LETTER OF CREDIT
A Letter of Credit (LC) is a mode of payment used for the importation of goods in international sales transactions. It provides an irrevocable guarantee to the exporter that, provided the goods and/or services are delivered to the importer according to contractual terms and with the compliant documents, it will be paid by the bank that issued that letter of credit (the bank of the importer). It also provides assurances to the importer that the goods and/or services ordered will be received. Malawi is largely dependent on the importation of goods worldwide. And banks in Malawi encourage the use of letters of credit as a payment mechanism for customers who are desirous of purchasing commodities such as raw materials, machinery, and other commodities from foreign sellers. This article considers the overall nature of letters of credit and highlights to the exporter or importer in Malawi the points to be considered when using an LC as payment for an international trade transaction.
The major participants in an LC transaction are:
- The Buyer/Importer/Applicant i.e. the customer requesting LC to be issued.
- The Seller/Exporter/Beneficiary i.e. the Recipient of the LC.
- The Issuing Bank – which gives the written undertaking.
- Advising Bank/Seller’s Bank i.e. the bank that advises the LC to the beneficiary.
TYPES OF LETTERS OF CREDIT
There are different types of letters of credit with different uses. The most popular types are Irrevocable LCs, Revocable LCs, Confirmed LCs, Revolving LCs, Transferrable LCs, and so on. This discussion is restricted to irrevocable Letters of Credit. By default, an LC is irrevocable even if it is not indicated anywhere. The instructions or terms on this type of LC cannot be amended or canceled without the agreement of the beneficiary and the confirming bank.
The benefits of Letters of Credit include:
- Guaranteed settlement of forex to supplier on due date and
- Protection of customer from unscrupulous suppliers.
Letters of Credit are designed to protect both exporters and importers. They can help win business with new clients in foreign markets. The exporter gets a guarantee of payment while offering the importer reasonable payment terms.
UNIFORM CUSTOMS AND PRACTICE FOR DOCUMENTARY CREDITS
A Letter of Credit is governed by UCP600 (Uniform Customs and Practice) which is an international code of practice (voluntary set of rules) drawn up by the International Chamber of Commerce. The development of the UCP is the result of a desire to address the challenges faced in the facilitation of the flow of international trade and also, to address the major developments in the trade and banking world.
THE MECHANISM OF LETTERS OF CREDIT
A letter of credit transaction normally operates in an order simplified below:
- When an international sale is agreed upon to be paid by way of a LC, the buyer/importer/applicant in Malawi will take steps to establish through the buyer’s bank [issuing bank] a letter of credit in favour of the international seller [beneficiary].
- Subject to the applicant meeting all the Bank’s requirements, the issuing Bank will open an irrevocablecredit in favour of the beneficiary.
- By issuing the LC, the buyer’s bank agrees to pay the seller a specified sum of money on presentation of such documents as are required by the terms of the letter of credit. A LC thus evidences a contract between an issuing bank and a seller. It is distinct and independent from the contract of sale although both the LC and the contract of sale relate to the same transaction.
- Upon the seller’s tender of the required documents which is most likely to be after goods have been shipped to the applicant’s country, the documents will be confirmed to be adequate by the seller’s Bank (advising Bank), and after the confirmation, the Bank will be required to pay the seller the contract sum.
- Upon payment of the agreed contract sum to the seller/beneficiary, the seller’s Bank/advising Bank is entitled to seek reimbursement from the issuing Bank/buyers’ Bank.
- The Documents will be passed unto the buyer by his Bank, he will pay the Bank the contract price in addition to any other payments for the service rendered.
Despite the forex challenge in the country, the Reserve Bank of Malawi and the various Commercial Banks in the country have developed stability in fulfillment of their obligations to their counterparty Banks in letters of credit transactions. This is done by channeling foreign exchange from export proceeds as well as funds provided by letters of credit applicants who source foreign exchange within the parallel market for “non-valid for forex” letters of credit.
ABOUT RITZ ATTORNEYS AT LAW
Our firm’s practice areas include International Trade and Investment, Banking and Finance including Trade Finance and aspects of Tax. Recently our firm has been providing advisory and dispute resolution services in contentious disputes arising from Letters of Credit in the area of International Trade Finance. The disputes involve:
- Commercial Case Number 47 of 2021: The Reserve Bank of Malawi and Mulli Brothers Limited and;
- Commercial Case Number 63 of 2021: The Reserve Bank of Malawi vs Web Commercials Limited
The disputes arise from claims over a balance on letters of credit of around USD2 Million and whether the dispute has to be resolved through arbitration before the International Chamber of Commerce following English Law or whether Malawian Courts should dispose of the matter