Understanding Letter of Credit (LC) and Its Operation in Apparel Industry
Noor Ahmed Raaz
Faculty Member, Dept. of Textile Engineering,
Atish Dipankar University of Science & Technology
Letter of Credit or L/C:
L/C means Letter of Credit. A letter of credit is a document issued by a financial institution, or a similar party, assuring payment to a seller of goods and/or services provided certain documents have been presented to the bank. Letter of credit is a guarantee given by the buyer’s bank to pay the amount to the seller’s bank on maturity. L/C helps in avoiding risk by having intermediate buyer and seller bank that ensure proper payment. A key principle underlying letter of credit (L/C) is that banks deal only in documents and not in goods. LC (Letter of Credit) is the familiar word in apparel industry. L/C set up is the work of merchandising section in apparel industry. A merchandiser should have clear concept on letter of credit. Letter of Credit (L/C) also known as Documentary Credit is a widely used term to make payment secure in domestic and international trade.
The International Chamber of Commerce (ICC) in the Uniform Custom and Practice for Documentary Credit (UCPDC) defines L/C as:
“An arrangement, however named or described, whereby bank (the Issuing bank) acting at the request and on the instructions of a customer (the Applicant) or on its own behalf.”
Actually, LC is such kinds of commercial letter which a bank issue on behalf of foreign seller (exporter) according to the direction of the (importers) purchasers. The documents shown under are known as export documents form the importer’s side. These are:
- Bill of exchange
- Bill of lading
- Airway bill / Railway receipt
- Commercial invoice
- Insurance policy
- Certificate of origin
- Packing list
- Bill of entry
A short description of above business terms is given below:
1. Bill of exchange:
The bill of exchange is that particular instrument through which payment is effected in trade deals internal and international. The payment for the goods is received by the seller through the medium of a bill of exchange drawn on the buyer for the amount depending on the contract. It is a negotiable instrument. There are five main parties involved in a bill of exchange. They are:
2. Bill of lading:
A bill lading is a document of title to goods entitling the holder to receive the goods as beneficiary or endorsee and it is with the help of this document on receipt from the exporter that the importer takes possession of the goods from the carrying vessel at the port of destination.
3. Airway bill / Railway receipt:
When goods to be transported are small in bulk or requiring speedy delivery or those are perishable in nature on the deal is in between the neighboring countries then mode of transports other than shipping may be resorted to far the carriage of the goods Airways bill / Railway receipt take place of Bill of lading depending on the nature of the carrier.
4. Commercial invoice:
It is the seller’s bill for the merchandise. It contains a description of goods, the price per unit at a particular location, total value of the goods, packing specifications, terms of sale, letter of credit, bill of lading number etc. There is no standard form far a commercial invoice. Each exporter designs his own commercial invoice form. The invoice is made out by the seller under his signature in the name of the buyer and must be submitted in a set of at least 3 copies. Its main purpose is to check whether the appropriate goods have been shipped and also that their unit price, total value, marking on the package etc. are consistent with those given in other documents.
5. Insurance policy:
In the international trade insurance policy is a must to cover the risk of loss on consignments while they are on seas, roads, airways. The insurance is the responsibility of the buyers (consignee) under FAS, FOB and C&F contracts and of the seller (consignor) under CIF contract. The policy must be of the type as specified in the relative contract / credit. The policy would be for the value of CIF price plus 10 (ten) percent to cover the expenses and that is required to be obtained in the same currency as that of the credit and dated not later than the date of shipment with claims* being payable at the destination. It must be properly stamped. Like a bill lading it must be negotiable and be endorsed where it is payable to order.
6. Certificate of origin:
This is a certificate issued by a recognized authority in exporting country certifying the country of origin of the goods. It is usually by the Chambers of commerce. Sometimes, it is certified by local consul or Trade Representative of the importing country as per terms of the credit.
7. Packing list:
The exporter must prepare an accurate packing list showing item by item, the contents of the consignment to enable the receiver of the shipment to check the contents of the goods, number and marks of the package, quality, per package net weight, gross weight, measurement etc. Weightment and measurement: Issued by recognized authority (like chambers of commerce and industry) in exporting country certifying correct weightment and measurement of the goods exported.
