TYPES OF LETTERS OF CREDIT
INTRODUCTION
In an international commercial contract, it is the duty of the buyer to pay for the goods delivered by the seller. Internationally, the payments need to be guaranteed so that parties are more willing to trade with each other and the risk factor of not receiving the payment is reduced to an absolute minimum. There are many methods of international payment, like, cash in advance, open account, documentary collections and Letters of credit.
Letters of credit is a documentary method of international payment and it is one of the most secure methods of payment used in an international commercial transaction. Since, they are so widely used the International Chamber of Commerce has come out with the UCP which stands for Uniform Customs and Practices. UCP-600 is a document which gives the rules and regulations for the utilization of Letters of credit. Just in case UCP-600 does not regularize the use of any type letters of credit, then UCP-500 can be referred. Letter of credit is a preferred method of international payment as it does not favourable to any one party.
There are various types of letters of credit that prevail in the international trade transactions. They are Transferable and Non-Transferable, Revocable and Irrevocable, Confirmed and Unconfirmed, Revolving, Back-to-Back, Red Clause, Green Clause, Deferred Payment credit and clean credit. The nature and differences between the types of letters of credit have been discussed in this paper.
DEFINTION OF LETTER OF CREDIT
A Letter of Credit is a financial document provided by a third-party (with no direct interest in the transaction), mostly a bank or a financial institution, that guarantees the payment of funds for goods and services to the seller once the seller submits the required documents. A letter of credit has three important elements – the beneficiary/seller who is the recipient of the Letter of Credit, the buyer/applicant who buys the goods or services and the issuing bank that issues the Letter of Credit on the buyer’s request. There is also an involvement of another bank as an advising bank that advises the beneficiary regarding the authenticity and validity of the letter of credit that was issued.
There are two main characteristics of letters of credit- Autonomy and Strict Compliance. According to the principle of Autonomy, a bank which undertakes to make the payment for the buyer cannot be stopped to do so. Therefore, letters of credit function in an autonomous manner
i.e. free from any external influence. The Doctrine of Strict Compliance means that the banks make the payments when the checklist is fulfilled. However, in case any document is lacking, then the bank can reject the payment.
TYPES OF LETTERS OF CREDIT
REVOCABLE CREDIT: Article 8(a) of the UCP 500 defines a revocable credit as a credit that may be amended or cancelled by the issuing bank at any moment and without prior notice to the beneficiary. The confirmation of such a letter of credit is not guaranteed. The credit can be revoked by either by the buyer or the issuing bank on its own initiative, to protect itself, just in case the buyer gets himself into some financial difficulties.
If seen from the seller’s perspective, this type of Letter of Credit is not much preferred as it offers the least amount of security because the issuing bank does not undertake to pay the seller on tender of stipulated documents and is under no obligation to inform the beneficiary about the revocation of the credit.
Revocable credits are usually used in transactions between sister companies or parent and subsidiary companies as the bank charges are less for these.
Cape Asbestos Co Ltd v Lloyds Banks Ltd2: In this case, the bank advised the sellers that they had opened a credit in their favour, and expressly stated that ‘This is merely an advice for the opening of the above-mentioned credit, and is not a confirmation of the same.’
IRREVOCABLE CREDIT: The irrevocable letter of credit is just the opposite of revocable letter of credit. According to Article 10(a) of the UCP, once the letter of credit has been communicated to the seller then, it cannot be withdrawn without prior permission from the buyer and without prior intimation to the beneficiary. According to Article 2 and 7(a) of the UCP, through irrevocable letter of credit, the issuing bank gives definite guarantee to the beneficiary ensuring payment for the goods. However, conditions specified in the credit should be satisfied.
If it is considered from the beneficiary’s point of view, irrevocable credit is preferred more than the revocable credit as it protects his interest by guaranteeing the payment for the goods already delivered.
A number of contractual undertakings are found in this type of credit. They are:
Between seller and buyer as a result of the contract of sale;
Between buyer and the issuing bank, as a result of the arrangements made for opening the credit;
Between issuing bank and the advising bank; and
Between issuing bank and the seller.
UNCONFIRMED CREDIT: A letter of credit where only the bank issuing it has agreed to guarantee the payment. In other words, a letter of credit which has not been guaranteed or confirmed by any bank other than the issuing bank. The advisory bank in this scenario merely informs the beneficiary of the terms and conditions of the letter of credit.
The disadvantage with an unconfirmed irrevocable credit is that, just in case the issuing bank rejects the documents, litigation would take place in a foreign jurisdiction.
