Other Letters of Credit

1. Transferable Letter of Credit

Exporters often use transferable L/C to pay a supplier, while keeping the identity of the supplier and the foreign customer from each other, lest they conduct the next transaction without the exporter. This method is often used when the exporter acts as an agent or intermediary. Under a transferable L/C, the exporter (beneficiary) transfers the rights and certain duties, such as ship­ment, under the credit to another person, usually its supplier (transferee), who receives payment, provided that the conditions of the original credit are met. The bank requested by the benefi­ciary to effect the transfer is under no obligation to do so, unless it has expressly consented to it.

It is important to note the following with respect to such letters of credit:

  • A credit is transferred only if it is expressly designated as “transferable” by the issuing bank.
  • It can be transferred only once. The credit is automatically divisible and can be trans­ferred in fractions, provided that partial shipments are not excluded.
  • The name and address of the first beneficiary may be substituted for those of the buyer. This masks the identity of the true suppliers of the merchandise from the buyer.
  • The transferee receives rights under this type of L/C. Such a transfer requires the con­sent of the buyer and of the issuing bank.
  • The supplier might demand that the exporter actually transfer the letter of credit in its entirety, without substitution of invoices. The beneficiary (exporter) will receive a commission independent of the L/C transaction.

Example 1: A Canadian bank opens a transferable credit in the amount of $90,000 in favor of a U.S. exporter in Florida for a shipment of tomatoes. The exporter had located a supplier in Texas and had decided to use $85,000 of the credit to pay the supplier. The exporter asks the advising bank in Florida to ef­fect a transfer in favor of the supplier. The supplier is advised of the transfer by the advising bank. The new credit does not mention the amount of the original credit or the name of the foreign buyer but substitutes the name of the exporter (original beneficiary) as the buyer. When the supplier presents conforming docu­ments to the advising bank in Florida, the bank substitutes the exporter’s invoice for that of the supplier, pays $85,000 to the supplier, and pays the difference to the exporter. The advising bank forwards the documents to the Canadian bank, which has no knowledge of the transfer for reimbursement.

Transferable L/C is different from assignment of proceeds under the credit. In assignment, the exporter asks the bank holding the L/C to pay either the entire amount or a percentage of the proceeds to a specified third party, usually a sup­plier. This allows the exporter to make domestic purchases with limited capital by using the overseas buyer’s credit. This is done by assigning the proceeds from the buyer’s L/C. The beneficiary (exporter) of a letter of credit may assign its rights to the proceeds of the L/C, even if the L/C expressly states that it is nontransferable. Only the beneficiary (not assignee) has rights under the credit, and the overseas buyer as well as the issuing bank often has no knowledge of the assignment.

Example 2: A U.S. exporter has a letter of credit for $40,000 from a buyer in Brazil. The exporter had located a supplier within the United States that will sell the product for $25,000. However, the supplier would not release the product for shipment without some down payment or collateral. The exporter (assignor) could assign part of the proceeds ($25,000) from the L/C to the supplier (as­signee). The assignee will then provide the merchandise to the exporter, who will arrange shipment. The exporter (assignor) must submit documents that comply with the credit in order for the advising bank to pay the assignee (supplier). The remainder ($15,000) will be paid to the exporter.

2. Back-to-Back Letter of Credit

A back-to-back is issued on the strength of another letter of credit. Such credits are issued when suppliers or subcontractors demand payment from the exporter before collections are received from the customer. The back-to-back L/C is separate from the original L/C, and the bank that issued the former is obligated to make payment to suppliers regardless of the outcome of the latter. If there is a default on the original L/C, the bank is left with worthless collateral.

Example: A Japanese manufacturer (exporter) of cars has a letter of credit is­sued for 1,000 cars by a buyer in New York. Payment is to be made ninety days after shipment. However, subcontractors require payment to be made for spare parts purchased in ten days (earlier than the date of payment provided under the L/C). The Japanese exporter presents the buyer’s L/C to the advising bank in Tokyo and asks the bank to issue a new L/C to the subcontractor, payable in ten days. The first L/C is used as collateral to issue the second L/C in favor of the subcontractor.

