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Documentary letters of credit

Presentation of the general technique | Intervention of a second bank | Legal framework | Documentary letters of credit and Incoterms | The role played by the documents themselves | Modes of use | Transfers | Costs | Recommendations

Before tackling this section we would advise you to make sure that you have a firm grasp of the general techniques involved in the documentary letter of credit, and of the intervention by a second bank in this mechanism. Should these require further attention, we invite you to take another look at the following sections : Presentation of the general technique Intervention by a second bank

It is a very common occurrence in international commerce for the exporter not to be the producer of the goods being exported, but to be a business enterprise that buys products with a view to reselling them. In this type of commerce, the transferable letter of credit kills two birds with one stone , namely the problem of financing the purchase , since it is possible for the business enterprise to be required to pay his supplier before he gets paid for the resale of the merchandise, and the problem of guarantee , since the supplier may wish to have some reassurance that he will receive payment for the goods that he has delivered to the premises of the trading company. Transferable letter of credit Counter-credit The difference between transferable credit and counter-credit

Transferable documentary (letter of) credit The beneficiary of the documentary (letter of) credit (i.e. the business enterprise) can request the importer to ensure that the letter of credit be expressly labelled transferable. This allows the exporter to ask the bank where the documentary credit has been designated to be made payable (very often this is done at the second bank), to issue a second letter of credit, this time in favor of his supplier. For the sake of convenience, let's dub this bank the transferring bank.

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Note : It is easier to interpret this diagram by following the numbering which is designed to take you step by step through the transaction as it unfolds.

In principle, the second credit will be made payable by an exchange of documents identical to those required to make use of the first documentary (letter of) credit, saving exceptions and limitations defined in the UCP . In a general way these exceptions are made in consideration of the interests of the trading company on the one hand, which may prefer its buyer and its supplier not to be in direct contact with one another, and on the other hand of the fact that the terms of purchase from the supplier are normally different to those on the final buyer's invoice. The supplier invoices the trading company for his goods. This invoice (which is for 90 in the above diagram) will allow the supplier to make use of the documentary (letter of) credit that has now been transferred to his name. As for the trading company, it will resell the goods to the final importer for a higher price than it has paid the supplier (100). The trading company will substitute its own invoice for the supplier's, and the transferring bank will pay it the difference between the two invoices (10), this difference representing its margin of profit. Once the transferring bank is in possession of the required documents, it will obtain reimbursement from the issuing bank of what it has paid to the supplier (90), and to the trading company (10), within the context of the transfer of the first documentary (letter of) credit, or as in our example 100.

It is important to note : that the documentary (letter of) credit can only be transferred once. The suppliers therefore are not able to transfer the credit to their own suppliers ; that this kind of credit is difficult to set up, because the contracts with the suppliers or sub-contractors must be drawn up in the same way as the contract with the client, particularly where currency, method of transportation / incoterm, and exact documents required are concerned. Moreover, particular vigilance will be required should it be necessary to issue any inspection certificates at the behest of the sub-contractor on the forms of the original letter of credit (consignee, distinguishing markings,...). Even more attention will need to be paid if it happens to be

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the suppliers that ship off the goods.

Back to back credit Should the importer refuse to apply for a transferable letter of credit, or should the exporter not wish his client to know that he is subcontracting out the implementation of the contract, the latter is at liberty to use the letter of credit he gets from his client, to generate credits that he out in favor of his sub-contractors. The bank advising of or guaranteeing the credit received from abroad, then also becomes the bank issuing the documentary (letter of) credit that the beneficiary intends to give his supplier. Unlike with the transferable letter of credit, the organisation of the back-to-back credit establishes no legal connection between the two letters of credit. The initial credit will be called "the basic credit". The second will be qualified as "counter credit" or "back to back credit". This back to back credit will be seen as "concordant" if it requires the same documents as the initial credit, and only gives rise to a single substitution of invoices. If it is "non concordant", the exporter will require other documents of his suppliers than those initially required of him by his client. Documentary counter-credits do not have the advantage of special consideration in the Uniform Customs Practice published by the International Chamber of Commerce, because they are nothing more than one separate and distinct credit stacked on top of another, even if they are issued to cover the same business transaction.

The difference between the transferable documentary credit and the documentary counter-credit The risk the bank issuing the counter-credit takes is totally different to the risk it takes in simply transferring the documentary (letter of) credit. In law, credit that is transferable and credit that has been transferred constitute but one single and identical operation: the commitment made by the initial supplier has its "raison d'tre" in the bank that has issued a letter of credit on behalf of the ultimate buyer, and the fact that the transferring bank guarantees the initial documentary (letter of) credit is its way of backing the commitments made by the issuing bank, should the latter fail to live up to them. On the other hand, when it issues a new (separate) letter of credit, the bank assumes a risk on behalf of the intermediary. For if the basic credit and the counter-credit only constitute a single operation on the commercial level, in law these two letters of credit are two totally independent entities. For example, lets suppose the intermediary had all his goods seized by the police or went bankrupt in between things, the bank issuing the counter-credit would no longer be able to make use of the funds coming from the settlement of the basic credit, to pay the supplier when this counter-credit needed to be settled. So as to keep on top of his commitments, this banker would himself need to be in control of the amount of the documentary (letter of) credit, of which the initial supplier is the beneficiary.

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