Documentary Credit A payment service with built-in security. Trade Finance

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1 Documentary Credit A payment service with built-in security Trade Finance 1

2 Faster and safer payments no matter where you do business The essence of Trade Finance is creating conditions for more profitable overseas trading, managing risk and clearing the way to effective financing of import and export. One of the most common Trade Finance instruments for establishing commitments between a buyer, a seller and their respective banks is the Documentary Credit (which we refer to as L/C, short for Letter of Credit, a commonly used synonym). In the following pages you will find a detailed description of it. At the same time we would like to help you develop a deeper understanding for the administrative and financial processes that concern the practical use of letters of credit and the various types that exist. It is important to get it right from the start and find the optimal balance between risk and cost. With enhanced process understanding, it is also easier to evaluate alternative payment and financing solutions for example Documentary Collections and Bills of Exchange. The greatest potential for savings lies in your ability to choose the right instrument for each unique situation to streamline your workflows into an effective whole. And it would be our pleasure to help you with this. Contact us at SEB so we can tell you more about how we can work together to develop your international trading with our method for process development the Trade Finance Value Chain. 2

3 Wherever you are, we can support your trade finance business. A payment service with built-in security L/Cs provide a payment service with built-in security for all parties involved, and are used primarily when the parties in a transaction are not familiar with each other or when, for some other reason, a Seller does not want to assume the financial risk associated with the Buyer or the Buyer s country. An L/C is a binding obligation on the part of the Issuing Bank to pay the Beneficiary (the Seller) a pre determined amount when he has complied with the terms of the L/C. The Seller is guaranteed payment even if the Buyer becomes insolvent. The Issuing Bank s obligation can be reinforced if the Beneficiary s bank confirms the L/C. By having the credit confirmed, the Seller avoids the commercial risk of the Issuing Bank refusing to honour the credit, as well as the political risks that may be inherent in the transaction, whether they arise from war, political disturbances, moratoria or new exchange regulations in the Issuing Bank s country. This is a brief explanation of an L/C. On the following pages we will go more into detail introducing the various parties in an L/C transaction and the relationship between them, a number of common terms used in connection with L/Cs and the rules and risks involved. 3

4 How do you open an L/C? The Buyer and Seller sign a sales contract, in which the payment terms include an L/C. 1 2 The Buyer asks his bank to issue an L/C in favour of the Seller. If the bank accepts, it assumes an independent credit obligation. The Issuing Bank then irrevocably guarantees that it will pay when the Seller has complied with the terms and conditions of the L/C. The underlying commercial transaction determines which documents will be presented under the L/C, what they should contain and the other terms and conditions of the L/C. The purpose of the L/C documents is to provide the bank information which, when compared with the terms of the L/C, allows the bank to decide whether or not payment should be made. 3 Most L/Cs are advised by the Issuing Bank through an Advising Bank, of which the Seller notifies the Buyer (the Beneficiary can also be advised of the L/C directly; see point 5). The Advising Bank can also be a Nominated Bank if it is asked to confirm the L/C and/or the L/C is made payable or negotiable with the Advising Bank. 4 Before the Beneficiary is advised of the L/C, the Advising Bank reviews the L/C to determine, among other things, its authenticity. If the L/C includes instructions to the effect that the Advising Bank must add its confirmation, the bank performs a credit analysis to determine whether or not the L/C should be confirmed. If the bank adds its confirmation, it assumes an independent obligation to pay the Beneficiary when the terms of the L/C are met. See also below regarding the various risks that L/Cs entail. 5 The Issuing Bank can advise the Beneficiary directly of the L/C without involving any other bank. In such cases, the Beneficiary should consult his bank regarding the authenticity of the L/C. 6 If the L/C currency differs from the national currency of the Buyer and Seller, or if the banks involved do not maintain accounts with each other, the Issuing Bank sends an authorisation to a Reimbursing Bank to pay the Nominated Bank when it has paid or negotiated the documents that have been presented. 4

5 BUYER 1 CONTRACT SELLER 2 L /C APPLICATION 5 L /C ADVICE 4 L /C ADVICE 3 L /C ISSUING BANK ADVISING BANK REIMBURSEMENT AUTHORISATION 6 REIMBURSING BANK 5

