Letters of Credit (LC)
Letters of Credit are a long established means of two businesses Trading securely with each other and is still widely used around the world. The latest statistics suggest that global annual trade using LC’s is around 2.3 Trilllion Dollars (US $)
Letters of credit (LC’s) are one of the most versatile and secure instruments available to international traders. An LC is a commitment by a bank on behalf of the importer (usually a foreign buyer) that payment will be made to the beneficiary (“the exporter or the seller”) provided that the terms and conditions stated in the LC have been met, as evidenced by the presentation of specified documents.
Since LC’s are credit instruments, traditionally, the importer’s (the buyer’s) credit arrangements with their bank have been used to obtain an LC. The importer pays the bank a fee to render this service. However, there are now many independent funders who will also provide LC’s for buyers based on the Transaction quality and will seek to recoup their funding by either having a reciprocal LC from the end buyer or assignment of an end receivable (Sales Invoice).
An LC is useful when reliable credit information about a foreign buyer is difficult to obtain or if the foreign buyer’s credit is unacceptable, but the exporter is satisfied with the creditworthiness of the buyer’s bank.
This method also protects the importer/buyer since the documents required to trigger payment provide evidence that goods have been shipped as agreed. However, because LCs have opportunities for discrepancies, which may negate payment to the exporter, documents should be prepared by trained professionals. Growth Finance have experts who can assist with this.
An LC, also sometimes referred to as a documentary credit, is a contractual agreement whereby the issuing bank (the importer’s bank), acting on behalf of their customer, promises to make payment to the beneficiary, the exporter (the seller/supplier) against the receipt of complying stipulated documents. The issuing bank will often use a local intermediary bank located in the seller’s country to facilitate the transaction and make payment to the exporter. Most major banks around the world have International Services departments with experienced staff who handle these transactions on a daily basis.
The LC is a separate contract from the sales contract for the goods on which it is based; therefore, banks are not concerned with the quality of the underlying goods or whether each party has fulfilled the terms of the sales contract.
The bank’s obligation to pay is solely conditioned upon the seller’s compliance with the terms and conditions of the LC. In LC transactions, banks deal in documents only, not goods.
LC’s can be arranged easily for one-time transactions between the exporter and importer or used for an ongoing series of transactions.
Unless the conditions of the LC state otherwise, it is always irrevocable, which means the document may not be changed or cancelled unless the importer, banks involved, and exporter agree.
Confirmed Letters of Credit
A greater degree of protection is afforded to the exporter where an LC issued by a foreign bank (the importer’s issuing bank) has low or weak International Credit rating so the exporter(the seller) asks its customer (the buyer) to have their issuing bank authorize another bank, often in the exporter’s country, (but not always) to “confirm” the LC. This Confirmation means that the confirming bank is now obliged to pay the exporter should the original bank fail to do so. If an LC is not confirmed, the exporter is subject to the payment risk of the foreign bank and the political risk of the importing country. Many major UK and EU banks will agree to confirm LC’s as will US and Asian banks – they will all have excellent ratings and most likely have an ongoing relationship with the buyer’s local country Bank.
Exporters should consider getting confirmed LC’s if they are concerned about the credit standing of the foreign bank or when they are operating in a high-risk market where political upheaval, economic collapse, devaluation, or exchange controls could put the payment at risk. Exporters should also consider getting confirmed LC’s when importers are asking for extended payment terms.
The Letter of Credit Process
There are typically seven steps that occur in order to get paid using a letter of credit:
- The importer (buyer) arranges for it’s bank to open an LC in favour of the exporter(the supplier).
- The buyer’s bank (the issuing bank) transmits the LC to the seller’s (the supplier/exporter) bank, which forwards it to the exporter for approval.
- The exporter forwards the goods and documents to a freight forwarder.
- The freight forwarder arranges shipment of the goods and submits documents to the seller’s bank.
- The seller’s bank checks documents for compliance with the LC terms and collects payment from the issuing bank on behalf of the exporter/seller, their customer.
- The importer’s account at the issuing bank is debited.
- The issuing bank releases documents to the importer to claim the goods from the shipper and to clear them at customs.
Special Letters of Credit
Letters of credit can take many forms. When an LC is made transferable, the payment obligation under the original LC can be transferred to one or more secondary beneficiaries. With a revolving LC, the issuing bank restores the credit to its original amount each time it is drawn down.
A standby LC is not intended to serve as the means of payment for goods but can be drawn in the event of a contractual default, including the failure of an importer to pay invoices when due. In addition, standby LCs are often used as counter guarantees against the provision of down payments and progress payments on the part of foreign buyers.
In summary
Letters of Credit are in use every day all around the world and can be an ideal way to trade with suppliers and or customers overseas. Whether an experienced user of LC’s or have that first LC trading opportunity Growth Finance can help with all types of LC arrangements.
