Letter Of Credit Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A letter of credit (LC) or documentary credit is a means of payment in a trade transaction that commits the issuer, usually a commercial bank, on behalf of its customer, a buyer, to pay a seller contingent on documentary evidence that the seller has met the terms and conditions of the letter of credit. A letter of credit is commonly used in international trade. A seller (exporter) who does not wish to risk nonpayment by a buyer (importer) may require the issuance of a letter of credit by the buyer’s bank as a condition of the sale. In a letter-of-credit transaction, the issuing bank’s credit risk is substituted for the credit risk of the buyer that is otherwise assumed by the seller whenever transactions are conducted on open account terms. The letter of credit serves as a method of payment when informational asymmetries exist about the buyer’s capacity to pay.

Process

A commercial letter-of-credit transaction involves six steps: (1) after a sales contract has been negotiated that requires a letter of credit, the buyer or applicant applies to its bank to issue the letter of credit, committing the bank to pay the seller or beneficiary upon the receipt of specified documents, such as a bill of lading and a draft drawn by the seller demanding payment, before the expiration of the letter of credit; (2) the issuing bank then requests a correspondent bank in the seller’s vicinity to advise the seller that a letter of credit has been issued in its behalf; (3) and (4) upon this advice from the advising bank, the seller arranges to ship the goods and then submits the required documents called for in the letter of credit to a local bank that serves as the negotiating bank, receiving and examining the documents for compliance with the terms and conditions of the letter of credit and then forwarding them to the issuing bank; (5) the issuing bank also examines the documents for compliance and then honors its commitment to pay once it is satisfied that the terms and conditions of the letter of credit have been met; and (6) the issuing bank arranges for repayment from its customer, the buyer, in return for the documents that allow the buyer to take possession of the merchandise. In practice, the negotiating bank may pay the seller immediately after confirming that the documents comply and either debit the issuing bank’s account immediately or await its repayment.

The documents that a letter of credit requires the seller to deliver vary but commonly include a transport document, such as an ocean or marine bill of lading, issued by the shipping company to the seller. The billing of lading serves as a receipt for the goods and also conveys title to them. Another is a draft or bill of exchange that is drawn by the seller on the buyer or buyer’s bank, demanding payment of the amount specified in the letter of credit. Other documents that may be required in a letter-of-credit transaction include a commercial invoice, certificate of origin, packing list, inspection certificate, and insurance documents.

Virtually all letters of credit are irrevocable; once issued, they cannot be changed or canceled without the agreement of the buyer and seller. Letter-of-credit payment terms vary according to the negotiated sales contract and are reflected in the draft drawn by the seller. A sight draft calls for immediate payment while a time draft defers payment into the future but rarely beyond 90 days. Additionally, the seller may wish to have added assurance of payment by requesting its local negotiating bank to commit to making the payment in the event the issuing bank does not by adding its confirmation to the letter of credit.

Governance

The use of letters of credit, which is estimated to account for 15 percent of the world’s trade transactions, is governed by the Uniform Customs and Practice for Documentary Credits (UCP), established in 1933 by the International Chamber of Commerce to harmonize practices across member countries. The latest revision, UCP 600, effective in July 2007, was intended to simplify and clarify the practices governing the use of letters of credit, which continues to be critical to facilitate trade when informational asymmetries about the creditworthiness of customers persist.

Bibliography:

A Basic Guide to Exporting (U.S. Department of Commerce, 1998);
Bellardine, “The New UCP 600: Rules to Better Facilitate International Trade,” GTNews.com (2007) (cited March 2009);
James E. Byrne, LC Rules & Laws: Critical Texts (Institute of International Banking Law & Practice, 2007);
Citi, “Documentary Credits; No More Ambiguity,” GTNews.com (2003) (cited March 2009);
Jaephil Hahn, “Governing Laws on Letters of Credit Under Uniform Commercial Code,” Journal of Korea Trade (v.11/3, 2007);
McCombs, “Export Letters of Credit Still Yield Multitude of Benefits,” GTNews.com (2008) (cited March 2009);
Oppenheim, International Banking, 6th ed. (American Bankers Association, 1991);
Pike et al., “Trade Credit Terms: Asymmetric Information and Price Discrimination Evidence From Three Continents,” Journal of Business Finance & Accounting (2005);
Susan Warner, The Letter of Credit (Gardners Books, 2007).

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