Letters of credit
If you are involved in import/export, then you have probably come across the term L/C (letter of credit). Although L/Cs can vary in type, this article will specifically discuss the commercial documentary letter of credit used for business transactions. This particular type of L/C is payable upon the presentation of specific documents.
An L/C can be thought of as a letter from an importer’s bank informing an exporter that they will be paid for a shipment upon presentation of the specified documentation. All communication takes place within banking channels and documentation must not contain discrepancies.
For example, if you wanted to import a shipment of clothing and the seller (exporter) has asked for an L/C. If you accept the exporter’s terms you will need to apply for an L/C from your bank in favor of the seller. L/C’s usually state a time period and manner in which the exporter must provide documentary proof that they have shipped the goods. Other obligations may also be included.
Obtaining an L/C is not as simple as just asking for one. As your bank is pledging to pay the exporter on your behalf, you will be required by your bank to demonstrate that they will be able to recover their funds from you.
Once it has agreed to open an L/C, the opening bank (the importer’s bank) will transmit the L/C to its branch or correspondent (the advising bank) closest to the exporter. The advising bank will notify the exporter that credit has been established in their name once they have received the L/C.
Exporters should make sure that they are capable of meeting the terms and conditions of an L/C upon receiving it. This is very important, as if the shipment does not match that described in the L/C; payment will in most cases be delayed until the discrepancy has been resolved.
After shipment and presentation of the necessary documentation to the advising bank, if no discrepancies are found, the exporter is due payment. The paying bank could be the advising bank and thus the exporter can receive payment very quickly. If the opening bank is the paying bank, payment may take a few days. Both importers and exporters may request that the paying bank be in their country as they are looking to the L/C to protect their interests.
Importers can ask for any legal terms to be included within and L/C and exporters must provide documentary evidence to prove that such terms have been met. As most L/C’s are irrevocable, once an L/C has been opened and advisement has been made, they cannot be altered or cancelled with the consent of the exporter.
On the occasion where an exporter doubts the solvency of an opening bank, they can request to have the L/C confirmed by the advising bank. This means that if the opening bank is responsible for making payment and cannot do so, the confirming bank will pay. For a cost of approximately 1% of the cost of the L/C an exporter receives a fair amount of added assurance.
In summary, an L/C is:
A formal document of payment Opened by a party wishing to import Communicated through banking channels Paid by the opening bank within a specified timeframe upon presentation of stipulated documentation The cost of an L/C to an importer is often a fixed fee plus a percentage or a percentage with a minimum commission. Additionally, exporters will be required to pay a variety of costs. Where an L/C is not payable on sight, costs increase. This is also the case where more than two banks are involved, exporters request confirmation of credit and when discrepancies are found within the documentation or additions/changes to the L/C are necessary.
TT (Telegraphic Transfer), DP bill etc. vs. LC (Letter of Credit)
I have seen discussions and debates on differences between LC and TT, TT and DP/DA bills etc. This article is to put the subject in its proper context.
We must note the distinction between the PROCESS (of moving money) in contrast to the PURPOSE (that generates or causes the movement). The first is answered bythe question "WHY"?, The second by the next question "HOW"? One very often fails to distinguish between the two. This is an area that happens to be confusing to many. Consequently, questions like "What is the difference between a TT and a D/P bill", or "While negotiating with my party, should I opt for TT payment or pay by LC?" keep cropping up during discussions at various forums or workshops. It is imperative that the basic concepts are clarified.
Cause and effect-------------------------The purpose or the transaction prompting the transfer of money (WHY transfer?) can be any of the reasons conceivable. Some examples: purchase or sale of goods, payment towards services, expenditure on capital goods, fixed or movable assets, expenditure on travel, gift or charity, deposit of cash or transfer to an account for savings or investment. There could be a million plus one reason giving rise to the transfer of money.
The next stage comes where we see money actually being transferred from one place to another, from one account to another, or from one bank to another. A physical movement takes place where the one who has the money (the remitter) foregoes possession in favour of another (the beneficiary) who then gains possession of it. How this physical movement takes place determines the process of transfer.
The remitter or the beneficiary may decide how exactly the physical action of movement of funds is to take place. The factors that guide such decision include the urgency, available technology, settlement procedure, cost of remittance, associated risks and mutual convenience.
