Letter of Credit

A letter of credit as name suggests is letter which is promising credit. It is developed to provide ease to
various traders and buyers. Generally what happens in the market is that sellers provide their services and
goods and buyers ready to buy at certain prices. A buyer makes a deal with seller pay, take control of goods
and bring them with him. But with the increase of trade and globalization in the world, the distance between
buyer and seller increases. It was inefficient for the buyer and seller to move, incur cost in moving the
goods. And there is always certain amount of risk involved, buyer are afraid that if they pay in advance and
seller would not deliver goods and seller are advance if they deliver goods and they remain unpaid in the
end. To resolve this problem financial institutions come up with a solution named “Letter of Credit” to
facilitate transactions and move money around the parties.

Skeleton form of Letter of Credit

Let us consider the example that Ramesh a farmer want 800 kg of special types of hybrid seeds. He found
a seller in USA. Ramesh approaches a bank, on the request of Ramesh bank issued a letter of credit to the
seller in USA that they would pay the mentioned amount of money on the behalf of Ramesh, if the seller
furnishes a bill of lading, evidencing that he has dispatched 800 kg of hybrid seeds deliverable to buyer.

A bill of lading is a statement/document issued by ship master describing that goods and quantity are
received and stating the person to whom the goods has to be delivered at the destination.

A seller gets the bill of lading in favor of buyer. As a result seller has committed the goods to buyer, but
buyer can receive goods only when he has the bill of lading. In this arrangement, bank is the intermediary
between the buyer and seller. The seller provide the required documents at the local branch of the money
and collect the money from them.

Parties involved in Letter of credit

1. Applicant – The person who approaches a bank for letter of credit to be issued is the applicant.

2. Beneficiary – The person in the name of which the letter of credit has been issued and who receive the
money is the beneficiary.
3. Issuing Bank – The bank which issue the letter of credit on behalf of applicant and to the seller is known
as issuing bank. Issuing bank send the letter of credit to the seller and it is this bank which deliver the money
to the seller.

4. Advising Bank – Sometimes what happens is that beneficiary may be at different location, may be at
location at which the issuing bank does not have branch and may not be able to give information to the
seller. For these situations issuing banks have correspondent bank in the country as well outside the country,
providing the services in the area in which the issuing bank does not have reach. It is through these banks
the issuing bank communicate the information to the seller about the letter of credit and the credit. As the
correspondent bank advices the seller on letter of credit, it is called as advising bank. It is also known as
notifying bank as it notify the seller about the letter of credit.

“The letter of credit in business world is abbreviated as L/C or LOC”

Types of Letter of Credit

1. Irrevocable letter of credit - This type of letter of credit once issued cannot be revoked buy the
applicant or buyer. In this seller has to complete all the conditions stated in the letter of credit and
approach the bank and can claim money.

2. Revocable letter of credit – In this type of Letter of credit, applicant can change the terms and
conditions of the letter without confirming with the seller. Seller can accept this revocable letter of credit
if he has the full confidence in the buyer that he will give the payment. A revocable letter of credit can
work as long as seller is not payment, flexibility regarding to quantity, price and time and the amount to
be paid.

3. Unconfirmed letter of credit – A letter of credit is issued by issuing bank. Issuing bank pay the seller
through the advising bank. When seller cleared all terms and conditions of letter of credit and approaches
the advising bank for the amount, advising bank reaches issuing bank for the release of money. Once the
money is received by the advising bank, they give it to the seller. The advising bank undertakes no
obligations on its own. Such type of letter of credit is known as unconfirmed letter of credit.

4. Confirmed letter of credit – In unconfirmed letter of credit, seller may have doubt about the payment as
advising would release money until the money comes from issuing bank. In that case the seller would ask
for confirm letter of credit. In that case the applicant approach to the issuing bank for the release of
confirmed letter of credit. Then issuing bank ask the advising bank to confirm the letter of credit. If advising
bank have trust in issuing bank that they do not default on payment, they confirm the letter of credit. Such
type of letter of credit are known as Confirmed letter of credit.

Document that may be requested for presentation

 Financial Documents
 Commercial Documents
 Shipping Documents
 Official Documents
 Insurance Documents

Letter of credit and Contractual Relationships –

In letter of credit there are various contractual relationships. First is the contract between the applicant and
issuing bank. Second is the contract between the issuing bank and advising bank. Third is the contract
between Buyer and seller. And in the last the contract between the issuing bank and seller or beneficiary on
term of letter of credit. However applicant is not privy to letter of credit.

Principles Regarding the Letter of Credit

1. Principle of strict compliance – According to this principle, the banks are entitle to reject the documents
which did not strictly comply with terms of letter of credit. This means that what has written in the LOC,
the seller has to follow exactly and to come with right papers in front of bank to claim the money. If it has
minute irregularity, banks can reject that claim on the basis of this principle. However if buyer has no issues
regarding that, bank can release the money.

2. Autonomy of Credit and Fraud Exception – The main purpose of the letter of credit is sale contract
between the seller and buyer. However only seller and issuing are privy to the letter of credit. Every contract
between the parties is independent of each other. The contract between buyer and seller, buyer and issuing
bank, seller and advising bank. This maintains stability in finance, trade and commerce. However due to
rapid globalization trade moves across the boundaries and due to which fraud has also increase. The banks
are not obliged to make any payment under the credit when it comes to knowledge that the presented
document is false, contains wrong statements being in knowledge of the beneficiary or the presence of the
false signatures is found on the face of the document or any form of the alteration which is subject to
fraudulent.

3. Sale contract and Letter of credit - A general contract of sale between two individuals signifies a
consensus between the two parties as to what duties applies to them which they would be liable for were
they unable to fulfil them in full. At the heart of this contract, especially with respect to sale of goods
contracts, is the agreement between the seller and the buyer with respect to the payment involved in the
contract.