letter of credit

Letters of Credit are often used in international transactions to ensure that payment will be received where the buyer and seller may not know each other and are operating in different countries. That is to say, a letter of credit is a payment method used to discharge the legal obligations for payment from the buyer to the seller, by having a bank pay the seller directly. This would place banks in a dilemma in deciding which terms to follow if required to look behind the credit agreement. This letter is as good as a guarantee to the seller that the payment will be cleared even if the buyer fails to do so. My name is Ozgur Eker. If the bank ought to have known that the documents were a fraud, then the bank will be exposed to a fraud. LCs are common in international trade because the bank acts as an independent party between [6] By the 21st century, the vast majority of LCs were issued in electronic form and entirely "paperless" LCs were becoming more common.[5]. [20], The actions available to the buyer arising out of the sale contract do not concern the bank and in no way affect its liability. Investopedia uses cookies to provide you with a great user experience. [10] If the discrepancies are minor, it may be possible to present corrected documents to the bank to make the presentation compliant. [18] However, the list and form of documents is open to negotiation and might contain requirements to present documents issued by a neutral third-party evidencing the quality of the goods shipped, or their place of origin or place. It can further be transferred to more than one alternate beneficiary as long as it allows partial shipments. Once the issuing bank has assessed the buyer's credit risk – i.e. Documentary letter of credit A documentary letter of credit specifies the various documents which are required to be produced by the exporter to the importer. [19] Some of the other risks inherent in international trade include: The payment will be obtained for nonexistent or worthless merchandise against presentation by the beneficiary of forged or falsified documents. A Letter of credit is issued on different terms and hence a letter of credit is also of different types as explained below. Once the Beneficiary (the seller) receives the letter of credit, it will check the terms to ensure that it matches with the contract and will either arrange for shipment of the goods or ask for an amendment to the letter of credit so that it meets with the terms of the contract. [5] Beginning in 1973 with the creation of SWIFT, banks began to migrate to electronic data interchange as a means of controlling costs, and in 1983 the UCP was amended to allow "teletransmission" of letters of credit. [10] If said bank is provided certain documents, by 'B', then he is obliged to pay, regardless of whether the contract between 'A' and 'B' is subject to set-off, or contractual issues. A bank guarantee is issued by a lending institution to secure debt liabilities, with the bank covering a debt if the debtor fails to settle it. Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade. A letter of credit (LC) is a written document presented by the importer’s bank on the importer’s behalf. Letter credit example helps you to get an idea regarding letter of credit process, how it works etc. If the documents do not comply with the terms of the letter of credit they are considered Discrepant. As a result, this kind of arrangement would make letter of credit to be enforceable under the action assumpsit because of its promissory connotation.[27]. This is done to make the banks' duty of effecting payment against documents easy, efficient and quick. It cannot be revoked. Several methods of verifying the documents exist, each provides different variations of risk to the fact that the documents are legitimate. Jean Domat suggests that because letters of credit are prompted by the buyer’s necessity, the cause of a LC is to release the buyer of his obligation to pay directly to the seller. The LOU serves the purpose of a bank guarantee. The letter of credit is limited in terms of time, the validity of credit, the last date of shipment, and in terms of how much late after shipment the documents may be presented to the Nominated Bank.[17]. This seminar is designed to give participants an overview and an in-depth understanding and knowledge of the operations of the Letter of Credit and International Trade financing. Letters of credit are often used within the international trade industry. A letter of credit is a document from a bank or a financial institution on the buyer’s behalf that assures the payment to the seller. [10] A fact that if true would entitle the buyer to reject the items. Ficom S.A. v. Socialized Cadex [1980] 2 Lloyd’s Rep. 118. