Understanding Letters Of Credit And How To Ensure You Get Paid: The Complete Guide
Letters of Credit are important financial instruments used in the international trade of commodities between a buyer and a seller in two different countries. It ensures that there is a security of payment and that the seller will not be left stranded if he or she ships the goods to the buyer.
In simple terms…
Letters of Credit are Bank Payment Guarantees issued by an importer’s bank to an exporter’s bank to guarantee that if the goods are supplied according to the terms of the Letter of Credit agreed by an importer and an exporter, payment would be made to the exporter’s bank account.
So what are the types of Letters of Credit?
While we have a previously published article that mentions several types of Letters of Credit, there are essentially two major types/categories of Letters of Credit that every other fall into.
- Commercial Letters of Credit
- Standby Letter of Credit (SBLC)
1). Commercial Letter of Credit:
Commercial Letters of Credit are the most common methods of payments in international trade transactions. They’re usually Documentary Letters of Credit (DLC), are guaranteed by the bank, and depending on what method of payment redemption was agreed between the buyer and the seller, payment is mostly made against the submission of all stated documents.
2). Standby Letter of Credit (SBLC):
Standby Letters of Credit are secondary payment methods because they’re scarcely used, although also guaranteed by the bank. The downside of a Standby Letter of Credit for a buyer is usually that he or she must have twice the value of the amount to be paid since an SBLC is pretty much a collateral to be called upon if the buyer fails to make payment from any other means.
How it works is a buyer would have their bank raise an SBLC for a transaction. The SBLC would be valid for a certain period of time, usually 90 to 366 days. Now, every time a delivery is made, instead of the seller having to submit all bank documents to the buyer’s bank, the buyer would make payment to the seller directly without the SBLC being drawn upon. This way, the buyer doesn’t have to reissue another SBLC which could take over a month to do.
If a seller were to draw against the SBLC, they’d first have to prove they have not been paid by the buyer for the transaction.
Since an SBLC is a blocked fund, the buyer would need to have twice the amount because one part is blocked, and the other is what will be paid from any other source to avoid the SBLC been drawn upon and its validity retained.
For buyers who don’t have the luxury of having twice the amount that they want to pay for a product, they’re better of issuing a Commercial Letter of Credit.
The Components of a Letter of Credit
- A Letter of Credit is an undertaking of payment issued by a bank known as the “issuing bank”.
- The Letter of Credit is issued on behalf of an importer known as the “applicant”.
- It is to be used as a financial instrument to pay a given amount of money to an exporter known as the “beneficiary”.
- The payment is made upon the submission of some specified documents proving the goods have been supplied within a particular period.
- The documents that are submitted must meet the terms and conditions mentioned in the Letter of Credit.
- And the documents must be submitted at a particular place.
Key Things To Know In A Letter of Credit
1). Issuing Bank:
The issuing bank is the buyer’s bank issuing the Letter of Credit to the seller’s bank. They are responsible and have full liability to pay the seller once the seller can meet all the terms and conditions mentioned in the Letter of Credit.
Here, the issuing bank’s job is to ensure that all documents meet all that’s mentioned in the Letter of Credit. They cannot guarantee the performance of the supplier, but can ensure they only pay against proper submitted documentation.
The issuing bank is bound by the provisions of the Uniform Customs and Practice for Documentary Credits, and so, is expected to honour the draft if they meet all the terms by the close of business on the third banking day after receiving the documents.
The beneficiary of every Letter of Credit is the supplier’s bank account in his or her bank. They receive the buyer’s Letter of Credit which is issued by the buyer’s bank and proceed to arrange the supply of the goods in order to meet the full terms of the Letter of Credit, by submitting the required documents, so that they can be paid unconditionally.
3). Advising Bank:
The advising bank is mostly a foreign correspondent bank with a relationship with the issuing bank to advice the beneficiary of the Letter of Credit.
Essentially, advising banks are used because the beneficiary of the Letter of Credit would prefer that a local bank in their country guarantees that the Letter of Credit is authentic. Also, the advising bank would also handle the courier of the required documents listed on the Letter of Credit to the issuing bank.
An advising bank is not required to pay the exporter if the issuing bank fails to make the payment, even if the seller meets the full terms of the Letter of Credit.
