PNB Fraud: Banks, businesses look for life after letter of undertaking

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PNB Fraud: Banks, businesses look for life after letter of undertaking

It also stopped roll over of buyers’ credit. It also stopped importers who were using buyers’ credit for Arbitrage to earn some profit out of it.The banks while sanctioning or renewing buyers’ credit limit to the importers shall show how the bank has decided the maximum tenure for buyers’ credit on the basis of operating cycle tenure. Banks are not permitted to issue guarantees/ standby letters of credit or letters of comfort in favour of overseas lenders relating to External Commercial Borrowing . Applications for providing guarantees/ standby letters of credit or letters of comfort by banks relating to ECB in the case of SMEs will be considered by the Reserve Bank on merit under the Approval Route, subject to prudential norms. Banks are advised to refer to the Master Circular on “ Risk Management & Inter Bank Dealings” dated July 1, 2009 for the conditions and guidelines based on which a standby letter of credit /bank guarantee under the facility may be issued by Authorised Dealer Category I banks.

  • While bid bonds and performance guarantees cannot be avoided, it is to be considered whether guarantees should be given by the banks in all cases of overseas borrowings for financing overseas projects.
  • For example, A enters into a contract with B for completion of a certain project and the contract is supported by a bank guarantee.
  • Where the lending institutions are not so convinced about the aspects of loan proposals mentioned above, they should seek to stipulate conditions to make the proposals acceptable without such guarantees.
  • Although, such an undertaking may not prevent the exporter from approaching the Court for an injunction order, it might weigh with the Court in taking a view whether injunction order should be issued.
  • P. Circular No. 60 dated January 31, 2004 and modified from time to time.

The business risk for importers is also poised to go up because they will now need higher finance limits for banks but the latter, still reeling from the country’s biggest banking fraud and piling up NPAs, are unlikely to be as generous as in the past. After digitalization, letter of credits is issued in electronic form. Thus it reduces the time and efforts for completion of the transaction. Letter of credit also protects the interest of the buyer. Bank will pay the seller on the condition that the seller will produce valid documents before the bank.

F. What was PNB scam? Why LOU was banned by the RBI?

When mobilised legally with appropriate margin money and bank guarantees logged into the bank’s formal transaction recording system LoUs have proven to be more convenient sources of funding than the conventional letters of credit . LoUs are used in international banking transactions. LoU is a bank guarantee under which a bank allows its customer to raise money from another Indian bank’s foreign branch in the form of short-term credit. These guarantees are issued for the performance of a contract or an obligation. In case, there is a default in the performance, non-performance or short performance of a contract, the beneficiary’s loss will be made good by the bank.

In the interest of the smooth working of the Bank Guarantee Scheme, it is essential to ensure that there is no discontentment on the part of the Government departments regarding its working. Banks are required to ensure that the guarantees issued by them are honoured without delay and hesitation when they are invoked by the Government departments in accordance with the terms and conditions of the guarantee deed, unless there is a Court order restraining the banks. 2.5.5 In this regard, the Delhi High Court has made adverse remarks against certain banks in not promptly honouring the commitment of guarantees when invoked. It has been observed that a bank guarantee is a contract between the beneficiary and the bank. When the beneficiary invokes the bank guarantee and a letter invoking the same is sent in terms of the bank guarantee, it is obligatory on the bank to make payment to the beneficiary. In respect of infrastructure projects, banks may issue guarantees favouring other lending institutions, provided the bank issuing the guarantee takes a funded share in the project at least to the extent of 5 percent of the project cost and undertakes normal credit appraisal, monitoring and follow up of the project.


Moreover, since LCs and bank guarantees continue to be available, he believes the RBI’s latest ban will have very little impact on trade. Nirav Modi with the help of the deputy manager of PNB Gokulnath Shetty and other bank officials of PNB procured Letter of Understanding from PNB for 7 years to pay his diamond suppliers. When LOU is issued, consent of the bank should pass through a message channel called SWIFT system. Details in the SWIFT should be recorded in the banking system. In this case, with the help of banking officials, SWIFT message for the LOU issued to the Nirav Modi for past 7 years has not been recorded in the banking system.

LCs are issued in serially numbered security forms with solid documentation, and there is a clause for the beneficiaries/financier that “they should, in their own interest, verify the genuineness of the guarantee with the issuing bank”. On buyers Credit maturity date, the working capital bank recovers the amount from the importer and makes the payment as our payment instructions. 2.6.3 In addition to the above safeguards to be observed by banks in co-accepting the bills, it must be noted that the banks are precluded from co-accepting bills drawn under Buyers Line of Credit Schemes introduced by IDBI Bank Ltd. and all India financial institutions like SIDBI, Power Finance Corporation Ltd., etc.

difference between lou and lc

The system of obtaining guarantees should not be used by the directors and other managerial personnel as a source of income from the company. Banks should obtain an undertaking from the borrowing company as well as the guarantors that no consideration whether by way of commission, brokerage fees or any other form, would be paid by the former or received by the latter, directly or indirectly. This requirement should be incorporated in the bank’s terms and conditions for sanctioning of credit limits.

He felt banks could also suggest RBI to help in creating a legal framework for LoUs by modifying the Contract Act so that contracts executed through SWIFT and other designated electronic channels would be treated as valid contracts. In the absence of such legislation, parties have to rely on case laws for clarity. Nirav Modi and his uncle Mehul Choksi struck a deal with a few officials of Punjab National Bank and took advantage of gaps in the bank’s system to make PNB issue unauthorised LoUs and continuously roll over old LoUs with new letters of higher amounts till it was no longer possible. Lenders are trying to find a way out while some banks are planning to approach the Reserve Bank of India to lift the ban on Lo-Us and reintroduce the instrument — or some variant of it — in a more structured form.

