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What is a Letter of
Credit?
A letter of credit is a
banking mechanism which allows importers to offer secure terms to
exporters. Letters of credit have been used for many years in
international trading transactions.
The issuing bank's role
is to guarantee to the seller that if compliant documents are presented,
the bank will pay the seller the amount due.
"A letter of credit
is a payment undertaking given by the issuing bank on behalf of the
buyer/applicant to pay a seller/beneficiary a given amount of money on
presentation of specified documents representing the supply of goods
within specific time limits. These documents must conform to terms and
conditions set out in the letter of credit and documents must be
presented at a specified place."
Advantages
There are a number of
advantages both for the seller/exporter and the buyer/importer.
Seller:
This offers security to
the seller as an assurance of payment from an international bank. (On
the condition that the terms of the letter of credit are complied with.)
The seller can raise
finance when a Letter of Credit has been issued in his favour.
Buyer:
The buyer does not have
to pay cash up front to a foreign country before receiving the documents
of title to the goods purchased. This is helpful when the buyer is
unfamiliar with local suppliers and legalities.
This protects the buyer's
interests as the bank will only pay your supplier on your behalf if they
present x,y,z documents that you have asked for. Payment will be given
if these documents comply with the terms and conditions set out in the
letter of credit.
The buyer can build
safeguards into the Letter of Credit such as inspection of the goods,
quality control and set production and delivery times.
How Does a Letter of
Credit Work?
| Step 1
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The
buyer and seller agree terms, including means of transport, period
of credit offered, latest date of shipment and the relevant Incoterm
to be used. |
| Step 2
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The
buyer applies to the bank for a letter of credit to be issued.
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| Step 3
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The bank
will then evaluate the buyer's credit rating, and may require a cash
cover and/or reduction of other lending limits. |
| Step 4 |
The
issuing bank will issue a letter of credit. This will be sent to the
advising bank by airmail, telex or SWIFT |
| Step 5
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The
advising bank will establish authenticity of the letter of credit
using signature books or test codes, then informs seller
(beneficiary). |
| Step 6 |
The
advising bank may confirm the letter of credit, i.e. add its own
payment undertaking |
| Step 7 |
The
seller should check that the letter of credit matches the commercial
agreement, and that the terms and conditions can be satisfied in
goodtime. |
| Step 8
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If there
is anything that may cause a problem, an amendment should be
requested. |
| Step 9
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The
seller ships the goods and gathers together all the documents asked
for in the letter of credit such as the invoice, transport document
... |
| Step 10
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Before
presenting the documents to the bank, the seller should check them
for discrepancies against the letter of credit, and correct the
documents where necessary. |
| Step 11
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The
documents are presented to a bank, often the advising bank.
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| Step12 |
The
advising bank checks the documents against the letter of credit . If
the documents are compliant, the bank pays the seller and forwards
the documents to the issuing bank. |
| Step 13
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The
issuing bank will also check the documents. If they are in order the
issuing bank will reimburse the seller's bank immediately.
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| Step 14
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The
issuing bank debits the buyer and releases the documents (including
transport document), so that the buyer can claim the goods from the
carrier. |
Notes:
1. The letter of
credit refers to documents representing the goods - not the goods
themselves.
2. Banks are not in
the business of examining goods on behalf of their customers.
3. Typically the
documents requested will include a commercial invoice, a transport
document such as a bill of lading or airway bill, an insurance
document; and many others.
Problems That You May
Encounter and Tips
.
Often the seller's
documents will be rejected by the banks.
The banks use limited
discretion in matching the terms and conditions of the letter of
credit against documents presented. There is often little room for
judgment.
For example, suppose
that a letter of credit describes goods as "cocoa butter with a
maximum fat content of 15%". However the exporter presents a
commercial invoice referring to the goods as "cocoa butter with12% fat
content".
Common sense would
suggest that this consignment would be accepted, yet some banks will
reject the documents on the grounds of a discrepancy in the goods
description.
Tip:
Exporters must check the wording of all documents before submission,
using the same criteria that the banks apply. Ensure that all terms
used match.
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Often the letter of credit fails to anticipate an aspect of the
transaction.
For example a common
requirement on a letter of credit is for a 'clean on-board bill of
lading' - a document supplied by the shipping company attesting that
the goods were received in apparently good condition, and were loaded
in the ship's hold. However if the goods are hazardous or flammable,
they will be put on the deck of the ship instead of the hold, and the
bill of lading will be marked 'on deck'. This is not an on-board bill
of lading, so the documents can be rejected by the bank.
Tip:
To avoid such problems, exporters need an understanding of the
different types of commercial document (transport document, insurance
document etc.) and the things on each document that may matter to a
bank in the context of presentation under a letter of credit.
Time limits can be
missed when presenting required documents.
Tip:
You must be aware of up to three time constraints - the expiry date of
the credit, the latest shipping date and the maximum time allowed
between dispatch and presentation. Upon first advice of the letter of
credit, check that all its terms and conditions can be complied with
within the prescribed time limits. If the letter of credit calls for
documents supplied by third parties, make reasonable allowance for the
time this may take to organize. After dispatch of the goods, check all
the documents both against the terms of the credit and against each
other for internal consistency.
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Advice on L/C
