Back-to-Back Letter of Credit Definition
Back-to-Back Letter of Credit is a negotiable instrument in which the seller gets a Letter of Credit from the buyer, and the seller further transfers the Letter of Credit to its supplier. In simple words, the seller first receives the Letter of Credit from the buyer to ensure timely payment, and further, the same seller hands over the Letter of Credit to someone from whom he buys goods or materials. There are various advantages and disadvantages of a Letter of Credit. Let us take an example under the concept of a Back-to-Back Letter Of Credit.
Example of Back-to-Back Letter of Credit
Suppose a garment manufacturer Xion Ltd. sells its product to Harry. In return, Harry did not make the payment. Instead, he gave Xion Ltd. a Letter of Credit. This Letter of Credit is an assurance to Xion Ltd. that if Harry fails to make a timely payment, Xion Ltd can use the negotiable instrument to get its claim from the bank. To process the order of Harry, Xion Ltd. purchases raw material from its supplier; Noble Ltd. Xion Ltd. does not make any payment to it. Instead, it hands over the original Letter of Credit received from Harry after changing the beneficiary name with its intermediary bank. Now Noble Ltd. assures that it will receive the payment for the material purchased by Xion Ltd. This transfer of a Letter of Credit from one seller to another seller is a Back-to-Back Letter of Credit (BBLC).
Parties to BBLC
- Issuing Bank
- Confirming Bank
- Transferring Bank
- Advising Bank
- Accepting Bank
Procedure for Back-to-Back Letter of Credit
Upon getting the instructions from the customer, the issuing bank agrees to issue a Letter of Credit, which is transferable to the first beneficiary. This means that the first beneficiary can transfer the letter of credit to its customer, third party, or secondary beneficiary. The transferring bank, i.e., the bank issuing the letter of credit, shall issue a “Transferred Letter of Credit.” The “Transferred Letter of Credit” looks identical to the original Letter of Credit. The first beneficiary holding the original Letter of Credit gives the “Transferred Letter of Credit” to the secondary beneficiary.
Essential Documents Required for Letter of Credit
- Bill of Lading
- Certificate of Origin
- Packing List
Payment Clause in Back-to-Back Letter of Credit
When the first beneficiary transfers the original LC to the secondary beneficiary, it is assumed that the payment has been made to the first beneficiary of the transaction when LC is presented at the bank. However, suppose partial payment is made to the secondary beneficiary in such a case. In that case, the original beneficiary has the right to present the invoice and draft to the bank after the secondary beneficiary has presented the documents.
Example of Payment in Back-to-Back Letter of Credit
Suppose Xion Ltd. has handed over Noble Ltd. a Back-to-Back LC. Noble Ltd. approaches the bank to claim its payment that was due from Xion Ltd. The original LC was issued for $ 15,000, but the payment due to Noble Ltd was only $ 10,000. Here the bank will require not only the original LC but also a written request to hand over the specified amount. Bank requires the original LC to endorse it further by writing the amount due and the name of the party. LC being a negotiable instrument can be endorsed further. After making the payment to Noble Ltd, the bank shall issue a document suggesting the payment made to the party of the original LC and the amount due on it.
Letter of Credit has become an important tool for reducing business risk and speeding up the cash flow cycle. It facilitates business to trade at ease. It can be endorsed multiple times as a negotiable instrument, making it the most flexible payment tool. Back-to-Back Letter of Credit facilitates payments to subcontractors. The first beneficiary can transfer the LC in favor of the secondary beneficiary, assuring payment to the supplier. This helps the business to continue its functions smoothly.
Read Types of Letter of Credit to know about its various other types.