Letter of Credit (LC): Meaning, Types and How It Works for Imports

International trade often brings together buyers and sellers who operate under different legal systems, banking arrangements and commercial practices. An overseas supplier may be reluctant to dispatch goods without payment assurance, while an importer may not want to pay before receiving evidence that the shipment has taken place.

A letter of credit (LC) provides a structured way to address this gap. It is an undertaking issued by a bank at the importer’s request, under which payment is made to the exporter when the stipulated documents are presented in accordance with the credit’s terms.

The arrangement does not guarantee the quality or physical condition of the goods. Banks examine documents rather than inspecting the underlying shipment. Understanding this distinction is central to the LC meaning in business.

This article explains how a letter of credit import transaction works, the parties involved, commonly used documents, major types of letter of credit, eligibility considerations and the difference between an LC vs bank guarantee.

What Is a Letter of Credit (LC)?

A letter of credit also known as a documentary credit is an independent undertaking issued by a bank in favour of a beneficiary, usually an exporter. The bank agrees to honour a complying presentation according to the terms stated in the credit.

In practical terms, the importer asks its bank to issue the credit. The exporter then ships the goods and presents the documents specified in the LC. These may include a commercial invoice, transport document, packing list, insurance document or certificate of origin.

The bank examines whether the documents appear to comply with the credit. It does not determine whether the goods are of the promised quality or whether every obligation under the commercial contract has been performed.

For this reason, the sales contract and the LC are separate arrangements. A dispute about damaged, defective or unsuitable goods does not automatically entitle a bank to disregard an otherwise complying documentary presentation.

Parties Commonly Involved in an Import LC

An import LC ordinarily involves the following parties:

• Applicant: The importer or buyer that asks its bank to issue the LC.
• Beneficiary: The exporter or seller in whose favour the LC is issued.
• Issuing bank: The importer’s bank, which issues the undertaking.
• Advising bank: The bank that authenticates and communicates the LC to the exporter.

Depending on the transaction, other institutions may also participate:

• Confirming bank: A bank that adds its own undertaking to honour or negotiate a complying presentation.
• Nominated bank: A bank with which the credit is available for payment, deferred payment, acceptance or negotiation.
• Reimbursing bank: A bank authorised to reimburse another bank under the credit.
• Negotiating bank: A nominated bank that purchases drafts or documents under a complying presentation, where the credit permits negotiation.

These roles should be identified from the LC itself because not every transaction involves all these banks.

Example of an Import LC

Consider an Indian manufacturer purchasing specialised components from an overseas supplier. The supplier wants reliable payment assurance before dispatching the order, while the manufacturer wants payment to depend on the presentation of agreed shipping documents.

The manufacturer may request its bank to issue an LC specifying the goods, shipment deadline, payment terms and required documents. After shipment, the exporter presents those documents through the relevant bank. Payment is then handled according to the LC terms if the presentation is found to comply.

The arrangement can reduce payment uncertainty, but it does not replace

How Does an LC Work? Step-by-Step Import Process

The exact letter of credit import process depends on the transaction and bank procedures. A conventional documentary-credit transaction may follow these stages.

1. Importer and Exporter Agree on Commercial Terms

The parties first enter into a sales contract covering matters such as:

• Description and quantity of goods
• Contract price and currency
• Delivery and shipment terms
• Applicable Incoterms
• Latest shipment date
• Payment method
• Required documents
• Inspection requirements
• Insurance responsibility
• Dispute-resolution terms

The contract may state that payment will be made through an LC subject to an agreed set of rules, such as UCP 600.

Careful alignment between the contract and proposed LC terms is important. Conflicting conditions can create uncertainty or make documentary compliance difficult.

2. Importer Applies to the Bank

The importer submits an LC application to an Authorised Dealer Category-I bank in India. The application may be supported by:

• Sales contract or purchase order
• Pro forma invoice
• Importer Exporter Code, where applicable
• KYC and business records
• Details of the goods and overseas supplier
• Applicable licences, permissions or declarations
• Requested LC amount, currency and validity
• Proposed shipment and payment terms
• Details of the required documents

The bank assesses the request under its credit policy and applicable foreign-exchange and trade requirements. It may consider the importer’s financial position, sanctioned non-fund-based limits, transaction history, security, margin and ability to meet the payment obligation.

Submission of an application does not guarantee issuance.

3. Issuing Bank Opens the LC

If the request is approved and the applicable conditions are completed, the issuing bank sends the LC to the advising bank.

The advising bank checks the apparent authenticity of the credit and communicates it to the exporter. Advising an LC does not, by itself, create a separate payment undertaking from the advising bank.

The exporter should examine whether the credit accurately reflects the contract and whether its conditions can be fulfilled. Where an amendment is needed, the parties may request one through the banking channel.

