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Definition: Letter of Credit can be defined as a binding document that a buyer can request from his bank in order to guarantee that the payment for goods will be transferred to the seller. Basically, a letter of credit gives the seller reassurance that he will receive the payment for the goods. In order for the payment to occur, the seller has to present the bank with the necessary shipping documents confirming the delivery of goods within a given time frame. It is often used in international trade to eliminate risks such as unfamiliarity with the foreign country, customs, or political instability.
Mechanism of Letter of Credit:
Here we assume that the payment will be made by the advising bank. Here we go ahead to explain the steps:
1. Here there is a contract between the exporter and the customer in which the need for a Letter of Credit is specified.
2. Then the customer requests his bank to issue a Letter of Credit.
3. Customer’s bank then issues a Letter of Credit via the Advising Bank.
4. Advising Bank then passes on the terms of Letter of Credit to the exporter.
5. Exporter nearly always requests amendments to the Letter of Credit and copies requests to the Advising Bank.
6. Customer goes ahead and requests his bank to issue an amendment.
7. Then the amendment is issued.
8. Amendment is then advised to exporter.
9. Goods are then dispatched.
10. Documents required by the Letter of Credit are presented to the Advising Bank.
11. Payment is then made by the Advising Bank to the exporter.
12. Issuing Bank’s account with the Advising Bank will then be debited.
13. Documents are then passed to the Issuing Bank.
14. Documents are finally passed to the customer enabling him to use the Bill of Lading to obtain goods if sent by sea and payment made by customer to Issuing Bank.
Uniform Customs and Practice and Documentary Credits (UCPDC):
These are universally recognized set of guidelines governing Letter of Credits. The guidelines are published in the form of a Brochure by the International Chamber of Commerce. First publication was made in the year 1933. Revised versions were issued in 1951, 1962, 1974 and 1983. Latest publication is known as ICC 500 and adopted with effect from January 1, 1994. The International Chamber of Commerce with its headquarters in Paris frames the guidelines for UCPDC. UCPDC has now becomes indispensable, since Letters of Credit have become one of the safe methods of International trade settlements. The reason being that sellers hesitate to release their goods before receiving the payment, while buyers feel the need to have more control over their goods before parting away with the payment.
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Matching payment with physical delivery is rarely possible. So a medium through which payment against “Constructive Delivery”, by handling over documents or transferring title to or control over the goods is possible through this mechanism.
It gives maximum possible guidance and assistance to all parties. It guides the buyer in getting the precise documents required and the conditions complied with it. It stipulates the liabilities and responsibilities of the Issuing Bank, Advising Bank, Confirming Bank, Negotiating Bank and Reimbursing Bank. UCPDC is applicable to all Documentary Credits including Standby letters.
For the purpose of UCPDC, the bank (Issuing Bank) acts on the request and instructions of the customer:
1. To make a payment to or to the order of the third party (the beneficiary/seller) or is to pay or accept bills of Exchange drawn by the beneficiary.
2. Authorizes another bank to effect such payment or to accept and pay such Bills of Exchange or against stipulated documents, provided that the terms and conditions of the credit are complied with.
3. Authorizes another bank to negotiate.
For the purpose of these articles, branch of a bank in a different country is considered as just another bank.
Letter of Credit are separate transactions on which they made be based and banks are in no way bound by such a contract. It also clarifies that neither the beneficiary nor the applicant can avail himself of any underlying contractual relationship. Non-fulfillment of contractual obligations under the Sale Contract cannot be disputed through the Letter of Credit mechanism. In a Letter of Credit, all parties concerned deal with documents and not with goods.
Liabilities/Responsibilities of parties to the documentary credit:
Parties to a Letter of Credit transaction:
1. Applicant/buyer: On whose behalf of Letter of Credit is opened should give precise details for opening the letter of credit. The applicant should assure banks against rules and regulations imposed by the foreign countries.
2. Beneficiary/seller: In whose favor the letter of credit is opened. The beneficiary, in whose favor the credit is established, can in no case avail himself of the contractual relationship existing between the banks or between the applicant for the credit and the issuing bank.
3. Opening Bank: Opens or establishes the letter of credit. The issuing bank gives a conditional undertaking and reimburses the negotiating bank against submission of the prescribed documents. It should verify the documents presented under the credit within 7 banking days. If it observes any discrepancy in the document, it refuses the reimbursement.
4. Advising Bank: The bank advising the letter of credit acts without any engagement on its part but will take reasonable care to check the authenticity of credit. If incomplete or unclear instructions are received, it gives the preliminary information to the beneficiary without any responsibility on its part.
5. Conforming Bank: It conforms the letter of credit. Conformation to the credit is done by a conforming bank at the specific request of the opening bank.
6. Negotiating Bank: Negotiating bank may be the bank of beneficiary of the credit/ or a bank, which pays a value against a set of documents drawn under a credit. Issuing bank will reimburse the nominated bank if it had negotiated the documents as per the letter of credit terms.
