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1. What is a letter of credit?
A letter of credit is a mechanism which allows importers to offer secure terms to
exporters.
All letters of credit contain these elements:
- a payment undertaking given by a bank (issuing bank)
- on behalf of a buyer (applicant)
- to pay a seller (beneficiary) a given amount of money
- on presentation of specified documents representing the supply of goods
- within specified time limits
- these documents conforming to terms and conditions set out in the letter of credit
- documents to be presented at a specified place
The issuing bank's role is twofold:
- to guarantee to the seller that if compliant documents are presented, the bank will pay
the seller the amount due. This offers security to the seller - the bank says in effect
"We will pay you if you present documents (XYZ)"
- to examine the documents, and only pay if these comply with the terms and conditions set
out in the letter of credit. This protects the buyer's interests - the bank says "We
will only pay your supplier on your behalf if they present documents (XYZ) that you have
asked for"
The letter of credit refers to documents representing the goods - not the goods
themselves! Banks are not in the business of examining goods on behalf of their customers.
Typically the documents requested will include a commercial invoice, a transport
document such as a bill of lading or airway bill, an insurance document; but there are
many others.
Letters of credit deal in documents, not goods.
Return to Letters of Credit Index
2. Why are letters of credit used?
- to protect against buyer risk. If the buyer is of unknown creditworthiness, then the
seller has the security of the bank's payment undertaking
- to protect against country risk. The buyer may be willing and able to pay; but economic
or political conditions in the buyer's country may prevent or delay payment. This is a
real concern when dealing with less developed countries and/or countries with foreign
exchange shortages. To protect against these risks, a confirmed letter of
credit will be necessary - a bank in the seller's country will (for a fee) add its own
payment undertaking to that of the issuing bank.
- letters of credit are also used as part of exchange control or import control regimes
operating in the buyer's country. In such cases the use of a letter of credit is
mandatory, even if not required by the seller for security reasons
Return to Letters of Credit Index
The stages in the use of a letter of credit are as follows:
- Buyer and seller agree terms (price, specification, method of transportation, who pays
for freight, insurance etc.)
- Buyer applies to issuing bank for a letter of credit. From the bank's point of view the
issue of a letter of credit is similar to supplying short-term finance. It will apply
similar criteria to the application, and may demand collateral, reduction in other lending
limits or even a cash advance before agreeing to issue the letter of credit.
- Issuing bank sends the letter of credit to a bank in the seller's country, the advising
bank. This may be done by mail, telex or SWIFT. The advising bank's main obligation is to
authenticate the letter of credit, i.e. use authentication codes or books of signatures to
assure the beneficiary that the letter of credit is genuine.
- Advising bank informs the beneficiary of the letter of credit. At this stage the
beneficiary should check that its terms and conditions match the commercial agreement and
can be complied with, e.g. the goods can be shipped by the required date, the required
documents can be obtained. If anything in the credit will cause the beneficiary a problem,
the applicant must be contacted immediately and an amendment requested
- Beneficiary (seller) ships the goods, then assembles the required documentation, which
will usually include a transport document such as a bill of lading.
- Beneficiary checks that all these documents conform to all the terms and conditions laid
down in the letter of credit. NB even minor discrepancies will often lead to the documents
being rejected by a bank and payment being declined
- Beneficiary presents the documents (usually) to a local bank. What happens next depends
on the arrangements specified in the letter of credit. The commonest arrangement is for
this bank to check the documents and, if they are in order, pay the beneficiary
immediately; but there are variations on this.
- The documents are sent back to the issuing bank. If they are in order, the issuing bank
will debit the applicant, remit the funds to the beneficiary's bank and pass the documents
to the applicant so the goods can be claimed from the carrier.
Return to Letters of Credit Index
Statistics show that, on an average, in as many as 50% of letter of credit
transactions, the seller's documents will be rejected by the banks at presentation. This
can be an extreme source of frustration to both the importer and the exporter.