4. Exporter Ships the Goods

After accepting the terms, the exporter arranges shipment within the specified period.

Shipment alone does not establish entitlement to payment. The exporter must also obtain and present the documents required by the LC in the prescribed form and within the applicable presentation period.

5. Exporter Presents the Documents

The exporter submits the stipulated documents to the nominated, confirming or advising bank, as applicable.

The presenting bank may examine the documents before forwarding them to the issuing bank. The documents must be consistent with the requirements of the credit and the applicable rules.

6. Banks Examine the Presentation

The relevant banks assess whether the documents constitute a complying presentation.

If the documents comply, the credit may be honoured or negotiated according to its terms. Payment timing depends on whether the credit is available by sight payment, deferred payment, acceptance or negotiation.

If discrepancies are identified, the issuing bank may refuse the presentation in accordance with the applicable rules. The importer may be asked whether it is willing to waive particular discrepancies, but such a waiver is not automatic and does not compel every participating bank to accept the documents.

7. Importer Receives Documents and Settles With the Bank

Following acceptance of the documents, the importer settles its obligation to the issuing bank under the agreed facility terms.

The relevant transport or title documents may then enable the importer to take delivery of the goods, depending on the shipping arrangement and form of documentation.

There is no universal completion period for an LC transaction. Timing depends on shipment, document preparation, presentation, bank examination, discrepancies, interbank communication and the agreed payment terms.

Does UCP 600 Apply to Every Letter of Credit?

UCP 600 is a set of rules issued by the International Chamber of Commerce for documentary credits. It covers matters such as interpretation, examination of documents, honour, negotiation, amendments and refusal of non-complying presentations.

UCP 600 does not automatically govern every LC merely because it is used in international trade. The credit should expressly state that it is subject to UCP 600 for those rules to apply.

Indian import transactions must also comply with applicable provisions of FEMA, RBI directions, the Foreign Trade Policy, customs requirements and the issuing bank’s procedures.

Documents Required Under a Letter of Credit

There is no single document list applicable to every import LC. The requirements depend on the goods, contract, transport mode, country of origin, regulatory conditions and wording of the credit.

Commonly requested documents include:

• Commercial invoice
• Bill of lading, airway bill or another transport document
• Packing list
• Certificate of origin
• Insurance policy or certificate, where applicable
• Inspection or quality certificate
• Weight or quantity certificate
• Beneficiary’s certificate
• Bill of exchange, if required
• Other licences, declarations or regulatory documents applicable to the goods

Document requirements should be limited to records that serve a clear commercial or regulatory purpose. Requiring unnecessary or difficult-to-obtain documents can increase the possibility of discrepancies.

Why Document Compliance Matters

Banks determine whether a presentation complies by examining the documents. Differences involving names, dates, quantities, ports, shipment details, document issuers or other stipulated information can result in discrepancies.

Typical issues include:

• Shipment after the latest permitted date
• Presentation after the allowed period
• Missing documents
• Inconsistent descriptions or quantities
• Incorrect transport-document details
• Inadequate insurance documentation
• Unsigned documents where signatures are required
• Documents issued by a party other than the one specified

A minor commercial difference can still matter if it results in documentary non-compliance. Importers and exporters should therefore agree on conditions that are precise, necessary and realistically capable of being fulfilled.

Main Types of Letter of Credit

Different types of letter of credit are used for different payment, performance and trading structures.

Note: Product terminology and availability may differ across banks. Each LC must be interpreted according to its own wording, incorporated rules and governing requirements.

Sight LC

A sight LC provides for payment after the relevant bank determines that the presentation complies.

“Sight” should not be interpreted as unconditional or instantaneous payment on document submission. Time is required for the bank to examine the documents, and discrepancies may delay or prevent honour.

Usance LC

A usance LC, also described in some transactions as a term or deferred-payment credit, provides for payment at a future date determined under the LC terms.

The maturity may be calculated from a specified event, such as:

• Date of shipment
• Transport-document date
• Date of presentation
• Date of acceptance
• Another event expressly stated in the credit

A usance LC may give the importer time between shipment and payment. However, it also creates a payment obligation at maturity and may involve bank charges, financing costs or exchange-rate exposure, depending on the structure.

Advantages and Limitations of an Import LC

An LC can provide a more structured payment mechanism, but its usefulness depends on the transaction.

