Kinds of LCs

Every LC must say how it is available, and that tells Evelyn when the money comes. Under UCP 600 there are four ways:

• Sight: the bank pays once it finds the documents in order. It has at most five banking days after the day of presentation to decide. This is the fastest for Evelyn.
• Deferred payment: the bank promises to pay on a set later date, for example 90 days after shipment. No bill of exchange is needed; the bank's promise is enough.
• Acceptance: Evelyn draws a bill of exchange (a draft) on the bank. The bank signs it as "accepted", which means "I will pay this on the due date". An accepted bill can often be sold early, at a discount.
• Negotiation: a nominated bank, often Evelyn's own, pays her (or gives her value) against complying documents before the issuing bank pays it back. Unless that bank has confirmed the LC, it normally keeps the right to claim the money back from Evelyn if the issuing bank doesn't pay.

Deferred payment and acceptance LCs are both usance LCs. The buyer gets time to sell the goods; the seller waits, or pays a bank to get her money early.

An unconfirmed LC carries one bank promise: the issuing bank's. When the issuing bank is large and well known, and its country is stable, one promise is usually enough.

A confirmed LC carries two. A second bank, often in Evelyn's country or in a big financial centre, adds its own promise at the issuing bank's request or with its authorisation. If Evelyn presents complying documents to the confirming bank, it must pay her, even if the issuing bank later can't or won't. Its promise is separate and its own.

When does a seller want confirmation?

• The issuing bank is small, or unknown to her.
• The buyer's country faces a war, a crisis or a dollar shortage (country risk).
• The deal is so large that one failed payment would hurt badly.

Confirmation isn't free. The confirming bank charges a confirmation fee, which depends on the amount, the period and the risk it takes. Who pays it is agreed in the sales contract; often it is the seller. And a bank confirms only if it is comfortable with the issuing bank, so for a very risky bank or country, no one may agree to confirm.

Garment exporters meet two kinds of LC that sound alike but work very differently.

Back-to-back LC: two separate LCs. Evelyn holds an export LC from Hamburg, often called the master LC. She needs fabric from a mill. Her bank, relying on the master LC and her track record, opens a brand-new import LC in favour of the mill. That is a fresh promise from Evelyn's bank. If the Hamburg deal goes wrong, her bank must still pay the mill against complying documents. Usually the export money, when it arrives, pays off the fabric bill. Back-to-back LCs are common in Bangladesh's garment sector, and the foreign exchange rules set conditions for them.

Transferable LC: one LC, passed on. A middleman, such as a buying house, holds an LC marked "transferable". It asks the transferring bank to pass all or part of it to the real maker, the second beneficiary. The middleman may lower the amount and unit price, shorten the dates, and swap in its own invoice to keep its margin. It works only if the LC says "transferable", and it can be transferred only once (though it can come back to the first beneficiary). The bank does not have to agree to transfer.

A quick test: back-to-back means two promises; transferable means one promise, shared.

Some LCs are shaped for a special job.

• Revolving LC: one LC that renews itself, by amount or by time. Say the Hamburg buyer orders 10,000 shirts every month for a year. Instead of twelve LCs, his bank opens one for a month's value that "revolves" after each use. The LC says whether unused amounts carry forward. Fewer LCs, fewer fees and less paperwork for steady, repeat orders.
• Red clause LC: lets a bank in the seller's country pay the seller an advance before shipment, to buy materials or pay wages. The name comes from the days when this clause was typed in red ink. If the seller takes the advance and never ships, the issuing bank must repay the bank that paid it, and then claims from the buyer. So the buyer is really trusting the seller, and it is used only between trusted partners.
• UPAS (usance payable at sight): for the importer it is a usance LC, but the seller is paid at sight. A financing bank pays the seller on time and then waits for the importer to pay on the due date. The importer gets time to pay and usually bears the interest cost. In Bangladesh, UPAS is used for some imports, within the import and foreign exchange rules.

Every LC so far is a commercial LC. It pays when things go right: Evelyn ships, presents her papers and gets paid. Payment is the normal ending.

A standby LC works the other way round. It is a safety net that usually pays only when something goes wrong. The documents are usually simple: a demand from the beneficiary saying the applicant failed to do what he promised, plus any other papers the standby asks for.

How might it be used?

• Evelyn sells to a long-standing buyer on open account. To sleep better, she asks for a standby: if the buyer doesn't pay an invoice on time, she can claim from the bank.
• A buyer may ask a supplier for a standby that pays if the supplier fails to deliver.

If all goes well, nobody claims, and the standby simply expires.

Which rules apply? A standby may follow ISP98, the ICC rules made especially for standbys, or UCP 600. The standby itself says which. Like a commercial LC, it is independent of the underlying deal, and the bank deals only in documents. In everyday purpose it is close to a bank guarantee. We will meet standbys again at a later level.