Documentary LC protects the interests of both sides in the following manner:
The Seller is certain to be paid for the the value of goods delivered and/or services provided upon the presentation of documents and compliance with LC terms and conditions, because honouring of the documents is guaranteed by the Issuing Bank.
The Buyer is certain that the bank will honour only documents which prove the compliance with all LC conditions and which consequently entitle them witht the right to dispose of the goods.
Principle of LC submission to Uniform Customs and Practice for Documentary Credits (UCP), Revision 2007, ICC Publication 600.
Principle of dealing with documents, rather than goods - In LC transactions, Banks deal with documents and not with goods, services or performance to which the documents may relate.
Principle of LC independence - A letter of credit by its nature is a separate transaction from the underlying contract.
Principle of LC irrevocability - A letter of credit is irrevocable even if there is no indication to that effect. A revocable LC will not be treated as a letter of credit any more.
Principle of LC ultimate obligation according to which an irrevocable LC can be neither amended nor canceled without agreement of the Issuing Bank, Confirming bank (if any), and Beneficiary.
Complying presentation is identified based on the International Standard Banking Practice for the Examination of Documents under Documentary Credits (ISBP, ICC Publication 681).
Benefits and Advantages for the Buyer
By depositing a cover with the Issuing Bank, the Buyer is protected from the risk, which he/she would be exposed to if the purchase price would have been delivered to an unknown Seller.
The Buyer is sure that the bank will pay after LC conditions are met.
The Buyer is sure that the goods will not be paid unless there is proof of delivery.
By submitting the shipping documents to the bank, the Seller is no longer able to dispose of the goods.
It enables the Buyer to be protected against the risk that the Seller does not deliver the goods in the quantity and quality as set in the contract.
When the LC domicile is the country of the Buyer, it ensures the jurisdiction of local courts and lawyers, and there are no extra costs in case of a dispute.
Benefits and Advantages for the Seller
By opening a Letter of Credit, the seller ensures the collection payment for the goods/services sold/exported
In addition to the value of goods, a Letter of Credit allows the seller to collect all costs related to its shipment (transportation, packing, insurance, analyses…)
The payment can occur immediately upon the shipment of goods, provided that the beneficiary submits documents to the bank strictly in compliance with LC conditions.
The Letter of Credit enables the seller to finance goods through the entire export transaction in case they themselves have neither the goods nor the funds at their disposal. In such a case, it is possible to negotiate a transferable LC, which will be transferred to the seller's supplier under such conditions which ensure a certain profit (lower price compared to the originally agreed export price) or to issue a back to back LC in favour of the real supplier.
How the LC works
Issuance of a Letter of Credit is preceded by entering into an underlying (sales) agreement by which the buyer undertakes to pay for the agreed goods/services with an LC.
The buyer (applicant) gives an order to their bank to issue an LC in favour of the seller (beneficiary).
The buyer's bank (Issuing Bank) issues an LC credit in accordance with the buyer's instructions.
The Issuing Bank sends the LC wording to the Beneficiary (usually via SWIFT through a bank in the seller's domicile country (Correspondent Bank).
Classification Based on Method of Honouring
Letter of Credit payable at sight – The payment is made upon the complying presentation of the documents and compliance with all LC conditions.
Letter of Credit with deferred payment – The payment is made within a defined time period upon the complying presentation of the documents and compliance with all LC conditions.
Acceptance Letter of Credit – These require drawing of a draft to a nominated bank, which may or may not accept the draft.
Letter of Credit Negotiation - The nominated bank is entitled to negotiate the draft drawn by the seller (Issuer).
Letters of Credit with a "Green" and "Red" Clause - A certain portion of the LC amount is paid to the seller as an advance payment prior to the goods delivery.
Classification Based on Obligation Level
Irrevocable Letters of Credit - Cannot be revoked or amended without prior agreement of all parties involved.
Confirmed Letters of Credit – the bank which is advising the LC to the beneficiary is confirming that it has undertaken the same commitment toward the beneficiary as the issuing Bank.
Stand-by Letters of Credit - a product which is a combination of documentary credit and bank guarantee.
Classification Based on Transferability
Transferable Letter of Credit – an LC received by the beneficiary and made available in total or partial amount of the LC to other beneficiary(ies).
Back to Back Letters of Credit - consist of two separate LCs, which are with the first LC serving as collateral for the second subject to UCP Rules.
Circular and Direct Letters of Credit – Documents may be presented to any bank selected by the beneficiary, while for Direct LCs, documents must be presented to the Issuing Bank.
Revolving Letters of Credit - LC amount is revolved after being used once, until the maximum approved amount is reached again.
Transport (shipping) documents (Sea Waybill, Non-negotiable Sea Waybill, Multimodal Transport Document, Charter Party Bill of Lading, Air Waybill, Rail Waybill, Road Waybill)
Insurance documents (Insurance Policy)
Documentary Bill of Exchange/draft
Other documents (EUR 1, Quality and Quantity Certificates, Phytosanitary Certificate, Factory Certificates, Attestation Report, Manufacturer Warrantee, etc.)
Key Term Definitions
Import Letter of Credit – represents an undertaking by the Issuing Bank, acting at the request and by order of the applicant, that it will pay to the beneficiary provided all required documents have been presented and LC conditions met.
Export Letter of Credit – represents an undertaking by the Issuing Bank, acting at the request and by order of the applicant, that it will pay to the beneficiary provided that all required documents have been presented and LC conditions met.
Applicant – a local or foreign entity importing goods/services giving an order to the Issuing Bank to issue a Letter of Credit (in case of an Import LC - Client).
Beneficiary – a local or foreign entity exporting goods/services in favour of whom the LC is issued
Confirmed LC – represents a definite undertaking of the Confirming Bank toward the beneficiary, which is equal to the Issuer Bank's commitment to honour a complying presentation.
LC Presentation – means the delivery of documents under the LC to the bank for examination and acceptance.
Order – Order completed by the applicant and submitted to the bank for the purpose of issuing an LC.
Purchase of Receivables under Confirmed/Unconfirmed Export LCs with deferred payment - represents a model of financing the exporter. After the Issuing Bank confirms receipt of documents and payment on the due date, the bank immediately pays out to the beneficiary the amount of purchased receivables under the LC reduced by a discount. The Issuing Bank pays out the LC value to the bank on the due date thus settling the receivables under the LC.