We are familiar with several of these processes of fund transfer. These include electronic transfer viz., telegraphic transfer (TT), S.W.I.F.T., ECS, RTGS etc., or transfer using a physical mode viz., mail transfer (MT), cheque, draft, cash, banker's cheque, pay order and so on. These are HOW money is transferred. We often discuss purchase and sale, export and import - where one party parts with goods or services in exchange for money from the other. We also discuss about some of the terms of settlement between the buyer and the seller. One should remember that bills and LCs are only documents that represent a transaction. They are neither purposes nor processes.
Advance payment, for example, is a purpose ("WHY?"); the advance payment being effected ("HOW?") by means of a TT or a bank draft is the process that translates a purpose - to bring the former to a conclusion. The cause has nothing to do with the choice of the process (or the method, how?) that one may use to consummate that cause. Conversely, the cause (the purpose or reason for transfer of funds) may be only one, but the processes that one may select, or the options to choose from (to effect the transfer) could be several.
The important thing to remember is to distinguish between the purpose of a transaction against the process to conclude the same.Ask yourself "WHY"? and then send the remittance by answering "HOW"?
BACK TO BACK LETTERS OF CREDITESTABLISHING BACK-TO-BACK CREDITS
This is how the whole process works.1) Issue of original LC In documentary credit operations the buyer (i.e. the applicant) arranges to establish the (original) credit through a bank (the issuing bank or the opener) in favour of the seller (the beneficiary). The buyer and the seller are the primary parties to the contract for the specific transaction. The issue of a credit is advised through a bank (called the ‘advising bank’) usually located in the city of the beneficiary. The beneficiary receives the original credit through the advising bank and/or his own bank.
2) Issue of Back-to-Back LCA back-to-back credit is (only then) established when the seller-cum-original-beneficiary, after receiving the notification about the issue of the original credit, arranges for a second, stand-alone credit to be established in favour of the (actual) supplier/manufacturer of goods or raw materials. Accordingly, and usually based on the original credit, the advising/confirming bank issues its own letter of credit – generally with terms exact or similar to the first i.e. the original LC (hence the term ‘back-to-back’) - except for alteration of beneficiary, expiry date, and invoicing requirements, if considered necessary.
3) No formal connection between the two LCsPlease be careful to note that there is no legal or formal connection between the ‘original’ LC and the ‘Back-to-Back’ Credit. Each credit stands on its own merit. The terms and conditions of the two are not the same because one has to make sure that the documents coming forward under the second credit come forward in such a form and in such a time that they can be presented under the first credit within the expiry date and in accordance with the terms and conditions of the first credit.
4) Back-to-Back LCs can be opened as a chainIf there are several middlemen (or manufacturers who must again procure input materials from other manufacturers), each may use the credit in his favour as security for the credit that he has to open in favour of his supplier in the chain of contracts, until first buyer in the chain has effectively opened a credit in favour of original supplier. In this chain, each credit – except the original one – is termed a credit that has been issued ‘back-to-back’ to the previous one.
WHEN IS BACK-TO-BACK CREDIT REQUIRED?
A ‘back-to-back’ arrangement may become necessary where the underlying contracts are on terms that do not match, or where a Transferable Credit is unable to maintain secrecy on a particular aspect of the transaction.
Need for such a credit may also arise where –a) ultimate buyer is not ready to open a transferable LC, or b) beneficiary is not ready to disclose or divulge to buyer source of his supply, and c) the manufacturer insists on payment against documents or goods but beneficiary is short of funds.
BACK-TO-BACK CREDIT NOT A PART OF THE UCP
Back-to-back Credit finds no mention in the UCP. Only transferable credit is mentioned. Therefore no specific or separate rules apply to back-to-back credit. (This should be evident from the fact that each LC is an independent entity and stands on its own footing.) A bank must treat each stage of the operation as a separate transaction, each legally independent of the other. Consequently, the issuing banks concerned must independently assess the risks and liabilities associated with issuance of each of the credits separately.
A CREDIT DECISION OF THE ISSUING BANK
The applicant for a Back-to-Back Credit takes off his hat as the beneficiary to the original credit and wears the hat of an “applicant” as far as the back-to-back credit is concerned. It is important to note that a bank may agree to issue a back-to-back credit only when the applicant-beneficiary is considered – in the eyes of the advising bank (the issuer of the second, i.e. the Back-to-Back Credit) – to be creditworthy on his own right. The decision by a bank to issue a (Back-to-Back) credit is neither a matter of right nor is it automatic – especially not just because a seller-cum-applicant in the chain happens to be in possession of another (the original) documentary credit as a beneficiary of the original credit.