6 When is payment made with an L/C? The Seller ships the goods to the Buyer and produces the documents that are required under the L/C. 1 2 The Seller presents the documents to the Advising Bank. The documents are examined by the bank to determine whether or not they comply with the terms and conditions of the L/C. If the documents comply with the terms of the L/C, the bank will proceed depending on the obligations it has assumed and the type of L/C involved: Confirmed L/C The Confirming Bank pays or ensures and assumes responsibility for payment on the maturity date in accordance with the terms of the L/C. Unconfirmed L/C, payable by or negotiable with the Advising Bank The Advising Bank in this case is also the Nominated Bank and has the right to approve the documents and determine the Issuing Bank s payment obligation. If the bank exercises its right, it takes responsibility for ensuring that the documents comply with the terms and conditions of the L/C. Note that an Advising Bank does not have any responsibility for payment under the L/C if the Issuing Bank does not pay due to political events or its own insolvency. 4 The Buyer obtains the documents and pays the amount stated in the contract he signed with his bank. 5 If the Beneficiary has been advised directly of the L/C and no other bank has been nominated, the Beneficiary can send the documents directly to the Issuing Bank or ask his bank to serve as his agent. In addition, the Beneficiary always has the right to send the documents directly to the Issuing Bank if for some reason he neither can nor wishes to present them to the Nominated Bank. If the Beneficiary decides not to use the Nominated Bank, all time limits expire at the desk of the Issuing Bank. If the L/C is confirmed, however, the documents must be presented to the Confirming Bank in order for the confirmation to apply. 6 If the Advising Bank has negotiated/effected payment against the documents that have been presented, it requests payment from the Reimbursing Bank, if such has been nominated. 3 The documents are sent to the Issuing Bank, which examines them. If the documents comply with the terms and conditions of the L/C, the Issuing Bank is unconditionally liable for payment in accordance with the terms of the L/C. 6

7 BUYER 1 GOODS SELLER 4 DOCUMENTS 5 PAYMENT 2 DOCUMENTARY PRESENTATION PAYMENT DOCUMENTS PAYMENT ISSUING BANK DOCUMENTS 3 ADVISING BANK TRANSFER OF FUNDS 6 TRANSFER OF FUNDS REIMBURSMENT AUTHORISATION TRANSFER OF FUNDS 6 CLAIM FOR PAYMENTS REIMBURSING BANK 7

8 How is an L/C designed? Regardless whether you are a Buyer or Seller, an L/C is a vehicle for facilitating a commercial transaction. The role of the banks is to assume a portion of the transaction risk, and to ensure that both parties meet their obligations. The terms of the L/C should be stipulated in the commercial contract. An ideal L/C has simplified terms and conditions and few documentary requirements but still provides the Buyer with reasonable security that the contracted goods have been shipped. It is vital that the terms of the L/C are included in the contract between the Buyer and Seller. The following points are particularly essential: Time limits The various time limits in the L/C must be set in such a way that there is enough time for the goods to be produced and shipped and for all documents to be put together and presented. Delivery terms These should comply with Incoterms. When indicating the place of shipment, avoid being overly precise, as this may prove to be an ob stacle later on in meeting the terms of the L/C. The destination, on the other hand, must be stated with exactitude so that the Buyer receives the goods at the desired location. Payment terms The payment terms of the L/C should be based on the commercial terms of the contract. Immediate payment is called at sight. If the Seller gives the Buyer credit, this can be expressed as payment a certain number of days after shipment or after presentation of the documents. Transhipment Since modern transport services often require transhipments these should be permitted. Partial shipment Unless there are good reasons to prohibit them partial shipments should also be permitted. Tolerance Is a tolerance needed for the quantities in question and/or the monetary amounts? Bear in mind that an L/C which rohibits partial shipments and where the quantity is hipped in full, at least 95 percent of the L/C amount must be drawn. Payable/Negotiable There is a conflict of interest here between the Buyer and Seller. The Seller naturally wants to be paid when he presents the documents to his bank, while the Buyer wants to wait as long as possible before paying, i.e. have the L/C payable at the Issuing Bank. Sometimes there are reasons to have the L/C payable at the Issuing Bank, but normally it is payable at, or at least negotiable at the Seller s bank. Documents The L/C should require presentation of as few documents as possible. An invoice and a transport document are usually required at a minimum. Depending on the delivery terms, insurance documents may also be necessary. In addition to these three documents, a certificate of origin, certificate of quality, certificate of inspection, etc. may be added. These other documents will depend primarily on the import regulations and procedures of each country, although they may also be included as means of increasing the Buyer s security. However, avoid including documents that are not needed to demonstrate that the requested goods have been delivered. Packing lists and other information that the Buyer may need serve no purpose in an L/C transaction. The greater the number of documents that have to comply with the L/C terms, the greater is the likelihood of a discrepancy arising. 8

