issue a credit on its own behalf or on the request of an applicant.
• The Advising Bank: This helps in advising the credit upon the request of the issuing bank.
• The Confirming Bank: This adds its confirmation to a credit along with the issuing bank to accept or negotiate a complying presentation.
• The Nominated Bank: This is usually the bank with which the credit is available but it can also be any other bank as long as the credit is also available with them.
• Beneficiary: This is the seller or exporter who is normally the provider of goods, services or performance. It is in their favour that the credit is issued.
Now, documentary credit has a variety of types and it is vital to know each one. It is also important to understand the differences between each type and the various circumstances in which they can be used.
TYPES OF DOCUMENTARY CREDIT
1. a) Irrevocable Credit: An irrevocable letter of credit is a financial instrument which is used by banks to guarantee a buyer’s obligations to a seller. It is known as irrevocable as the letter of credit cannot be modified unless all parties agree to the modification.
b) Revocable Credit: Even though most of the credits used in global trade are irrevocable, the need for revocable credits also surface from time to time. It is however important to remember that even the most experienced businessmen take extreme caution while using this payment instrument. This is because of the fact that revocable credits can be cancelled at any time even without the consent of the beneficiary. Furthermore, no bank would ever confirm a revocable credit. These factors lead to a decreased sense of security which is why revocable credits are not the first choice in the export and import world.
Some important things to know about the irrevocable and revocable credits are:
• By default a credit is irrevocable. This is applicable even if there is no indication to that effect.
• The ICC rules covering the UCP 600 (Uniform Customs and Practice for Documentary Credits) does not include the concept of revocability.
• In case of a revocable credit being used, the terms of the revocability need to be incorporated into the credit.
2. Confirmed Credit: Confirmation can be defined as a definite undertaking of the confirming bank as well as that of the issuing bank. This is done to honour or negotiate a complying presentation. Confirmation is a pre-condition included in the proforma invoice or sales contract. It is normally requester by a beneficiary or seller at the time of agreeing to the sale of the goods or while agreeing to provide any kind of services or performance.Confirmation is usually requested by the beneficiary when they have the following concerns:
• The risks concerned with the issuing bank- Doubts about the ability of the bank to honour its undertaking.
• Country risk- The payment risks of the country where the bank has its roots.
• Documentary risk- If the issuing banks determines that the documents do not comply, another bank is required to take the risk of non- payment.
3. Silent Confirmation Credit: This is a kind of private arrangement between a bank and the beneficiary or seller. Here the advising bank adds a conditional guarantee of payment to the beneficiary. This entire process is done without the knowledge of the issuing bank. This situation usually arises when a bank does not want a confirmation added to their credit.Since there is a higher risk in this process, this is a more costly arrangement. This is because of the following facts:
• Although it is anticipated by the UCP 600 sub-article 12(a), it is still not covered by the UCP.
• Since no confirmation request is in place from the issuing bank, it becomes the responsibility of the issuing bank towards confirming a bank not in existence.
4. Revolving Credit: Normally an amendment is required to increase the value of a credit that has been partially or fully utilized. To find a way around this businessmen use revolving credit which provides for the value of the credit to be restored. Revolving credits are also useful in reducing the administrative workload for repetitive purchases of the same kind of goods at regular intervals from the same supplier. For example: A credit that is issued on a revolving cumulative basis can allow a monthly drawing of INR 0.7 MM over a period of three months. If there is no drawing done in month one, it gets rolled over to the next month. Similarly if there is no drawing done in month two then it is rolled over to the third and final month.These kinds of credits may revolve in relation to time, that is, monthly, in which case it will either be:
• Cumulative- Any sum which is not utilized is carried forward to the next month.
• Non-Cumulative- An explicit shipment every month.
Alternately these credits can also revolve in relation to value which means it gets reinstated each time a shipment is made.
5. Red and Green Clause: Historically this clause was written in red or green ink therefore providing it with this name. This type of credit allows the seller to draw on the credit prior to the presentation of documents and the shipment of goods.
The red and green clause has three types. They are the following:
• Unsecured or Clean Red Clause: Here the required documents do not include evidence of the goods.
• Secured or Documentary Red Clause: Here advances can be made against presentation of warehouse receipts or other similar documents along with the seller’s undertaking promising to deliver the bill of lading along with any other required documents upon shipment.
6. Transferable Credit: This is the kind of credit that allows the seller to transfer the credit either fully or partially to one or more third parties. In this way the credit goes from the first beneficiary (seller) to the second beneficiary (third parties). However, in order for this practice to be effective the credit must clearly state that it is transferable.Any transfers must be made on the exact same terms and conditions of the credit including confirmation if any. The only exceptions to this are:
• The credit amount
• Any unit price which is stated therein
• The expiration date
• The presentation period
• The latest shipment date or the given period for the shipment.
It must however be kept in mind that a bank is under no obligation to transfer a credit beyond the extent. It does so in a manner expressly consented to by the bank. All charges such as commissions, fees, costs or expenses must be paid by the first beneficiary unless otherwise agreed to at the time of the transfer.
Some of the key issues in this kind of credits are:
• A credit may be transferred in part to more than one second beneficiary provided shipments or partial drawings are allowed.
• A second beneficiary cannot transfer a transferred credit to any subsequent beneficiary.
• The percentage of which insurance cover must be affected can be increased to provide the amount of cover stipulated in the credit.
• The name of the first beneficiary may be substituted for the name of the applicant in the credit.
7. Back to Back: These kinds of credits are usually used by traders who act as the middlemen between the supplier of the source and the final buyer. To do this two separate credits are issues. Namely:
• A Master Credit which acts in favour of the middleman.
• A Back to Back Credit which acts in favour of the source supplier.
The primary source of repayment for the person who issues the back to back credit are the proceeds received from master credit. The terms and conditions of the back to back credit are likely to be similar to those of the master credit with the exception of:
• The amount of credit.
• The price of the unit.
• The date of expiry.
• The latest date of shipment
• The period of presentation.
Care should be taken during these kinds of transactions as each bank has their own sets of terms and conditions.
8. Standby Letter of Credit: These credits are used globally but are the most common in the United States. Such credits represent a secondary obligation covering default only and they provide security against non- performance. This means that if an expected actions does not take place as covered by the standby then a claim can be made. A key feature of a standby is independence from the underlying contract. This kind of autonomy provides the concerned parties with separate security in the event of non-performance. A standby is commonly used to cover and mitigate the many risks that can take place while finalizing a contract between a buyer and a seller.
There are a wide variety of types of standby credits but the most commonly used ones are:
• Performance- Agreeing to undertake, deliver and complete contractual obligations.
• Advance Payment- Undertaking repayment of all or a percentage of the value of a contract that has been paid to the applicant by the beneficiary as down payment, advance or deposit upon the signing of the contract.
• Bid or Tender Bond- This ensures that a bidder cannot withdraw from the tender process or alter its proposal before the tender is awarded.
• Counter- This is a standby issued by one bank for another to support the issuance of a standby, guarantee, documentary credit or any other form of undertaking by the other bank.
• Financial- Ensures a financial obligation to pay or repay.
• Insurance- Reinforces the obligations of applicants in respect of insurance or reinsurance activity.
• Direct Pay- This is likely to be the primary means of payment.
• Commercial- This acts as a security for payment of goods or services that has not been settled by a buyer under arrangements like open account trading or documentary collection.
To sum it up, a letter of documentary credit is a kind of arrangement made by banks to settle international commercial transactions. It provides a form of security for the parties involved and ensures payment provided that the terms and conditions of the credit have been fulfilled.
By- Antashri Banerjee
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