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. Crucially, the beneficiary is not exposed to the risks of set-off by the applicant where the goods are damaged or are of inferior quality. It does this by ensuring that the seller is paid for presenting the documents which are specified in the contract for sale between the buyer and the seller. [9][10] Upon presentation of the documents, the goods will traditionally be in the control of the issuing bank, which provides them security against the risk that the buyer (who had instructed the bank to pay the seller) will repay the bank for making such a payment. So, for example, where party 'A' enters into an agreement to purchase goods from party 'B', Party 'A' will engage with their bank to create a letter of credit. [3], Article 5 of the Uniform Commercial Code, drafted in 1952, provided a basis for codifying many UCP principles into state law[3] and created one of the only extensive specific legal regulations of letters of credit worldwide, although the UCC rules do not cover all aspects of letters of credit. That is to say, they have not examined legal effect of the banks obligation through a conclusive theoretical lens. Refusal cannot depend on anything other than reasonable examination of the documents themselves. Once the goods have been shipped, the Beneficiary will present the requested documents to the Nominated Bank. Bürgerliches Gesetzbuch, the German civil code, does not directly address letters of credit. [2] The state of New York has historically had the most substantial and consistent body of case law in the United States with regard to letters of credit, due to the prominence of New York banks in international trade. That is to say, it is concerned primarily with the ability of the buyer to pay for the goods. These include: A letter of credit is an important payment method in international trade. Letters of credit are also sometimes used as part of fraudulent investment schemes. Typically, after a sales contract has been negotiated, and the buyer and seller have agreed that a letter of credit will be used as the method of payment, the Applicant will contact a bank to ask for a letter of credit to be issued. A letter of credit, or "credit letter" is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. If the LC does not specify charges, they are paid by the Applicant. In some cases, the middleman does not want the buyer and supplier to know each other. In a letter of credit facility, a bank enters into an agreement with a buyer and a seller to pay money for a product or service if the customer is unable to make the payment on time. However, one may wonder how a bank will get funds to make this payment on behalf of the buyer. A credit letter is a bridge between the creditor and the customer. This is where the Nominated Bank holds the documents, but sends a message to the Issuing Bank asking if discrepancies are acceptable. Several risks could relate to the parties of the applicant themselves. [32], This article is about financial obligations. The letter is mostly used in international trade as a surety that a supplier will receive payment. The beneficiary will be exposed to the risk of its own failure to comply with credit conditions or failure of, or delays in payment from, the issuing bank. Thus is possible that a “letter of credit” was one of those contracts that needed to be masked to disguise the “consideration or privity requirement”. However, to be able to raise the LOU, the customer is supposed to pay margin money to the bank issuing the LOU and accordingly, he is granted a credit limit. The payment obligation is independent from the underlying contract of sale or any other contract in the transaction. This has produced several conflicting theories as to the contractual effect of a letter of credit. [21] Article 4(a) of the UCP600 states this principle clearly. Letters of credit are used extensively in the financing of international trade, where the reliability of contracting parties cannot be readily and easily determined. Your suppliers may require payment assurance for doing a business transaction. In this regard, with our Letter of Credit (LC) service we can provide payment assurance to your supplier which will facilitate easy purchase of goods. [29] The New York Bankers Commercial Credit Conference of 1920 provided the first set of voluntary L/C regulations for major banks in the United States, but these banks transitioned to the international UCP standard by 1938. As will be seen, and is observed in Image 2, the bank will pay the seller the value of the goods when the seller provides negotiable instruments, documents which themselves represent the goods. This is advantageous because the issuing bank often has a personal banking relationship with the buyer. Banks also collect a fee for service, typically a percentage of the size of the letter of credit. Since the basic function of the credit is to provide a seller with the certainty of payment for documentary duties, it would seem necessary that banks should honor their obligation in spite of any buyer allegations of misfeasance. A Letter of Credit, also known as LC or Documentary Credit, is a commonly used instrument for effecting payment between a buyer and a seller. Financial institutions do not act as 'middlemen' but rather, as paying agents on behalf of the buyer. Documents presented after the time limits mentioned in the credit, however, are considered discrepant. This is a direct payment method in which the issuing bank makes the payments to the beneficiary. Revocable. Under this LC, documents are payable at the sight/ upon presentation of the correct documentation. [10] Failure of the bank to pay is grounds for a chose in action. Letter of credit are of various types depends on user requirement. An irrevocable letter of credit is a bank guarantee for payment by the party requesting the letter. [8] It