9 What does the Seller do when he receives an L/C advice? Measures to be taken by the Beneficiary and the division of responsibilties are contingent upon the company s organisation. There are certain general recommendations, however: If the L/C is advised directly from the Issuing Bank or by a foreign bank that the company has no relationship with, the company should consult its own bank to verify the credit s authenticity. Check the L/C against the underlying con tract: are the goods correct, as well as quantities, times, delivery terms, payment terms, etc.? Can delivery be made within the time frame stipulated in the L/C? Can shipment be made in accordance with the terms? Can the documents be produced and pre sented within the required time limits? Note especially whether the documents need to be legalised by an embassy or other authority. Are there any documents that have to be produced by third parties? Verify that this can be arranged. If a third-party inspection is required, make an appointment. Are you familiar with all the documents that have to be presented? If not, get a sample of those that are unfamiliar. Are all the terms clear? If there is any doubt, consult your bank for an interpretation and, if necessary, advice as to how the documents should be drafted. If there are any terms in the L/C that cannot be met with certainty, do not conform to the underlying contract or are unacceptable, the Beneficiary must contact the Buyer and ask to have the terms of the L/C amended. In many countries the amendment of an L/C is contingent upon an import licence which can slow down the process. What should the Seller do before he presents the documents to the bank? Before the documents are sent to the bank, the Seller must verify that they comply with the terms and conditions of the L/C. If there is any doubt, consult your bank for an interpretation. It is impossible to draw up a complete checklist here, but the following general recommendations may be of help. Check to ensure that: You have the correct number of original documents and copies. The descriptions of the goods in the invoice and L/C are compliant. Other designations and specifications that are used in the L/C are included in the correct documents. The correct quantities have been shipped. The various documents do not contain any contradictory information. Signing of the documents as per the L/C rules and the conditions in the L/C. 9

10 Which rules and laws govern L/Cs? L/C instruments have been used internationally since the beginning of the 20th century. Since the 1920 s, international rules have applied to their use. The rules are set by the International Chamber of Commerce (ICC), based in Paris. The rules were revised by the ICC s Banking Commission in The current rules are contained in ICC Uniform Customs and Practice for Documentary Credits, publication no. 600, (UCP 600). Since January 2003, the International Standard Banking Practice for the examination of documents under documentary credits (ISBP-publication no. 645) has provided a practical complement to UCP publication no It does not amend the UCP, but provides more details as to how the rules are to be applied on a day-to-day basis. It has been updated and aligned with UCP 600. The revised version is called ISBP publication No 681. The rules are globally acknowledged. The rules are not laws and, in the event of a conflict, local law always takes precedence. Experience has shown that most courts of law have great respect for the rules. Note that in any discussion of the interpretation of the rules, the English original text should be used, since a translated version might not be considered official. What is a document examination? An obligation to pay under an L/C is determined solely on the basis of the contents and formulation of the documents that are presented. They must comply with the terms and conditions of the L/C. In addition to the text of the L/C, the ICC s rules must always be taken into consideration. If there are any contradictions between the wording of the L/C and the rules, the L/C s wording applies. According to the rules, the banks involved assume no responsibility for the authenticity of the documents that are presented. They examine the documents according to UCP 600, the L/C and international standard banking practice. Banks, for example, do not have to verify the various sections of the transport documents that contain the transport contract or check the calculations in the invoices. Discrepancies in the documents If the Nominated Bank finds a discrepancy in the documents when compared with the terms of the L/C, the documents are rejected. The Beneficiary must correct the documents and resubmit them if this is feasible. The corrected documents must be resubmitted within the deadline specified in the L/C, and in accordance with the UCP 600. If the documents cannot be corrected, the Beneficiary has to decide whether they should be sent to the Issuing Bank for approval under the L/C. The Issuing Bank then contacts the Buyer to obtain approval for the payment. Note that the documents should not be sent for collection, but rather for approval under the L/C. If the Issuing Bank, after the Buyer s approval, accepts the documents under the L/C, the Issuing Bank reassumes the obligation to pay. What is a discrepancy? In simple terms, a discrepancy is anything that does not comply with the terms and conditions of the L/C. Many discrepancies, such as late presentation of documents, an obvious inaccuracy in a document, etc. are not disputed by the parties involved. Others, however, can give rise to discussion. Is a typing error a discrepancy? Yes and no. If there is a spelling mistake in a company name, it may very well signify a different company. An error in a description of goods in the invoice should probably be regarded as a discrepancy, while a typing error in a more general description can frequently be disregarded. There are two doctrines when it comes to document examinations that they should agree exactly, or that they should agree essentially. We subscribe to the latter doctrine, which means, among other things, that we do not purposely look for errors; our concern is that the stipulated terms have been met. This also means that any supplementary information that is usually always included with the documents will not affect our decision, provided it does not directly contradict the other information in the documents. The doctrine to which a particular bank adheres depends upon how L/C disputes are resolved in its country s courts. In other words, there are no simple answers to the question of what constitutes a discrepancy. According to the rules, the banks determine this. Obviously, the Beneficiary has the right to challenge the banks assessments, while the banks always have to specify the basis for their rejections. Moreover, the bank must indicate any discrepancies that it claims to have identified in its first decision. It may not subsequently add new discrepancies for the same set of documents. 10

