Unit 9: Legal aspect of Trade Finance: LH 4

Letter of credit
Guarantee
Basic features
Parties involves in various trade finance
Roles and responsibilities of parties.
 Concepts of Trade Finance

 Trade finance represents the financial instruments

and products that are used by companies to
facilitate international trade and commerce.
 Trade finance makes it possible and easier for
importers and exporters to transact business
through trade.
 Trade finance is an umbrella term meaning it covers
many financial products that banks and
companies utilize to make trade transactions
feasible.
 Features

 It involves the financing of international trade

transactions
 Itprovides various financial instruments and tools to
support international trade, including letters of
credit, guarantees, export credit insurance, and
factoring services.
 Trade finance is designed to mitigate the risks
associated with international trade
 Itcan help to improve cash flow for both the buyer
and seller
 Types
1. Letters of credit (LCs)
 A letter of credit is a financial instrument that guarantees payment
to the exporter in exchange for the delivery of goods or services to
the importer.
 It provides a level of security for both the buyer and seller and
ensures that the transaction will be completed in a timely and efficient
manner.
2. Guarantees
 A guarantee is a promise by a bank to pay a specified amount of
money if the buyer or seller fails to meet their contractual obligations.
 It can be used to mitigate various types of risks, including political and
economic risks, as well as currency and credit risks.
Types
 Types
3. Export credit insurance:
 Export credit insurance protects exporters against the
risk of non-payment by buyers.
 The insurance usually covers commercial risks such as
buyer insolvency, bankruptcy, or default.
 It usually covers some political risks as well, including
war, terrorism, riots, revolution, currency
inconvertibility, and changes in import or export
regulations.
 Sellers are thus protected from things both within and
outside the buyer's control.
 Types
4. Pre-shipment finance: Pre-
shipment finance is a short-term
loan provided to an exporter to
finance the production and
shipment of goods.
 Letter of Credit
 A letter of credit (LC) is a bank-issued document that affirms
(confirms) the seller on behalf of the buyer, the guarantees
payment upon delivery of the goods or services.
 It is a form of negotiable instrument whereby the buyer makes
an unconditional promise to pay.
 The seller or beneficiary can also transfer the LC to another
party to further mitigate their liability.
 If the buyer doesn’t pay the amount, this burden falls upon the
issuing bank.
 Therefore, for issuing LCs, banks charge the buyer a
particular percentage as a fee.
 Letter of Credit
A letter of Credit (LC) is a legal document
backed and issued by the bank.
 Therefore, it is an essential piece of paper for
the reliable export and import of products or
services.
 It ensures that both the buyer and the seller
fulfill the commitments stated in the sales
contract.
 Features
1. Issued by Buyer’s Bank
 An LC is released by the buyer’s bank to the seller
and is a formal document that comprises all the
conditions of the deal.
2. Transferability
 The LC can be assigned or transferred to a third
party by the beneficiary as a mode of payment, and this
third party can get it encased on the due date.
 Further, it can be transferred several times and remains
valid.
 Features
3. Revocability (Cancellation)
 Some letters of credit are revocable, and therefore these can be
canceled at any time; however, most credit letters are
irrevocable.
4. Maturity
 The LC is a time draft which means it has a due date on which
the beneficiary can encash the amount from the issuing bank.
5. Negotiability
 It is a negotiable instrument whereby the parties can discuss
and amend the terms and conditions of the LC.
 Similar to other negotiable instruments, the letters of credit
bear an unconditional promise to pay a certain sum on the due
date or demand of the beneficiary.
Process Step 1: - The buyer makes agreement to purchase goods from the seller. This
agreement can be a purchase order, an accepted pro-forma invoice, or a formal
contract. Agreement is made as to goods being purchased, how and when they
are to be shipped and insured, and how and when payment is to be made. In
this case, the agreement is to use a Letter of Credit as the payment mechanism.
Step 2: - The buyer gives application to his bank (issuing bank) for a letter of
credit, by signing the bank's Letter of Credit agreement form.
Step 3: - After approval of the application, the issuing bank issues the Letter
of Credit instrument and sends it to the seller (beneficiary) through
advising/confirming bank (beneficiary bank).
Step 4: - After receiving the issuing bank's assurance of payment, the seller
makes shipment of the goods to the buyer.
Step 5: - The seller prepares the required documents in the Letter of Credit
and presents them to the issuing bank through his/her advising/confirming
bank.
Step 6: - The issuing bank verifies the documents. If it finds that the
documents comply with the letter of credit, the issuing bank makes payment to
the seller through advising/confirming bank.
Step 7: - The issuing bank gets payment from the buyer in accordance with
the terms of the applicant’s Letter of Credit agreement.
Step 8: - Forwards the documents to the applicant.
Step 9: - The buyer uses those documents to pick up the merchandise from the
shipment carrier, completes the Letter of Credit cycle.
Terminology/parties involve in LC
1. The Applicant is the person or company who has
requested the letter of credit to be issued; this will normally
be the buyer.
2. The Beneficiary is the person or company who will be
paid under the letter of credit; this will normally be the seller
(defines the beneficiary as "the party in whose favour a
credit is issued").
3. The Issuing Bank is the bank that issues the credit,
usually following a request from an Applicant.
4. The bank nominated by the Issuing Bank as being the
bank at which the Beneficiary may present the documents
required by the credit and obtain payment.
5. An advising bank (also known as a notifying
bank) advises a beneficiary (exporter) that a letter of
credit (L/C) opened by an issuing bank for an
applicant (importer) is available. An advising bank's
responsibility is to authenticate the letter of credit
issued by the issuer to avoid fraud.
6. A Confirming Bank provides guarantee to the
seller or exporter as backed up or second bank. In
simple words, in case if the first bank defaults to
pay, then the payment will be covered by the
second
7. Negotiating Bank
