Import From China: Letter of Credit Explained

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Table of Contents

Definition

Letter of Credit (L/C) refers to a written document issued by the bank (issuing bank) to the beneficiary for payment against the stipulated documents according to the requirements and instructions of the applicant and in accordance with the terms and conditions of the Letter of Credit. In short, a letter of credit is a written document issued by a bank with a conditional promise of payment. In international trade, the applicant is generally the importer, the L/C is generally issued by the bank at the place of import, and the beneficiary is usually the exporter.

Letter of Credit (L/C) Process

The specific payment process of a letter of credit varies according to the type of letter of credit, but it generally includes the following procedures.

  • The import and export parties sign a sales contract which stipulates that payment shall be made by L/C.
  • The importer shall apply to the bank at his place of origin for opening the L/C, fill out the L/C application and pay a certain deposit or provide other guarantees, and request the bank (the issuing bank) to issue the L/C to the exporter.
  • The issuing bank shall issue a letter of credit in favor of the exporter according to the contents of the application and notify the exporter through its advising bank at the place where the exporter is located.
  • After the exporter has shipped the goods and obtained the shipping documents required by the L/C, the seller shall negotiate with the nominated bank for payment in accordance with the stipulations of the L/C.
  • The advising bank notifies the issuing bank of the amount due and the issuing bank notifies the importer to make payment.
  • After the importer pays, he can get the documents to take delivery of the goods, while the beneficiary, the exporter, can get the payment.
Letter of Credit
Letter of Credit

Disadvantages of Letter of Credit

Although L/C is widely used in international trade, it still has some disadvantages.

  • The importer may fail to open the L/C on time and can’t comply with the terms and conditions stipulated in the contract or intentionally set traps to make the exporter unable to fulfill the contract and suffer losses.
  • Exporters may forge seemingly qualified and conforming documents or even make fake documents to get money from the bank, making importers become the victims of such fraud.
  • An issuing bank may face losses due to improper handling of the L/C and careless examination of the creditworthiness of importers and nominated banks.
  • There may be a risk of unscrupulous merchants conspiring with shipowners to commit bill of lading fraud.

How to Avoid Risks

Based on the shortcomings mentioned above, how can the parties of L/C avoid risks?

Beneficiary (Exporter)

  • Carefully examine the credit status of importers.
  • At the time of signing the contract, the issuing date of the credit shall be clearly determined.
  • Strictly establish contract terms and do not accept unfavorable terms if possible.
  • Upon receiving the L/C, you should examine it carefully.
  • Prepare, load, and prepare documents in accordance with the provisions of the L/C and present documents to the nominated bank or issuing bank within the specified time.

Issuing Applicant (Importer)

  • Investigate the creditworthiness of the exporter.
  • Establish the inspection clause in the contract and stipulate the shipment clause.
  • Apply for issuing the L/C in accordance with the time and content stipulated in the contract.
  • The application made to the issuing bank shall be concise, definite, and complete.
  • When making payment to the issuing bank, the documents should be carefully examined. If the goods are not good, the relevant documents can be used to claim from the relevant responsible party.

Issuing Bank

  • Investigate the credit situation of the importer, control the credit limit, collect the deposit and collateral when necessary.
  • To issue the L/C in strict accordance with the application.
  • Carefully examine the beneficiary’s documents, decide whether to pay or refuse to pay, and give appropriate notice within the specified time.
  • When the importer refuses to pay, issuing bank should try to seize the title to the goods.

Letter of Credit Types

There are many types of Letter of Credit and different L/C have different functions.

Revocable L/C & Irrevocable L/C

It can be divided into revocable and irrevocable letters of credit according to whether they can be revocable or not.

Irrevocable L/C: it means that once a L/C is issued within the validity period, the issuing bank cannot unilaterally amend or cancel it without the consent of the beneficiary and the parties concerned. As long as the documents provided by the beneficiary conform to the stipulations of the L/C, the issuing bank must fulfill its obligation of payment.

Revocable L/C: the issuing bank has the right to revoke the L/C at any time without the consent of the beneficiary or the party concerned and which should be marked as “revocable”.

However, according to the instructions of UCP600, it is usually irrevocable unless the Letter of Credit is specifically stated.

Documentary L/C & Clean L/C

It can be divided into Documentary L/C and Clean L/C according to the presence of shipping documents.

Documentary L/C: it is a credit payable against a documentary draft or against documents only.

In this case, documents mean the documents representing title to the goods (e.g. ocean bill of lading and so on) or the documents certifying delivery of the goods (e.g. railway waybill, air waybill, parcel post receipt, etc.).