In the United States, the National Council on Trade Documentation showed Letter
of Credit failure rates of 77% in Saint Louis, 75% in San Francisco and between 40
to 70% at four New York Banks.
Shockingly, major corporations, with a rejection rate of 49% were almost as
unsuccessful in obtaining payment as small firms. The worst record was held by medium
sized companies doing business in the 50 to 100$ million range; whose failure rate was
63.3%
| Non-Payment? |
| Non payment happens more
than you may realize. We at tradecorp have seen many customers loosing almost all their
business because of some defaulters. Many companies end up in arbitration courts still
many DO NOT have any recourse or resource left and they manage to survive only if the loss
is small. Many parties have been known to go bankrupt. We have evidence of this and believe or not the offenders can be
very big companies.
We have evidence of such transactions of non-payment by bad-faith and fraud, where the
L.C. was opened by major state companies or government owned companies. One such
government company is Tabacalera and Tabacos de Filipinas of SPAIN who defrauded many
companies by signing contracts, opening LCs and later due to some corporate change; found
some innocent discrepancy in the LCs and outrightly denied payment, causing enormous
damage to the Suppliers.
We caution you to be extremely careful in your contracts.
The problems may come from Buyers as well as from Suppliers.
Many companies are there to fraud and damage your business.
It is your duty as Manager to check all points. |
A few years ago, a big British bank found that during three random weeks, one out of two
of all Documentary presentations against credit were rejected.
It is estimated that the amount of Letter of Credit business that goes wrong every year in
United Kingdom alone is at more than 5 Billion Pounds.
We have gathered information from over 60 most trading nations and found that Letter of
Credit is one of the most popular mode of payment yet many transactions are delayed and go
into loss, due to one or the other problem. Fortunately, a majority of problems can be
resolved between 2 parties but what do you do when the buyer has foul intentions.
No one can stop a wrongful, criminal act. Yet we can take pre-caution and go carefully.
Most suppliers do not go bankrupt yet there is enormous loss of time, capital and
resources.
Due to delays in payments and dilly-dallying many transactions loose profit and the
relationship sours.
Banks do their utmost in protecting their customers
yet the banks can not play much role as they are simply acting as
neutral parties not involved with trading and manufacturing and dealings of merchandise.
At the heart of the problem is the very limited discretion available to banks in the
matching of the terms and conditions of the credit against the documents presented. They
must do this in a very literal way, with no room for the exercise of judgement.
For example, suppose that a commercial invoice describes the goods as "Potassium
chlorate crystals, 99.5% purity". However the letter of credit describes the goods as
"Potassium chlorate crystals, minimum purity 98%". Common sense would suggest
that this consignment will be acceptable to the buyer! However some banks do not feel able
to make this assumption, and will reject the documents on the grounds of a discrepancy in
the goods description.
There are numerous cases of apparently trivial variations between the terms of the
credit and the documents (or between one document and another document) causing documents
to be rejected. Hence exporters must learn to check documents before submission, using the
same criteria that will be applied by the banks themselves.
Another source of problems is the failure of the letter of credit to anticipate some
aspect of the transaction. For example a common requirement on a credit is for
presentation of 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 must be rejected by the
bank.
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.
A v o i d
costly mistakes |
Once an error or mistake has been made
in the process,
it is usually irreparable and quite EXPENSIVE!! |
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The Bank is usually not concerned
whether the contract between BUYER and SELLER is performed exactly as per its terms. The
Bank's only concern is whether the documents presented by the seller conform to the
documents required under the L.C. and whether the documents are presented within the time
periods required by the L/C.
The Bank officials who examine the documents presented under the L/C are essentially
bureaucrats and naturally their job is not to make any judgements, but simply to make sure
the documents presented by the seller comply strictly with the requirements of the L/C.
In most cases, unless, the bank is
too small or an ill-reputed bank is impartial and they practice their business very
seriously. The parties involved can not blame the Banks as they are merely the messengers
and responsible for money exchange.
So the responsibility lies with the
exporter or Seller or Supplier.
Return to Letters of Credit Index
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