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What is a letter of credit?

A letter of credit is a promise to pay. Banks issue letters of credit as a way to ensure sellers that they will get paid as long as they do what they've agreed to do. Letters of credit are common in international trade because the bank acts as an uninterested party between buyer and seller. For example, importers and exporters might use letters of credit to protect themselves. In addition, communication can be difficult across thousands of miles and different time zones. A letter of credit spells out the details so that everybody's on the same page.

Money Behind a Letter of Credit
A bank promises to pay on behalf of a customer, but where does the money come from? The bank will only issue a letter of credit if they know the buyer will pay. Some buyers have to deposit (or already have) enough money to cover the letter of credit, and some customers use a line of credit with the bank. Sellers must trust that the bank issuing the letter of credit is legitimate.

Executing a Letter of Credit
A seller only gets paid after performing specific actions that the buyer and seller agree to. For example, the seller may have to deliver merchandise to a shipyard in order to satisfy requirements for the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that he made delivery. The letter of credit now must be paid even if something happens to the merchandise. If a crane falls on the merchandise or the ship sinks, it's not the seller's problem. To pay on a letter of credit, banks simply review documents proving that a seller performed his required actions. They do not worry about the quality of goods or other items that may be important to the buyer and seller.

Pitfalls of Letters of Credit
Letters of credit make it possible to do business worldwide. They are important and helpful tools, but you should be careful when using letters of credit. As a seller, make sure you:

Carefully review all requirements for the letter of credit before moving forward with a deal Understand all the documents required
Can get all the documents required for the letter of credit
Understand the time limits associated with the letter of credit, and whether they are reasonable
Know how quickly your service providers (shippers, etc) will produce documents for you
Can get the documents to the bank on time
Make all documents required by the letter of credit match the letter of credit application exactly

Getting a Letter of Credit
To get a letter of credit, visit your bank. Ask if they can help you with a letter of credit, or if they have any suggestions.Small banks and credit unions might not be able to accommodate you.

Definition of Letter of Credit
Credit means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation. (UCP 600, article 2) This letter of credit definition is taken from the UCP 600 (ICC Uniform Customs and Practice for Documentary Credits) which is the latest version of the rules published by ICC (International Chamber of Commerce ) regulating the letters of credit operations all around the world.

What is UCP600?
UCP 600 is the latest version of the rules that govern letters of credit transactions worldwide. Its full name is Uniform Customs and Practice for Documentary Credits UCP 600. The rules have been effective since 1 July 2007.

What is advising bank?
Advising bank means the bank that advises the credit at the request of the issuing bank.

Applicant
Applicant means the party on whose request the credit is issued.

Banking Day
Banking day means a day on which a bank is regularly open at the place at which an act subject to these rules is to be performed.

Beneficiary
Beneficiary means the party in whose favour a credit is issued.

Complying presentation
Complying presentation means a presentation that is in accordance with the terms and conditions of the credit, the applicable provisions of these rules and international standard banking practice.

Confirmation
Confirmation means a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying presentation.

Confirming Bank
Confirming Bank means the bank that adds its confirmation to a credit upon the issuing bank's authorization or request.

Credit
Credit means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation.

Honour
Hounour means:

to pay at sight if the credit is available by sight payment.
to incur a deferred payment undertaking and pay at maturity if the credit is available by deferred payment.
to accept a bill of exchange (draft) drawn by the beneficiary and pay at maturity if the credit is available by acceptance.

Issuing bank
Issuing bank means the bank that issues a credit at the request of an applicant or on its own behalf.

Negotiation
Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.

Nominated bank
Nominated bank means the bank with which the credit is available or any bank in the case of a credit available with any bank.

Presentation
Presentation means either the delivery of documents under a credit to the issuing bank or nominated bank or the documents so delivered.

Presenter
Presenter means a beneficiary, bank or other party that makes a presentation.

Irrevocable letters of credit
An irrevocable letter of credit cannot be changed or cancelled unless everyone involved agrees. Irrevocable letters of credit provide more security than revocable ones.

Revocable letters of credit
A revocable letter of credit can be changed or cancelled by the bank that issued it at any time and for any reason.

Confirmed letters of credit
When a buyer arranges a letter of credit they usually do so with their own bank, known as the issuing bank. The seller will usually want a bank in their country to check that the letter of credit is valid.

For extra security, the seller may require the letter of credit to be confirmed by the bank that checks it. By confirming the letter of credit, the second bank agrees to guarantee payment even if the issuing bank fails to make it. So a confirmed letter of credit provides more security than an unconfirmed one.

Transferable letters of credit
A transferable letter of credit can be passed from one beneficiary (person receiving payment) to others. They're commonly used when intermediaries are involved in a transaction.

Standby letters of credit
A standby letter of credit is an assurance from a bank that a buyer is able to pay a seller. The seller doesn't expect to have to draw on the letter of credit to get paid.

