letter of credit

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kalpana (Querist)
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17 May 2008 Hai every body,

I am kalpana, I want to know the exact terms and conditions of Letter of credit, how many members involve in that and how will be procedure and details of that.

Please provide me the details,

thanking you

R.V.RAO

R.V.RAO (Expert)
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17 May 2008 A letter of credit is a document issued mostly by a financial institution which usually provides an irrevocable payment undertaking (it can also be revocable, confirmed, unconfirmed, transferable or others e.g. back to back: revolving but is most commonly irrevocable/confirmed) to a beneficiary against complying documents as stated in the Letter of Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any, within the expiry date of the LC, comprising documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirming bank, if any, is obliged to honour irrespective of any instructions from the applicant to the contrary. In other words, the obligation to honour (usually payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks can also issue letters of credit however parties must balance potential risks.

The LC can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, stormwater ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheques. Typically, the documents a beneficiary has to present in order to avail himself of the credit, are commercial invoice, bill of lading, insurance documents. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped.

Terminology
The English name “letter of credit” derives from the French word “accreditif”, a power to do something, which in turn is derivative of the Latin word “accreditivus”, meaning trust. S.‘The Application of the Letter of Credit Form of Payment in International Business Transactions’ (2001) 10 Int’l Trade L.J. p. 37 This in effect reflects the modern understanding of the instrument. When a seller agrees to be paid by means of a letter of credit he is looking at a reliable bank that has an obligation to pay him the amount stipulated in the credit notwithstanding any defence relating to the underlying contract of sale. This is as long as the seller performs their duties to an extent that meets the credit terms.

How it works
Imagine that a business called the WAPRO from time to time imports steel from a business called MIL, which banks with the India Business Bank. WAPRO holds an account at the Commonwealth Financials. WAPRO wants to buy $500,000 worth of merchandise from MIL, who agrees to sell the goods and give WAPRO 60 days to pay for them, on the condition that they are provided with a 90-day LC for the full amount. The steps to get the letter of credit would be as follows:

WAPRO goes to The Commonwealth Financials and requests a $500,000 letter of credit, with MIL as the beneficiary.
The Commonwealth Financials can issue an LC either on approval of a standard loan underwriting process or by WAPRO funding it directly with a deposit of $500,000 plus fees between 1% and 8%.
The Commonwealth Financials sends a copy of the LC to the India Business Bank, which notifies the MIL that payment is ready and they can ship the merchandise WAPRO has ordered with the full assurance of payment to them.
On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of the letter of credit, the Commonwealth Financials transfers the $500,000 to the India Business Bank, which then credits the account to the MIL by that amount.
Note that banks deal only with documents under the letter of credit and not the underlying transaction.
Many exporters have misunderstood that the payment is guaranteed after receiving the LC. The issuing bank is obligated to pay under the letter of credit only when the stipulated documents are presented and the terms and conditions of the letter of credit have been met accordingly.

Legal principles governing documentary credits
One of the primary peculiarities of the documentary credit is that the payment obligation is abstract and independent from the underlying contract of sale or any other contract in the transaction. Thus the bank’s obligation is defined by the terms of the credit alone, and the sale contract is irrelevant. The defences of the buyer arising out of the sale contract do not concern the bank and in no way affect its liability.[1] Article 3(a) UCP states this principle clearly. Article 4 the UCP further states that banks deal with documents only, they are not concerned with the goods (facts). Accordingly, if the documents tendered by the beneficiary, or his agent, appear to be in order, then in general the bank is both entitled and obliged to pay without further qualifications.

The policies behind adopting the abstraction principle are purely commercial and reflect a party’s expectations: firstly, if the responsibility for the validity of documents was thrown onto banks, they would be burdened with investigating the underlying facts of each transaction and would thus be less inclined to issue documentary credits as the transaction would involve great risk and inconvenience. Secondly, documents required under the credit could in certain circumstances be different from those required under the sale transaction; banks would then be placed in a dilemma in deciding which terms to follow if required to look behind the credit agreement. Thirdly, the fact that the basic function of the credit is to provide the seller with the certainty of receiving payment, as long as he performs his documentary duties, suggests that banks should honour their obligation notwithstanding allegations of misfeasance by the buyer. [2] Finally, courts have emphasised that buyers always have a remedy for an action upon the contract of sale, and that it would be a calamity for the business world if, for every breach of contract between the seller and buyer, a bank were required to investigate said breach.

The “principle of strict compliance” also aims to make the bank’s duty of effecting payment against documents easy, efficient and quick. Hence, if the documents tendered under the credit deviate from the language of the credit the bank is entitled to withhold payment even if the deviation is purely terminological.[3] The general legal maxim de minimis non curat lex has no place in the field of documentary credits. In this phenomenon it is not possible for the invester to be sure that to get bank money from bank.

The price of LCs
The applicant pays the LC fee to the bank, and may in turn charge this on to the beneficiary. From the bank's point of view, the LC they have issued can be called upon at any time (subject to the relevant terms and conditions), and the bank then looks to reclaim this from the applicant.

Legal Basis for Letters of Credit
Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. In addition, the performance of an existing duty under a contract cannot be a valid consideration for a new promise made by the bank: the delivery of the goods is consideration for enforcing the underlying contract of sale and cannot be used, as it were, a second time to establish the enforceability of the bank-beneficiary relation.

Most parties subject themselves to the Uniform Customs and Practices (UCP) issued by the International Chamber of Commerce (ICC) in Paris. The ICC has no legislative authority, rather, representatives of various industry and trade groups from various countries get together to discuss how to revise the UCP and adapt them to new technologies.

SOURCE:http://en.wikipedia.org/wiki/Letter_of_credit

R.V.RAO