4). Confirming Bank:
The confirming bank is the bank that adds its confirmation to the Letter of Credit, and by so doing, indemnifies itself to make payment to the exporter according to the terms of the Letter of Credit. The confirming bank laters collects the amount it paid to the exporter from the issuing bank by the issuing bank either paying them directly or by the confirming bank debiting the issuing bank’s account in their bank.
The confirming bank is mostly the corresponding advising bank. The only difference is that the advising bank decides to add its confirmation to the Letter of Credit, and by doing this, the exporter doesn’t have to wait till the documents reach the issuing bank, but can simply collect payments directly from the advising bank in their country.
But generally, the advising bank won’t add its confirmation to the Letter of Credit if they do not have a proper relationship with the issuing bank.
A confirmed Letter of Credit is more secure as two banks are consecutively guaranteeing payment. But this usually comes at a cost from the confirming bank.
When a transfer clause is added to a Letter of Credit, it means the beneficiary of the Letter of Credit has the rights to transfer the Letter of Credit to a third party to execute the transaction.
Most buyers don’t want their Letters of Credit to be transferrable as it could imply that the supplier is not the real owner of the product. But in some cases where a supplier is working with third-party financiers, the financiers may require that the Letter of Credit be transferrable to them before they fund the supplier’s export transaction.
A revocable Letter of Credit means that once it has been issued, the buyer can easily revoke or modify the Letter of Credit without notice to the supplier, whether the supplier already has the products on the ocean sailing to the buyer’s country or not.
An offered revocable Letter of Credit is never a sign of good faith from an importer. For every exporter looking to ensure they’re safe, the Letter of Credit must be irrevocable, so a malicious importer wouldn’t suddenly change their minds within the period of the required order. But if the required documents have been submitted and fully meet the terms of the Letter of Credit, the Letter of credit can no longer be revoked.
If the issued Letter of Credit is marked as irrevocable, a buyer would need the permission of the issuing bank, corresponding bank, and the beneficiary to all agree to revoke it.
Letters of Credit must be negotiable because negotiable Letters of Credit are easily passed from one financial institution to another, just as money is easily moved. For any Letter of Credit to be negotiable, it means that it has an irrevocable commitment to pay either at sight of the required documents or at a specified time in the future.
The Letter of Credit could be negotiable either at the advising bank counters or at the issuing bank’s counters. To be safe, it’s always better it is negotiated at the advising or confirming bank counters to avoid any problems from the issuing bank since the advising or confirming bank is likely a registered local bank in the beneficiary’s country and bound by certain laws that secure the exporter.
8). Sight & Time:
When a beneficiary is to redeem payment against a Letter of credit, they’re required to submit a draft (also called a Bill of Exchange) alongside other specified documents in the Letter of Credit in order to receive payment.
The two types of drafts required are:
- Sight: A draft at sight is payable to the exporter upon presentation to and revised by the issuing or corresponding bank.
- Time: A time draft is only payable after a certain time specified on the Letter of Credit has passed. Here, the issuing bank pays after the maturity of the time draft, but after successfully reviewing the documents to ensure they meet the full terms of the Letter of Credit.
9). Required Documentation:
These are the documents required to be submitted to the issuing bank of the Letter of Credit to enable the exporter to redeem the full payment for the transaction. The required documents must be fully negotiated before the buyer issues the Letter of Credit because some documents may be unrealistic to obtain.
The most commonly demanded documents to redeem payment against a Letter of Credit are:
- Commercial Invoice
- Bill of Lading
- Packing List
Depending on the type of product, some other documentation may be further required to be submitted. Some of them are:
- Phytosanitary Certificate
- Fumigation Certificate
- Warranty of Title
- Letter of Indemnity
- Insurance Certificate
- Inspection Certificate
- Health Certificate
- And several others.
Some documents to strike off no matter what are things like vessel certificate from the shipping company, malicious indemnities that state unrealistic timelines, and much more. Some buyers use these items to try to trap the exporter and ensure that the exporter getting a Letter of Credit is practically still useless since they cannot draw on it without the buyer’s permission when the most important documents have been submitted.
It is important that the full information on the documents submitted must match/correspond exactly to the descriptions listed in the letter of credit. The bank understands the Letter of Credit and not your contract with your buyer, and so, you must match every single thing listed on the Letter of Credit exactly as the issuing bank wants, else, you’d run into discrepancies and have problems redeeming your payments.
The Most Common Problems With Issued Letters of Credits
While a Letter of Credit is the most secure form of payment security an exporter can have, 70% of all Letter of Credits in the UK, for instance, are rejected for payment for many reasons that the exporter fails to pay attention to.