Revolving letters of credit
A single revolving letter of credit can cover several transactions between the same buyer and seller.

Back-to-back letters of credit
Back-to-back letters of credit may be used when an intermediary is involved but a transferable letter of credit is unsuitable.

Advantages for sellers
By asking for an appropriate letter of credit a seller is reassured that they will receive their money in full and on time. A letter of credit is one of the most secure methods of payment for exporters as long as they meet all the terms and conditions. The risk of non-payment is transferred from the seller to the bank (or banks).

Advantages for buyers
When a buyer uses a letter of credit they get a guarantee that the seller will honour their side of the deal and provide documentary proof of this.

Other things to consider
It's important to be aware of the additional costs involved in using a letter of credit. Banks make charges for providing them, so it's sensible to weigh up the costs against the security benefits.

If you're an exporter you should be aware that you'll only receive payment if you keep to the strict terms of the letter of credit. You'll need to give documentary proof that you have supplied exactly what you contracted to supply. Using a letter of credit can sometimes cause delays and other administrative problems.

When to use a letter of credit
Although letters of credit can be useful, it's often best to avoid using one for a transaction. They can sometimes result in expensive delays, bureaucracy and unexpected costs. As a general rule you should probably only consider opening a letter of credit as an importer if:

your supplier insists on it
national exchange controls require it

When to ask for a letter of credit?
Think carefully about whether or not you need to ask an overseas customer for a letter of credit. Some important things to consider include:

Legal matters - does the country you're exporting to require one?
Costs - does the value of the order justify the bank charges and extra costs involved, and who pays these costs?
The customer's creditworthiness - do they have a track record with you?
Risks associated with the country you're exporting to - is it politically stable with a good reputation as an international trading partner?
Normal trading practices - is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity?
Available advice and guidance - banks may recommend using of a letter of credit in certain trading situations regardless of other factors, while credit insurers sometimes insist on it.

Give some thought to alternative arrangements, such as credit insurance, export factoring or cash in advance terms. If you do decide that a letter of credit is the best option you'll need to consider which type of letter to use. A confirmed and irrevocable letter of credit is the most secure type
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Unclaimed money: Rights and wrongs

If you forget about a bank account, the money in it is still yours forever. No matter how many years or decades pass by, you or your descendants can turn up and claim the funds and the interest earned on it.

That is as it should be, since the money is your property. The same is true for almost all forms of financial investments and the returns generated from them. However, through some twisted piece of legal logic, this is not true of dividends , whether from stocks or from mutual funds. If a dividend cheque is sent to you and it is not encashed, and you don't turn up to claim the money for seven years, then the money is appropriated and spent on 'investor education' .

Actually, on a closer look, it gets even more curious. It's not about dividends alone. It seems that if your investments are in any cumulative form, then the government doesn't grab it. However, if any part of your investment (or income from it) is disbursed to you, and you or your descendants are unable to claim it, then it can be grabbed away and spent on this so-called investor education. In mutual funds, if you invest in an open-ended growth plan, it's yours forever.

However , if you invest in a dividend plan, or a closed-end plan (which will get automatically redeemed at a point), then the dividends and redemption money are up for grabs. If the investor shifts residence, closes a bank account, or (as often happens ) passes away without leaving complete information for descendants, then after seven years, the money can be appropriated . Even if a genuine claimant appears after seven years, the money will not be restored to him or her.

This is not a small problem. For the latest year for which numbers are available (2012-13 ), there are Rs 1,100 crore of unclaimed dividend with companies. Do note that this is the number for just the last seven years — money which is unclaimed but not yet transferred to the investor education fund.

The sum with mutual funds will easily be of the same scale but I don't have updated numbers yet. The total cumulated sum is bound to be much larger. There are a number of problems here.

The first is, of course, the basic principle of whether the government has the right to deprive you or your descendants of your own money merely because you may not have up to date information about your investments.

Second is the relevance of the seven years period. Why seven? Why not twenty or fifty or a hundred years? Lawyers tell me that the time period is probably based on the fact that a person who is untraceable for seven years is presumed to be dead by law. However, this situation clearly is very different.

When someone disappears for seven years, their property is inherited by their descendants, not spent away on some dubious cause. The other problem is that there is no standard for how much effort should be made to trace the rightful claimants. Companies and mutual funds wait for cheques to be encashed, then perhaps send or two more letters to the same address if they feel like spending the money , and that's that.

No one cares. All the while, the investors' descendants may be in financial difficulties but their money will be spent away by someone else. It's instructive to see how other countries handle this. In both the UK and the US, such unclaimed assets are held in perpetuity. No one but the rightful descendants have a right to it, ever.

Not just that, the information on unclaimed assets is available publicly and there are specialist locator companies that work to trace owners. What we need is a change in these unjust and unreasonable law, as well as provision to spend a small part of the unclaimed money to actually trace the real claimants.

Currently, it is clear that no one has any interest in making that effort.
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