11 Various risks in connection with L/Cs When an L/C is issued, the Seller no longer faces a commercial risk vis-à-vis the Buyer. The risk has been shifted to the Issuing Bank. The country risk, also called the political risk, still remains. This can best be described as the risk that the Issuing Bank, due to a political decision or act of war, is prevented from fulfilling its obligations. The Seller can shift this risk to his own bank by having the L/C confirmed. The Seller then is left with only a transaction risk, which can be difficult enough to handle at times. This means having the goods produced and shipped on time and producing the documents on time and in accordance with the terms of the L/C. Counterfeit L/Cs and documents Counterfeit L/Cs do occur on the market. Usually, they come directly from the Seller without having passed through the Seller s bank. In general they also contain certain characteristics that give them away. Never hesitate to consult us, so that we can verify the authenticity of your L/C. The greatest risk for the Buyer is that the Seller is presenting falsified documents and that the goods have not been shipped. When working with a new supplier with whom the Buyer is unfamiliar, the terms of the L/C should be formulated with caution. There are various ways of protecting the Buyer, for example, by having a neutral party inspect the goods when they are loaded and issue a certificate that is presented along with the other documents required for in the L/C. The risk of receiving inferior quality can be handled via an inspection or by requiring the Seller to present a bank guarantee with the L/C documents. Goods consigned directly to the Buyer A risk that is often overlooked is that the Seller cannot present the correct documents. If this happens, the banks are not liable to pay and the documents remain in the Seller s possession. Despite this, the Buyer may have already received the goods. The situation is further complicated if the Buyer refuses to give the Issuing Bank permission to accept the documents and pay. He may want to exploit the situation and renegotiate the price or obtain a credit. The issue now needs to be resolved without the help of the banks, solely on the basis of the commercial agreement. If the L/C requires the goods to be shipped directly to the Buyer by any other means than sea transport, the goods will be delivered directly, without any documents being presented, unless this is prohibited by the country s import regulations. The same situation arises with sea cargo if one original bill of lading is sent directly to the Buyer and is consigned or has been endorsed to him. To avoid this risk, the goods should always be consigned to the Issuing Bank (who will often request this anyway). If the Issuing Bank in any way gives the Buyer, or anyone else, the opportunity to take possession of the goods, the Issuing Bank assumes responsibility for payment. 11

12 Back-to-back L/Cs The term back-to-back L/C is actually misleading, since there is no special back-to-back L/C. The term refers to a situation in which an L/C first is issued in favour of the trader/middleman by the ultimate buyer (L/C A). The trader uses his L/C as means by which he requests a bank to issue a separate L/C on his behalf in favour of the supplier (L/C B). This is so that the original shipping documents from the supplier can be submitted under the Seller s L/C, after the invoice and other documents have been replaced if necessary. However both L/Cs are completely separate obligations without any connection, and are governed by ICC s rules and other laws.

