Letter of Credit

A Report for the course

Contract Management

30th December 2019

Submitted to: Submitted by:

Instructor: Dr. R.K. Singh Name: Shahin Selkar

Adani Institute of Infrastructure Management PGDM (2019-21) | Roll No: 40

1. Introduction

Since the advent of Industrial Revolution and opening up of economies because of

globalization leading to integration of economies, free trade transactions between countries
and/or players of the two or more countries have grown multifold times. Newer opportunities
often come with its own set of newer and unconventional threats. In case of trade transactions
in a closed economy, the problem of credit risk was miniscule as various measures like
realizing money due from collateralized assets, seeking services of a debt collector, recovering
from guarantors and such other measures. However, in case of International trade deals the
operation of such measures is neither possible nor financial viable, if at all it was possible.
To bridge this gap, the most reverend institutions-Banking partners were sought after for
providing auxiliary services of becoming an intermediator between two or more parties of
such trade deals, off course against some fees; thereby leading to creation of services in form
of ‘Letter of Credit’ came into being.

2. Definition of Letter of Credit

‘Letters of Credit’ are guarantees issued by a buyer’s bank in favour of the supplier,
guaranteeing that payments will be made against documents listed in the Letter of Credit, inter
alia evidencing completion of supplies/services/stages of progress of work before the delivery
dates specified in the Letter of Credit and subject to the conditions as specified therein. (B,
2016)

3. Literature Review

As Letters of Credit are widely used instruments throughout the globe, various authors have
provided various opinions on various aspects of Letter of Credit in form of books, journals,
articles, periodicals, blogs, etc. For the purpose of this study, the book by B S Ramaswamy
titled “Contracts and their Management” has been considered to be the primary source for
information along with some reading from online articles & blogs form the basis on which
this study is carried out.

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4. Hypothesis

Letter of Credit is very important in international transaction involving trade of goods and/or
services.

5. Statement of Purpose

To understand the various intricacies of Letter of Credit in terms of the procedure, its utility
and its importance in international trade transactions.

6. Methodology for Study

The study conducted is of doctrinal form. It is descriptive and analytical in nature. A brief
Modus Operandi adopted for this concept discussion is highlighted hereunder:
 Determination of area/ topic to be discussed for the assignment
 Read through of the topic selected from the official course material
 Establishing a Hypothesis which is to be tested in the assignment
 Identifying key concepts and procedural aspects in the topic concerned
 Framing and critically analyzing examples for portrayal of understanding of the topic
 Concluding by providing an opinion on case and how it is important for an Infrastructure
Management student perspective.

7. Analysis

For analyzing various aspects of Letter of Credit, the analysis is sub-divided into three broad
segments:
I. Procedure
II. Types of Letters of Credit
III. Validity period

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 I. Procedure

Figure 1: Process of Letter of Credit

Source: (Letter of Credit Basics: L/C Transaction, 2017)

Suppose, there is an Importer- Mr. A, situated in India, who wants certain goods from an
Exporter- Mr. B, situated in USA. Now due to distance and all practicable reasons there is a
human tendency to be risk averse and so the Mr. B would be reluctant in shipping the goods
first to the buyer and on the other hand too Mr. A will also be relunctant in releasing payments
prior to delivery of goods and owing to this uncertainty, they would try to bring in a third
party on whom they can trust, in this case being the Bank.
1. Mr. B hence request Mr. A to open a Letter of Credit and nominate Mr. B as the
beneficiary and enters into the Sale contract;
2. Mr. A reaches out to the Bank of his choice, in this case referred as ‘Issuing Bank’ and
applies for a Letter of Credit facility and provides for details such as the name of
nominee, value of contract, delivery date, last date for negotiation and such other
details and submits either an upfront fee or provides some collaterized security or
guarantee (as per Bank’s policy) for availing the facility;
3. The Issuing Bank now issues the Letter of Credit to the ‘Advising Bank’ i.e. the Bank
of the Supplier/ Exporter, in this case Mr. B;

