Understanding Letter of Credit for beginners (Part One)

In trade transaction, there are two main objectives to be achieved; consideration for payment and consideration for the goods. Buyer wants to be assured that he received his goods and on the other hand, the seller would like to ensure that he would receive the value for his goods.

Let say, Sharif is a small trader in Malaysia operating his business in a shop lot in Kuala Lumpur selling canned food. He wants to buy a large quantity, one full container load (FCL) of canned sardine from Abdul, who is a food manufacturer residing in Singapore.

Shariff informs Abdul that he will list down important details like quantity of the canned sardine, brands, the place to deliver, time to deliver, amount and so on to show his intention to buy and to engage in this trade. The total value is, say, USD100,000.00. Abdul on the other hand, needs some time to prepare the delivery where he needs to process the sardine, to label the can, to pack and to contract for the transport before the goods can be delivered.

Now, there is one major problem. How can Abdul be sure that this list is coming from Shariff and Sharif would honour his word to pay him for USD100,000.00?

To ensure that this request is genuine and not a fake order, Abdul requires a third party, a bank, the organization recognized by law to give a confirmation or some kind of guarantee to ensure that Sharif would take the delivery of the goods on the agreed date and pay him the agreed amount. Without this confirmation or a guarantee by a bank, Abdul would refuse to prepare the goods for deliver.

So, Sharif goes to his bank, Maybank, and discusses this matter with his bank. His bank agrees to provide confirmation as well as a guarantee to Abdul provided that Shariff deposits USD100,000.00 equivalent sums with Maybank. Sharif agrees and hands over the list he made to Maybank and requests Maybank to issue the same instruction to Abdul in Singapore.

Maybank prepares the list based on the list which Sharif made with the inclusion of a few additional instructions where among others, Abdul is required to produce documentary evident for the delivery and how to obtain his payment. This list is sent through Abdul’s Bank in Singapore, DBS Bank. Upon receipt of the same, DBS Bank notifies Abdul and hands over the said list to him incorporating a guarantee for payment from Maybank.

Having received this list from Maybank in Malaysia, Abdul is assured that he will receive his payment from Maybank, not from Sharif provided that documentary evident must be sent to Maybank as evident that the delivery has been made on the agreed date to Sharif.

Upon making of the delivery, he sends the required documents to DBS Bank where they will be sent to Maybank for examination and when all the documents are presented as required, Maybank will debit Sharif’s account for USD100,000.00 and pay to Abdul through DBS Bank in Singapore.

Upon remittance of the money, Maybank will deliver the said documents to Sharif to enable him to collect the goods and pay the necessary duties and taxes.

The list issued by Maybank to Abdul through DBS Bank is called Letter of Credit. It contains the details like issuing date, expiry date, name of the buyer, name of the seller, address of both buyer and seller, type of goods, amount, documents required, shipment date, place of delivery and other important details related to this particular trade. All these details which are expressly stated are called ‘terms and conditions’.

In layman term, a Letter of Credit is a piece of list or letter incorporating terms and conditions for the seller to fulfill in order for him to obtain payment for goods he sold to the buyer.

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