Letter of Credit (LC) is a conditional undertaking to pay a certain amount of money, given by a bank, at the request of an applicant, to a beneficiary, upon presentation of specified documents. Therefore, it is also called a Documentary Letter of Credit.
In a trade transaction, the buyer wants to be sure that the seller will ship/dispatch the goods of specified quantity and specifications by a certain date by the mode of shipment/dispatch as agreed. The seller wants to be sure that he will get the payment if he has shipped/dispatched the goods as agreed. Quite often the seller and buyer may be in different countries and may not know much about the competence, commitment and standing of the other. So, they bring in a third party, usually a bank (called an issuing bank) to assure payment to the seller, provided that he performs as per the conditions specified by the bank in the Letter of Credit. Usually, the conditions include presentation of certain documents that will ensure that the goods are shipped as required by the buyer.
Typically, after a sales contract has been negotiated, and the buyer and seller have agreed that a LC will be used as the method of payment, the Applicant i.e. the buyer will contact a bank to ask for a LC to be issued. Once the issuing bank has assessed the buyer’s credit risk – i.e. that the Applicant will be able to pay for the goods – it will issue the LC, meaning that it will provide a promise to pay the seller upon presentation of certain documents. Once the Beneficiary (the seller) receives the Letter of Credit, it will check the terms to ensure that it matches with the contract and will either arrange for shipment of the goods or ask for an amendment to the LC so that it meets with the terms of the contract. The LC is limited in terms of time, the validity of credit, the last date of shipment, and in terms of how much late after shipment the documents may be presented to the Nominated Bank. Once the goods have been shipped, the Beneficiary will present the requested documents to the Nominated Bank. This bank will check the documents, and if they comply with the terms of the Letter of Credit, the LC issuing Bank is bound to honor the terms of the LC by paying the Beneficiary.
This way, the seller is assured of payment if he tenders the documents specified in the LC and the buyer is sure that the seller will get payment only if he presents the documents specified in the Letter of Credit. Usually the documentation requirements are so spelt out that they evidence performance of as per the contract. However, it must be noted that LCs are different from the underlying sale-purchase contracts.
The International Chamber of Commerce (ICC) has developed certain disciplines, termed ‘Uniform Customs and Practices for documentary Credits (UCP) that all parties to a LC should follow. The latest version of the UCP is the UCP600 effective July 1, 2007. Since the UCP are not laws, parties have to include them into their arrangements as normal contractual provisions. UCP 600 is almost universally accepted and followed.
Thus the LC mechanism enables easy flow of trade by bringing much needed certainty to the seller and buyer and even intermediaries or other beneficiaries, especially in international trade. The LC also enables the parties to raise finance by linking payment to performance and by specifying obligations of the parties.