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 4. The Advising Bank issues an Advising Letter to Mr. B;
5. On receipt of this document, Mr. B ships the order to Mr. A;
6. Mr. B than provides the documents such as Bill of Lading and other relevant
documents to its Advising Bank for initiating the processing of its dues;
7. The Advising Bank in return furnishes these documents to the Issuing Bank and
requests for releasing the payments;
8. The Issuing Bank examines the documents, confirms the receipt of the goods, and
examines the performance of contractual obligations by the supplier / exporter. The
Issuing Bank thereafter intimates Mr. A regarding debiting his bank account with the
amount of Letter of credit releases payment to the Advising Bank and provides all the
relevant documents to Mr. A.

II. Types of Letters of Credit

There are basically two types of Letter of Credit, based on the security offered by the type of
Letter of Credit in terms of payment assurance to the seller, namely:

a. Confirmed Letter of Credit:

A Confirmed Letter of Credit is one in which the seller/ exporter has a payment
guarantee from a confirming bank i.e. in case the issuing bank fails to pay then
the payment will be done by the confirming bank. (Confirmed Letter of Credit,
n.d.) A premium amount is charged for Confirming the Letter of Credit. Payment
terms for confirmation can be negotiated in the contract itself, however, in
common parlance it is the supplier who bears the cost of confirmation.

b. Unconfirmed Letter of Credit

An Unconfirmed Letter of Credit is when there is only a payment guarantee by
the Issuing Bank. There is no additional confirmation or guarantee. With obvious
reasons, the charges would be much lesser in comparison to a Confirmed Letter
of Credit.
In case of Unconfirmed Letter of Credit, the Advising Bank can re-debit the supplier’s bank
account by exercising its Right of Recourse (i.e. recover dues from supplier) - in the event of
the issuing bank being unable to recover dues from the buyer or advising bank being unable
to recover dues from issuing bank on account of various unforeseen circumstances like
bankruptcy of issuing bank and such other.
The Supplier, in case of a Confirmed Letter of Credit envisages the possibility of such an
event and looking forward at the credit default risk assures oneself from such inadvertent
process, which would be prejudicial to their interest. So, this form an example of Forward
Operating Cycle. In our case, Mr. B can request Mr. A for a Confirmed Letter of Credit to

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protect itself from credit default risk. It is also important to note that it is thereafter upon the
Advising Bank to recover its dues from parties concerned. For purpose of this study and
example mentioned Backward Operating Cycle is not discussed as same is not affected in it.

III. Validity period

Usually, the currency of a Letter of Credit is predefined at time of application of Letter of

Credit. However, things might go haywire even in case when all due diligence is undertaken
by either of the parties. In such cases, an extension might be required. In all kinds of
reasonable situations and in case of delay on account of force majeure circumstances, an
extension can be rightfully sought after by the supplier or even by the buyer too.
It is important to note that in either of the cases, the party seeking for an extension usually has
to bear the expenses for amending the validity period of the Letter of Credit.

8. Conclusion

The conclusion to this study would be that the researcher fails to reject the hypothesis in light
of the discussions and evidence laid. It is hence a good practice to enter into an arrangement
involving Letter of Credit when entering into an international trade deal. Moreover, from the
supplier’s perspective based on risk assessment carried out it is advisable to get a Confirmed
Letter of Credit, if the credit default risk is substantial, from the assessments carried out. This
implies that Letters of Credit are almost like an indispensable part of international trade deal.
As Infrastructure Management student, this topic is critical to be aware of as in case of
infrastructure projects quite often international collaborations might been sought after. It is
quintessential for us to know that instruments such as Letter of Credit exists which can
facilitate ease of transaction without either of the party having to worry about the potential
risk of the opposite party not obliging to the stipulations of their part of the contract.

References
 B, R. (2016). Contracts and their Management. Gurgaon: LexisNexis.

 Confirmed Letter of Credit. (n.d.). Retrieved from efinancemanagement.com:

https://efinancemanagement.com/

 Letter of Credit Basics: L/C Transaction. (2017, March). Retrieved from

advancedontrade.com: https://www.advancedontrade.com/

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