CONFIRMED CREDIT: A letter of credit which confirms the credit is known as the confirmed letter of credit and it is always irrevocable. Where the letter of credit is a confirmed credit, the seller receives a letter of credit from the confirming bank, which is located in his country. This is basically an additional set of confirmation which states that the seller will get paid if he presents the stipulated documents and the same is the approach of the UCP according to Article 2 and 8(a)4. A confirmed credit is the highest-level security to the seller for receiving his due payment. Another advantage of confirmed credit is that, in case of non-payment, if a dispute arises, the proceedings can be initiated in the jurisdiction of the seller. In a confirmed credit, other than the four contractual undertakings listed under irrevocable credits, there is one other contractual undertaking- which is between confirming bank and the seller.
BACK-TO-BACK CREDITS: Back-to-back letter of credit is a letter of credit which commonly involves an intermediary in a transaction. In this type of credit, there are two letters of credit, the first issued by the bank of the buyer to the intermediary and the second issued by the bank of an intermediary to the seller. In this scenario, the issuing bank upon getting the instructions from the customer agrees to issue letter of credit, which is transferable to the first beneficiary. This means that the first beneficiary can transfer the letter of credit to its customer or third party or a secondary beneficiary or he can use that letter of credit as a security for the issuance of another letter of credit in favour of the third party. The transferring bank i.e. the bank issuing the letter of credit shall issue a “transferred letter of credit”. This letter of credit looks identical to the original letter of credit. The first beneficiary holding the original letter of credit gives this letter of credit to the secondary beneficiary.
TRANSFERABLE CREDITS: Article 38(b) of the UCP recognizes the transferable credit. A transferable credit is one that allows a beneficiary to further transfer all or a part of the payment to another supplier in the chain or any other beneficiary. This generally happens when the beneficiary is just an intermediary for the actual supplier. Such letter of credit allows the beneficiary to provide its own documents but transfer the money further. According to Article 38(a) and (b), transferable credit means a credit that specifically states it as ‘transferable’ in the letter of credit. A transferable credit may be made available in whole or in part to another beneficiary at the request of the first beneficiary and the second beneficiary has no right to transfer the same letter of credit to a third beneficiary. However, he can retransfer to the first beneficiary. Also, a bank is under no obligation to transfer credit except to the extent and in the manner expressly consented to by that bank. This is a better alternative to back-to-back credit.
NON-TRANSFERABLE CREDITS: It is just the opposite of transferable credits. It is a letter of credit that does not allow the transfer of credit to any other party. The beneficiary is the only recipient of the money and cannot further use the letter of credit to pay anyone.
RED CLAUSE CREDITS: The red clause credit first came to be used in New Zealand, Australia and South Africa. These credits allow the seller to draw on the documentary credit in advance of shipments partially. The advance is paid against the written confirmation from the seller and the receipt. This type of letter of credit is called Red Clause because it’s written in red ink.
GREEN CLAUSE CREDITS: This letter of credit came up for coffee trade. Its origins are similar to red clause credit. It is defined as a letter of credit that pays advance to the seller just not against the written undertaking and a receipt, but also a proof of warehousing the goods. It is called as such because it’s written in green ink. Here, the goods are stored in the name of the bank. Red clause and Green clause credits are also known as anticipatory credits.
REVOLVING CREDITS: A revolving letter of credit is one where, under the terms and conditions thereof, the amount is renewed or reinstated without specific amendments to the credit being needed. It can revolve in relation to time and value. Credit can be availed against one the same letter of credit for all subsequent international transactions. There is no need to issue a separate letter of credit for every transaction. This type of credit is generally used in local trade or where there is regular trading between the same parties. Such credits are issued for a stated amount and the drawings under the letter of credit are reinstated as soon as the documents are presented. The issuing bank has to confirm about the acceptance or payment of the documents for reinstatement of the amount in the letter of credit.
DEFERRED PAYMENT CREDIT: Deferred payment credit is a usance credit where, payment will be made by issuing bank, on respective due dates, determined in stipulations of the credit, without the drawing of bills of exchange. In a way, it is an extended payment credit. Under deferred payment credit, no bill of exchange will be called upon to be drawn, but it must specify the maturity at which the payment is to be made and how such maturity is to be determined. In India, Deferred payment arrangements for imports, providing for payment beyond six months from the date of shipment up to a period of less than three years are treated as trade credits for which procedural guidelines are laid down by RBI for external commercial borrowing and trade credits are required to be followed.
CLEAN CREDIT: A clean letter of credit does not lay down any condition with regards to making the payment. Further, it does not contain any condition for acceptance of bill of exchange drawn by the seller upon the buyer. It is clean in the sense that there is no condition for the payment to be made.
REFERENCES
https://efinancemanagement.com/sources-of-finance/types-of-letter-of-credit- lc
https://cleartax.in/s/letters-of-credit
Indira Carr and Peter Stone, ‘International Trade Law’ Sixth Edition
NAME: Kritika Chhabra
COLLEGE: Vivekananda Institute of Professional Studies, GGSIPU
YEAR: 5th Year
CITY: Delhi, India