LC is a very familiar term that you know it very well, that if the buyer fails to pay then Bank will pay, but how true and simple is that !!!!
In actual LC is called the documentary Letter of Credit so we will coin the Documentary Credit or Documentary LC in this article.
LC is the game of 4 Players
1. Applicant - An importer who gives application to Open an LC to his bank.
2. Issuing Bank - Opening Bank of Importer who opens an LC for the importer
3. Beneficiary - Exporter who will get the benefit of money once he follows Documentary LC terms.
4. Advising Bank - Exporters Bank who is also called Negotiating bank whose role is to forward the documents to Issuing Bank.
Now there is not much problem if this game remains with these 4 players but in this game, there are some more hidden players who could act as a spoiler if precautions not taken.
Conforming Bank - Its the bank who conforms and takes the guarantee and pays the money to an exporter who has done the proper formalities done of Documentary LC.
Q. Are Issuing Bank / Opening Bank [Bank of Importer] Called Conforming Bank?
A. No, Not Necessary, Generally issuing bank may select the Conforming Bank as per their choice who might not be that strong financially.
So what should be done to safeguard the interest of Exporter?
A. The exporter may select the conforming bank of his choice, that is he must only accept the Documentary LC once he finds the Conforming bank Strong and reputed.
Let us understand this by an example.
Suppose A is a very reputed and credible bank in the USA. Buyer Opens LC from A Bank. Exporter Accepts the LC because he finds the A issuing bank as safe but in actual if A opt for conforming bank as B, then B would be liable for the money, in that normal course B has to pay money to the exporter at first and then he has to get the funds from the issuing bank A. Now if Conforming Bank B defaults then it would be very difficult to generate the funds from A Bank as they would be shooting up with the discrepancies in the LC.
So How to Safeguard the Interest of Exporter, How Exporter could be safe?
A. The exporter may opt for the conforming bank [in his own country] as the same bank in which he has his own current account. Yes, our Indian bank, Exporter's bank [Advising bank] could be the conforming bank. Once it's confirmed by them its called the "Confirmed Documentary Letter of Credit". If conforming bank in India is reputed then we can take the control in the deal as we are the captain of SWIFT as we have an account there and can bind Conforming and Issuing Bank to pay us. In this case, we as an Exporter are better secured.
Now let us understand the types of LC.
1. Irrevocable Documentary LC - The Draft / Order can not be cancelled without the permission of Exporter once executed than its called Irrevocable LC. Now you must understand that you must also make it "Irrevocable and Confirmed Documentary Letter of Credit". Confirmed by the reputed bank [Recomanded for Startups]
2.Revocable LC - One of the most unsafe LC as buyer can cancel the deal anytime based on his wish.
3. Transferable LC - Beneficiary [Exporter] could be transferred, in this case, the 1st Beneficiary has to tell to Applicant [Buyer] about the 2ed Beneficiary, Buyer will amend the draft and he will resend again, in this case, the 2ed Exporter is exposed to the buyer so there are chances that Buyer may prefer to order from 2ed Exporter for the future deals.
Q. Can Transferable LC be irrevocable and Conformed? - Yes it could be "Irrevocable, Transferable and Conformed Documentary Credit"
4. Revolving LC - For long terms deals, frequent opening of LC from buyers end is not practically possible, so the buyer may prefer revolving documentary credit which could be prolonged to a year or two.
5. StandBy LC - In such documentary LC, the Applicant [Buyer] does not emphasise on shipping docs, the only exporter can submit in his letter pad that he has done the formalities of Documentary Letter of Credit, SBLC are generally never conformed and are not safe for startups.
There are many such Documentary LCs like Green Clause LC or Red Clause LC which are outdated and are normally not used in the trade. In the Green Clause LC some claused are written with green ink which narrates the pre-shipment finance to be given to Exporter for shipment with the conformation of Buyer and its Bank in writing which is considered as collateral. Same is with Red Clause LC demanding Post shipment finance with red ink in Documentary LC. There are also many kind of LC such as Back to Back LC which is not the title or type of LC but its open twice which is coined at the end portion of this article.
There is sub types in LC
1. At Sight - Its the DP with Bank Guarantee
2. Deferred Payment - Usance LC like DA with Bank Guarantee
Now kindly understand why we are using the word "Documentary LC" again and again in this article? - It's not only about this article but even in actual in every LC its written Documentary LC as we all know that Banks only Deal with the documents but not with the goods.
A. As per the UCP and ISBP, The issuing Bank only has to check the documents and if it's fine they will release the funds. Now understand the difference between the check and verify. UCP and ISBP say that Bank is not the Judge nor can act as a Judge. Banks could only be forced to verify and check the transport documents with the tired party, else for other documents like certificate of Inspection, Certificate of Origin, Insurance bank will check but may not verify with other agencies. In such a case, the importer may lose his money and may not receive any proper goods.