3. Revolving Letter of Credit

Banks make available letters of credit with a set limit for their customers that allow for a free flow of merchandise until the expiry date of the credit. This avoids the need to open credits for each shipment. The value of the credit allowed can be reinstated automatically or by amendment. If credits designated for use during one period can be carried over to the next period, they are termed “cumulative.” They are noncumulative if any unused amount is no longer available.

Example 1: Queen’s Bank in Fort Lauderdale opens a revolving line of credit for up to $150,000 in favor of Kegan Enterprises, Inc., for the importation of handi­crafts. Kegan Enterprises agrees to purchase toys (for $50,000) from South Ko­rea and requests Queen’s Bank to open an L/C for $50,000 in favor of the seller in that country. If the credit provides for automatic reinstatement, $100,000 will be readily available for other purchases. In other cases, Kegan Enterprises will have to wait for approval from the bank, reinstating the credit ($100,000) to use for another shipment.

Example 2: Suppose Queen’s Bank opens a letter of credit of up to $15,000 a month for six months in favor of Kegan Enterprises. If the credit states that it is cumulative, $30,000 credit not used during the first two months could still be used during the next four months. If it is noncumulative, the credit not used dur­ing the two-month period cannot be carried over for use in the next four months.

4. Red-Clause Credit

Red-clause credits provide for advance payment to an exporter before presentation of ship­ping documents. It is intended to provide pre-export financing to an agent or distributor for purchase of the merchandise from a supplier. Financing conditional on presentation of negotiable warehouse receipts issued in favor of the advising bank is termed “green-clause credit.”

5. Deferred-Payment Credit

Deferred-payment credit is a letter of credit by which the bank undertakes an obligation to pay at a future date stipulated on the credit, provided that the terms and conditions of the credit are met.

Example: Suppose a U.S. buyer agrees to buy lumber valued at $40 million from a Canadian seller. The parties agree to use a deferred-payment credit. In this case, the U.S. buyer asks its bank to open (issue) a letter of credit obligat­ing itself to pay the seller sixty days after the date of the bill of lading. If the documents are as stipulated in the credit, the bank undertakes an obligation to pay the Canadian seller sixty days after the date of the bill of lading. No draft, however, need accompany the documents.

What are the major differences between an acceptance letter of credit and a deferred- payment credit?

In the case of acceptance credits, the bank undertakes an obligation to accept drafts drawn on itself provided that stipulated documents are presented. Assume that a Canadian seller and a U.S. buyer agreed to use an acceptance credit payable sixty days after presentation of shipping documents. Once the Canadian seller presents the requisite shipping documents and draft of the advising bank, the bank will stamp the draft “accepted” if it is in strict com­pliance with the credit. This represents the bank’s obligation to pay on the maturity date of the draft. Once accepted by the bank, the draft becomes a negotiable instrument that can be discounted by the accepting bank, enabling the seller to receive payment for the goods in advance of the maturity date of the acceptance. In the case of deferred-payment credits, no draft accompanies the documents. The agreement providing for the Canadian bank to pay the seller sixty days after the date of the bill of lading represents the bank’s undertaking of a deferred-payment obligation. In this case, no negotiable draft is generated, and there is no way to discount the bank’s deferred payment obligation. Any advance payment by the bank to the seller often requires a collateral or security interest in the proceeds of the deferred credit.

Such credits developed primarily as a way of avoiding charges and fees associated with acceptance credits.

6. Standby Letter of Credit

The standby letter of credit is generally used to guarantee that a party will fulfill its obligation under a contract. Such credits are opened to cover the account party’s business obligations to the beneficiary. A standby letter of credit is thus a bank’s guarantee to the beneficiary that a specific sum of the money will be received by the beneficiary in the event of default or nonperformance by the account party under a sales or service contract (Reynolds, 2003). Similar to the documentary letter of credit, a standby credit is payable against presentation of documents that comply with the terms of the standby credit. The documents required to be presented by the beneficiary often include a sight draft and the beneficiary’s written state­ment of default by the account party.

