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What is a Letter of Credit (LC) in Export & Import

What is a Letter of Credit (LC)?

A letter of credit is a formal, legally binding document from a bank that guarantees timely payment in full, from the buyer of any goods to the seller, provided that certain terms and conditions mentioned in the LC are met by the seller. In case a buyer is not able to make the full payment, LC binds the bank to cover the full or remaining payment.

LC benefits and provides security to both – the buyer and the seller. The seller is guaranteed payment even if the buyer is unable to make it and the buyer is secured, as he is only obligated to pay if the seller furnishes the proper required documents and meets the precisely defined terms mentioned in the LC.

Essentially, LCs act as formal trade instruments where the financial dependability of the buyer is replaced by the dependability of the bank

How does LC work?

  • An importer and exporter enter into business and sign a contract with each other for the international trade of goods. A need to secure the transaction may emerge if the parties do not know each other or are unsure of the other’s financial background. To ensure the delivery of goods to the importer and payment to the exporter, LC is issued.
    1. Description of goods
    2. Quantity of goods
    3. Technical description
    4. Documentary requirements, such as commercial invoices, bills of lading etc.
    5. Details of the consignee, which is generally the issuing bank
    6. Latest date of shipment
    7. Modes of transport and shipping ports to be used

Following this, the buyer’s bank, also known as the issuing bank, issues the LC. It is then sent to the seller and his bank, known as the nominated bank.
  • Based on the terms and conditions listed in the LC, the exporter prepares the goods and documents and ships the goods to the importer. 
  • The exporter then, submits copies of all the documents to the nominated bank for verification. Once the veracity and correctness of the documents is established against the terms and conditions specified by the importer in the LC, the exporter is duly paid the price agreed between him and the importer by the nominated bank
  • After the payment is made to the exporter, the submitted documents are sent to the issuing bank by the nominated bank. 
  • The issuing bank further verifies the documents. Once they are properly verified, the nominated bank is reimbursed the money paid to the seller by the issuing bank. 
  • The issuing bank then intimates the buyer about the shipment of goods and the possession of the documents by them. The buyer then pays the issuing bank, the money they have reimbursed to the nominated bank and the issuing bank endorses the bill of lading so that the cargo can be released to the buyer. 
  • The banks involved also charge a service fee for carrying out the transactions.

How are LCs regulated?

LCs are regulated by a number of domestic and international regulations.

International guidelines
The international guidelines issued by the International Chamber of Commerce (ICC) and are voluntary in nature. Parties have to contract to have their LCs subjected to them.

  •  UCP 600
    • UCP (Uniform Customs and Practices for Documentary Credits) (available for purchase here)   is a set of transnational rules issued by the International Chamber of Commerce’s Commission on Banking Technique and Practice that govern LC transactions worldwide. 
    • These apply to financial institutions which issue LC and aim to standardise and govern international trade and reduce the risks related to it. 
    • These rules have to be voluntarily incorporated into LCs and are the most successful rules developed to regulate them. The UCPs are not laws, but have been frequently used by the Courts to decide disputes concerning LCs
  •  Uniform Rules for Bank-to-Bank Reimbursements (URR)
    1. The ICC has also issued uniform rules for bank-to-bank reimbursements known as URR 725 to decide the responsibilities and rights of banks.
    2. Made as an accompaniment to the UCP, the URR are applicable on bank to bank reimbursements and are binding on agreements expressly subjected to these rules
  •  INCOTERMs (International Commercial Terms)

    The International Standard Banking Practices refers to a comprehensive set of guidelines issued by the ICC for the handling and examination of trade documents under letter of credit as an accompaniment to the UCP.
    Domestic regulations 
  • The Banking Regulation Act, 1949