Negotiating bank is the bank that verifies
documents and confirms the terms and
conditions under LC on behalf of beneficiary
to avoid discrepancies
 Bank Guarantee
 A bank guarantee is a written contract given by a bank on
behalf of a customer.
 By issuing this guarantee, a bank takes responsibility for
payment of a sum of money in case, if it is not paid by the
customer on whose behalf the guarantee has been issued.
 In return, a bank gets some commission for issuing the
guarantee
 It is a supplementary agreement or form of collateral or
security relating to a specific transaction
 Bank gives the recipient of the guarantee the promise to pay
compensation in the extent of the guarantee amount
 Bank Guarantee
 There are different types of bank
guarantees, including performance
guarantees, bid bonds, advance payment
guarantees, and payment guarantees.
 These guarantees may be required by a
variety of parties, including contractors,
suppliers, and buyers, depending on the
specifics of the transaction.
 Features
1. Security
 A bank guarantee provides a level of security for the beneficiary
of a transaction, as it ensures that a certain amount of money
will be paid if the party responsible for the transaction fails to
meet their obligations.
2. Customizable
 Bank guarantees can be customized to fit the specific needs of
the parties involved in a transaction.
 Different types of guarantees may be required depending on the
nature of the transaction and the risks involved.
 Features
3. Legal binding
 A bank guarantee is a legally binding contract between the
bank, the beneficiary, and the party providing the guarantee.
 This means that all parties are bound by the terms of the
guarantee.
4. Collateral
 In order to obtain a bank guarantee, the party providing the
guarantee must typically provide collateral to the bank.
 This helps to ensure that the party is able to meet their obligations
if required.
 Features
5. International acceptance
 Bank guarantees are widely accepted in international
transactions, and can be used in a variety of industries, including
construction, manufacturing, and finance.
6. Time-bound
 Bank guarantees typically have a time-bound validity, meaning
that they are only in effect for a specific period of time.
 This helps to ensure that the guarantee is not in effect indefinitely,
and provides a level of certainty for all parties involved in the
transaction.
 Importance
 It provides a level of security to the beneficiary of a transaction
because the sum is assured if the transactions fail to meet
obligations
 Different types of bank guarantee are available as per the need
so it is customized products
 It is a legal binding contract between the bank, beneficiary and
the party providing the guarantee
 The party providing the guarantee must typically provide
collateral to the bank
 It is internationally accepted
 Parties Involved
1. The Applicant
 The applicant is the party requesting the bank guarantee from the bank.
 This party is typically the buyer or the party responsible for fulfilling the obligations of
the transaction.
2. The Beneficiary
 The beneficiary is the party who will receive payment under the terms of the bank
guarantee if the party responsible for the transaction fails to fulfill their obligations.
 This party is typically the seller or the party who is entitled to receive payment under
the terms of the transaction.
3. The Bank
 The bank is the financial institution providing the guarantee to the beneficiary on
behalf of the applicant.
 The bank is responsible for ensuring that the terms of the guarantee are met, and will
typically require collateral from the applicant in order to provide the guarantee.
 Types of Guarantee
1. Performance Guarantee
 This type of guarantee is used to ensure that the party responsible for
completing a project or fulfilling a contract meets their obligations in a
timely and satisfactory manner.
2. Bid Bond Guarantee
 This type of guarantee is used in the bidding process for contracts.
 It ensures that the bidder will accept the contract if they are awarded it, and
that they will provide the required performance guarantee if selected.
3. Advance Payment Guarantee
 This type of guarantee is used when an advance payment is made by the
buyer to the seller.
 It ensures that the seller will use the advance payment for the intended purpose,
and that they will refund the advance payment if they fail to meet their
obligations.
 Types
4. Payment Guarantee
 This type of guarantee is used to ensure that the buyer will make
payment to the seller in accordance with the terms of the
contract.
5. Financial Guarantee
 This type of guarantee is used to provide assurance to a third
party that the applicant will fulfill their financial obligations,
such as paying back a loan or meeting other financial obligations.
6. Customs Guarantee
This type of guarantee is used in international trade to ensure that
the importer will pay any customs duties or taxes owed to the
government.
 Roles and Responsibilities of Parties in LC
1. Applicant
 The applicant is responsible for initiating the letter of credit and
ensuring that the issuing bank has all the necessary information and
documentation to issue the letter of credit.
2. Issuing bank
 The issuing bank is responsible for issuing the letter of credit based
on the applicant's instructions and ensuring that the terms and
conditions of the letter of credit are met.
3. Beneficiary
 The beneficiary is responsible for ensuring that the goods or services
are delivered in accordance with the terms and conditions of the letter
of credit and for presenting the required documentation to the issuing
bank to receive payment.
 In Summary ( Parties involved in different Trade Finance)

1. Importers: Companies or individuals who buy goods or services from overseas.

2. Exporters: Companies or individuals who sell goods or services to overseas buyers.
3. Banks: Financial institutions that provide trade finance services to importers and
exporters.
4. Freight forwarders: Companies that arrange for the transportation of goods from the
exporter to the importer.
5. Insurance companies: Companies that provide insurance against various risks
involved in international trade, such as loss or damage to goods, non-payment, or
political risks.
6. Inspection agencies: Companies that provide quality control and inspection services to
ensure that goods meet the agreed-upon specifications.
7. Customs authorities: Government agencies responsible for regulating the movement
of goods across borders and collecting taxes and duties.
8. Trade associations: Industry groups that provide information, networking
opportunities, and other resources to businesses involved in international trade.