Clean L/C: it is a letter of credit payable against Clean Draft without accompanying shipping documents. The bank shall make payment against clean L/C. It may also request the beneficiary to present some non-shipping documents, such as invoices, payment lists, etc.

Documentary letter of credit is used in most international trade settlement.

Confirmed L/C & Unconfirmed L/C

According to whether there is another bank other than the issuing bank that can guarantee to honor, it can be divided into Confirmed L/C & Unconfirmed L/C.

Confirmed L/C: A Letter of Credit issued by an issuing bank in which another bank undertakes to pay for documents that comply with the terms of the credit. The bank that confirms the credit is called the confirming bank. A confirming bank is as liable to the beneficiary as the issuing bank for payment and is without recourse upon payment.

Unconfirmed L/C: A credit issued by the issuing bank is not confirmed by another bank, that is, a normal irrevocable letter of credit. Issuing bank is solely responsible for making payment against the beneficiary’s complying documents.

Anticipatory L/C & Sight L/C & Usance L/C

According to the payment time, L/C can be divided into Anticipatory L/C, Sight L/C, and Usance L/C.

Anticipatory L/C: Beneficiary can receive payment L/C prior to shipment, that is, importer pays before exporter presenting documents.

Sight L/C: A credit under which the issuing bank or the paying bank should pay upon receiving a documentary draft or shipping document in compliance with the terms of the credit.

Example: AVAILABLE WITH A BANK BY SIGHT PAYMENT

Usance L/C: It means that the issuing bank or the paying bank does not need to make payment immediately upon receipt of the L/C documents but only needs to fulfill the payment obligation within the specified time limit.

Example: AVAILABLE WITH A BANK BY DEFERRED PAYMENT

The usance payment date is usually calculated in two ways:

  1. Days after the date of the transport document.
  2. Days from the date of arrival of documents at the issuing bank.

Because the draft is not used in the Usance L/C, the beneficiary can neither have the acceptance draft nor discount the draft for financing after the presentation of the documents and because the payment is in the long term and usually only the issuing bank bears the payment responsibility, it lacks certain guarantee for the beneficiary.

Acceptance L/C & Negotiation L/C

Acceptance L/C: it means that the issuing bank or its nominated bank accepts a draft drawn by the beneficiary on receipt of a complying presentation and pays the draft on maturity.

Example: AVAILABLE WITH A BANK BY ACCEPTANCE

If it is discounted in advance, the beneficiary is responsible for the interest and charges.

So it can also be called “seller’s Usance L/C”.

Negotiation L/C: it means the issuing bank purchases a beneficiary’s drafts and documents under a complying presentation by inviting a nominated bank to pay or agree to pay in advance to the beneficiary on or before the banking day on which reimbursement is due.

Transferable L/C & Back to Back L/C

Transferable L/C: the word “Transferable” must be marked. The beneficiary of transferable credit may transfer the credit in whole or in part to the second beneficiary for redemption. After the second beneficiary has shipped the goods and presented the documents, the first beneficiary has the opportunity to exchange the documents and get the price difference between his own invoice and the first beneficiary’s invoice. A transferable credit can only be transferred once. Multiple clients can be concurrently assigned as the second beneficiary. A transfer to the first beneficiary does not count as a second transfer.

Back to Back L/C: it is usually used for middlemen to resell other people’s goods, or two countries can not directly handle import and export trade through a third party in this way to conclude trade.

Upon receipt of the L/C from the importer, the middleman shall request the original advising bank or another bank to open a new L/C with similar contents on the basis of the original L/C to another beneficiary. The new L/C is the Back-to-Back L/C. The amount (unit price) of the original L/C should be higher than that of the new L/C, and the time of shipment of the new L/C should be earlier than that stipulated in the original L/C.

Differences:

  • In a transferable L/C business, there is only one issuing bank and one L/C (wholly or partially transferred to the second beneficiary).
  • As the original L/C is not transferable, the middleman has to use the original L/C as collateral and request the advising bank or another bank to issue a new L/C. Therefore, there are two issuing banks and two L/Cs, being responsible for the beneficiary of the L/C, respectively.

Revolving L/C

It is a Letter of Credit in which the original amount can be reused after it has been used in whole or in part. Whereas a regular Letter of Credit becomes invalid after full use, a Revolving Letter of Credit can be reused several times until the specified number of cycles expires or the specified total amount is used up.

Reciprocal L/C

It is a settlement of transactions by issuing Letters of Credit to each other. The beneficiary of the first L/C is the applicant of the second L/C, and the applicant of the first L/C is the beneficiary of the second L/C.

The amount of the two L/Cs may be the same or approximately the same or significantly different.

