Letter of Credit
As the name suggests a letter of credit (LC) is nothing but a set of instructions where one bank gives guarantee to other on behalf of his client. Normally LC is used when goods are sold and seller wants guarantee of his payment.
LC can be inland or out of country also. LC rules are governed by UPCDC (Uniform Customs and Practices for documentary credits).
Basically there is two type of LCs
- Clean LC
- Documentary LC
Clean LC as the name suggests is a set of instruction which include only amount and payment date. This is best of beneficiary because there is no condition for stop payment. Normally this type of LC is not used So we will not discuss about this.
Documentary LC: Practically this LC is in use. In this type of LCs there is instruction to attach documents for payment. This can be invoice copy, packing list, Bill of lading/GR copy, insurance etc. If these documents are not attached then Bank will not pay the amount. Actually this is the real form of LC for which LC was originally created. When a seller sends the material then buyer issue LC. For payment seller must prove to bank that he has sent the material. For this purpose these documents are required.
Documentary LC can be of following types:
- Sight LC: this means when the buyer received the LC immediately he will pay the LC amount to bank. 3 days grace period is available only.
- Usuance LC: this is the LC for which buyer of goods goes to bank. In this there is a payment term like 30-180 days. It can be more but if payment term is more than 180 days then documents must be stamped by court for payment. In this type of LC buyer pays after the credit period. 3 grace days are available. But in practical, it can be paid late 3-4 more days. This is also called collection base LC.
- Revolving LC: This kind of LC are required when goods are periodically purchased under LC. So for saving time to go to bank everytime this type of LC is used. A credit limit is fixed for monthly, quarterly or for more period. For this period goods are send in this LC. When limit is over LC can be renewed.
- Standby LC: it is in some countries like USA. This LC is like bank guarantee. In india this type of LC is not used.
- Transferable LC: this type of LC is used in india. This condition must be mentioned in LC that it is transferable. Then beneficiary can transfer this LC to another for payment. It can be used to pay more than one also. But total credit limit will be till original LC
- Back to Back LC: this is normally used in international business. When an exporter gets material from others. In this he get LC from importer of goods and on the basis bank issued LC for raw material providers. It is some type of transferable LC. But in legal term it is different.
- Red Clause LC: in this LC there is one clause that beneficiary can get some advance on basis of this LC. This clause is mentioned in red ink that’s why it is called Red clause LC.
A letter of credit can be irrevocable. This is the best method. So when you get an LC then see this clause first. Because an revocable LC can be cancelled by the opener.
LC can be amended after issuance. But there are charges on that. So it is advisable to check with seller before final the LC. But after opening LC it can be amended.
LC are part of non fund base limit. Some bank don’t take it in credit limit because in this banks fund is not used. But mostly bank take it in their limit because if there is mistake on part of client then bank has got the liability.
Bank take margin money to open LC. It depends on clients credit and previous experience with bank. It can be 10% to 25%.
When LC is received then one must look all the conditions. Because if any condition is not fulfilled then bank can stop the payment.