A letter of credit is considered as a legal document in international trade. Lc is issued by a bank on behalf of the importer to the exporter. As per this legal document the bank is responsible for the drafts drawn on the importer, for the consignment being shipped, provided the terms and conditions written within lc are satisfied by the seller.
The supplier is supposed to comply with all the conditions described in the letter of credit, and are set by the buyer. Further, the supplier has to submit some documentary evidence along with the relevant shipping documents. As soon the terms and conditions are met by the supplier, the bank transfers the funds to the supplier.
Functions performed by letter of credit are:
Various types of Letter of credit include Sight letter of credit, Usance letter of credit, Revolving letter of credit, Irrevocable and revocable letter of credit, Standby letter of credit, Confirmed letter of credit and much more.
A bank guarantee is considered as a contract, in which the bank is supposed to provide the guarantee on customer’s behalf to the beneficiary that the bank will pay the seller the required payment, if in case customer defaults in discharging obligations. As per this agreement, the bank will act as a surety, to make the debt good within 3 working days, if not paid by the applicant.
Bank Guarantees are used for reducing the risk of loss that is attached to the commercial contracts. For providing such sureties so, the bank will get certain amount of commission which may vary as per the amount being guaranteed. Apart from this, the bank is not bound for making the payment, i.e. payment can be refused if the claim is not found genuine.
There are two types of bank guarantee:
|Letter of credit||Bank Guarantee|
|Letter of credit is a legal document for assured payments, i.e. an undertaking of the importer’s bank to make payment to supplier, against the mentioned documents.||A bank guarantee is a surety which is given by the bank to its beneficiary on behalf of the applicant, for effecting payment, if the applicant fails to pay.|
|LC is considered as a primary liability.||Bank guarantee is given secondary liability.|
|LC involves fewer risks for the trader and more on banks part.||Bank guarantee involves more risks for trader and fewer on banks part.|
|Generally five or more parties are involved.||Generally three parties are involved.|
|For invoking the undertaking, LC doesn’t wait for applicant’s default and beneficiary.||Bank guarantee becomes active only if the applicant defaults to make payment.|
|Payment is made when the specified conditions are met.||Non-fulfilment of obligation results in payment.|
|Usually, it is suitable for import and export business.||Usually, it is suitable for government contracts.|
Both of these trade finance products ensure that the sellers will be paid for the associated goods and services. As a supplier or exporter, you can avail a letter of credit or bank guarantee for ensuring that you receive payment for the consignment you deliver. If you are a buyer or importer, the supplier will definitely expect direct payment from you. If in case you do not make payments on time then the seller can your bank to act as per the conditions on the letter of credit or bank guarantee to pay on your behalf.
Although both these trade finance products serve as the primary purpose to ensure that the seller gets paid, but there is a legal difference in terms of protection they provide. A bank guarantee not only protects the supplier, but it also protects the importer. For sellers, it totally depends on the buyer whether your buyer chooses to avail a letter of credit or bank guarantee. However, when it comes to buyer, then a bank guarantee must be preferred. It can even protect you if the supplier fails to send your purchases or if the consignment arrived in damaged condition. A bank guarantee reimburses the amount you have sent to the non-performing seller.
Letter of credit is preferred in terms of performance. When it comes to trade, after delivering the relevant product, seller can ask buyer’s bank to make payment for the exported products on presenting the required documents and meeting the terms and conditions being mentioned within the letter of credit. Whereas, a Bank guarantee will come into performance only in case of default payment i.e. if the buyer fails to pay for the goods and services being delivered, only then the bank guarantee comes into a role play.
There exists a major legal difference amongst these trade finance products. A bank guarantee can be seen as a simple obligation subject to the civil law whereas a letter of credit can be seen as a subject to banking protocols – UCP 500 and ISP 98.