Potential Advantages for the Exporter

• An undertaking from the issuing bank, subject to compliant presentation
• Defined documentary and payment conditions
• Reduced dependence solely on the importer’s willingness to pay
• Possible confirmation by another bank, where agreed and available
• Access to negotiation or financing arrangements, subject to bank assessment

Potential Advantages for the Importer

• Payment linked to the presentation of specified documents
• Ability to define shipment and documentary requirements
• A recognised payment structure for overseas suppliers
• Possible deferred-payment terms under a usance arrangement
• A documentary record of the trade transaction

Important Limitations

• Banks do not verify the quality, condition or existence of goods in the manner a physical inspector would.
• Complying documents can result in payment even if a later commercial dispute arises.
• Documentary discrepancies can delay payment or create additional costs.
• Amendments may require consent and bank processing.
• Charges may arise at different stages and through more than one bank.
• Currency movements can affect the importer’s rupee payment obligation.
• Fraud, sanctions, legal restrictions and country or bank risk are not eliminated merely because an LC is used.
• The importer remains responsible for settling with the issuing bank under the agreed facility.

An LC should therefore form part of a broader trade-risk framework that may also include supplier due diligence, suitable insurance, inspection arrangements and a clearly drafted sales contract.

LC vs Bank Guarantee: Key Differences

A letter of credit and a bank guarantee are both bank undertakings, but their commercial functions are different.

Note: The legal and commercial effect depends on the wording of the particular instrument. Product labels alone should not be used to determine liability or payment rights.

There is no universally superior option in an LC vs bank guarantee comparison. An LC is generally suited to a transaction where payment is expected against specified documents. A bank guarantee is more commonly intended to respond when a contractual obligation is not met.

Who May Be Eligible to Open an LC?

An Indian importer with a genuine and permissible trade transaction may approach an Authorised Dealer Category-I bank for an LC. Eligibility is not established merely by holding a current account.

The bank may assess:

• Nature and operating history of the business
• KYC and constitution documents
• Importer Exporter Code, where applicable
• Purchase contract or pro forma invoice
• Permissibility of the underlying import
• Licences or approvals required for restricted goods
• Financial statements and cash flows
• Credit history and existing banking conduct
• Available non-fund-based facility limits
• Margin or security requirements
• Supplier, country, currency and transaction risks
• Ability to pay the bank when the LC is honoured
• Compliance with FEMA, RBI directions and internal bank policies

An LC is usually treated as a non-fund-based facility at the time of issuance. It can result in a funded liability if the bank makes payment and the importer does not provide the required funds.

Approval, LC value, validity, margin and other conditions depend on the bank’s assessment and the transaction. No applicant should assume that a prior facility or established banking relationship guarantees issuance.

Costs Associated With a Letter of Credit

The cost of an LC varies by bank and transaction. It may include:

• Issuance or opening commission
• Advising charges
• Confirmation charges, where confirmation is added
• Amendment charges
• Document-handling or examination charges
• Negotiation or payment charges
• Reimbursement charges
• SWIFT or communication charges
• Discrepancy fees
• Acceptance or deferred-payment charges
• Applicable taxes
• Foreign-exchange conversion costs

The contract should clearly state which party bears each category of bank charge. Charges imposed by overseas or intermediary banks may otherwise become a source of disagreement.

Pricing should be reviewed through the bank’s written sanction and schedule of charges rather than assumed from general market information.

Practical Points to Review Before Opening an LC

Before applying for an LC, the transaction structure should be reviewed for:

• Accurate legal names and addresses of the parties
• Correct currency and maximum credit amount
• Clear description of goods
• Suitable Incoterms
• Shipment origin and destination
• Latest shipment date and expiry date
• Place of presentation
• Time allowed for presenting documents
• Required transport, insurance and commercial documents
• Sight or deferred-payment terms
• Partial-shipment and transshipment conditions
• Responsibility for bank charges
• Applicable ICC rules
• Amendment process
• Inspection and quality-control arrangements
• Consequences of discrepancies
• Foreign-exchange exposure
• Sanctions and trade-control requirements

Conditions that require the importer’s direct confirmation after shipment can make payment uncertain for the exporter and may be difficult for banks to evaluate. Documentary requirements should therefore be objective and capable of being evidenced through identifiable records.

Conclusion

A letter of credit can bring structure to an import transaction by replacing an open-ended promise to pay with a bank undertaking linked to specified documents. It can give the exporter greater payment assurance while allowing the importer to define documentary conditions connected with shipment.

That protection has clear boundaries. Banks assess documents rather than the physical goods, and an LC does not replace supplier verification, inspection, insurance or a well-drafted sales contract. Discrepancies, unsuitable conditions and unclear allocation of bank charges can also reduce its practical value.

For an Indian importer, the suitability of an import LC depends on the commercial contract, cash-flow cycle, supplier expectations, foreign-exchange exposure and the issuing bank’s assessment. Reviewing the complete instrument not merely its label or value provides a clearer understanding of the obligations involved.

Disclaimer : The information in this blog is for general purposes only and may change without notice. It does not constitute legal, tax, or financial advice. Readers should seek professional guidance and make decisions at their own discretion. IIFL Finance is not liable for any reliance on this content. Read more