UTILISATION: SAME AS WITH ANY NORMAL CREDIT Since the back-to-back credit is an independent credit and because here we are not dealing with the transfer of a credit as defined in Article 47 (ICC 500) of the UCP, the practices and procedure for utilisation of a back-to-back credit would be the same as in the case of any LC. The documents required are, therefore, presented in the normal course by the beneficiary via his bank to the original advising bank. The documents are honoured – provided they conform to the terms of the back-to-back credit – to the debit of the intermediary (i.e. the original beneficiary who initiated the issue of the back-to-back credit).
Caution: The intermediary bank should not take comfort in the fact that the credit under which the documents are being handled is a “back-to-back” credit, thus causing it to be lax in recovering funds from the intermediary towards documents so received under its own (back-to-back) credit.
SUBSTITUTION OF DOCUMENTS
At this stage the exchange of invoices (and drafts, if any) is a must, because – contrary to the transferred credit – the original credit opened in favour of the intermediary / middleman cannot be negotiated by simply using the documents of the supplier. The actual supplier in the chain has no locus-standi as far as the applicant to the original credit is concerned.
Any other differences allowed in the opening of the back-to-back credit must also be eliminated at this point.
NEGOTIATION AND PAYMENTAfter these changes have been effected, the documents are used for negotiation of the original credit and the proceeds are credited to the account of the intermediary / middleman (the original beneficiary) in the usual manner. Procuring, exchange and substitution of documents and the process of negotiation may now continue up the chain in the normal course.BACK TO BACK LETTERS OF CREDIT
You won't find ANY bank, not in the US, not anywhere in the world who'd open a "Back-to-back" LC. Not even in the UCP. There is no such thing as a "back-to-back" LC. These have been explained in the article itself.
An LC that's opened on the *back* of another is called a "Back-to-back" LC. It is a matter of nomenclature. The two LCs are INDEPENDENT, STAND ALONE instruments of payment. All banks open LCs, some of which could be opened as "Back-to-back" LCs.
THANKS TO ALIBABA.COM
An L/C can be thought of as a letter from an importer’s bank informing an exporter that they will be paid for a shipment upon presentation of the specified documentation. All communication takes place within banking channels and documentation must not contain discrepancies.
For example, if you wanted to import a shipment of clothing and the seller (exporter) has asked for an L/C. If you accept the exporter’s terms you will need to apply for an L/C from your bank in favor of the seller. L/C’s usually state a time period and manner in which the exporter must provide documentary proof that they have shipped the goods. Other obligations may also be included.
Obtaining an L/C is not as simple as just asking for one. As your bank is pledging to pay the exporter on your behalf, you will be required by your bank to demonstrate that they will be able to recover their funds from you.
Once it has agreed to open an L/C, the opening bank (the importer’s bank) will transmit the L/C to its branch or correspondent (the advising bank) closest to the exporter. The advising bank will notify the exporter that credit has been established in their name once they have received the L/C.
Exporters should make sure that they are capable of meeting the terms and conditions of an L/C upon receiving it. This is very important, as if the shipment does not match that described in the L/C; payment will in most cases be delayed until the discrepancy has been resolved.
After shipment and presentation of the necessary documentation to the advising bank, if no discrepancies are found, the exporter is due payment. The paying bank could be the advising bank and thus the exporter can receive payment very quickly. If the opening bank is the paying bank, payment may take a few days. Both importers and exporters may request that the paying bank be in their country as they are looking to the L/C to protect their interests.
Importers can ask for any legal terms to be included within and L/C and exporters must provide documentary evidence to prove that such terms have been met. As most L/C’s are irrevocable, once an L/C has been opened and advisement has been made, they cannot be altered or cancelled with the consent of the exporter.
On the occasion where an exporter doubts the solvency of an opening bank, they can request to have the L/C confirmed by the advising bank. This means that if the opening bank is responsible for making payment and cannot do so, the confirming bank will pay. For a cost of approximately 1% of the cost of the L/C an exporter receives a fair amount of added assurance.