8. Bill of entry:
A bill of entry is a document which contain the particulars of the imported goods as well as the amount of customs duty payable.
The exporter submits the following papers/documents to the Negotiating bank:
- Bill of exchange / Draft.
- Bill of lading.
- Airway bill / Railway receipt.
- Commercial invoice.
- Insurance policy.
- Certificate of origin.
- Packing list.
- Weightment & measurement list.
- Other etc.
The negotiating bank after received the above documents / papers then this bank scrutiny the documents. The negotiating bank sends the original shipping documents to the L/C opening bank and keeping the second copy with the negotiating bank.
Types of Letter of Credit (LC):
An Import/Export Letter of Credit (popularly called Master LC) is used in international trade between buyers and sellers of different countries but Back to Back letter of credit can be used in both local and international trade. Let us get introduced with different types of letters of credit used in apparel export business:
Import/Export Letter of Credit
The same credit is termed as Import Letter of Credit or Export Letter of Credit. It depends on whose perspective it is being considered. For the importer it is termed as Import Letter of Credit and for the exporter it is termed Export Letter of Credit.
Revolving Letter of Credit (L/C)
Revolving letters of credit were a tool created to allow companies conducting regular business to issue a letter of credit that could “roll-over” without the company having to reapply, thus enabling business flow to continue without interruption as long as the terms and conditions, quantities, and other transaction details did not change.
Revocable Letter of Credit
Without the authentication of the seller/exporter(beneficiary), buyer/importer (applicant) can cancel or make any amendment of this type of Letter of Credit through the issuing Bank. This type of letter of credit is totally manipulated by the buyer. None accepts this type of letter of credit these days.
Irrevocable Letter of Credit
Without the authentication of the seller/exporter(beneficiary), buyer/importer (applicant) cannot cancel or make any amendment of this type of Letter of Credit through the issuing Bank. It can only be cancelled without the authentication of the seller/exporter (beneficiary) if it is expired. Exporters always prefer this type of letter of credit.
Transferable Letter of Credit
Transferable Letter of Credit is required when the exporter is middleman or agent (not the actual supplier) of the goods but buyer finds it valuable to work with this type of agent/middleman. This is also fact that sometimes agent/middleman does not want the buyer and supplier know each other. In this type of Credit, the exporter has the right to transfer the credit to one or more subsequent beneficiaries to procure the goods and arrange them to be sent to the buyer. Usually buying houses prefer this type of letter of credit.
Nontransferable Letter of Credit
The credit cannot be transferred to anyone by the exporter/beneficiary.
Confirmed Letter of Credit
An additional confirmation or guarantee that commits to payment of the letter of credit. A confirmed letter of credit is typically used when the issuing bank of the letter of credit may have questionable creditworthiness and the seller seeks to get a second guarantee to assure payment.
Unconfirmed Letter of Credit
This type of letter of credit, does not acquire the other bank’s confirmation.
Sight Credit and Usance Credit (L/C)
Sight credit states that the payments would be made by the issuing bank at sight, on demand or on presentation. In case of usance credit, as per agreement by both of the exporter/beneficiary and importer/applicant this type of letter of credit requires an indicated duration for payment instead of getting paid immediately after the valid documents are checked. By this time importer/buyer can take the opportunity to arrange money selling the goods.
At Sight Letter of Credit
As mentioned in this type of letter of credit, payment is made to the exporter/beneficiary immediately upon presentation of the correct document. Apparel exporter prefer this type of letter of credit.
Red Clause Letter of Credit
This is the specific type of letter of credit that carries a provision (traditionally written or typed in red ink) which allows an exporter/beneficiary to draw up to a fixed sum from the advising or paying-bank, in advance of the shipment or before presenting the prescribed documents.
Back to Back Letter of Credit
The Back to Back Letter of Credit (sometimes referred to as the Baby or Slave Letter of Credit) is issued on the strength of the Master Letter of Credit (Master LC). Back to Back Letter of Credit is issued by the exporter’s bank (advising bank) to the supplier to procure raw materials. Permission of the ultimate buyer or that of the issuing bank is not required to issue a back to back letter of credit.