7. Reimbursing Bank: Reimbursing bank will reimburse the claim made by the negotiating bank or by any claiming bank under a documentary credit under the authority of credit bank.
Types of Documentary Credit:
Revocable credit: Letter of credit can be cancelled by the applicant without the consent of the beneficiary.
Irrevocable credit: It is a definite undertaking of the issuing bank and can not be cancelled without the agreement of the issuing bank, the conforming bank and the beneficiary.
Confirmed credit: When a bank in the exporter’s country has added its conformation by way of an additional undertaking to make payment at the specific request of the issuing bank, it becomes a conformed credit.
Transferable credit: One can transfer the L/C to the second beneficiary only if the L/C is transferable. But the second beneficiary can not transfer the L/C to other beneficiary. Only one transfer is allowed. But second beneficiary can transfer it back to the first beneficiary. In case of transferable L/C partial shipment should be permitted.
Red clause credit: The beneficiary can make part withdrawal of advance payment form the bank to meet the pre-shipment credit requirements.
Back-to-Back credit: In case if the exporter is not the actual manufacturer and he gets his work done by the sub-suppliers. If sub suppliers demand L/C in their favor then the exporter approaches his banker to establish second set of letters of credit for export. This second set of credit opened by the bank at the request of the exporter is known as back-to-back credit.
Revolving credit: Value of the L/C will be re-credited by the beneficiary. Revolving credit is a type of credit that does not have a fixed number of payments, in contrast to installment credit.
Standby letter of credit
Deferred payment credits and Acceptance credits: It is an arrangement under which payments due to the exporter on presentation of the shipping documents are deferred for an agreed period of time. Under deferred payment credit the amount is payable in installments for a stipulated longer period of time. No time draft is required
Regulations under Foreign Trade Policy:
The Foreign Trade Policy of the Government of India is embodied in the F.T policy book. Rules and procedures to be observed under Trade control Regulation are contained in the Hand-book for Foreign Trade. Changes in the Policies, rules and procedures are notified for information to the public by DGFT through public notices. Authorized dealers should make their own arrangements for obtaining the above publication as also public notices. Authorized dealers should make their own arrangements for obtaining the above publication as also public notices regularly and be conversant with provisions thereof having a bearing on the operations of authorized dealers such as opening of Letters of Credit, Remittances etc. towards imports into India.
The present Foreign Trade Policy came into effect from 1st Sept 2004 and shall remain in force for a period of five years i.e., up to 31st March 2009. The salient features of the policies are:
i) Exports and Imports may be done freely except the goods which are regulated by the Policy.
ii) The importability of the goods to be ascertained through ITC HS Code Number of the respective item against which a specific note will appear either as free or prohibited or canalized or restricted.
iii) Prohibited goods shall not be imported.
iv) Any goods the export or import of, which is restricted through licensing may be exported or imported only in accordance with a license issued in this behalf.
v) A license shall contain such terms and conditions as may be specified by the licensing authority and may include:
a) Description of the goods, quantity and value
b) Actual user condition if any
c) Export obligation if any
d) The value addition to be achieved if any
e) The country of origin or destination of goods
f) Period of validity
vi) Every License shall be valid for the period of validity specified in the license
and if no period is specified it shall be valid the 31st March of the licensing
vii) Any good the imports or export which is canalized may be imported or
Exported by the canalizing agency specified in the list. However the DGFT may grant a license to any other person to import or export any of the canalized goods.
viii) An Importer Exporter Code (IEC) number shall be granted on application by
The competent authority in accordance with the procedure specified in this behalf by the Director General of Foreign Trade. No export or import shall be made by any person not granted an Importer Exporter Code number unless specifically exempted under any other provision of the policy.
ix) Capital goods, Raw materials. intermediates, components , consumable
Spare parts ,accessories ,instruments and other goods may be imported without any restrictions except to the extent of such imports are regulated by the negative list of imports or any other provision of the policy or any other law for the time being in force.
x) Capital goods, Raw materials. intermediates, components , consumable spare parts ,accessories ,instruments and other goods may be imported without any restrictions may be imported by any person weather he is actual user or not. However if such imports require a license the Actual user (AU) alone may import such goods, unless the actual user condition is specifically dispensed with by licensing authority.
Application of Letter of Credit:
Application for opening a letter of credit should contain the following information:
2. Without resource
3. Amount(State Currency)
4. By cable/Airmail
5. Beneficiary Full Name & Address
7. Shipment by Steamer/Post parcel/Airfreight
8. Country of origin
9. Usance of draft
10. Freight Prepaid/Paid destination
11. Insurance by Beneficiaries/covered here
12. Part Shipment/Permitted/Prohibited
14. Shipment from: _________________shipment to:________________
15. Latest date shipment
16. Latest date presentation of document
17. Documents may be presented for negotiation within ____ days from shipment date:
18. License No.:
19. Import permitted under Para no.________________ Foreign Trade Policy 2004-2005.
20. We confirm described merchandise can be imported against above mentioned License/Para __________of Foreign Trade Policy 2004-09
21. Special instructions if any