In summary, an L/C is:
A formal document of payment Opened by a party wishing to import Communicated through banking channels Paid by the opening bank within a specified timeframe upon presentation of stipulated documentation The cost of an L/C to an importer is often a fixed fee plus a percentage or a percentage with a minimum commission. Additionally, exporters will be required to pay a variety of costs. Where an L/C is not payable on sight, costs increase. This is also the case where more than two banks are involved, exporters request confirmation of credit and when discrepancies are found within the documentation or additions/changes to the L/C are necessary.
TT (Telegraphic Transfer), DP bill etc. vs. LC (Letter of Credit)
I have seen discussions and debates on differences between LC and TT, TT and DP/DA bills etc. This article is to put the subject in its proper context.
We must note the distinction between the PROCESS (of moving money) in contrast to the PURPOSE (that generates or causes the movement). The first is answered bythe question "WHY"?, The second by the next question "HOW"? One very often fails to distinguish between the two. This is an area that happens to be confusing to many. Consequently, questions like "What is the difference between a TT and a D/P bill", or "While negotiating with my party, should I opt for TT payment or pay by LC?" keep cropping up during discussions at various forums or workshops. It is imperative that the basic concepts are clarified.
Cause and effect-------------------------The purpose or the transaction prompting the transfer of money (WHY transfer?) can be any of the reasons conceivable. Some examples: purchase or sale of goods, payment towards services, expenditure on capital goods, fixed or movable assets, expenditure on travel, gift or charity, deposit of cash or transfer to an account for savings or investment. There could be a million plus one reason giving rise to the transfer of money.
The next stage comes where we see money actually being transferred from one place to another, from one account to another, or from one bank to another. A physical movement takes place where the one who has the money (the remitter) foregoes possession in favour of another (the beneficiary) who then gains possession of it. How this physical movement takes place determines the process of transfer.
The remitter or the beneficiary may decide how exactly the physical action of movement of funds is to take place. The factors that guide such decision include the urgency, available technology, settlement procedure, cost of remittance, associated risks and mutual convenience.
We are familiar with several of these processes of fund transfer. These include electronic transfer viz., telegraphic transfer (TT), S.W.I.F.T., ECS, RTGS etc., or transfer using a physical mode viz., mail transfer (MT), cheque, draft, cash, banker's cheque, pay order and so on. These are HOW money is transferred. We often discuss purchase and sale, export and import - where one party parts with goods or services in exchange for money from the other. We also discuss about some of the terms of settlement between the buyer and the seller. One should remember that bills and LCs are only documents that represent a transaction. They are neither purposes nor processes.
Advance payment, for example, is a purpose ("WHY?"); the advance payment being effected ("HOW?") by means of a TT or a bank draft is the process that translates a purpose - to bring the former to a conclusion. The cause has nothing to do with the choice of the process (or the method, how?) that one may use to consummate that cause. Conversely, the cause (the purpose or reason for transfer of funds) may be only one, but the processes that one may select, or the options to choose from (to effect the transfer) could be several.
The important thing to remember is to distinguish between the purpose of a transaction against the process to conclude the same.Ask yourself "WHY"? and then send the remittance by answering "HOW"?
BACK TO BACK LETTERS OF CREDITESTABLISHING BACK-TO-BACK CREDITS
This is how the whole process works.1) Issue of original LC In documentary credit operations the buyer (i.e. the applicant) arranges to establish the (original) credit through a bank (the issuing bank or the opener) in favour of the seller (the beneficiary). The buyer and the seller are the primary parties to the contract for the specific transaction. The issue of a credit is advised through a bank (called the ‘advising bank’) usually located in the city of the beneficiary. The beneficiary receives the original credit through the advising bank and/or his own bank.
2) Issue of Back-to-Back LCA back-to-back credit is (only then) established when the seller-cum-original-beneficiary, after receiving the notification about the issue of the original credit, arranges for a second, stand-alone credit to be established in favour of the (actual) supplier/manufacturer of goods or raw materials. Accordingly, and usually based on the original credit, the advising/confirming bank issues its own letter of credit – generally with terms exact or similar to the first i.e. the original LC (hence the term ‘back-to-back’) - except for alteration of beneficiary, expiry date, and invoicing requirements, if considered necessary.
