A transferrable letter of credit provides further flexibility to all the parties in the trade. It primarily acts as the documentary credit for payment confirmation, while provides the advance credit facility to the seller (middleman).
The first beneficiary upon approval can include one or more secondary beneficiaries in the credit transfer list. The first beneficiary can opt to transfer part of full credit to another beneficiary.
What is a Transferrable Letter of Credit?
A transferrable letter of credit acts as the financial guarantee as well as the credit advance. The primary beneficiary upon approval from the lending bank can transfer part or full credit to other parties.
The first beneficiary holds the primary obligation in the case of the default. The process of approval for a transferrable LC is more like a loan approval than a conventional documentary credit.
A transferrable LC involves only one bank as the issuing bank. However, if the documentary credit also includes the confirmation clause, it will involve another bank and the confirmation house. A transferrable LC ter of credit remains a convenient option for many international trade parties as it provides flexible terms to both parties.
How Does Transferrable Letter of Credit Work?
In a conventional agreement, the sellers require a form of financial guarantee from the buyer. The trade payments usually proceed with the letter of credit providing financial security to the seller. However, with large trade deals, the sellers often require upfront cash to manage large orders. The buyers provide these advances in some cases too. A convenient option for both parties in unknown relations is to utilize the transferable letter of credit.
The issuer bank remains the same in a transferrable letter of the credit arrangement. There are three other parties involved in the agreement, the buyer, the seller (first beneficiary), and the manufacturer (second beneficiary).
A transferrable LC provides an opportunity for the sellers to act as the middleman in the trade deals. Many modern traders outsource their production to other manufacturers and keep their profits. Sellers working for commission and the middlemen for the international traders also benefit from such arrangements.
The Approval of the Transferrable Letter of Credit
The buyer becomes the primary applicant for the letter of credit. The trade deal terms and conditions often dictate the type of documentary credit. In large trade deals, the sellers usually prefer the transferrable letter of credit. The bank approves the letter of credit after appraising the applicant’s creditworthiness.
The issuing bank may require additional collateral with a transferrable LC. The credit transfer to the second beneficiary includes an additional clause in the original letter of credit. The transferrable clause does not transfer the primary obligation to the second beneficiary though. The applicant needs to maintain sufficient creditworthiness with its bank to get the approval.
Key Points to note with a Transferrable Letter of Credit
Although the concept of the transferrable letter of credit remains the same as providing the financial guarantee, it differs in a few ways from other documentary credits.
- The bank has no obligation to provide the transferability clause in the primary documentary credit approval.
- The second beneficiary cannot request the issuing bank to add the transferability clause.
- The bank may approve the full or part of the total letter of credit approval as the transferrable credit.
- The transferrable LC must include the same agreements as in the primary trade deal.
- The letter of credit must explicitly state the transferability clause and the number of beneficiaries.
- The primary beneficiary may require providing the additional insurance cover with the transferability clause.
The approval of a transferrable LC may incur additional charges such as insurance, commission, interest, and service charges. The second beneficiary bears the charges unless otherwise agreed by both parties.
Example of a Transferrable Letter of Credit
Suppose a buyer company Green Star Co. in the US contracts for a trade deal with another company Blue Chips in the UK. The trade deal is worth $100,000. The seller may request the buyer to provide the advance payments. They can alternatively request the buyer to issue a transferrable letter of credit. The seller can then use that transferrable LC to outsource the production/raw material expenses to another beneficiary.
Usually, the transferrable LC will include part of the total credit approval amount. The sellers utilize that pat transferability clause to proceed with their productions. In some cases, the primary beneficiary may act as the middleman and transfer the full letter of credit to the secondary beneficiary.
Advantages of Transferrable Letter of Credit
A letter of credit provides the financial guarantee in the international and domestic trade to both parties. It may take several forms as it can embed several characteristics depending upon the trade deal and other terms. A transferrable letter of credit also comes with several advantages to all four parties involved in the transaction.
- It provides the flexibility of both the financial guarantee as well as the advance payments to the seller and the secondary beneficiary.
- The applicant keeps the control by offering full or part amount as the transferrable letter of credit to the secondary beneficiary.
- The buyer can argue for better prices with an additional provision of transferability clause for the seller.
- The seller can utilize the facility as the trade advance payment or utilize it to outsource all the production to another party.
- It helps retain the trade deal for all three parties involved in the trade.
- It helps the sellers and manufacturers to maintain their cash flows, which often remains a critical hurdle for many companies in large trade deals.
Disadvantages of Transferrable Letter of Credit
A transferrable letter of credit also comes with some limitations for all parties in the trade deal.
- The approval of a transferability clause may require additional creditworthiness or collateral by the issuing bank.
- Additional charges such as insurance, interest, and servicing charges must be covered by the seller.
- The seller may have to offer discounts in prices to bargain for the transferability clause.
- The primary beneficiary cannot avail of the facility unless agreed with the buyer.
- The issuing bank may impose further covenants with a transferability clause for additional protection.
A transferrable letter of credit allows the primary beneficiary to transfer part or full credit to another party. It allows the flexibility of financial guarantee and the cash flow for the seller. The buyer holds the control for allowing the transferability clause for part or full, and to the number of beneficiaries.