The two L/C can come into force separately, that is, first issued, first effective, or simultaneously effective, that is, the first L/C is not effective until the second L/C is issued and accepted by the beneficiary, and the relevant banks will be notified that the two L/Cs are effective at the same time. In practice, Reciprocal  L/C is widely used in the processing of supplied materials and assembling of supplied parts.

Standby L/C

It is Also known as Commercial paper credit. Standby L/C is a guarantee from the issuing bank that if the applicant fails to fulfill its obligations, the beneficiary can obtain reimbursement from the issuing bank by presenting the provisions of the Standby L/C and submitting the certificate of breach of contract to the applicant. It is the bank credit, a means for the beneficiary to obtain compensation in the event of default by the issuer.

Case Study

Case 1

An exporter exported a batch of goods to Country B, the importer and exporter agreed to settle the payment by L/C.Therefore, the importer of Country B has entrusted Bank E to open an irrevocable negotiation L/C, which is confirmed by Bank F. After the exporter had completed everything in accordance with the L/C, he presented the full set of documents to Bank F within the stipulated validity of the L/C. Bank F considered the documents to be in compliance with the terms of the L/C and made the payment. After receiving the documents, E Bank found the documents to be unqualified and rejected to pay. As a result, bank F suffered huge losses. Is it reasonable?

Analysis

Yes, bank F should be responsible for the loss. According to Article 8 of UCP600, the confirming bank has accepted the documents and therefore has no recourse. If the issuing bank refuses to accept the documents because of discrepancies that were overlooked by the confirming bank, the confirming bank shall be responsible for such consequences. The confirming bank cannot, in turn, make the drawer/or bona fide holder liable for errors in its examination of the documents.

In this case, bank F, the confirming bank, has lost the right of recourse against the beneficiary (the exporter) by wrongly negotiating the documents without noticing the discrepancy. At the same time, since the issuing bank’s payment is based on single and consistent documents, Bank F cannot get reimbursed. As a result, Bank F is the only bank to suffer loss.

Case 2

A company in Hong Kong entrusted local bank A to collect payment from an import and export company through mainland bank B. Upon receipt of the documents, Bank B presented the documents to an import and export company (drawee) for payment of the collection amount of USD205020.00. In December of the same year, the drawee informed Bank B that the company had directly remitted USD165,020.00 to the drawee and authorized Bank B to pay the remaining USD40,00.00 to the drawee through Bank A. After the payer had paid the balance, Bank B delivered the documents to the payer. Then the Hong Kong company wrote a letter to Bank B, saying that this practice seriously harmed the legitimate rights and interests of the company and violated international practices and URC522 standards. Is bank B doing the right thing?

Analysis

Bank B made a mistake. Article 19 (6) of ICC URC522 states: “In the case of documentary collection, partial payments will be accepted only if specifically authorized by the collection instruction. However, unless otherwise instructed, the presenting bank shall release the documents to the drawee only when the full amount has been received.”In this case, the collection instruction did not authorize the collecting bank B to execute the partial D/P, and the presenting bank did not obtain the consent of the applicant. However, collecting bank B executed the partial D/P just according to the authorization of the drawee, which doesn’t make sense.

Case 3

Bank I issued an irrevocable and transferable documentary credit in favor of M with bank A as an advising bank. After Bank A notified M of the L/C, M asked Bank A to transfer the L/C to X. The expiry date of this transfer was one month earlier than that of the original certificate. The second beneficiary X had a disagreement with the first beneficiary M on some terms of the transfer after receiving the transfer. After many negotiations, the two sides failed to reach an agreement. At this time, the L/C has expired. Then M requested bank A to re-transfer the original credit to the new second beneficiary Y. Bank A refused since the transfer of the L/C to Y constitutes a second transfer of the L/C, which violated the provisions of Article 38 of UCP600. Is that right?

Analysis

Bank A has a misunderstanding in Transferable L/C. That is the secondary transfer of an unused credit to another new second beneficiary shall not be regarded as a second assignment.

 According to Article 38 of UCP600, a Transferable L/C can only be transferred once unless otherwise stipulated in the letter of credit. Therefore, the Letter of Credit cannot be transferred to a subsequent third beneficiary as required by the second beneficiary. According to the meaning of this article, a second transfer by the first beneficiary does not constitute a second transfer but is treated as a simultaneous transfer to more than one beneficiary. Therefore, such transfer is not prohibited by UCP600.

In this case, the second beneficiary X did not accept the transferred L/C, and the first beneficiary M could transfer the L/C to Y again.

Conclusion

UCP600

L/C is a very important method of payment in international trade. It is necessary to understand the characteristics of L/C to avoid possible risks. If you want to know more about Letters of Credit, the book called UCP600 (Uniform Customs and Practice for Documentary Credits) is a good choice.

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