Letter of Credit (LOC)

Table of Contents
1. Introduction
2. Why a Letter of Credit is Needed
3. Parties to a Letter of Credit
4. How a Letter of Credit Works (Procedure)
5. Documents Commonly Required Under an LOC
6. Types of Letters of Credit
7. Key Concepts and Definitions
8. Advantages of Using an LOC
9. Risk Factors and Limitations
10. Practical Example
11. Common Examination and Practical Points to Remember
12. Conclusion
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Introduction

The letter of credit (LOC), also called a documentary credit, is a bank's written undertaking to pay the seller (the beneficiary) a specified sum provided the seller presents documents that comply strictly with the terms and conditions of the credit. The LOC shifts the seller's payment risk from the buyer to a bank: if the buyer fails to pay, the issuing bank meets the obligation subject to presentation of complying documents.

Why a Letter of Credit is Needed

Letters of credit are especially important in international trade because trading partners are often separated by distance, different legal systems, unfamiliar commercial practices and limited ability to verify each other personally. A properly issued LOC provides assurance to the beneficiary that payment will be received if documentary conditions are met, while providing the applicant (buyer) with the comfort that payment will be made only on presentation of the agreed documents.

Parties to a Letter of Credit

• Applicant - the buyer/importer who requests the issuing bank to open the LOC.
• Beneficiary - the seller/exporter in whose favour the LOC is issued.
• Issuing bank - the bank that issues the LOC at the request of the applicant and undertakes to pay on presentation of complying documents.
• Advising bank - a bank (often in the beneficiary's country) that advises the LOC to the beneficiary and authenticates it as received from the issuing bank.
• Confirming bank - a bank (if any) that adds its own undertaking to pay in addition to the issuing bank; this is used when the beneficiary needs creditworthiness assurance beyond the issuing bank.
• Nominated bank - the bank authorised under the LOC to examine documents and, as applicable, to pay, accept or negotiate.

How a Letter of Credit Works (Procedure)

1. The buyer and seller agree a sales contract and decide that payment will be by letter of credit.
2. The buyer (applicant) applies to its bank for an LOC in favour of the seller (beneficiary) giving contract terms, amount, expiry, and required documents.
3. The issuing bank issues the LOC and sends it to the advising bank, which authenticates it and forwards it to the beneficiary.
4. The beneficiary checks the LOC terms against the sales contract. If acceptable, the beneficiary ships the goods and obtains the required transport and trade documents.
5. The beneficiary presents the required documents to the nominated/advising bank for payment or negotiation.
6. The presenting bank examines the documents for compliance with the LOC terms. If documents comply, the bank pays (or accepts bill of exchange or negotiates) and forwards documents to the issuing bank for reimbursement.
7. The issuing bank pays the presenting bank and sends documents to the applicant so that goods can be cleared on arrival.
8. If documents are discrepant, the bank may refuse payment or ask the beneficiary for corrective action or a waiver from the applicant; the LOC remains subject to its expiry and time limits.

Documents Commonly Required Under an LOC

• Commercial invoice
• Bill of lading or airway bill (transport document)
• Packing list
• Bill of exchange (where required)
• Insurance policy or certificate (when insurance is for seller's account)
• Certificate of origin (if required by contract)
• Inspection or quality certificates (if required)
• Licences and permits (where statutory)

Types of Letters of Credit

• Sight LOC - pays on presentation of complying documents; payment is immediate.
• Usance (deferred) LOC - payment is made at a specified future date after presentation (e.g. 30, 60 or 90 days).
• Revocable LOC - may be amended or cancelled by the issuing bank without prior notice to the beneficiary; rare in modern international trade.
• Irrevocable LOC - cannot be amended or cancelled without agreement of all parties (issuing bank and beneficiary). This is the common form used today.
• Confirmed LOC - a confirming bank adds its own confirmation to the issuing bank's undertaking, providing additional security to the beneficiary.
• Transferable LOC - allows the beneficiary (first beneficiary) to transfer part or whole of the credit to another party (second beneficiary); used when middlemen are involved.
• Non-transferable LOC - prohibits transfer; only the named beneficiary may draw under the credit.
• Standby LOC (Standby Letter of Credit) - a bank guarantee-like instrument that is called upon if the applicant fails to perform; used as back-up security rather than routine payment.
• Red clause LOC - contains an advance payment clause allowing the beneficiary to obtain pre-shipment advances from the advising bank.
• Back-to-back LOC - two LOCs used together where an intermediary beneficiary uses an LOC received to open another LOC in favour of his supplier.

Key Concepts and Definitions

• Complying presentation - a set of documents presented in the exact terms and time prescribed by the LOC; strict compliance governs payment.
• Discrepant documents - documents that do not meet the LOC terms; they may lead to refusal of payment unless the applicant waives the discrepancies.
• Negotiation - purchase of documents by a nominated bank under a negotiable LOC, typically at a discount when the bank advances funds to the beneficiary.
• Expiry date and place of expiry - last date and location where documents can be presented under the credit; compliance after expiry is not accepted.
• Reimbursement - the issuing bank's settlement to the paying/negotiating bank once it has examined the documents.

Advantages of Using an LOC

• Provides payment certainty to the seller when documents comply.
• Protects the buyer because payment is made only against required documents evidencing shipment or performance.
• Facilitates international trade between unfamiliar partners by involving banks.
• Can be structured to provide finance to the seller (e.g. negotiation, red clause).

Risk Factors and Limitations

• Risk of payment on the basis of forged or fraudulent documents even if they appear to comply.
• Bank failure or credit risk if the issuing or confirming bank is unable to honour commitments.
• Regulatory and country risk arising from exchange controls, sanctions or restrictions imposed by governments.
• Operational risk from incorrect document checking, timing errors or failure to follow strict documentary rules.
• Costs and bank charges may be significant compared with other payment methods.

Practical Example

1. An importer in Country A buys goods from an exporter in Country B and requests his bank to open an irrevocable LOC for USD 50,000 payable at sight.
2. The issuing bank sends the LOC to a local advising bank in Country B, which forwards it to the exporter.
3. The exporter ships goods and obtains the bill of lading, commercial invoice, packing list and insurance certificate.
4. The exporter presents these documents to the advising bank. The advising bank checks the documents against the LOC.
5. If documents comply, the advising bank pays the exporter (or negotiates) and sends the documents to the issuing bank to claim reimbursement.
6. The issuing bank pays the advising bank and releases the documents to the importer to clear the goods.

Common Examination and Practical Points to Remember

• Always note the parties: applicant = buyer, beneficiary = seller, issuing bank = party giving the payment undertaking.
• Strict compliance principle is central - banks examine only documents, not the underlying goods or contract performance.
• Understand differences between sight and usance credits, and between revocable and irrevocable.
• Be aware that a confirmed LOC gives additional protection to the beneficiary against issuing bank or country risk.
• Discrepancies must be resolved before payment; banks may request waiver from the applicant or refuse payment.

Conclusion

A well-drafted letter of credit is a powerful instrument in international trade that balances the interests of buyer and seller by tying payment to documentary proof. Its effective use requires clear contract terms, accurate paperwork, timely presentation and an understanding of the types of LOC and the risks involved.