As a result, it is important that the buyer and the seller fully negotiate and agree to the complete terms of the Letter of Credit, before it is issued. The seller should require the buyer has their bank to send the Letter of Credit draft/verbiage, so the seller’s bank can fully scrutinise and analyse the document completely to be sure that the seller would have absolutely no issues receiving payment when all the terms have been met.
Some common reasons Letters of Credit are unpayable are:
- The timeline on the Letter of Credit was too short, and so, expired before the draft and other documents could be submitted. Always ensure that you meet the date of expiration of the Letter of Credit, the latest date of shipping, and the maximum amount of time that is allowed between the dispatch of the documents and their submission at the bank.
- The date on the Bill of Lading shows that delivery was made before or after the date range mentioned in the Letter of Credit.
- The date on the documents submitted is either before or after the dates required on the Letter of Credit.
- The information in the commercial invoice is not as stated in the Letter of Credit.
- The description of the goods are all inconsistent with each other.
- The insurance document contains errors that don’t add up.
- The amount stated on the commercial invoice is not the same amount stated on the draft.
- The ports of loading and destination stated on the documents are not the same as stated on the Letter of Credit.
- The product description is not the same as the description stated in the Letter of Credit.
- One or more documents required to be submitted by the Letter of Credit were not submitted.
- The general information on the submitted documents is very inconsistent.
- The names of/on the documents submitted are not exactly the same thing as described in the Letter of Credit.
- Some documents and statements are not signed as required in the Letter of Credit.
When there are issues mentioned in these points above, the issuing bank flags the inconsistencies as discrepancies and will require that they are either corrected or that the buyer chooses to waive them or not. when a discrepancy is corrected, the issuing bank usually charges a certain amount of money per discrepancy. But if the buyer refuses to allow the discrepancy to scale through and the discrepancy is something that cannot easily be corrected, the seller falls at the mercy of the buyer to make payment against the goods they have already shipped.
To Sum It Up
Letters of Credit are a great way to secure payment for goods and services supplied, but must be carefully addressed to ensure no party is at risk of losing money.
For exporters to ensure they don’t get cheated if a Letter of Credit is to be issued, they should always do the following:
- Have an in-depth conversation/negotiation with your clients before they apply for a Letter of Credit from their bank to be issued to your bank.
- Decide whether you may need a confirmed Letter of Credit or not. Confirmed Letters of Credit are far more secure to guarantee your payment since a third party bank is now involved.
- Ask that a copy of the Letter of Credit application be sent to you so that you and your bank can check the terms to ensure they don’t cause any compliance problems that would prevent you from getting paid.
- When the Letter of Credit is first received by your bank, make sure you check all the terms again to ensure it meets exactly what you agreed, before you start preparing the goods for export.
- Many people run into problems with meeting the terms of the letter of credit within the required time period. You must know that there are at least three timelines to meet and always pay attention to them. These are the date of expiration of the Letter of Credit, the latest date of shipping, and the maximum amount of time that is allowed between the courier of the documents and their submission at the buyer’s bank.
- If the letter of credit states that you must submit some documents which you can only get from third-party organisations, ensure there’s adequate time allowed for you to get them ready.
- Before and after shipping the goods, ensure you check all the information on the documents prepared, both against the terms of the Letter of Credit and other compliances to ensure you will get paid by the buyer’s bank and that you won’t run into any issues with the local authorities.
Remember that while Letters of Credit are deemed the most secure form of payment guarantee for an exporter, many buyers would try to insert some unnoticeable clauses to ensure they still have the final say before payment is made, and in the process, making it virtually impossible for the exporter to redeem full payment when the transaction has been executed. You should watch out for these hidden terms and ensure that the Letter of Credit draft/verbiage has been vetted by both you and your bank to ensure nothing can absolutely go wrong and prevent your organisation from being paid as at when due.
About The Author
This is an article written by Stan Edom, the Editor In Chief of Startuptipsdaily.com and the founder of Globexia Limited, a global commodity trading firm that exports solid minerals & agricultural products from Nigeria, facilitates the trade of oil & gas commodities, and offers commodity trade consulting like importer & exporter due diligence checks, feasibility studies & reports, and trade licence registrations for international buyers in Nigeria.
This article along with others are written to help exporters and importers around the world to have a better understanding of the commodity trading business and to improve their chances of becoming successful in the industry.
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