Documentary Letters of Credit
The Documentary Letters of Credit are basic tools which are very often used in foreign trade practices. This article explains how they work in Brazil.
The documentary letters of credit work as a security system to the buyer and the seller involved in a negotiation – it's a promise of payment. It's issued by the buyer's bank in order to ensure sellers that their payment will be conditionally provided.
The document is very common in international trade because, in this situation the bank acts as a neutral party between the buyer and the seller. The national and distances barriers are resolved and the letter of credit figures out all the necessary details of the negotiation, putting everyone involved on the same page.
Parties Involved in the Process
Normally the parts involved in documentary letters of credit are the taker of credit, the beneficiary, and the issuer bank, although there are more complex modalities of this type of operation. In these, the number of parties comprised can vary as follows:
The Taker of Credit
The taker of credit or tomador de crédito - it's the private person or legal entity, company, governmental body of direct or indirect administration, institution, or any other organization that, in front of an agreement, instructs the bank to issue the credit. Normally is a buyer or importer.
The Beneficiary
The private person or legal entity, company, governmental body of direct or indirect administration, institution, or any other organization from which the payment for the exportation was secured, can be considered a beneficiary – the beneficiário. Normally is a seller.
The Bank
The bank is the party that could expand or not his participation in documentary letters of credit negotiations, according to the modality chosen for this process.
- Issuing Bank or Banco Emitente: it's the bank that, in accordance with the order/agreement of the customer, having received the cash deposit, or, accepted other convenient guarantees, issues the letter of credit in accordance with the instructions of the taker of credit.
- Advising Bank or Banco Avisador: the one that, at the request of the issuing bank, tells to the beneficiary the existence and the conditions of credit, delivering to the same its terms without any responsibility.
- Confirming Bank or Banco confirmador: it's the bank that, at the request of the beneficiary, ratifies the credit, being this ratification the establishment of its firm commitment to pay the beneficiary the credit value – in addition to the obligation of the issuing bank – and without the right of recourse against the drawers. This is the guarantor of the issuing bank.
- Negotiating Bank or Banco Negociador: the one that is specifically nominated in the credit – generally there's an express nomination in the letter of credit – unless when the credit was freely negotiable. In this last case, any bank that has the required documentation can accomplish the credit, which means, that any bank can pay the value to the beneficiary or accept the bills of exchange issued by it.
How It Works?
The bank, at the request and according to the taker of credit instructions, agrees to effect payment to the beneficiary, on the spot or forward. Though the payment is secured by the bank, the beneficiary needs to certify his compliance by filing certain documents.
Types of Documentary Credits
The documentary credit can acquire some modalities, such as:
- revocable or revogável
- irrevocable or irrevogável
- transferable or transferível
- revolving or rotativo
- back-to-back credit
Revocable Credit
The credit that can be modified or canceled at any time without notice to the beneficiary is named as revocable documentary credit. Its use has been falling, since sellers don't want to risk having the credit changed or canceled unilaterally by the taker of credit, on the eve of the departure of the goods already prepared.
Normally, this type of documentary credit is used by companies of the same financial group, connected to each other, or that has transnational character, having a certain term of validity, without further formalities. It gives to the taker of credit maximum flexibility, since it can be amended or canceled without any previous warning to the beneficiary.
Irrevocable Credit
The irrevocable documentary credit is the most common form of credit utilized in the international trade negotiations. It's a firm commitment of the issuing bank, since the required documentation was presented to the bank and the terms and conditions of credit were accomplished.
Being a firm commitment, this type of credit cannot be amended or canceled unless all parties involved in the process agreed with it. Which implies less flexibility to the buyer (taker of credit) and offers more payment security to the seller (beneficiary).
Irrevocable Confirmed Credit
This credit it's established when another bank (the confirming bank) became responsible for the credit, the confirmation is considered as a new promise in relation to the original commitment.
This credit is the one which requires the ratification of another bank, such confirmation constitutes a positive obligation on the part of the bank – in addition to the obligation of the issuing bank – to pay, secure payment, accept withdrawals, buying/negotiating withdrawals, and others, without recourse against the beneficiary.
The confirmed credit is used by the seller on demand. It's more expensive, because the confirming bank usually charges a commission for confirmation, which is generally confirmed if the exporter signs the exchange agreement with the confirming bank. The confirmation gives the seller a dual payment security, since the buyer's bank gathered his responsibilities to the ones of the issuing bank.
Irrevocable Unconfirmed Credit
When the ratifier bank doesn't assume any obligation, the issuing bank would be the only one to answer to the beneficiary.
Transferable Credit
The transferable documentary credit is the one that the beneficiary has the right to ask the bank – that is responsible for paying or accepting – to make the credit usable in whole or in part by other party or parties (seconds beneficiaries).
This credit can be transferred only once. Fractions of it, which in total do not exceed the full credit amount, can be transmitted separately, since partial shipments haven't been banned and each set of such transfer shall be deemed to constitute separate ones.
It should be noted that the credit can only be set as "transferable" under specific instructions of the taker. This means that both – the credit application and the credit itself – should clearly show that the credit is transferable, and only the irrevocable credit is established in this way.
Revolving Credit
The revolving credit is the one which, under some terms and conditions, had it's the value renewed or restored without specific amendment.
Related to Time
In the case of a revolving credit related to time, the credit can be used until a certain value per month. Every month, regardless of any amount that has been drawn during the previous month, the credit is automatically usable until the preset value.
Related to Value
In such cases, the importance of credit is restored after use, within a given period of validity. Credit may stipulate the automatic restoration immediately after the presentation of specified documents, or may stipulate the restoration only after the receipt of the documents by the issuing bank.
Back-to-back Credits
These transaction consist in the institution of an import credit. The credit it's paid by the broker in the country, in favor of the exporter abroad. This covers the payment of goods destined to the ultimate buyer in a third country. These operations require prior authorization from the Brazilian Central Bank, to which should be submitted the request of brokers in the country.
Under the concept of back-to-back credits, the seller, as a beneficiary of the first credit offers it as a guarantee to the advising bank, for the issuance of a second credit. As the taker of this second credit, the seller is responsible for reimbursing the bank for their payments made, regardless of whether the seller was paid or not by the first credit.