Understanding Letters of Credit

In international trade where buyers and sellers are located in

different countries, there is little comfort about the credit
worthiness and business standing of the parties. To overcome this,
remove the risk of insolvency of the buyer and provide a degree of
comfort to the parties, Letter of Credit (LC) plays a crucial role.
Our aim in publishing this guide is to provide a basic understanding
of Letters of Credit.
A] What is a letter of credit?
In its simplest term, a letter of credit (LC) is a guarantee from a
bank that a party to a contract (typically a seller) will receive a
payment from the other party (typically a buyer) upon fulfilling
certain pre-agreed obligations. To process payment, the bank will
require that strict terms are met.
This is most commonly used (but not restricted to) overseas trade
as it can give security both to the seller and the buyer. The bank
will only issue a letter of credit if it is confident that the buyer will
pay, whether by an up-front payment to the bank or through a line
of credit with the bank.
It is important to note, the letter of credit is a distinct and separate
transaction from the contract on which it is based.
B] Parties commonly involved in a Letter of Credit
1] Applicant:
Applicant is the party who opens the Letter of Credit in favor of the
other party to the contract (beneficiary). Normally, the applicant is
the party who is buying the goods. The applicant is the one who
arrange the opening of letter of credit with his bank as per the
terms and conditions agreed between him and the seller.
2] Beneficiary
Beneficiary is the one who gets the benefit and receives amount
under letter of credit (eg. the seller). Payment cannot be released
until fulfilling certain pre-agreed obligations and submission of a set
of pre-defined documents to the issuing bank.
3] Issuing Bank
Issuing bank is the bank that issues a letter of credit at the request
of an applicant. The issuing bank is not liable for the performance of
the underlying contract between the applicant and beneficiary as,
its obligation to the buyer is to examine all documents to insure

compliance with the terms and conditions of the LC. In a similar

fashion, the issuing banks obligation to the seller is to provide a
guarantee that if compliant documents are presented, the bank will
pay the amount due.
Reference to compliant documents would typically include
commercial invoice, bill of lading, insurance document, etc.
4] Advising Bank
Advising bank is the party responsible for sending the documents to
the issuing bank. It is also the bank where the beneficiary must
present documents required by the LC in order to be paid. There is
no obligation on the advising bank to pay in the event the issuing
bank does not pay the beneficiary.
5] Confirming Bank
Confirming bank is the bank who adds his undertaking to the letter
of credit thus providing an additional/second guarantee to assure
payment. This commonly happens when the issuing bank may have
questionable creditworthiness.
Different to the advising bank, the confirming bank is under
obligation to pay in the event the issuing bank does not pay the
beneficiary. The confirming bank is usually the advising bank and it
is noteworthy, only irrevocable letters of credit can be confirmed.
C] Characteristics of Letter of Credit
1] Negotiability
Negotiation is a very important aspect of letter of credit. LCs are
usually negotiable where the issuing bank obligation is extended to
pay not only the beneficiary, but also any other bank nominated by
the beneficiary.
For an LC to be negotiable, it must include an unconditional promise
to pay, on demand or at some specific time. The nominated bank
takes the letter of credit for value, in good faith, without notice of
any claims against it.
2] Revocability
Whilst revocable letter of credits are not commonly used
instruments, letters of credit may be either revocable or irrevocable.
A revocable letter of credit may be revoked or modified by the
issuing bank without notification. On the other hand, irrevocable
letter of credit (the commonly used option) may not be revoked or
amended without the agreement of the issuing bank, the confirming
bank and the beneficiary.

3] Transferrable
Under a transferable LC the rights and obligations of the beneficiary
are transferred, in whole or in part, to another party, usually a
supplier or a manufacturer. This will enable the beneficiary to pay
the supplier by letter of credit. Under this process the supplier or
manufacture (i.e. the transferee) becomes a substitute beneficiary
with the right to submit documents and make draws in its own
name. To be transferable, the LC must state that it is transferable.
This shall not be confused with assignment of proceeds where the
assignee is not entitled to make a draw directly or to submit
documents in its own name.
4] Revolving
For long terms business relationship, revolving LC allows companies
to issue a letter of credit that could revolve either in value or in time
without the need to reapply for a new LC. In simple terms it is a
single letter of credit which can be used several times over a long
period of time.
D] Payment against LC:
All letters of credit require the beneficiary to present some specified
documents in order to receive payment. In accordance with the
rules in place for letters of credit (UCP 600), credit must also state
whether it is available by sight payment, deferred payment,
acceptance or negotiation.
1] Sight payment
In this scenario, the beneficiary will receive payment immediately
upon submission of the required documents. It is important to
realize that "immediately" does not literally mean that the payment
will be made immediately as the bank is allowed a reasonable time
to review the documents before making payment.
2] Deferred payment
In this situation, payment is made at a future date stipulated in the
LC (for example 60 days after submission of commercial invoice).
This does not mean that the issuing bank will not review the
document upon its submission. The bank is still required to review
the documents upon submission to ensure they are credit compliant
and thereafter pay at maturity.
3] Acceptance
This is similar to the deferred payment method but do require the

issuance of bills of exchange. In this situation, the confirming bank

would have to accept a bill of exchange ("draft") drawn by the
beneficiary and pay at maturity.
4] Negotiation
The UCP 600 defines negotiation as the purchase by the nominated
bank of drafts (drawn on a bank other than the nominated bank)
and/or documents under a complying presentation, by advancing or
agreeing to advance funds to the beneficiary on or before the
banking day on which reimbursement is due to the nominated bank.
This effectively means that the beneficiary is allowed to receive
payment by negotiating the sight drafts and documents at a
nominated negotiating bank that shall then pay the beneficiary prior
to receiving the reimbursement. It is important to note, in the
context of UCP 600, only a nominated bank can negotiate and this
can only be done under a credit available by negotiation.
E] Main types of Letter of Credit
There are basically two types: commercial and standby. The
commercial letter of credit is the primary payment mechanism for a
transaction, whereas the standby letter of credit acts as a
secondary payment mechanism.
1] Commercial Letter of Credit
A letter of credit is a contractual relationship between a bank
(issuing bank) that on behalf of his customer (the applicant)
authorizes another bank (advising/confirming bank) to pay a
beneficiary subject to presenting certain documents. The beneficiary
is normally the provider of goods and/or services under a separate
contract between the applicant and the beneficiary.
2] Standby Letter of Credit
A stand-by Letter of Credit serves a different function than the
commercial one. It is simply a bank's commitment to make
payment in the event of default on the part of the Applicant. This is
to typically provide assurance of the applicant ability to perform its
obligations (commonly payment obligations) under the terms of a
contract between the beneficiary. Under this transaction the parties
do not expect that the letter of credit will ever be drawn upon.
Important note:
One thing to remember, Banks deal in documents only. The issuing
bank is only replacing its credit worthiness to that of applicant and

not undertaking to ensure the quality of the goods. If a dispute

arises between the applicant and beneficiary over the quality of the
goods, the seller upon presenting complying documents to the
Issuing Bank, will be entitled to receive the money and the buyer
does not have any authority or remedy to stop the Issuing Bank
from making payment. The dispute will then need to be resolved
separately.