3) No formal connection between the two LCsPlease be careful to note that there is no legal or formal connection between the ‘original’ LC and the ‘Back-to-Back’ Credit. Each credit stands on its own merit. The terms and conditions of the two are not the same because one has to make sure that the documents coming forward under the second credit come forward in such a form and in such a time that they can be presented under the first credit within the expiry date and in accordance with the terms and conditions of the first credit.
4) Back-to-Back LCs can be opened as a chainIf there are several middlemen (or manufacturers who must again procure input materials from other manufacturers), each may use the credit in his favour as security for the credit that he has to open in favour of his supplier in the chain of contracts, until first buyer in the chain has effectively opened a credit in favour of original supplier. In this chain, each credit – except the original one – is termed a credit that has been issued ‘back-to-back’ to the previous one.
WHEN IS BACK-TO-BACK CREDIT REQUIRED?
A ‘back-to-back’ arrangement may become necessary where the underlying contracts are on terms that do not match, or where a Transferable Credit is unable to maintain secrecy on a particular aspect of the transaction.
Need for such a credit may also arise where –a) ultimate buyer is not ready to open a transferable LC, or b) beneficiary is not ready to disclose or divulge to buyer source of his supply, and c) the manufacturer insists on payment against documents or goods but beneficiary is short of funds.
BACK-TO-BACK CREDIT NOT A PART OF THE UCP
Back-to-back Credit finds no mention in the UCP. Only transferable credit is mentioned. Therefore no specific or separate rules apply to back-to-back credit. (This should be evident from the fact that each LC is an independent entity and stands on its own footing.) A bank must treat each stage of the operation as a separate transaction, each legally independent of the other. Consequently, the issuing banks concerned must independently assess the risks and liabilities associated with issuance of each of the credits separately.
A CREDIT DECISION OF THE ISSUING BANK
The applicant for a Back-to-Back Credit takes off his hat as the beneficiary to the original credit and wears the hat of an “applicant” as far as the back-to-back credit is concerned. It is important to note that a bank may agree to issue a back-to-back credit only when the applicant-beneficiary is considered – in the eyes of the advising bank (the issuer of the second, i.e. the Back-to-Back Credit) – to be creditworthy on his own right. The decision by a bank to issue a (Back-to-Back) credit is neither a matter of right nor is it automatic – especially not just because a seller-cum-applicant in the chain happens to be in possession of another (the original) documentary credit as a beneficiary of the original credit.
UTILISATION: SAME AS WITH ANY NORMAL CREDIT Since the back-to-back credit is an independent credit and because here we are not dealing with the transfer of a credit as defined in Article 47 (ICC 500) of the UCP, the practices and procedure for utilisation of a back-to-back credit would be the same as in the case of any LC. The documents required are, therefore, presented in the normal course by the beneficiary via his bank to the original advising bank. The documents are honoured – provided they conform to the terms of the back-to-back credit – to the debit of the intermediary (i.e. the original beneficiary who initiated the issue of the back-to-back credit).
Caution: The intermediary bank should not take comfort in the fact that the credit under which the documents are being handled is a “back-to-back” credit, thus causing it to be lax in recovering funds from the intermediary towards documents so received under its own (back-to-back) credit.
SUBSTITUTION OF DOCUMENTS
At this stage the exchange of invoices (and drafts, if any) is a must, because – contrary to the transferred credit – the original credit opened in favour of the intermediary / middleman cannot be negotiated by simply using the documents of the supplier. The actual supplier in the chain has no locus-standi as far as the applicant to the original credit is concerned.
Any other differences allowed in the opening of the back-to-back credit must also be eliminated at this point.
NEGOTIATION AND PAYMENTAfter these changes have been effected, the documents are used for negotiation of the original credit and the proceeds are credited to the account of the intermediary / middleman (the original beneficiary) in the usual manner. Procuring, exchange and substitution of documents and the process of negotiation may now continue up the chain in the normal course.BACK TO BACK LETTERS OF CREDIT
You won't find ANY bank, not in the US, not anywhere in the world who'd open a "Back-to-back" LC. Not even in the UCP. There is no such thing as a "back-to-back" LC. These have been explained in the article itself.
An LC that's opened on the *back* of another is called a "Back-to-back" LC. It is a matter of nomenclature. The two LCs are INDEPENDENT, STAND ALONE instruments of payment. All banks open LCs, some of which could be opened as "Back-to-back" LCs.
THANKS TO ALIBABA.COM
