Objective:
To provide bank staff with a clear understanding of the roles, responsibilities, and rights of each party involved in a Letter of Credit (LC) transaction, in accordance with international banking practices and regulatory frameworks.
1. Introduction to Letter of Credit (LC)
A Letter of Credit (LC) is a financial instrument issued by a bank on behalf of an applicant (buyer), guaranteeing payment to a beneficiary (seller), provided that the stipulated documents are presented in compliance with the LC terms. As a documentary credit, the LC operates strictly on the basis of documents, not the physical goods or services.
The functioning of LCs is governed by the Uniform Customs and Practice for Documentary Credits (UCP), published by the International Chamber of Commerce (ICC).
2. Key Parties and Their Responsibilities and Rights
1. Applicant (Buyer/Importer)
- Responsibility:
- Initiates the request for the LC through their bank.
- Provides full details of the transaction and required documents.
- Ensures availability of funds or credit limit to honor payment upon document compliance.
- Right:
- Entitled to receive the goods or services as per the agreed terms, following due payment against conforming documents.
2. Beneficiary (Seller/Exporter)
- Responsibility:
- Executes the trade contract by supplying goods or services.
- Submits stipulated documents (e.g., invoice, transport document, insurance, certificate of origin) to the nominated bank for payment.
- Right:
- Has the right to receive payment from the issuing or nominated bank, provided all LC conditions are met.
3. Issuing Bank
- Responsibility:
- Issues the LC at the request of the applicant.
- Provides an irrevocable undertaking to pay the beneficiary, subject to document compliance.
- Verifies documents for compliance and processes payment accordingly.
- Right:
- Entitled to reimbursement from the applicant for the amount paid to the beneficiary, along with applicable charges.
4. Advising Bank
- Responsibility:
- Advises (forwards) the LC to the beneficiary after authenticating its genuineness.
- Acts as a communication conduit between the issuing bank and the beneficiary.
- Does not assume any payment obligation unless specifically requested and agreed.
- Right:
- Receives advising charges for its services.
5. Confirming Bank (if applicable)
- Responsibility:
- Adds its confirmation to the LC, thereby undertaking to pay the beneficiary in addition to the issuing bank’s guarantee.
- Takes on payment responsibility upon presentation of compliant documents.
- Right:
- Receives a fee for providing confirmation, typically based on the risk associated with the issuing bank and country.
6. Nominated Bank
- Responsibility:
- Authorized in the LC to make payment, accept drafts, or negotiate documents on behalf of the issuing bank.
- Examines documents and either makes payment or forwards the documents to the issuing bank for reimbursement.
- Right:
- Entitled to reimbursement and service charges from the issuing bank or the applicant, depending on arrangements.
7. Reimbursing Bank
- Responsibility:
- Makes payment to the nominated bank based on reimbursement instructions from the issuing bank.
- Usually maintains an account relationship with the issuing bank.
- Right:
- Receives reimbursement from the issuing bank for the disbursed amount.
3. Additional Key Considerations
- Documentary Nature:
An LC is strictly document-based. Banks deal exclusively with documents, not goods, services, or performance of the contract. - Compliance:
All parties must adhere strictly to the terms and conditions specified in the LC, especially with respect to documentation and timelines. - Governing Rules (UCP 600):
The current version of the Uniform Customs and Practice for Documentary Credits (UCP 600) issued by the ICC is widely accepted and governs the operation and interpretation of LCs globally.
Conclusion
Understanding the distinct roles and responsibilities of each party in an LC transaction is essential for bank personnel involved in trade finance operations. Proper compliance with LC terms, careful scrutiny of documents, and adherence to ICC and RBI guidelines ensures smooth execution of international trade transactions while minimizing risk to the bank.
Disclaimer: The information provided herein is exclusively for educational purposes. The information is based on publicly available sources and subject to change. The author shall not be responsible for any direct/indirect loss or liability incurred by the reader for taking any financial/real estate decisions based on the contents and information. Please consult your financial advisor before making any financial decision.
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