Letters of Credit have been a cornerstone of international trade dating back to the early 1900s. They continue to play a critical role in world trade today. Letters of credit (LCs) are among the most secure instruments available to international traders. For any company entering the international market, Letters of Credit are an important payment mechanism which helps eliminate certain risks. An LC is useful when reliable credit information about a foreign buyer is difficult to obtain, but we are satisfied with the credit worthiness of buyer’s foreign bank. This method also protects the buyer, since no payment obligation arises until the documents proving that the goods have been shipped or delivered as promised are presented. A Letter of Credit, is a written instrument issued by a bank at the request of its customer, the Importer (Buyer), whereby the bank promises to pay the Exporter (Beneficiary) for goods or services, provided that the Exporter presents all documents called for, exactly as stipulated in the Letter of Credit, and meet all other terms and conditions set out in the Letter of Credit. A Letter of Credit is also commonly referred to as a Documentary Credit. The L/C is not a guarantee of the underlying commercial transaction. Indeed, the L/C is a separate transaction from any sales or other contracts on which it might be based. To constitute a true L/C transaction. the following elements must be present with respect to the issuing bank:
- The issuing bank must receive a fee or other valid business consideration for issuing the L/C.
- The bank’s L/C must contain a specified expiration date or a definite maturity.
- The bank’s commitment must have a stated maximum amount of money.
- The bank’s obligation to pay must arise only on the presentation of specific documents, and the bank must not be called on to determine disputed questions of fact or law.
- The bank’s customer must have an unqualified obligation to reimburse the hank on the same condition as the bank has paid.
FIGURE 1: LETTER OF CREDIT
1.2 POINTS TO CONSIDER WHEN USING LETTER OF CREDIT
An LC, also referred to as a documentary credit, is a contractual agreement whereby a bank in the buyer’s country, known as the issuing bank, acting on behalf of its customer (the buyer or importer), authorizes a bank in the seller’s country, known as the advising bank, to make payment to the beneficiary (the seller or exporter) against the receipt of stipulated documents. The features of letter of credit as follows:
- The LC is a separate contract from the sales contract on which it is based and, therefore, the bank is not concerned whether each party fulfills the terms of the sales contract.
- A letter of credit is used as a guarantee in case of doubts surrounding the importer’s ability or willingness to pay
- The terms of a letter of credit should allow sufficient time for the payment flows to take place otherwise the letter could be nullified due to missed deadlines
- The bank’s obligation to pay is solely conditional upon the seller’s compliance with the terms and conditions of the LC. In LC transactions, banks deal in documents only, not goods.
- Exporters should consider the degree of risk involved before asking for a letter of credit.
- What is the value of the order, and would the bank fees be out of proportion to the value?
- What is the credit rating of the importer, and is this importer entirely unknown to the exporter?
- What is the country risk of the importing country?
1.3 PARTIES INVOLVED IN A LETTER OF CREDIT
- Accepting bank
- Advising bank
- “Available with” Bank
- Confirming bank
- Drawee Bank
- Issuing Bank
- Reimbursing Bank
- Transferring Bank
- Accepting Bank
The bank named in a Letter of Credit on which drafts are drawn that has agreed to accept the draft. By accepting the draft, the Drawee Bank signifies its commitment to pay, the face amount at maturity to anyone who presents it at maturity. After accepting the draft, the Drawee Bank becomes the Accepting Bank.
- Advising Bank
The bank to which the Issuing Bank forwards the Letter of Credit with instructions to notify the Exporter (Beneficiary).
- “Available with” Bank
The bank authorized in the Letter of Credit to effect Payment under, accept or negotiate the Letter of Credit.
- Confirming Bank
The bank which, at the request of the Issuing Bank, adds its confirmation to the Letter of Credit. In doing so, the Confirming Bank undertake to make payment to the Exporter upon presentation of documents under the Letter of Credit.
- Drawee Bank
The bank named in the Letter of Credit on which the drafts are to be drawn.
The party that has contracted to sell goods.