Standby Letter of Credit (L/C)
The standby letter of credit is very much similar in nature to a bank guarantee. The main objective of issuing such a credit is to secure bank loans. Standby credits are usually issued by the applicant’s bank in the applicant’s country and advised to the beneficiary by a bank in the beneficiary’s country.
Operation Flow of LC in Apparel Industry:
The operation flow of an L/C is explained below with a line sketch in Fig.
- Once the buyer gives the purchase order to the seller (apparel company), then he approaches his bank (issuing bank) to open a LC.
- The bank instructs the seller to fill the form for opening an L/C. Along with required documents, copy of purchase order is enclosed for opening the L/C. Seller details, seller bank details are also clearly mentioned in the form.
- Once the buyer maintains the required margin amount, buyer’s bank issues the L/C to the exporter’s bank which is also known as advising bank or negotiating bank based on the role played by the bank.
- The exporter is advised by the exporter’s bank that L/C has been opened with him as the beneficiary and gives the L/C to the exporter so that he can start working the order and also use the L/C to arrange for pre-shipment funds.
- The exporter ships the goods once manufactured to the importer on the agreed terms of delivery and shipment mode along with invoice.
- Then the exporter submits all those documents to his bank and those documents are sent by his bank to the issuing bank to issue the payment.
- The issuing bank will check with the importer to ascertain that the goods are received by him as per L/C terms and conditions. On confirmation from the importer, the issuing bank accepts the bill for payment and pays the exporter’s bank.
- In case of more margin given to the buyer by his bank, it waits for the buyer to make the payment and then transfers the payment to the exporter’s bank.
- The exporter’s bank releases payment to the exporter and issuing bank releases all the original documents to the buyer thereby completing the transaction and L/C is closed.
Parties to Letters of Credit:
Applicant which is also referred to as account party is normally a buyer or customer of the goods, who has to make payment to beneficiary. LC is initiated and issued at his request and on the basis of his instructions.
Issuing Bank (Opening Bank):
The issuing bank is the one which create a letter of credit and takes the responsibility to make the payments on receipt of the documents from the beneficiary or through their banker. The payments have to be made to the beneficiary within seven working days from the date of receipt of documents at their end, provided the documents are in accordance with the terms and conditions of the letter of credit. If the documents are discrepant one, the rejection thereof to be communicated within seven working days from the date of receipt of documents at their end.
Beneficiary is normally standing for a seller of the goods, who has to receive payment from the applicant. A credit is issued in his favour to enable him or his agent to obtain payment on surrender of stipulated document and comply with the term and conditions of the L/C.
If L/C is a transferable one and he transfers the credit to another party, then he is referred to as the first or original beneficiary.
An Advising Bank provides advice to the beneficiary and takes the responsibility for sending the documents to the issuing bank and is normally located in the country of the beneficiary.
Confirming bank adds its guarantee to the credit opened by another bank, thereby undertaking the responsibility of payment/negotiation acceptance under the credit, in additional to that of the issuing bank. Confirming bank play an important role where the exporter is not satisfied with the undertaking of only the issuing bank.
The Negotiating Bank is the bank who negotiates the documents submitted to them by the beneficiary under the credit either advised through them or restricted to them for negotiation. On negotiation of the documents they will claim the reimbursement under the credit and makes the payment to the beneficiary provided the documents submitted are in accordance with the terms and conditions of the letters of credit.
Reimbursing Bank is the bank authorized to honor the reimbursement claim in settlement of negotiation/acceptance/payment lodged with it by the negotiating bank. It is normally the bank with which issuing bank has an account from which payment has to be made.
Second Beneficiary is the person who represents the first or original Beneficiary of credit in his absence. In this case, the credits belonging to the original beneficiary is transferable. The rights of the transferee are subject to terms of transfer.
Risk Associated with Opening Import L/Cs:
The basic risks associated with an issuing bank while opening an import L/C are:
The financial standing of the importer
As the bank is responsible to pay the money on the behalf of the importer; thereby the bank should make sure that it has the proper funds to pay.
