Trade Finance Tools: Letter of Credit and Letter of Guarantee

In case of importing stock or beginning to export goods to overseas markets, there are ranges of trade finance tools helping in making the operation run smoothly. Trade finance involves managing capital flows in international trade – this means money is deposited where it needs to be and on time, and both parties are given confidence that each will benefit from a smooth transaction. A wide variety of tools determine how cash, credit, investments, and other assets can be used for trading internationally. The best of them all are the letter of guarantee and letter of credit; herein below we will shed the light on their definitions, types and the different aspects between them, as follows: 

1. Letter of Credit

Letter of Credit (L/C) is one of the most frequently used payment mechanism in the international trade. Usually it satisfies the buyer (importer) need for credit and the seller (exporter) desire for cash. It is an irrevocable arrangement and constitutes a definite undertaking of the issuing bank to honor a complying presentation meaning a presentation that is in accordance with the terms and conditions of the Letter of Credit.

LCs are governed by the Uniform Customs and Practice for Documentary Credits, 2007 Revision, and ICC Pub. 600 (Applied to all documentary credits including to the extent to which they may be applicable, any standby LCs). Standby LCs could alternatively be made subject to ICC International Standby Practices (ISP98).

LC is governed, also, the Egyptian Commercial Law No.17 of the year 1999; as it is defined by Article (341) which stipulates that “Letter of Credit is an Agreement by virtue of which the bank undertakes to open a credit upon the request of one of his clients (called ‘the remitter’) in favor of another person (called ‘the beneficiary’ guaranteed by documents representing the shipped goods or goods prepared for shipment”. 

•  Terms of payment

• Sight Payment: The Bank pays the stipulated sum immediately against a complying presentation.
• Deferred Payment: The Bank undertakes to pay on a specified future date after a complying presentation and no draft or bill of exchange is required.
• Acceptance: The Bank accepts the draft or bill of exchange drawn by the beneficiary and pays at maturity after a complying presentation.
• Negotiation: Immediate payment to the beneficiary against negotiation of a draft or a bill of exchange and a complying presentation.

• Types of Letter of credit

• Confirmed L/C: It provides a double assurance of payment to the beneficiary, in addition to the issuing bank undertaking; there is a definite undertaking of the confirming bank, to honor or negotiate a complying presentation.
• Transferable L/C: The beneficiary may transfer his right to perform under the L/C to a third party (the second beneficiary or beneficiaries). It is usually used when the first beneficiary is a middleman who wishes to transfer all, or part of the value of the LC to his supplier.
• Assignment of Proceeds: The beneficiary may assign his right to receive the L/C proceeds to a third party. Such an assignment does not give to the designated payee any interest and does not affect the beneficiary or the bank right to agree to amendments, cancellation or any substitution.
• Revolving L/C: It permits reinstatement renewal or reinstatement of the amount without requiring specific amendments to the L/C.
• Standby L/C: It provides security against default in performance of an obligation.
• Back to Back L/C: It is basically used when a transferable L/C cannot be applied to the commercial transaction. It involves two separate L/Cs: One is opened in favor of a first beneficiary and another is opened on behalf of the first beneficiary (the back-to-back L/C) in favor of a second beneficiary (the supplier of goods). The first L/C is offered as sole collateral.

2. Letter of Guarantee

The Letter of Guarantee (L/G) is an international trade product/ service that properly meet the needs of the buyers, importers or project owners in securing their contractual agreements with the sellers, exporters or contracting companies. It has therefore become a standard requirement and due to its wide usage, its purpose has expanded to various other types of payment obligations. 

A Letter of Guarantee is a written undertaking given by a bank (The Guarantor) for the payment of a stated amount of money (letter of guarantee value) to another party (Beneficiary or Oblige) on presentation in conformity with the terms of the undertaking of a written demand for payment and other documents as may be specified in the guarantee at the request or on the instructions and under the liability of a party/ bank (the principal/the instructing party). 

The main purpose of this product is to guarantee payment to the beneficiary regardless of any objection or contestation from any other party.

The Letter of Guarantee by its nature is independent from the underlying project or contract described in it, therefore it is the issuing bank obligation to pay in accordance with the terms of the guarantee only. There are various types of guarantees some of which are as described below:

• Guarantee of payment. This type of guarantee is a security of payment obligations of Buyer to Seller.
• Guarantees of advance payment return. This guarantee represents an obligation of the bank to return advance payment in the event that, after receiving an advance, the Seller does not perform its contractual obligations.
• Contract execution guarantee. This guarantee is a security of timely delivery of goods or performance of services according to a contract.
• Tender guarantees. This guarantee plays a role of security in those cases when the Company fails to perform its obligations to tender organization or other party that is stipulated in the order received by winning the tender.
• Guarantee in favor of the customs authorities. This guarantee is a security of obligation of the company performing import and export operations to the Customs authorities for payment of customs taxes and duties.
• Guarantees of warranty execution. This guarantee plays a role of security of quality for delivery to the contract terms.

• Guarantee of credit return. This guarantee is a security for repayment of credit.