13 Transferable L/Cs An L/C can be made transferable by the Issuing Bank. This means that the Beneficiary can request that the Nominated Bank transfers the rights to all or part of the L/C to one or more Second Beneficiaries. The bank then transfers the right to draw the desired amount to the second beneficiary(ies) upon presentation of the documents in accordance with the terms of the L/C. The terms of the transferred L/C must be the same as the original L/C apart from the fact that the validity period and period of presentation may be reduced and that the amounts involved may be adjusted so that the terms of the transferred portion and the original L/C concur. The First Beneficiary may replace the Second Beneficiaries invoices and bills of exchange with his own; other documents must be used as they were presented. The Nominated Bank has the right to submit the Second Beneficiaries documents to the Issuing Bank if the First Beneficiary is unable to submit his own invoice and bill of exchange. Transferable L/Cs are useful when a Seller is using a supplier. The transferred L/C does not involve the first Beneficiary in a credit obligation, and therefore is not charged against his other commitments with the bank. L/Cs as financing instruments By accepting a usance credit, the Seller can give the Buyer a supplier s credit that is guaranteed by the Issuing Bank and, for confirmed L/Cs, the Confirming Bank as well. After the documents have been approved by the banks, the Seller may be able to have his receivables discounted by his bank or in the open market if he wishes to. If the Seller needs credit during the manufacturing stage, this can be arranged by including the possibility of advance payment in the terms of the L/C. The advance can be paid either against an advance payment guarantee, presented in accordance with the L/C, or against a simple receipt. In the latter case, the Buyer assumes a credit risk with respect to the Seller. This is also known as a Red Clause L/C. The expression Red Clause dates back to the times when this term was written in red ink so that it could be seen clearly. In many parts of the world, the Seller s bank frequently uses the L/C as added security in order to grant financing during the manufacturing stage. 13

14 Glossary of technical terms listed alphabetically Advising Bank The bank that advises the L/C at the request of the issuing bank. Applicant Means the party on whose request the L/C is issued. At sight Payable upon presentation of documents. Generally at sight L/Cs contain instructions as to how the proceeds should be paid, which may involve a delay of several days. Back-to-Back Arrangement whereby a Seller holding an L/C asks his bank to issue a matching L/C in favour of his supplier. Beneficiary Means the party in whose favour an L/C is issued. Normally the Seller. Bill of Exchange An unconditional order to pay a determinate sum of money and if accepted by the paying party - an irrevocable obligation to pay, either on demand, or at a set time. Confirming Bank Bank that adds it confirmation to an L/C upon the issuing bank s authorization or request. Usually the Advising Bank, although it may also be another bank. Confirmation of an L/C Means a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying presentation. Deferred Payment Payable at a future date. Discrepancy Disparity between the contents of the documents and the terms and conditions of the L/C. Draft Demand for payment. Expiry Date An L/C s expiration date, i.e. the latest date on which the documents can be presented. Irrevocable A credit is irrevocable even if there is no indication to that effect. It cannot be cancelled or amended during its validity period without the approval of all parties involved. Issuing Bank Bank that issues the L/C and has an independent obligation to pay when the terms of the L/C terms are complied with. Latest Date of Shipment Latest date on which the goods may be shipped, i.e. the transport documents must be issued or, when applicable, shipped on board no later than this date. Negotiate Means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank. Nominated Bank Means the bank with which the L/C is available or in any bank in the case of a credit available with any bank. Partial shipment If a partial shipment is permitted, the L/C may be utilised for several shipments, up to a maximum of the amount in the L/C or a specific quantity of goods. Payment terms These specify when the Beneficiary will be paid, e.g. at sight or 180 days after shipment. Period of Presentation Maximum time allowed from shipment until the documents are presented to the Nominated Bank. If no time is stipulated, the period of presentation is 21 days. 14

15 Place of Expiration Location where the L/C s validity period expires, i.e. the place where the documents can be presented until expiry date. Reimbursing Bank Bank that has been provided with the Issuing Bank s authorisation to debit its account and pay the Nominated Bank when it has paid for/ negotiated the documents. Silent confirmation If no bank has been instructed to add its confirmation, the Beneficiary may ask the Advising Bank to issue a so-called silent confirmation. A silent confirmation is not governed by the ICC-rules, it is a separate agreement outside of the L/C. Transferable L/C The First Beneficiary has the right to transfer all or parts of the L/C to one or more Second Beneficiaries. Transhipment If transhipment is allowed, the goods may be transhipped during transport from the place of shipment to the destination. Certain transport documents showing transhipment are acceptable to banks even if prohibited according to the L/C. Usance Credit L/C payable at a future date. Can be expressed as deferred payment or XX days sight. In essence, the Seller has given the Buyer credit. Validity Period Period of time during which the L/C is valid. XX Days Sight Payable XX days after presentation of documents. Further information Would you like to know more? Please contact your local SEB representative or send an to tradefinance@seb.se The Benche an online community for trade professionals Meet the best experts, gain new knowledge and share your experiences at This information-brochure is produced by Skandinaviska Enskilda Banken AB (publ) for corporate customers only. Information and opinions contained within this document are given in good faith and are based on sources belived to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any direct or consequential loss resulting from reliance on this document. Changes may be made to opinions or information contained herein without notice. 15

16 SE Blomquist & Co.