The party that has contracted to buy goods.
- Issuing Bank
The bank issuing the Letter of Credit on behalf of the Importer (Buyer).
- Reimbursing Bank
The bank designated in the Letter of Credit to reimburse the “available with” Bank which submits payment claims under the Letter of Credit.
- Transferring Bank
The bank authorized by the Issuing Bank to transfer all or part of the Letter of Credit to another party at the Beneficiary’s request.
1.4 STEP-BY-STEP DESCRIPTION OF A TYPICAL LETTER OF CREDIT TRANSACTION:
- An Importer (Buyer) and Exporter (Seller) agree on a purchase and sale of goods where payment is made by Letter of Credit.
- The Importer completes an application requesting its bank (Issuing Bank) to issue a Letter of Credit in favour of the Exporter. Note that the Importer must have a line of credit with the Issuing Bank in order to request that a Letter of Credit be issued.
- The Issuing Bank issues the Letter of Credit and sent it to the Advising Bank by telecommunication or registered mail in accordance with the Importer, instructions. A request may be included for the Advising Bank to add its confirmation.
- The Advising Bank will verify the Letter of Credit for authenticity and send a copy to the Exporter.
- The Exporter examines the Letter of Credit to ensure:
- It corresponds to the terms and conditions in the purchase and sale agreement;
- Documents stipulated in the letter of credit cat be produced; and
- The terms and conditions of the Letter of Credit may be fulfilled.
If the Exporter is unable to comply with any term or condition of the Letter of Credit or if the Letter of Credit differs from the purchase and sale agreement, the Exporter should immediately notify the Importer and request an amendment to the Letter of Credit.
- When all parties agree to the amendments, they are incorporated into the terms of the Letter of Credit and advised to the Exporter through the Advising Bank. It is recommended that the Exporter does not make any shipments against the Letter of Credit until the required amendments have been received.
- The Exporter arranges for shipment of the goods prepares and/or obtains the documents specified in the Letter of Credit and makes demand under the Letter of Credit by presenting the documents within the stated period and before the expiry date to the “available with” Bank. This may be the Advising/Confirming Bank. That bank checks the documents against the Letter of Credit and forwards them to the Issuing Bank. The drawing is negotiated, paid or accepted as the case may be.
- The Issuing Bank examines the documents to ensure they comply with the Letter of Credit terms and conditions. The Issuing Bank obtains payment from the Importer for payment already made to the “available with” or the Confirming Bank.
- Documents are delivered to the Importer to allow them to take possession of the goods from the transport company. The trade cycle is complete as the Importer has received its goods and the Exporter has obtained payment.
TYPES OF LETTERS OF CREDIT
- Irrevocable/Revocable Letters of Credit
- Standby Letters of Credit
- Confirmed/Unconfirmed Letters of Credit
- Sight/Deferred Payment Letters of Credit
- Revolving Letters of Credit
- Transferable Letters of Credit
- Back-to-Back Letters of Credit
- Red Clause Letters of Credit
- Irrevocable/Revocable Letters of Credit
An irrevocable letter of credit cannot be cancelled before a specific date without agreement by all the parties involved, revocable letter of credit can be amended at any time by issuing bank. Letters of credit are automatically considered irrevocable unless they expressly state otherwise.
2. Confirmed/Unconfirmed Letters of Credit
A confirmed letter of credit gives the exporter a double guarantee of payment, one from the issuing bank and one from the advisory bank. Under a confirmed letter of credit, the advisory bank agrees to pay the exporter for the goods, even if the issuing bank ultimately fails to honour its obligations. An unconfirmed letter, in contrast, offers no express guarantee the advisory bank. Letters of credit are usually unconfirmed. Confirmed letters are used when an exporter has doubts about the issuing bank’s ability to pay perhaps because of potential currency restrictions in the importers’ country.