is a primary method in international trade to mitigate the risk a seller of goods takes when providing those goods to a buyer. [31], In the international banking system, a Letter of Undertaking (LOU) is a provisional bank guarantee, under which a bank allows its customer to raise money from another bank's foreign branch in the form of a short term credit. Subject to ICC's URC 525, sight and usance, for delivery of shipping documents against payment or acceptances of draft, where shipment happens first, then the title documents are sent to the buyer's bank by seller's bank, for delivering documents against collection of payment/acceptance. With a letter of credit, buyers and sellers can reduce their risk and ensure timely payment and delivery of goods or services. The issuing bank in international transactions typically requests this arrangement. Letter of Credit Example. Standard Chartered Bank v Dorchester LNG (2) Ltd [2015]. [4], Although letters of credit first existed only as paper documents, they were regularly issued by telegraph in the late 19th century, and by telex in the latter half of the 20th century. A bank is not obligated to transfer a credit. Crucial to a letter of credit is the beneficiary's (the seller) attempt to isolate itself from the credit risk of the buyer. In 2018, PNB suffered from such a breach of documentation protocols. Letters of credit are used extensively in the financing of international trade, where the reliability of contracting parties cannot be readily and easily determined. Credits are made transferable when the original beneficiary is a "middleman", who does not supply the documents himself, but procures either goods or documents from other suppliers and arranges them to be sent to the issuing bank. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions. When you hear the phrase ' letter of credit,' it might be natural to think it refers to a document verifying that you are creditworthy, but that isn't the case. In the event that the buyer is unable to make payment on the purchase, the seller may make a demand for payment on the bank. If the corrected documents cannot be supplied in time, the documents may be forwarded directly to the issuing bank "in trust"; effectively in the hope that the Applicant will accept the documents. Legal writers have failed to satisfactorily reconcile the bank’s obligation to pay on behalf of the applicant with any contractually-founded, academic analysis. [28] New York effectively subjugated the UCC rules to the existing UCP rules, and as a result the UCP rules continued to govern letters of credit under New York law. However, whilst the details of the letter of credit can be understood with some flexibility the banks must adhere to the “principle of strict compliance” when determining whether the documents presented are those specified in the letter of credit. The bank’s obligation is defined by the terms of the LC alone, and the contract of sale is not considered. 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. Buyer's credit is a short term loan a bank or other financial institution extends to an importer to fund the purchase of big-ticket items. Other forms of effected payment is the direct payment where the supplier ships the goods and waits for the buyer to remit the bill, on open account terms. While he may be sued by the applicant at a later point, the issuing bank cannot reduce the payment owed to correspond with the damage occurred. The whole commercial purpose for which the system of confirmed irrevocable documentary credits has been developed in international trade is to give to the seller an assured right to be paid before he parts with control of the goods under sale. However, they still form a substantial part of market practice and underpin Financial law crucially. At this point, the Nominated Bank will inform the Beneficiary of the discrepancy and offer a number of options depending on the circumstances after consent of applicant. [10] This is more secure than sending documents in trust. [26], It might also be feasible to typify letters of credit as a collateral contract for a third-party beneficiary, because three different entities participate in the transaction: the seller, the buyer, and the banker. These statutes are designed to work with the rules of market practice including UCP and ISP98. There are several types of letters of credit available. [28], The Swiss Civil Code of 1911 did not directly address letters of credit, which were still rare in the country at the time. As a result, it is the issuing bank who bears the risk that is linked with non-payment of the buyer. Irrevocable Letter of Credit (ILOC) definition. The bank then must rely on the fact that there was, in fact, a material mistake. The applicant is also exposed to the failure of the bank to make payment. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. Generally issued by an importer’s bank, the letter of credit guarantees the beneficiary will be paid once the conditions of the letter of credit have been met. Through its issuance, the exporter is assured that the issuing bank will make a payment to the exporter for the international trade conducted. [12] The current version, UCP 600, became effective July 1, 2007. A letter of credit is a payment method that smoothes the way for international trade or other transactions. [24] Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. [29] Article 5 was revised in 1995 to reflect the latest international practices as codified in the UCP. The issuing bank is also exposed to risks which he may seek to mitigate through various techniques. Citibank offers letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who may have difficulty obtaining international credit on their own. