LC – Letter of Credit

A standard, commercial letter of credit (LC) is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking.

The letter of credit can also be source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter.

Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another.In such cases the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built.

The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client.

Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any.

In executing a transaction, letters of credit incorporate functions common to giros and Traveler’s cheques. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and documents proving the shipment was insured against loss or damage in transit.

However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin.

Value conversion depends on many factors, some fixed, some floating such as:

• Type of Letter of Credit varies and includes (SBLC, ILC, LC, Pay Order, etc.)
• It is Usually viewed as a SBLC is the Better Bank Instrument
• SBLC is issued on a Bank-to-Bank Basis only
• The Issuing Bank Rating as well as location (branch) of Bank
• Who is issuing the instrument – individual, company, government, etc.
• Instrument Must Be in US Dollars only
• Bank Policy
• Market Conditions
• Client Anticipation of Return
• Place Transaction Occurs

What is done with ‘Cash’ after conversion – this is becoming a paramount issue with banks converting the instrument, the preferred and acceptable method is to deposit a portion of the redeemed funds with the honoring bank, usually not less than 20% for a period of not less than six (6) months.

Hints

• These types of Bank Instruments can be issued to individuals, corporations, trust, pension funds, endowments, non profit organizations, or to any payable entity.
• Individuals who hold such an instrument may have problems with 3rd party transactions or banks.
• LC, ILC, or SBLC are often times issued for the sale and purchase of tangible assets.
• It is often easier to raise a ‘Credit Line’ than convert the instrument to CASH!
• Fluctuating World Market Conditions set the pace and determine the trading value, if any.
• Usually most every instrument can be converted, however, some are just Not desirable Trading Instruments on the current World Market.
• Certain Required “Documentation’ is needed for this type of transaction.

Risk situations in letter-of-credit (LC) transactions

Fraud Risks

• The payment will be obtained for nonexistent or worthless merchandise against presentation by the beneficiary of forged or falsified documents.
• Credit itself may be forged.

Sovereign and Regulatory Risks

• Performance of the Documentary Credit may be prevented by government action outside the control of the parties.

Legal Risks

• Possibility that performance of a Documentary Credit may be disturbed by legal action relating directly to the parties and their rights and obligations under the Documentary Credit

Force Majeure and Frustration of Contract

• Performance of a contract – including an obligation under a Documentary Credit relationship – is prevented by external factors such as natural disasters or armed conflicts

Risks to the Applicant

• Non-delivery of Goods
• Short Shipment
• Inferior Quality
• Early /Late Shipment
• Damaged in transit
• Foreign exchange
• Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

• Insolvency of the Applicant
• Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

• No obligation to reimburse the Claiming Bank unless it has issued a reimbursement undertaking.

Risks to the Beneficiary

• Failure to Comply with Credit Conditions
• Failure of, or Delays in Payment from, the Issuing Bank
• Credit Issued by Party other than Bank

Risks to the Advising Bank

• The Advising Bank’s only obligation – if it accepts the Issuing Bank’s instructions – is to check the apparent authenticity of the Credit and advising it to the Beneficiary

Risks to the Nominated Bank

• Nominated Bank has made a payment to the Beneficiary against documents that comply with the terms and conditions of the Credit and is unable to obtain reimbursement from the Issuing Bank

Risks to the Confirming Bank

• If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may not be able to obtain reimbursement from the Issuing Bank because of insolvency of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a dispute as to whether or not payment should have been made under the Credit

Other Risks in International Trade

• A Credit risk risk from change in the credit of an opposing business.
• An Exchange risk is a risk from a change in the foreign exchange rate.
• A Force majeure risk is 1. a risk in trade incapability caused by a change in a country’s policy, and 2. a risk caused by a natural disaster.
• Other risks are mainly risks caused by a difference in law, language or culture. In these cases, the cargo might be found late because of a dispute in import and export dealings.

This is some common business terms in international trade.