What is Letter of Credit??
What is a Letter of Credit (LC)?
Definition
Letters of credit (also know as documentary credits) are payment instruments that constitute a definite undertaking of the issuer (“the issuing bank”) on the instruction of the buyer (“applicant”) to pay a certain specified amount to a seller (“the beneficiary”) at sight or on a future determinable date (“the maturity date”) provided that documents stipulated in the letter of credit/documentary credit are presented in compliance with the stated terms and conditions.
The issuing bank issues the documentary credit on behalf of its customer (“the applicant”) or on its own behalf.
These undertakings are known as “documentary credits”, as they specify the documents that must be presented in order for the credit to be honoured.
These are also known as “letters of credit” (LCs) as they were originally issued in a physical document form addressed to the beneficiary with the issuing bank’s undertaking to pay upon receipt of complying documents.
There are several critical features of documentary credits/letters of credit:
- Irrevocability: documentary credits constitute an irrevocable undertaking of the issuer to pay, meaning that, once issued, the credit cannot be revoked or changed by the issuing bank. A credit can only be amended or cancelled with the consent of the issuing bank, the beneficiary, and the confirming bank (if any).
- Documentary nature: documentary credits are documentary in nature and any payment undertakings contained in them are conditional upon receipt of documents as stated in the terms and conditions of the credit.
- Compliance: documentary credits are settled only when the documents presented by or on behalf of the beneficiary comply with the terms and conditions of the documentary credit. Therefore, to obtain payment under a documentary credit, the beneficiary must present documents which comply with each credit’s terms & conditions. If the documents contained do not comply (also known as discrepancies), an issuing bank may refuse to honour and is only obligated to pay if the non-complying documents are corrected and made compliant before the credit expires, or if the applicant waives the discrepancies and the issuing bank also agrees to waive any discrepancy(ies).
- Payment mechanism: documentary credits constitute a payment mechanism designed to facilitate the settlement of an underlying trade transaction whereby the applicant (the buyer) receives the goods or services, and the beneficiary (the seller) obtains payment via the credit which would then satisfy the applicant’s payment obligations against the underlying sales or other contract on which it may be based.
- Independence and autonomy: documentary credits constitute an independent undertaking of the issuing bank and the confirming bank (if any) separate from the underlying sale or other contract on which it may be based. The principle of autonomy is articulated within the ICC Uniform Customs and Practice for Documentary Credits 2007 Revision (“UCP 600”) and is upheld throughout the world.
Purpose
The purpose of a documentary credit is to provide a mechanism or arrangement to facilitate the settlement of an international or domestic trade transaction by use of a bank undertaking.
It should be noted that banks only deal with documents and not with goods, services or performance to which the documents may relate.
The terms and conditions of a documentary credit form the basis upon which the applicant must reimburse an issuing bank when a complying presentation is made.
Documentary credits assure the beneficiary of payment as long as they present the requisite complying documents to the nominated bank, the confirming bank (if any), or the issuing bank.
Diagram: Letter of Credit Issuance & Settlement
