CHAPTER 8 Documentary Letters of Credit

1. CHAPTER 8Documentary Letters of Credit A letter of credit is a substitute for cash. It allows the seller to receive payment after the goods hav3e been properly shipped and the buyer’s bank receives important documents relating to the transaction—even if the buyer has not ye paid! So it gives the seller more security than the system of documentary collection, under which the seller is not paid until after the buyer pays. Of course. Like documentary collection, the letter of credit system gives the buyer some assurance that the proper goods have in fact been shipped before requiring her to pay.

2. I. Main Types of Documentary Letters of Credit (1) Confirmed Letter of Credit Under a confirmed letter of credit, the seller’s bank is called the confirming bank. The buyer’s bank is called the issuing bank, since it issues the letter of credit for the buyer. In this situation, the confirming bank agrees to pay the seller after the seller presents to the confirming bank the documents required by the letter of credit. Then the confirming bank collects the money from the issuing bank, which in turn collects it from the buyer. This process will be explained in more detail in Section 4.5b below.

3. (2) Unconfirmed Letter of Credit Under an unconfirmed letter of credit, there is no confirming bank. In this situation, the seller may provide the documents required by the letter of credit directly to the issuing bank, or the seller may use an intermediary bank called an advising bank. If there is an advising bank, the seller gives the required documents to that bank, which then forwards those documents to the issuing bank, which then forwards payment for the seller. The issuing bank may forward this payment through an advising bank, but the advising bank does not have an independent duty to pay the seller upon receipt of the proper documents, a s a confirming bank would. So it is not accepting the same risk as a confirming bank would, and its help is less valuable to the seller. Again, Section 4.5b explains this process in detail.

4. II. How a Letter of Credit Works This Section provides a basic explanation of how a letter of credit works. More specifically, it outlines the steps involved in making a typical contract where payment is made by letter of credit. This outline is intended to illustrate how this process works in basic terms; in practice, there may be some variations in how these steps occur. You should read these points while you look at the Illustrations of Confirm and Unconfirmed Letters of Credit which appear on the following pages. The first illustration below is for a confirmed letter of credit, while the second illustration is for an unconfirmed letter of credit. Steps 8-10 in the illustrations below are in bold to show that these steps differ depending on whether a confirming bank is involved in the transaction

5. (1) The sales contract First, a buyer and seller make a sale of goods contract. Suppose the seller agrees to deliver certain goods to the buyer in return for payment by letter of credit. As part of the contract, the buyer agrees to open a letter of credit in favor of the seller with a bank, which promises to pay if certain conditions occur. The contract should specify the terms of the letter of credit particularly the documents that the seller must provide. However, in practice, the contract may simply state that the buyer agrees to open a letter of credit in favor of the seller. The bank issuing the letter of credit then uses a standard form letter of credit, which already specifies the documents required.

6. Usually, the documents required under a letter of credit include: (1) a transport document, generally a bill of lading, which indicates that the goods have been shipped to the buyer, or received by the carrier for shipment to the buyer; (2) an invoice for the goods; and (3) an insurance certificate. Other documents may also be required under a letter of credit. Examples include export licenses, customs clearance documents, and inspection certificates from inspection agencies certifying that the goods conform to the contract. These documents are discussed in more detail in Section 4.5c, below.

7. (2) Opening the letter of credit After the buyer agrees to open a letter of credit as part of a sales contract, the buyer applies to its bank—the issuing bank—to obtain the letter of credit. If the issuing bank approves the buyer’s application, the bank then issues the letter of credit in favor of the seller. This means there is actually a separate contract between the buyer and the issuing bank. In issuing the letter of credit, the issuing bank promises to pay the amount of the letter of credit after it receives the documents specified in the letter of credit.

8. (3) The issuing bank tells the confirming or advising bank of the credit After the issuing bank issues the letter of credit, the issuing bank notifies a second bank, usually in the seller’s nation, which will act as either a confirming bank or an advising bank. The sales contract between buyer and seller specifies whether a confirming or an advising bank is required. The sales contract may state that the seller will select the confirming or advising bank.

9. The difference between confirming banks and advising banks is very important. As noted above, a confirming bank agrees to pay the seller the amount due under the sales contract, provided that the seller presents all the proper documents to the confirming bank. By contrast, an advising bank helps the seller collect payment from the issuing bank under the letter of credit by transmitting documents between the parties, but an advising bank does not have an independent duty to pay the seller on receipt of the proper documents from the seller. For example, an advising bank may help the seller by sending the documents required under the letter of credit to the issuing bank via the international telecommunications network called SWIFT ( Society for World wide Inter-Bank Financial Telecommunications).

10. (4) The confirming bank confirms the credit or the advising bank advises the seller of the credit The advising or confirming bank then gives the seller a document confirming the credit or advising the seller of the credit, depending on what the bank’s agreed role is. (5) The seller collects the documents that the letter of credit requires and ships the goods Once the seller has confirmation or advice of the letter of credit from the confirming or advising bank, the seller gets all the documents required under the letter of credit, and ships the goods in accord with the sales contract. As noted above, the documents required generally include an invoice for the goods, an insurance certificate, and a transport document, usually a bill of lading, which the seller will get from the carrier. (6) The carrier issues a transport document, usually a bill of lading, to the seller When the seller gives the goods to a carrier for transport, the carrier provides a transport document, usually a bill of lading, which shows that the seller has in fact shipped the goods. This important document is discussed further in Section 4.5c, below.

11. (7) The seller gives the documents to the confirming or advising bank After the seller has gathered the documents required by the letter of credit, including the bill of lading, the seller takes the documents to the confirming bank or advising bank with a request for payment of the amount due to the seller under the sales contract. (8) The confirming or advising bank checks the documents; a confirming bank pays the seller; if there is only an advising bank, it forwards the documents to the issuing bank The confirming or advising bank then checks the documents against the requirements of the letter of credit. If the documents meet these requirements. Then the confirming bank pays the seller. However, advising banks do not agree to do that, so an advising bank would merely forward the documents to the issuing bank in the buyer’s nation. (9) A confirming bank forwards the documents to the issuing bank; if there is only an advising bank, then the issuing bank checks the documents (which it already has) and forwards payment to the advising bank After verifying that the documents from the seller conform to the requirements of the letter of credit, a confirming bank forwards the documents to the issuing bank. However, if there is only an advising bank, that bank would have already forwarded the documents to the issuing bank. In that situation, it is the issuing bank which now checks the documents and forwards payment in favor of the seller to the advising bank.

12. (10) The issuing bank pays the confirming bank; if there is only an advising bank, it forwards payment to the seller or the seller’s account After a confirming bank forwards the documents to the issuing bank, the issuing bank inspects the documents. If the documents conform to the requirements of the letter of credit, the issuing bank then reimburses the confirming bank. However, if there is only an advising bank, it has already received payment for the seller from the issuing bank, and it now forwards this payment to the seller or the seller’s account. (11) The buyer pays the issuing bank After the issuing bank pays in accordance with its letter of credit, it requests and gets payment from the buyer. The issuing bank may bill the buyer or debit the buyer’s account, depending on its agreement with the buyer. (12) The issuing bank provides the documents to the buyer After the issuing bank receives payment from the buyer, it releases the documents to the buyer. This will enable the buyer to take possession of the goods from the carrier.

13. (13) The buyer provides the bill of lading to the carrier After the buyer gets the documents from the issuing bank, it provides the bill of lading the carrier who holds the goods originally sent by the seller. (14) The carrier gives the goods to the buyer Once the carrier receives the bill of lading from the buyer, the carrier provides the goods to the buyer. The transaction is complete.