Introduction to Letter of Credit
A Letter of Credit (LC) is a document issued by a bank, guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make the payment, the bank will cover the full or remaining amount on behalf of the buyer.
It is most commonly used in international trade transactions, where buyers and sellers operate in different countries, making trust and legal recourse more complex. The LC acts as a payment assurance tool that protects both parties.
Definition of Letter of Credit
According to UCP 600, a Letter of Credit is:
“A definite undertaking by the issuing bank to honor a complying presentation.”
In simple terms, it is a written promise by a bank to pay a certain amount to the seller (beneficiary), provided that the seller fulfills all conditions mentioned in the LC, usually by submitting specified documents (e.g., invoice, bill of lading, insurance, etc.).
Types of Letters of Credit
- Revocable and Irrevocable LCs
- Confirmed and Unconfirmed LCs
- Sight and Usance LCs
- Back-to-Back LCs
- Standby LCs
- Revolving LCs
- Transferable LCs
Parties Involved in a Letter of Credit
| Party | Role Description |
|---|---|
| Applicant (Buyer) | Requests the LC from the issuing bank |
| Beneficiary (Seller) | Receives payment upon satisfying LC terms |
| Issuing Bank | Issues the LC on behalf of the buyer |
| Advising Bank | Informs the seller and authenticates the LC |
| Confirming Bank (optional) | Adds its own guarantee in case of default |
| Negotiating Bank | Pays the seller upon receipt of compliant docs |
Merits of Letters of Credit
1. Risk Reduction
Provides payment assurance to the seller and protects the buyer by ensuring payment is made only after receipt of specified documents.
2. Enhanced Trust in International Trade
Builds confidence between unknown parties in cross-border transactions.
3. Access to Finance
Sellers can use the LC to obtain pre-shipment or post-shipment finance from banks.
4. Compliance-Driven
Payment is made only if all terms and documents match, thus ensuring discipline.
5. Customizable Terms
Parties can include specific terms and conditions that suit their needs.
6. Currency Flexibility
Payments can be made in foreign currencies, minimizing forex risk.
Demerits of Letters of Credit
1. High Cost
Includes bank charges, confirmation fees, document processing fees, etc.
2. Complex Documentation
Requires strict compliance with terms; even minor discrepancies may lead to rejection of payment.
3. Time-Consuming
Preparing documents, verifying compliance, and handling disputes may delay payments.
4. Legal and Procedural Rigidity
Adheres to UCP 600 rules, which may not reflect local legal remedies.
5. Fraud Risk
Possibility of presentation fraud if the documents are forged but appear compliant.
6. Not a Guarantee of Goods
LC only assures payment for documents, not quality or condition of goods received.
Difference Between Bank Guarantee and Letter of Credit
| Feature | Letter of Credit | Bank Guarantee |
|---|---|---|
| Purpose | Ensures payment to seller | Ensures compensation in case of default |
| Nature | Primary obligation | Secondary obligation |
| Usage | Common in trade transactions | Used in contract performance |
| Trigger for payment | Based on document compliance | Based on default |
| Risk Coverage | Seller’s risk of non-payment | Buyer’s failure in contract obligations |
Legal Backing
Though primarily governed by UCP 600, Letters of Credit are recognized under Indian law via:
- The Indian Contract Act, 1872
- The Negotiable Instruments Act, 1881
- The Banking Regulation Act, 1949
- Relevant case laws like United Commercial Bank v. Bank of India (AIR 1981 SC 1426), affirming autonomy and sanctity of LCs.
Real-Life Application Example
Scenario: An Indian importer buys raw materials from a supplier in Germany. Since they don’t know each other, the German supplier requests a Letter of Credit.
- The Indian buyer approaches a bank, which issues an LC.
- The German supplier ships goods and submits all required documents.
- After the bank verifies documents, it releases the payment.
- The buyer receives the goods and the transaction is completed securely.
Code to Remember: “CREDIT” for LC Features
| Letter | Stands For |
|---|---|
| C | Compliance-based payment |
| R | Risk mitigation |
| E | Enhanced trade confidence |
| D | Document-centric |
| I | International trade tool |
| T | Third-party (bank) involvement |