Bankers need to do a detail analysis against the risks associated with perishability of the goods, possible obsolescence, import regulations packing and storage, etc. Price risk is the crucial factor associated with all modes of international trade.
There is always the risk of exporting inferior quality goods. Banks need to be protective by finding out as much possible about the exporter using status report and other confidential information.
These types of risks are mainly associated with the political and economic scenario of a country. To solve this issue, most banks have specialized unit which control the level of exposure that that the bank will assumes for each country.
Foreign exchange risk
Foreign exchange risk is another most sensitive risk associated with the banks. As the transaction is done in foreign currency, the traders depend a lot on exchange rate fluctuations.
Export Operations Under L/C:
Export Letter of Credit is issued in for a trader for his native country for the purchase of goods and services. Such letters of credit may be received for following purpose:
- For physical export of goods and services from India to a Foreign Country.
- For execution of projects outside India by Indian exporters by supply of goods and services from Indian or partly from India and partly from outside India.
- Towards deemed exports where there are no physical movements of goods from outside India but the supplies are being made to a project financed in foreign exchange by multilateral agencies, organization or project being executed in India with the aid of external agencies.
- For sale of goods by Indian exporters with total procurement and supply from outside India. In all the above cases there would be earning of Foreign Exchange or conservation of Foreign Exchange.
- Banks in India associated themselves with the export letters of credit in various capacities such as advising bank, confirming bank, transferring bank and reimbursing bank.
- In every case the bank will be rendering services not only to the Issuing Bank as its agent correspondent bank but also to the exporter in advising and financing his export activity.
Advising an Export L/C:
The basic responsibility of an advising bank is to advise the credit received from its overseas branch after checking the apparent genuineness of the credit recognized by the issuing bank.
It is also necessary for the advising bank to go through the letter of credit, try to understand the underlying transaction, terms and conditions of the credit and advice the beneficiary in the matter.
The main features of advising export LCs are:
- There are no credit risks as the bank receives a onetime commission for the advising service.
- There are no capital adequacy needs for the advising function.
Advising of Amendments to L/Cs:
Amendment of LCs is done for various reasons and it is necessary to fallow all the necessary the procedures outlined for advising. In the process of advising the amendments the Issuing bank serializes the amendment number and also ensures that no previous amendment is missing from the list. Only on receipt of satisfactory information/ clarification the amendment may be advised.
Confirmation of Export Letters of Credit:
It constitutes a definite undertaking of the confirming bank, in addition to that of the issuing bank, which undertakes the sight payment, deferred payment, acceptance or negotiation.
Banks in India have the facility of covering the credit confirmation risks with ECGC under their “Transfer Guarantee” scheme and include both the commercial and political risk involved.
Discounting/Negotiation of Export LCs:
When the exporter requires funds before due date then he can discount or negotiate the LCs with the negotiating bank. Once the issuing bank nominates the negotiating bank, it can take the credit risk on the issuing bank or confirming bank.
However, in such a situation, the negotiating bank bears the risk associated with the document that sometimes arises when the issuing bank discover discrepancies in the documents and refuses to honor its commitment on the due date.
Reimbursement of Export LCs:
- Sometimes reimbursing bank, on the recommendation of issuing bank allows the negotiating bank to collect the money from the reimbursing bank once the goods have been shipped. It is quite similar to a cheque facility provided by a bank.
- In return, the reimbursement bank earns a commission per transaction and enjoys float income without getting involve in the checking the transaction documents.
- Bank play an important role in payment on the due date (for usance LCs) or the days on which the negotiating bank demands the same (for sight LCs)
You may also like:
- Step by Step Execution of Garment Export Order
- L/C (Letter of Credit) Operation Chart
- How to Open Back to Back L/C in Garment Export Business
- Master Export LC Opening Process in Garment Buying House
- Factoring Finance in Apparel Sector: An Alternative to LCs
Founder & Editor of Textile Learner. He is a Textile Consultant, Blogger & Entrepreneur. He is working as a textile consultant in several local and international companies. He is also a contributor of Wikipedia.