Bank-wise limits should be fixed, taking into consideration the size of each bank for discounting bills co-accepted by other banks, and the relative powers of the officials of the other banks should be got registered with the discounting banks. V. The banks discounting such bills, co-accepted by other banks, should also ensure that the bills are not accommodation bills and that the co-accepting bank has the capacity to redeem the obligation in case of need. 2.5.1 Where guarantees are invoked, payment should be made to the beneficiaries without delay and demur. An appropriate procedure for ensuring such immediate honouring of guarantees should be laid down so that there is no delay on the pretext that legal advice or approval of higher authorities is being obtained.

Rs 114-bn PNB scam: Why fraudsters prefer to use Letter of Undertaking

These letters were used by importers to borrow money from other Indian banks located offshore to pay their suppliers. You purchase some material from a seller and that material is to come on continuous basis for a month, you can get issue a letter of credit from bank and give to the seller which will ensure that the seller will receive his payments on regular basis. So the seller will believe more on the letter of credit issued than you for the payments. He restricted letter of credit, seller nominates specific bank for the payment. The issuing bank on the default of buyer makes the payment to only to the specific bank nominated by the seller. Importers or buyers are set to see a hit on their costs of fund raising as the Reserve Bank of India on Tuesday disallowed banks to use LoUs or Letters of Undertaking and Letters of Comfort as trade credit for imports.

difference between lou and lc

In other cases, where such counter-guarantees of ECGC are not available, for whatever reasons, the banks may stipulate a reasonable cash margin only where it is considered absolutely necessary, as they satisfy themselves generally about the capacity and financial position of the exporter while issuing such bid bonds/ guarantees. Banks should make similar provisions in the bank guarantees for automatic extension of the guarantee period. The LoU was an inexpensive arrangement where the importer’s bank issued a guarantee to borrow from an overseas bank to pay off the bank that funds the overseas supplier. The abinitio contract period should be 6 months for all trade credits. It means buyers credit for capital goods can be taken and roll over in multiple of six months up to 5 years. Implication-It won’t be easy for the importers to pay their suppliers merely on the basis of guarantee letters issued by Indian banks.

Buyers’ credit finance means finance for payment of imports in India arranged by the importer from a bank or financial institution outside India. The suppliers’ credit means credits extended for imports directly by the overseas supplier instead of a bank or financial institution. Although both buyers credit and supplier credit are credit facility to the importer, depending upon the sources of credit they are classified as Buyers’ credit or Suppliers’ credit. Banks may issue guarantees on behalf of share and stock brokers in favour of stock exchanges in lieu of security deposit to the extent it is acceptable in the form of bank guarantee as laid down by stock exchanges. Banks may also issue guarantees in lieu of margin requirements as per stock exchange regulations.


The person dealing in the Commercial International trades made the methods and techniques to handle letter of credit worldwide. It was identified by the International Chamber of Commerce , which publishes the Uniform Customs and Practice for Documentary Credits in 1933. UCP is the set of standardized and unified rules to control the issuance of the letter of credit worldwide.

This type of tendency of the importers used to expose them to currency risks in the situation of volatile market conditions if the currency positions held unhedged. Banks can issue Letter of Credit /Letter of undertaking /letter of comfort in favour of overseas supplier, bank or financial institutions up to USD 20 million per transaction for a period of up to one year for non-capital goods and up to three years for capital goods permissible under Foreign Trade Policy. It is important to note that as per existing guidelines ‘Buyers Credit/Trade Credits’ for capital goods are allowed up to five years, but banks cannot issue LC/LoU/LoC beyond 3 years from the date of shipment.

The Reserve Bank of India in 2018 barred all lenders from issuing letters of undertaking , a form of credit guarantee. It can be used when someone imports goods from another country. In this case also a letter of credit can be given to seller. Step 5 -Advising Bank transfers the letter of credit to the seller.

Bank guarantee also has the functions as are of letter of credit with a small distinction. It eliminates the financial risk because payment is to come from a bank. When the letter of credit cannot be transferred to the third party than it is called non-transferable letter of credit. In this sole and ultimate beneficiary is the seller only.

Unconfirmed letter of credit is a letter in which only issuing bank is liable to pay the seller on the breach of the buyer. It is riskier than the confirmed letter of credit. A revocable letter of credit can be altered, amended or canceled by the issuing bank or buyer at any time. Bank and buyer are not bound to give notice to the seller for such letter of credit. It cannot be altered, amended or canceled after the seller had submitted the document to the issuing bank.

2.6.5 There have been instances where branches of banks open L/Cs on behalf of their constituents and also co-accept the bills drawn under such L/Cs. Legally, if a bank co-accepts a bill drawn under its own L/C, the bill so co-accepted becomes an independent document. The special rules applicable to commercial credits do not apply to such a bill and the bill is exclusively governed by the law relating to Bills of Exchange, i.e. the Negotiable Instruments Act.

Thus this integration should be the focus of the RBI’s concerns for all banks that are involved in export finance so that disclosure is institutionalised rather than dependent on the integrity of a bank executive. Apart from other anxieties this ban comes at a time when disruptions caused by the goods and services tax are yet to be sorted out, as many exporters have been waiting for months for offset dues from the Integrated GST to materialise. The LoU is akin to a letter of credit or a guarantee.

But it will be a pity if small and medium enterprise players – especially those in the gold business who reportedly face a 0.5-1% uptick in costs in an already low-margin business – are left paying the price for a billionaire scamster’s greed. Letter of Undertaking is cheaper and requires less documentation than letter difference between lou and lc of credit. When the letter of credit can be transferred to the third party than it is called the transferable letter of credit. In earlier articles, termsLetter of Undertaking and Letter of Comfortare used regularly. Below article gives difference between both these terms from perspective of buyers credit.