    Section 6 of the Banking Regulation Act, 1949 allows banking companies in India to issue LCs.
  • RBI Guidelines
    The RBI issued guidelines regulating LCs in its Master Circular No.4/09.27.000/2013-14 issued on 1.07.2017 on Guarantees, Co- Acceptances and Letters of Credit (available here). These guidelines regulate the grant of LCs facilities, safeguards in opening LCs, LCs for commodities under Selective Credit Controls and immediate payment for settlement of claims under fraudulent LCs. It is pertinent to note that:
    • Banks cannot open inland LCs with clauses permitting other banks to discount usance bills under them.
    • Co-operative banks are not to grant LC facilities to parties maintaining nominal current accounts with them. For parties maintaining only current accounts, proper inquiries are to be made from their regular bankers about their antecedents.
    • LCs should only be issued on security forms.
    • Large LCs should be issued under two authorized signatures, with one being from the Head/Controlling Office. 
    • LCs should not be for amounts disproportionate to actual requirements and should only be issued after ensuring that the borrower has adequate financial resources. 
    • When borrowers have banking arrangements on a consortium basis, LCs have to be opened within the sanctioned limit on the basis of the agreed share of the banks. 
    • In the Master Circular No. Dir. BC.11/13.03.00/2015-16 issued on 01.07.2015 on Guarantees and Co-acceptances (available here), the RBI issued the following precautions to be taken by banks while issuing LCs: 
    • Banks are recommended to not extend non-fund based facilities, additional/ad-hoc credit facilities or discounted letters of credit to people who are not their regular clients. 
    • They are advised to be extremely vigilant in scrutinising the documents to ensure their strict conformity to the LC and in releasing payments to foreign suppliers. 
    • Banks are also to take action against their officials, the importer and the exporter in case of a criminal conspiracy regarding a fraudulent LC. 
    • Banks have to honour their commitments under LCs and make payments promptly. 
    • Export performance guarantees are not to contain any clauses that could allow them to be used as standby LCs. 
    • Standby LCs are not to be issued on behalf of wholly owned subsidiaries, overseas joint ventures or wholly owned step down subsidiaries of Indian companies for raising loans or advances except in the normal course of overseas business. 
    • The RBI also prescribes adherence to the directions and regulations issued under the Foreign Exchange Management (Guarantee) Regulations, 2000. 
Moreover, in Master Direction No. 17/2016-17 issued on 1.01.2016 and updated as on 12.1.2017 on Import of Goods and Services (available here), the RBI further lays down guidelines on advance remittances under LCs for the import of goods, merchanting trade transactions and the settlement of import transactions in currencies without a direct exchange rate. These are: 

    • All authorized banks are required to adhere to the UCP 600 while opening LCs for import into India.
    • The ‘For Exchange Control Purposes’ copy of the import license of the importer is required to be attached with an import LC. This has to be preserved until verification by an internal auditor.
    • An unconditional, irrevocable LC is required to be obtained from a reputed overseas bank or an AD-I bank in India for advance remittances in imports exceeding US$200,000 against a guarantee of a reputable international bank. If an importer cannot get this from an overseas supplier and an AD Category-I bank is satisfied with the importer’s track record, a standby LC is not required for advance remittances upto US$5,000,000.
    • Where an LC has already been used to cover the cost of goods short-supplied, damaged, short-landed or lost in transit, the AD Category-I bank can cancel theoriginal endorsement to the extent of the value of the lost goods and issue a fresh remittance for replacement imports if the insurance claim has been settled in favour of the importer.
    • All authorized banks are required to adhere to the UCP 600 while opening LCs for import into India.
    • The ‘For Exchange Control Purposes’ copy of the import license of the importer is required to be attached with an import LC. This has to be preserved until verification by an internal auditor.
    • An unconditional, irrevocable LC is required to be obtained from a reputed overseas bank or an AD-I bank in India for advance remittances in imports exceeding US$200,000 against a guarantee of a reputable international bank. If an importer cannot get this from an overseas supplier and an AD Category-I bank is satisfied with the importer’s track record, a standby LC is not required for advance remittances upto US$5,000,000.

What are the risks associated with LCs?

International letters of credit may be risky because of a number of reasons. Key reasons are as under

    • Bank Risk

    • Since the responsibility to pay is undertaken by the issuing bank, the exporter must ensure that the bank is financially dependable. Any guarantee of payment from a foreign bank that isn’t creditworthy is not useful.
    • Manipulation by Importer

      The onus of opening an LC is on the importer. While doing so, he might neglect to reflect the terms of the agreement or try to introduce his own clauses. The importer can also intentionally introduce conditions that are difficult to fulfil


    • Fraud Risk

      Fraud risk also arises as the importer can also send fraudulent LCs or get LCs issued from un-creditworthy banks.

      Thus, exporters must undertake a due diligence exercise must be undertaken to ensure that foreign banks which have issued letters of credit are genuine. It may not be prudent to accept letters of credit from importers without any verification of the issuing bank.

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