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How Letter of Credit Works

Dev Patel 
on 15 October 2017

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Any person involved in the trade is familiar with the term Letter of credit. Letter of credit in general term is an assurance given to remit the amount to the seller through seller's bank, by the buyer's bank, on maturity as per the terms and agreement of agreement between the parties.

It is a letter from buyer's bank guaranteeing that the Buyer's payment to a seller will be made on time and for the proper amount. The Buyer's Bank will make full or part payment of purchase price on behalf of Buyer if he fails to make full payment.

FEMA Regulations and Uniform Customs and Practice of Documentary Credit of International Chamber of Commerce (UCP 600) regulates the letter of credit under export and import. The exporter may get the sum of money under a letter of credit as per the agreement between the parties, according to this time for making payment by buyer's bank is fixed. It is one of the methods of payment in international trade.

Parties to Letter of credit


S.No.

Parties

Who?

Activity

1.

Applicant

Importer/ buyer

Buy Goods

2.

Beneficiary

Exporter/ seller

Sell Goods

3.

Issuing bank/ opening bank

Importer's Bank

Issues letters of credit

4.

Advising/ corresponding bank

Exporter's Bank

Advises letter of credit

5.

Confirming Bank

Advising Bank / 3rd party Bank

Confirms letter of credit

6.

Paying Bank

Issuing Bank / other Bank as specified in Letter of credit

Pays the amount


Types of letter of credit

1. Letter Of Credit at sight - This is mostly followed in an business where the seller bank will receive the payment of export proceeds sent by buyer's bank immediately on receipt of original shipping document, as per the agreement on Letters of credit.

2. Time or date Letter of credit - There the letter of credit specifies the date in future to make the payments. It is based on the fact that the time for payment has been specified in the Letter of credit.

3. Irrevocable letter of credit - It cannot be amended or without the express agreement of the all parties concerned i.e. Applicant, issuing bank beneficiary and confirming bank.

4. Revocable Letter of credit - It has been withdrawn by UPCDC 500 till 30th June 2007.

5. Standby Letter of credit - Here the letter of credit is issued for non-performance of some activity and is same as a bank guarantee. It is payable only when the even agreed has occurred performance for the event has not happened.

Credit period under Letters of Credit:

The credit period is as per the agreement of the parties before the sales take place. It can be for 30, 60 or 90 days etc. although government regulations have put a restriction on the credit period i.e. not exceeding 180 days. The same is calculated generally from the date of shipment. Date of shipment is determined by the date of airway bill or bill of lading as the case may be. 

Documents required for Letters of credit:

Procedure for Letters of credit:

  • The exporter prepares all documents required as per the conditions in a letter of credit, once all the export custom clearance procedures are completed.
  • Documents will be submitted to exporter's bank along with the original Letters of credit.
  • Exporter's Bank will verify all the documents and conditions of Letters of credit fulfills.
  • Then Exporter's bank will send all verified documents to seller's bank.
  • Here as the banks receive documents exporter's bank will receive the export sales amount as per the documents.
  • Every consignment should be documented as per the letter of credit.
  • If not documented as per Letters of credit then buyer's bank has right to reject payment.

Conclusion:

Letter of credit is important mainly in the international trade. This has become most widely accepted method of payment in case of import and export. But one has to be careful that one that one should be vigilant while doing a letter of credit like doing business with person you have real information. Also one should not underestimate the risk included in the transaction as mainly not flexible in terms of regulation.

The author is a Legal Expert at myonlineca which deals in msme registration online and company registration across India.


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