A contract between an importer and an exporter may call for payment under a letter of credit, often abbreviated as L/C or LC.
A letter of credit is a written commitment by a bank to make payment at sight of a defined amount of money to a beneficiary (exporter) according to the terms and conditions specified by the importer (applicant). The letter of credit should set a time limit for completion and specify which documents are needed to confirm the transaction’s fulfillment.
More properly called a documentary letter of credit, it is important to remember that a letter of credit is an additional contract dealing with credit between the applicant (importer) and the issuing bank and separate from the original grain contract.
Proper letters of credit have the following basic components:
The party applying for the letter of credit, usually the importer in a grain transaction.
The Issuing Bank:
The bank that issues the letter of credit and assumes the obligation to make payment to the beneficiary, usually the exporter.
The party in whose favor the letter of credit is issued, usually the exporter in a grain transaction.
The sum of money, usually expressed as a maximum amount, of the credit defined in a specific currency.
The requirements, including documents, that must be met for the collection of the credit.
The final date for the beneficiary to present against the credit.
These are the necessary components of any letter of credit for the credit to become a valid, operable instrument. In addition, letters of credit come in various forms that define their level of risk. A revocable letter of credit allows the issuing bank (at the applicant’s request) to amend or cancel the credit at any time without the approval of the exporter (beneficiary) and is the most risky form. In contrast, an irrevocable letter of credit has terms and conditions that cannot be amended or changed without the expressed consent of all parties, the issuing bank, the exporter (beneficiary) and the importer (applicant). Finally, the addition of a commitment by a bank other than the issuing bank to irrevocably honor the payment of the credit, provided the exporter meets the terms and conditions of the credit, results in a confirmed irrevocable letter of credit.
Once the exporter and importer have concluded a transaction that calls for payment under some form of letter of credit, the importer makes application for the credit to the bank, either locally or in another country, that will issue the credit.
The importer/applicant will give the issuing bank instructions that cover such items as:
- The full, correct name, address and contact information of the beneficiary, usually the exporter.
- A brief description of the grain involved, including the quantity, quality and unit price.
- The method, place and form of shipment, the location of the final destination and other shipping issues including transhipment, partial shipment and the latest shipping date.
- The full, correct description of the documents required, including the period of time after the documents are issued within which they must be presented for payment. In addition, the credit should specify if payment is to be immediate (at sight) or with some degree of deferment (i.e., four days after acceptance).
- Details of the letter of credit itself, including the amount (usually expressed as a maximum), the expiry date, how the credit will be made available and the transferability of the credit.
- The type of credit. The revocable credit, the irrevocable credit or the confirmed irrevocable letter of credit.
Upon approval of the credit application by the issuing bank, the letter of credit is usually advised to the exporter; that is, the bank makes the exporter (beneficiary) aware that a letter of credit is opened.
The advising is often done by a bank other than the issuing bank, and this second bank may also confirm the credit. Once the importer and exporter are satisfied that the credit is operable, the exporter ships against the original grain contract and presents the required documents and a draft (the instrument by which the exporter directs the importer to make payment) to the confirming, correspondent or issuing bank, as the case may be. Upon checking the documents for accuracy, the bank(s) passes the documents onto the importer and makes payment against the draft to the exporter.