What is Letter of Credit? What are the procedures of Opening a Letter of Credit?

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What is a Letter of Credit?

Letter of Credit (L/C)  is one kind of guarantee in the form of a letter that is issued by a buyer’s bank on behalf of the buyer to the seller. Letters of credit are usually issued by banks or other financial institutions, but some creditworthy financial services companies, like insurance companies or mutual funds, might issue letters of credit under certain circumstances.

There are two types of Letter of Credit, such as –

A) Revocable Letter Of Credit 

B) Irrevocable Letter of Credit

Documents for Opening a Letter of Credit

While opening a letter of credit at the request of a buyer, the bank normally examines the following issues:

  • Buyer’s Creditworthiness
  • Import Trade Regulations
  • Exchange Control Regulations
  • Supplier’s creditworthiness report
  • Marketability of the products

The buyer must submit the following documents at the time of opening a letter of credit:

  • Letter of Credit Application to the Bank manager
  • LC application form duly filled and signed
  • Import License/Import Authorization form, or Import registration Certificate
  • Board resolution – stating the L/C facility and the amount of L/C for the corporation, or photocopy of partnership deed and partner consent letter or request letter in case of the proprietary firm – as applicable
  • Indent/ Proforma Invoice Certified Copy
  • Margin money as per the understanding between the importer and his bank. Generally, 10% to 25% of L/C amount is considered as margin money. The amounts of the margin are given by way of Fixed Deposit. The margin money depends upon the creditworthiness of the applicant. For a new customer bank may ask for 100% of L/C amount as margin money.
  • Insurance Cover Note
  • Import Form (IMP Form) and other documents
  • Tax Payment certificate
  • Membership Certificate from the Chamber of Commerce

Procedures of Opening a Letter of Credit

  • A contract is signed between a buyer and the seller
  • The Buyer submits necessary documents as directed by the LC Issuing Bank, and Bank opens a Letter of Credit.
  • After getting the Letter of Credit, the beneficiary confirms regarding the receiving money of supplied goods. Beneficiary Consigns the goods to a carrier, in exchange of a Bill of Lading (one kind of Challan provided by the carrier of goods)
  • Seller takes the Bill of Lading and provides it to his bank (Beneficiary’s Bank), who eventually transfer it to the buyer’s bank, and the buyer’s bank provides it to the buyer.
  • Buyer receives the Bill of Lading and gives it to the carries to unload the goods. The Carrier then getting his own bill of lading, deliver the goods to the buyer.
  • The Carrier then request to the buyer to pay the LC amount
  • The seller then asks his bank (i.e., sellers bank) for payment, who eventually asks the buyers bank. The buyer’s bank settles the payment.

Here, the buyer’s bank is obliged to pay the full amount to the seller’s bank whether the buyer paid or not paid. If the buyer doesn’t pay, the bank will settle it later in the form of loan or advances.