3. Transferable Letters of Credit
A transferable letter of credit is used when the exporter is essentially a middleman between a product manufacturer an importer. The exporter (ie, the middleman) may not want the manufacturer to know the identity of the importer, to avoid enabling the two parties to “eliminate the middleman”. In this case, the exporter will request a transferable letter of credit, and uses it to guarantee payment to the manufacturer. Once he has paid the manufacturer, the exporter can use the letter to receive payment for the export. Transferable letters require the agreement of the importer and the issuing bank. Only one transfer per letter is allowed.
4. Back-to-Back Letters of Credit
If a transferable letter is not possible, then back-to- back letters of credit can be used. This involves two parallel letter of credit transactions, one involving the middleman and manufacturer, and the other involving the middleman and his end-buyer (usually an importer in another country). These two transactions are independent of each other.
However, the letter issued by the importer’s bank can offer security to the middleman’s bank that its letter (guaranteeing payment to the manufacturer) will ultimately be covered in the export sale.
5. Standby Letters of Credit
A standby letter of credit is a second line of defence for exporters, in cases where an importer has an open (revolving) line of credit, has received advance payment in some form or otherwise has ongoing contractual obligations to the exporter. A standby letter is usually issued in addition to the regular letter of credit. Under a standby letter, the issuing bank agrees to pay the exporter in case the importer fails to perform as called for by the contract. It there by strengthens the importer’s creditworthiness in the eyes of the exporter.
6. Sight/Deferred Payment Letters of Credit
Sight letters of credit are payable as soon as the required documents have been presented. Usually, however, several days are allowed under such letters, to permit the banks to examine the documents in detail. A deferred payment letter of credit allows the importer to take possession of goods by agreeing to pay the issuing bank or the advisory bank at a future date, for example 60 days after the date of shipment. The issuing and advisory banks state that they will pay the exporter on the agreed future date. Deferred payment letters serve as financing instruments for the importer. He can, during the waiting period, sell the goods onward and use the proceeds to pay for the import.
7. Revolving Letters of Credit
Under a revolving letter of credit, the issuing bank establishes a line of credit to the importer, and restores the credit to its original amount once the importer has drawn is down. Usually these arrangements limit the number of time the importer may draw down its line over a predetermined period.
8. Red Clause Letters of Credit
These letters provide the exporter with cash prior to shipment, to finance production of the goods. The issuing bank may advance some or all of the funds. The importer is essentially financing the exporter, and takes on the risk for all advance payments
POINT TO CONSIDER BY EXPORTERS
- Consult with bank before the importer applies for an LC.
- Consider whether a confirmed LC is needed.
- Negotiate with the importer and agree upon detailed terms to be incorporated into the LC.
- Determine if all LC terms can be compiled within the prescribed time limits.
- Ensure that all the documents are consistent with the terms and conditions of the LC.
- Beware of many discrepancy opportunities that may cause non payment or delayed payment.
1.6 ADVANTAGES AND DISADVANTAGES OF USING A LETTER OF CREDIT
Advantages to the Exporter
- The risk of payment relies upon the creditworthiness of the Issuing Bank and the political risk of the Issuing Bank’s domicile, and not the creditworthiness of the Importer.
- Exporter agrees in advance to all requirements for payment under the Letter of Credit. If the Letter of Credit is not issued as agreed, the Exporter is not obligated to ship against it.
Disadvantages to the Exporter
- Documents must be prepared and presented in strict compliance with the requirements stipulated in the Letter of Credit.
- Some Importers may not be able to open Letters of Credit due to the lack of credit facilities with their bank which consequently inhibits export growth.
Advantages to the Importer
- Importer is assured that the Exporter will be paid only if all terms and conditions of the Letter of Credit have been met.
- Importer is able to negotiate more favourable trade terms with the Exporter when payment by Letter of Credit is offered.
Disadvantages to the Importer
A Letter of Credit does not offer protection to the Importer against the Exporter shipping inferior quality goods and/or a lesser quantity of goods. Consequently, it is important that the Importer performs the appropriate due diligence to assess the reputation of the Exporter. If the Exporter acts fraudulently, the only recourse available to the Importer is through legal proceedings.