Letter of Credit (LOC)

Letter of Credit (LOC)

Introduction

·       A Letter of Credit (LOC) is a financial document issued by a bank on behalf of a buyer (importer), guaranteeing that the seller (exporter) will receive payment for goods or services provided, provided that the terms and conditions specified in the LOC are met.

·       It acts as a payment assurance mechanism in international and domestic trade.

·       The issuing bank substitutes its own creditworthiness in place of the buyer’s, thereby reducing the risk for the seller.

·       The seller is assured of payment once they present the required documents (such as bill of lading, invoice, insurance certificate, etc.) to the bank.

·        LOC = Trust + Security + Assurance in trade transactions.

Opening of Letter of Credit

1. Request by Buyer/Importer
• The importer approaches their bank (issuing bank) to open an LOC in favor of the exporter.
• Buyer submits application form, trade agreement, and supporting documents.
2. Assessment by Issuing Bank
• The bank evaluates the buyer’s creditworthiness, financial standing, and past history.
• Depending on assessment, the bank may demand collateral, margin money, or credit limit sanction.
3. Drafting of LOC Terms
• LOC is prepared clearly defining payment conditions, documents required, shipping deadlines, validity period, etc.
4. Transmission to Advising Bank
• Issuing bank sends the LOC to the exporter’s bank (advising bank), usually via SWIFT (Society for Worldwide Interbank Financial Telecommunication).
5. Notification to Seller/Exporter
• The advising bank authenticates the LOC and informs the exporter about the terms.
• Exporter reviews and confirms whether they can comply.

Types of Letter of Credit

1. Revocable LOC
• Can be amended or canceled by the issuing bank without prior notice to the exporter.
• Rarely used due to high risk for the seller.
2. Irrevocable LOC
• Cannot be changed or canceled without the consent of all parties (buyer, seller, and banks).
• Provides maximum security and is the most common type.
3. Confirmed LOC
• Apart from issuing bank’s guarantee, another bank (confirming bank) also undertakes the responsibility of payment.
• Provides extra assurance to the seller, especially when the issuing bank is in a politically or economically unstable country.
4. Unconfirmed LOC
• Only the issuing bank is liable for payment; no additional bank guarantee is involved.
5. Sight LOC
• Payment is made immediately “at sight” upon presentation and verification of documents.
6. Usance/Deferred Payment LOC
• Payment is made at a later date (e.g., 30, 60, 90 days after shipment).
7. Transferable LOC
• Beneficiary (exporter) can transfer all or part of the credit to another party (useful for intermediaries/traders).
8. Back-to-Back LOC
• One LOC issued based on another LOC as security. Common in trade intermediaries.
9. Standby LOC
• Works like a guarantee; payment is made only if the buyer defaults.
10. Red Clause LOC
• Allows the exporter to receive advance payment before shipment, against a written undertaking.

Precautions While Opening LOC

• Clear Agreement: Ensure sales contract terms match LOC conditions.
• Accuracy of Details: Exporter’s name, amount, shipment dates, and documents required must be precise.
• Documents Required: Clearly list documents (invoice, bill of lading, packing list, certificate of origin, insurance certificate, etc.).
• Bank Credibility: Choose reputed and financially strong banks to avoid default risks.
• Currency Risks: Ensure clarity on exchange rates and payment currency.
• Country Risks: Consider political stability of the issuing bank’s country.
• Shipping & Insurance: Clearly mention responsibilities (Incoterms: FOB, CIF, etc.).
• Expiry Date & Shipment Deadlines: Must be realistic to avoid lapses.

Bank Charges

Banks levy charges for issuing, advising, confirming, and handling LOCs.

1. Issuance Charges – Fee for drafting and issuing the LOC.
2. Advising Charges – Charged by the advising bank to authenticate and notify the exporter.
3. Confirmation Charges – Levied if an additional bank confirms the LOC.
4. Amendment Charges – For modifying terms of an existing LOC.
5. Negotiation Charges – For negotiating or purchasing export bills under LOC.
6. Discrepancy Charges – Applied when documents submitted do not comply with LOC terms.
7. Reimbursement Charges – Handling fees for payment settlement.

Scrutiny of Letter of Credit

• Completeness of Information (beneficiary’s name, issuing bank, advising bank, amount, validity).
• Consistency with Sales Contract (goods description, Incoterms, quality specifications).
• Documentary Requirements – Must be clear, achievable, and aligned with international rules (UCP 600 – Uniform Customs and Practice for Documentary Credits).
• Time Frames – Check shipment deadlines, presentation period, and LOC expiry date.
• Discrepancy Risk – Ensure terms are not too rigid to reduce chances of rejection.
• Payment Terms – Sight vs usance must be acceptable to both parties.

Insurance in LOC Transactions

1. Marine Insurance / Cargo Insurance
• Covers goods during shipment from exporter’s location to importer’s destination.
• Common policies: Institute Cargo Clauses (A, B, C).
2. Insurance Certificate in LOC
• Often required as a compulsory document for payment.
• Should match LOC terms exactly (insured value, risk covered, policy currency).
3. Who Takes Insurance?
• Depends on contract terms (Incoterms):
• Under CIF (Cost, Insurance, Freight): Exporter arranges insurance.
• Under FOB (Free on Board): Buyer arranges insurance.
4. Coverage Risks
• Loss/damage in transit, war risk, strike risk, pilferage, theft.

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