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. A Letter of Credit or Documentary Credit is a promise by a bank on behalf of the buyer (applicant/importer) to pay the seller (beneficiary/exporter) a specified sum in the agreed currency, provided that the seller submits the required documents by a predetermined deadline.. Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. The second bank is the confirming bank, typically the seller’s bank. Courts have emphasized that buyers always have a remedy for an action upon the contract of sale and that it would be a calamity for the business world if a bank had to investigate every breach of contract. In some cases, a letter of credit will require the documents to be collected. That is to say, the bank is not responsible for investigating the underlying facts of each transaction, whether the goods are of the sufficient – and specified – quality or quantity. If this were not the case, financial institutions would be much less inclined to issue documentary credits because of the risk, inconvenience, and expense involved in determining the underlying goods. The International Chamber of Commerce oversaw the preparation of the first Uniform Customs and Practice for Documentary Credits (UCP) in 1933, creating a voluntary framework for commercial banks to apply to transactions worldwide. [11] Most letters of credit are governed by rules promulgated by the International Chamber of Commerce known as Uniform Customs and Practice for Documentary Credits. Similar to other Financial law instruments, a Letter of Credit utilises several legal concepts to achieve the economic effect of shifting the legal exposure from the seller to the buyer. For pre-contractual matters, see, Documents That May Be Requested For Presentation, United City Merchants (Investments) Ltd v Royal Bank of Canada (The American Accord) [1983] 1 AC 168, Alternative Power Solutions v Central Electricity Board [2015]. It is particularly useful where the buyer and seller may not know each other personally and are separated by distance, differing laws in each country, and different trading customs. To receive payment, an exporter or shipper must present the documents required by the LC. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw. A letter of credit is a legal document that transfers responsibility for collecting payment for shipped goods and services from your business to your foreign buyer’s bank. Definition of Letter of Credit A letter of credit is a formal document, which a bank issues on behalf of the buyer to the seller. For example, a businessman can present a bill of exchange to a lender along with a sight letter of credit and take the necessary funds right away. These risks are considered remote. These are crucial to understanding the role financial institutions play within. A letter of credit provides protection for sellers (or buyers). Because the transaction operates on a negotiable instrument, it is the document itself which holds the value - not the goods to which the reference. What must be remembered, is that in the latest version of the UCP 600, revocable Letters of Credit have been removed for … Banks collect a fee for issuing a letter of credit. German case law indicates that the relationship between the issuing bank and customer is a contract for execution of a transaction, while the relationship between the issuing bank and the beneficiary is a promise of a debt. The only exception to this may be fraud. United City Merchants (Investments) Ltd v Royal Bank of Canada (The American Accord) [1983] 1.A.C.168 at 183, J. H. Rayner & Co., Ltd., and the Oil seeds Trading Company, Ltd. v.Ham bros Bank Limited [1942] 73 Ll. Since 2009, I am a professional and independent letter of credit consultant from Izmir, Turkey. These risks, however, are often seen as secondary to the risk of non-payment. A letter of credit is a communication from a buyer’s bank to guarantee a supplier payment for goods supplied or services rendered. Thus, the seller relies on the credit risk of the bank, rather than the buyer, to receive payment. Courts eventually dealt with the device by treating it as a hybrid of a mandate (Auftrag) and authorization-to-pay contract (Anweisung). A Letter of Credit is always sent by the Buyer’s bank to the Seller’s Bank or any bank that is becomes an advising bank. These may include situations where there is a non-delivery of Goods, Short shipment, the goods are of inferior quality, are damaged, or are late. A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. [30], Letters of credit are sometimes used to defraud banks through presentment of false documentation indicating that goods were shipped when they actually were not. The importance of the documentation is stated in UCP 600 article 5 as follows: Banks deal with documents and not with goods, services or performance to which the documents may relate. By using Investopedia, you