Then how Importer could be safe in LC?
A. As per UCP and ISBP Guidelines, banks get 5 days to check the documents and verify the BL or Airwaybill, now importer has to understand he can take the copies of other docs like inspections and insurance and can verify it from the issuing agencies, an importer can also conduct survey at port and he has to set the LC expiry date long so that before signing the bills of exchange he may refuse to take the delivery of goods if found defective by the survey company but at the same time this goods must be rejected by the custom or government bodies like DGFT, moreover 5% tolerance has to be accepted by the importer if its in measurable units of KG. Else if tolerance 5% will not be allowed if Invoice and packing list Qty is in Pcs, how tolerance of 5% could be allowed in price per PCS [pieces] deal?
Now there are Key Points in the Documentary LC you must know
1. The bank is not the judge, whatsoever about the contract written in LC especially related to goods banks will only check that such things are written in docs, if they find the docs correct in terms of written description based on the draft they will release the funds i.e one has to understand that UCP and ISBP also instruct the banks to keep LC away from more contract terms in LC as banks deal only with documents but not with the goods, moreover they will take little effort the BL to verify from shipping line, for other docs bank may not be forced verify from respective agencies.
2. Advising bank could be Conforming Bank, Negotiating Bank, Nominated Bank and Reimbursing Bank, all at the same time.
3. When any Advising Bank could be used such LC issued by issuing bank is called Fully Negotiable LC it could be very risky if it remails conformed by Non-reputed bank or remains un conformed.
4. LC could not be termed as the sales contract based on UCP and ISBP guidelines. The documentary credit must be seen essentially as a tool to facilitate the process of payment against the performance as evidenced by the documents presented
5. As per ICC: An issuing bank should, therefore, discourage or reject any attempt by the applicant to include excessive details of the contract in the Letter of Credit.
6. 21 Calander days are there in the exporter's hand to submit the required documents to the buyer after the latest shipment date.
7. If latest shipment date missed then BL submitted to the bank would be considered as stale BL and payment would not be made.
8. Even if Insurance not mentioned in List of Docs required from Buyer, then also Exporter has to present the Insurance copy if deal done on CIF Incoterms.
9. The role of the nominated bank is to receive the documents from the exporter and forward it to the issuing bank, the exporter bank could not be liable for any missing of documents or payment delay or payment failure unless it's also the conforming bank.
10. If Non-Negotiable BL demanded in LC and god forbids if goods get cleared from the port without payment or docs then banks could not be held liable in case of such cases, so always make sure BL must be marked "To ORDER of Bank"
At End lets discuss......
Back to Back LC.
When Exporter does not have funds and received LC then he may give this order to another exporter and earn comission or brokrage from another exporter. In Transfarable LC the buyer is exposed to seller as buyer only have the right to change the beneficiary in LC. But in case of Back to Back LC buyer remains the secret Hidden for the exporter.
4 Basic Steps in Back to Back Documentary LC.
1. Exporters receive "irrevocable and conformed documentary credit at sight" from buyer's bank
2. Exporter asks his bank to open the 2ed "irrevocable and conformed documentary credit at sight" in favour of the local supplier.
3. Banks open another LC based on 1st LC collateral so it's called Back to Back LC [2ed LC Opened], in this the supplier will not know the buyer as local supplier cant sees 1st LC.
4. The exporter will send the goods to buyer sourced from a local supplier in credit, as he receives funds he would be paying back to the supplier
The Practical Challenges in Documentary LC
-> Inspite of Back to Back, most of the bank is demanding the security of money as par with the bill for startups because it might be possible that startup take the goods from a supplier and sell locally so the bank is not taking any risk.
-> Most LC comes from countries like Bangladesh, Iran, Africa are un-conformed. No bank is able to take any security of money so trade with them remains risky.
-> Many countries like Ghana have lost the trust in banks in modern times because of more bank defaults people are worried and saying that their money are not safe in banks, so they are using mobile wallets and mobile money more https://qz.com/africa/1662059/ghana-is-africas-fastest-growing-mobile-money-market/
-> Even if banks do not get default due to clash between the issuing and confirming banks the funds of exporter gets struck. At the end, the exporter is being given with discrepancies in LC, which proves to be a very expensive loss for the exporter.
-> After most powerful AAA rating bank in the USA : Lehman brothers bank bankrupt and collapse, no one is able to trust any company [thomas cook famous company collapse] or bank.
Cordially Yours,
Kishan Barai