A major problem with such credits is that payments are often required to be made upon the issuing bank’s receipt of a signed statement by the beneficiary that the account party did not perform under the contract and that the credit is currently due and payable. There is a possibility of unfair and capricious calling in of the credit, despite the absence of default or nonperformance by the account party. To protect account parties under a standby credit from such unjustified demand by beneficiaries, the following steps are often recommended:

  • Include a clause under the credit requiring that the beneficiary present certification by a third party or court that default has occurred.
  • Take out an insurance policy that covers commercial and political risk. This would cover exporters against, inter alia, contract repudiation as well as unfair callings by private entities or governments.
  • Take out a surety bond issued by an insurance company (instead of a performance bond issued by a bank) to guarantee performance under the contract. Whereas banks honor a drawing under a standby letter of credit based on the face value of the benefi­ciary’s statement of default, insurance companies verify the validity of the claim before payment. If the claim is unfounded, the insurance company will deny payment. How­ever, if the insured’s default is proved, payment is made under the credit and thereafter the company will recover from the insured (Kozolchyk, 1996).

The standby letter of credit is commonly used in the case of contractor bids and perfor­mance bonds, advance payments, open-account sales, and loan guarantees.

6.1. Contractor Bids and Performance Bonds

Bid bonds are issued to a customer to show the seller’s real interest and ability to undertake the resulting contract. This is intended to protect buyers from losses incurred in accepting invalid bids. The bid would be legitimately called in if a successful bidder failed to accept the contract.

Example: The Ministry of Defense of the state of Urbania wants to buy 400,000 pairs of winter boots for the military. It invites domestic and foreign manufactur­ers to submit bids. All bidders are also required to submit a bid bond issued by a reputable surety company or a bank. Nunez Shoes, Ltd., a U.S. footwear company, is awarded the contract. A few days later, Nunez Shoes writes a letter to the Ministry of Urbania, stating that it cannot carry out the contract because the company does not have enough supplies and an adequate labor force. Ac­cording to the contract, the ministry will be entitled to draw under the credit.

Standby credits are also issued to guarantee performance under a sales and service con­tract. Using the previous example, suppose Nunez Shoes signs the contract to deliver 400,000 winter boots to Urbania. The ministry could require Nunez Shoes to post a performance bond issued by a reputable bank as guarantee that it will live up to the terms of the sales contract. Performance bond credits are issued for a percentage of the total contract value. Suppose Nunez Shoes manages to deliver only 50 percent of the shoes before the expiry of the sales contract. The ministry will then be entitled to draw under the credit on presentation of the necessary documents.

6.2. Performance Guarantees Against Advance Payments

Performance guarantees are bonds issued to guarantee the return of cash advanced by the customer if the seller does not comply with the terms of the contract.

Example: Using the previous example, suppose Nunez Shoes signs the contract with the Ministry of Urbania to supply the winter boots but requires an advance payment of $40,000. The ministry, in turn, could require Nunez Shoes to post an advance payment bond (a standby L/C with a bank to guarantee the return of money advanced by the ministry in the event of default by the seller). In the event that Nunez Shoes does not deliver the product as agreed under the contract, the ministry would be entitled to call in the credit, that is, to recover its advance payment on presentation of complying documents.

6.3. Guarantee Against Payments on Open Account

This type of credit protects the seller in the event that the buyer fails to pay or delays pay­ment. The seller asks the buyer to have a standby letter of credit issued in its favor. Suppose payment is to be made within ninety days to the seller under an open-account transaction and the buyer fails to pay. The seller could then request payment under the credit against presentation of stipulated documents, such as a sight draft, commercial invoice, and the seller’s signed written statement.

6.4. Loan Guarantees

Standby credits are often issued by banks when an applicant guarantees repayment of a loan taken by another party. Suppose a subsidiary of Nunez Shoes, in England, borrows 200,000 British pounds from a bank in London. If the applicant’s financial position is not well known to the bank, the bank could agree to extend the loan provided the parent company (Nunez Shoes in the United States) guarantees payment. Under this arrangement, Nunez Shoes, United States, would have a standby L/C issued in favor of the bank in London. Upon receiving the credit, the London bank would grant the loan to the subsidiary. If Nunez Shoes, England, defaults in repaying the loan, the bank will draw on the credit. In addition to this situation, standby credits are employed to cover rental payments, customs duties, royalties, and tax shelter transactions.

Source: Seyoum Belay (2014), Export-import theory, practices, and procedures, Routledge; 3rd edition.

2 thoughts on “Other Letters of Credit

  1. Jesse Trana says:

    It’s really a great and useful piece of information. I am glad that you shared this helpful information with us. Please keep us up to date like this. Thanks for sharing.

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