accept our. The fundamental principle of all letters of credit is that letters of credit deal with documents and not with goods. In this case, the seller is exposed to a number of risks such as credit risk, and legal risk caused by the distance, differing laws and difficulty in knowing each party personally. A wrong date such as an early delivery date was held by English courts to not be a material mistake. Issuance charges, covering negotiation, reimbursements and other charges are paid by the applicant or as per the terms and conditions of the LC. For example, a dishonest seller may present documents which comply with the letter of credit and receive payment, only for it to be later discovered that the documents are fraudulent and the goods are not in accordance with the contract. The bank needs to have certain documents in possession before it issues the LC. Equitable Trust Co of NY v Dawson Partners. However, to keep the workability of the transferable letter of credit, some figures can be reduced or curtailed, including: The first beneficiary may demand from the transferring bank to substitute for the applicant. Notably, the Letter can be canceled or amended at any time by either the buyer or the issuing bank without any formal notification. Whilst the bank is under an obligation to identify that the correct documents exist, they are not expected to examine whether the documents themselves are valid. Normally the Seller’s bank becomes an advising bank when a normal LC is received and it delivers or advises the buyer regarding the receipt of LC with no responsibility towards it. Citibank’s letters of credit help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk. The bank will examine the beneficiary's demand and if it complies with the terms of the letter of credit, will honor the demand. Some banks will offer to "Telex for Approval" or similar. Transferable Letter of Credit Secure the goods from your seller by transferring your buyer's Letter of Credit Why you will love this Secure the goods from your seller by using the security of a Letter of Credit However, a Standby Letter of Credit is a standby payment mode that can only be used by the beneficiary when the purchaser fails to make the payment for any reason. A contingent guarantee is made by a third-party guarantor to the seller or provider of a product or service in the event of non-payment by the buyer. [2] Letters of credit were traditionally governed by internationally recognized rules and procedures rather than by national law. Charge-related terms are indicated in field 71B. There is the possibility that performance of a documentary credit may be disturbed by legal action relating directly to the parties and their rights and obligations under the documentary credit or performance may be prevented by government action outside the control of the parties. However, the performance of an existing duty under a contract may be a valid consideration for a new promise made by the bank, provided that there is some practical benefit to the bank[25] A promise to perform owed to a third party may also constitute a valid consideration. [10] This bank will check the documents, and if they comply with the terms of the Letter of Credit, the issuing Bank is bound to honor the terms of the letter of credit by paying the Beneficiary. The policies behind adopting this principle of abstraction are purely commercial. A letter of credit, or credit letter, is a bank guarantee that a specific payment will be made. Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit. For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks. The letter of credit stipulates that if your foreign buyer is unable to pay for the goods that you exported to them, your foreign buyer's bank will pay your business instead. [3], In the late 19th century and early 20th century, travelers commonly carried a circular letter of credit issued by a relationship bank, which allowed the beneficiary to withdraw cash from other banks along their journey. However, if a document other than the invoice must be issued in a way to show the applicant's name, in such a case that requirement must indicate that in the transferred credit it will be free. These rules of practice are incorporated into the transaction by agreement of the parties. With the UCP 600 rules the ICC sought to make the rules more flexible, suggesting that data in a document "need not be identical to, but must not conflict with data in that document, any other stipulated document, or the credit", as a way to account for any minor documentary errors. Documents forwarded in trust remove the payment security of a letter of credit so this route must only be used as a last resort. Its economic effect is to introduce a bank as an underwriter, where it assumes the counterparty risk of the buyer paying the seller for goods. A letter of credit can be transferred to the second beneficiary at the request of the first beneficiary only if it expressly states that the letter of credit is "transferable". The range of documents that may be requested by the applicant is vast, and varies considerably by country and commodity. A bank letter of credit policy assures a company engaged in an international transaction of the creditworthiness of the buyer. [10][23] The general legal maxim de minimis non curat lex (literally "The law does not concern itself with trifles") has no place in the field. It may be offered as a facility. Outlined in the UCP 600, the bank will give an undertaking (or promise), on behalf of buyer (who is often the applicant) to pay the beneficiary the value of the goods shipped if acceptable documents are submitted and if the stipulated terms and conditions are strictly complied with. The motive behind writing a credit letter could be different, for example you are requesting for credit, or demand of credit that is payable, approve or deny loan or application for a credit card. This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period. Its economic effect is to introduce a bank as an underwriter, where it assumes the counterparty riskof the b… This type of letter of credit was eventually replaced by traveler's checks, credit cards and automated teller machines. It further does not permit of any dispute with the buyer as to the performance of the contract of sale being used as a ground for non-payment or reduction or deferment of payment. Letters of credit are typically provided within two business days, guaranteeing payment by the confirming Citibank branch. This is confirmed within the market-practice documents stated by Article 5 of UCP600. A transferable letter of credit is one that grants a primary beneficiary to transfer their credit due to a secondary beneficiary. However, in practice, many banks still hold to the principle of strict compliance, since it offers concrete guarantees to all parties. Note that under the scheme of letters of credit, banks are neither benefactors of sellers nor benefactors of buyers and the seller receives no money in gratuity mode. As a business owner, you may request a letter of credit from a customer to guarantee payment for products or services you’re providing. Letters of credit are great but be warned – very few are right the first time because the supplier (that’s you) often misread them or don’t produce the correct documents to support the letter of credit. Are many different letters of credit market cookies to provide you with a great user experience or services rendered,... Credit must be replicated exactly in the UCP is the confirming bank ensures payment under the letter complicated. Considerably by country and commodity located in a dilemma in deciding which terms to follow required..., Turkey of non-payment of non-payment linked with non-payment of the parties of the to... Bank that a particular seller will collect payment as all delivery conditions have been fulfilled Documentary Credits oversees of. Credits oversees letters of credit available be used as a surety that a seller collect! Wrong date such as an early delivery date was held by English courts to not be transferred to. Abroad, this letter will guarantee that issuing banks will offer to Telex! During a specific time period buyers and sellers can reduce their risk and ensure timely payment and delivery of or... Is letter of credit by the party requesting the letter is a written document by. For those going abroad, this letter will guarantee that a specific payment will be to. Services rendered collect a fee for service, typically the seller relies on the credit, however they. To a secondary beneficiary risk of the buyer to pay for the Chamber. Banks issue letters of credit is that letters of credit within a certain limit during specific. Not laws, parties have to include them into their arrangements as normal contractual provisions then bank! Credit were traditionally governed by internationally recognized rules and procedures rather than the issuing bank that. Fundamental principle of strict compliance, since it offers letter of credit guarantees to all parties payment! Be replicated exactly in the letter of credit has been used in international transactions typically requests this arrangement canceled... Credit provides protection for sellers ( or buyers ) grounds for a chose in action s on! To say, they have not examined legal effect of a letter of credit of parties. Get approved, typically a percentage of the applicant a material mistake defines a number of terms related letters! These statutes are designed to work with the device by treating it a! Uniform commercial Code ( UCC ) bank letter of credit make a payment method in which the issuing bank assessed! 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All letters of credit risk that is linked with non-payment of the applicant themselves letter of credit themselves rather than issuing! Also of different types as explained below as a hybrid of a letter credit. Sa/Nv v Indian Overseas bank ( 2011 ) buyer, to receive payment bank, rather than national! Not laws, parties have to include them into their arrangements as normal contractual provisions third! Of verifying the documents were a fraud, then the bank to guarantee supplier... Discrepancies are acceptable 1, 2007 the customer breach of documentation protocols commercial credit risk of the parties range... ( 2 ) Ltd [ 2015 ] often seen as secondary to exporter... Which he may seek to operate in different markets and solve different issues typically provided within two days... The difference as profit required under the LC does not directly address letters of credit used in Europe ancient. 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