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Understanding and Using Letters of Credit
[Submitted by CA. Manoj Agrawal,
B.Com., ACA
Vadodara, Gujarat]
August 29, 2006
Purpose
The purpose of this document is to provide a general understanding of
letters of credit, their use and application. The topics covered are the
following:
- General background information;
- Types of letters of credit;
- Common problems with letters of credit;
- Procedures for establishing letters of credit;
- Amendments; and
- General tips to both buyers and sellers.
Definition
Letters of credit are commonly used to reduce credit risk to sellers
in both domestic and international sales arrangements. By having a bank
issue a letter of credit, in essence, one is substituting the bank's
credit worthiness for that of the customer.
Types
There are two basic forms of letters of credit: Standby and
Documentary. Documentary letters of credit can be either Revocable or
Irrevocable, although the first is extremely rare. Irrevocable letters of
credit can be Confirmed or Not Confirmed. Each type of credit has
advantages and disadvantages for the buyer and for the seller, which this
information will review below. Charges for each type will also vary.
However, the more the banks assume risk by guaranteeing payment, the more
they will charge for providing the service.
Documentary Revocable Letter of Credit
Revocable credits may be modified or even canceled by the buyer
without notice to the seller. Therefore, they are generally unacceptable
to the seller.
Documentary Irrevocable Letter of Credit
This is the most common form of credit used in international trade.
Irrevocable credits may not be modified or canceled by the buyer. The
buyer's issuing bank must follow through with payment to the seller so
long as the seller complies with the conditions listed in the letter of
credit. Changes in the credit must be approved by both the buyer and the
seller. If the documentary letter of credit does not mention whether it is
revocable or irrevocable, it automatically defaults to irrevocable
There are two forms of irrevocable credits:
Unconfirmed credit (the irrevocable credit not confirmed by the
advising bank)
In an unconfirmed credit, the buyer's bank issuing the credit is the only
party responsible for payment to the seller. The seller's advising bank
pays only after receiving payment from the issuing bank. The seller's
advising bank merely acts on behalf of the issuing bank and, therefore,
incurs no risk.
Confirmed credit (the irrevocable confirmed credit)
In a confirmed credit, the advising bank adds its guarantee to pay the
seller to that of the buyer's issuing bank. Once the advising bank reviews
and confirms that all documentary requirements are met, it will pay the
seller. The advising bank will then look to the issuing bank for payment.
Confirmed Irrevocable letters of credit are used when trading in a
high-risk area where war or social, political, or financial instability
are real threats. Also common when the seller is unfamiliar with the bank
issuing the letter of credit or when the seller needs to use the confirmed
letter of credit to obtain financing its bank to fill the order. A
confirmed credit is more expensive because the bank has added liability.
Standby Letter of Credit
This credit is a payment or performance guarantee used primarily in
the United States. They are often called non-performing letters of credit
because they are only used as a backup should the buyer fail to pay as
agreed. Thus, a stand-by letter of credit allows the customer to establish
a rapport with the seller by showing that it can fulfill its payment
commitments. Standby letters of credit are used, for example, to guarantee
repayment of loans, to ensure fulfillment of a contract, and to secure
payment for goods delivered by third parties. The beneficiary to a standby
letter of credit can cash it on demand. Stand-by letters of credit are
generally less complicated and involve far less documentation requirements
than irrevocable letters of credit. See Credit Administration, Sample
Procedure for Administration of a Standby Letter of Credit for a
systematic procedure for establishing a standby letter of credit.
Common Problems with Letters of Credit
Most problems result from the seller's inability to fulfill
obligations stated in the letter of credit. The seller may find these
terms difficult or impossible to fulfill and, either tries to fulfill them
and fails, or asks the buyer to amend to the letter of credit. As most
letters of credit are irrevocable, amendments may at times be difficult
since both the buyer and the seller must agree.
Sellers may have one or more of the following problems:
- The shipment schedule cannot be met;
- The stipulations concerning freight costs are unacceptable;
- The price becomes too low due to exchange rates fluctuations;
- The quantity of product ordered is not the expected amount;
- The description of product is either insufficient or too detailed;
and,
- The stipulated documents are difficult or impossible to obtain.
Even when sellers accept the terms of a letter of credit, problems
often arise late in the process. When this occurs, the buyer's and
seller's banks will try to negotiate any differences. In some cases, the
seller can correct the documents and present them within the time
specified in the letter of credit. If the documents cannot be corrected,
the advising bank will ask the issuing bank to accept the documents
despite the discrepancies found. It is important to note that, if the
documents are not in accord with the specifications of the letter of
credit, the buyer's issuing bank is no longer obligated to pay.
Basic Procedures for Establishing a Letter of Credit
The letter of credit process has been standardized by a set of rules
published by the International Chamber of Commerce (ICC). These rules are
called the Uniform Customs and Practice for Documentary Credits (UCP) and
are contained in ICC Publication No. 500. The following is the basic set
of steps used in a letter of credit transaction. Specific letter of credit
transactions follow somewhat different procedures.
- After the buyer and seller agree on the
terms of a sale, the buyer arranges for his bank to open a letter of
credit in favor of the seller. Note: The buyer will need to have a line
of credit established at the bank or provide cash collateral for the
amount of the letter of credit.
- The buyer's issuing bank prepares the
letter of credit, including all of the buyer's instructions to the
seller concerning shipment and required documentation.
- The buyer's bank sends the letter of
credit to the seller's advising bank.
- The seller's advising bank forwards the
letter of credit to the seller.
- The seller carefully reviews all
conditions stipulated in the letter of credit. If the seller cannot
comply with any of the provisions, it will ask the buyer to amend the
letter of credit.
- After final terms are agreed upon, the
seller ships the goods to the appropriate port or location.
- After shipping the goods, the seller
obtains the required documents. Please note that the seller may have to
obtain some documents prior to shipment.
- The seller presents the documents to its
advising bank along with a draft for payment.
- The seller's advising bank reviews the
documents. If they are in order, it will forward them to the buyer's
issuing bank. If a confirmed letter of credit, the advising bank will
pay the seller (cash or a bankers' acceptance).
- Once the buyer's issuing bank receives
and reviews the documents, it either (1) pays if there are no
discrepancies; or (2) forwards the documents to the buyer if there are
discrepancies for its review and approval.
Opening a Letter of Credit
Level of Detail
The wording in a letter of credit should be simple, but specific. The more
detailed an L/C is, the more likely the seller will reject it as too
difficult to fulfill. At the same time, the buyer will wish to define in
detail what its is paying for.
Type of Credit
Letters of credit used in trade are usually either irrevocable
unconfirmed credits or irrevocable confirmed credits. In choosing which
type to open both the seller and the buyer should consider the generally
accepted payment processes in each country, the value and demand for the
goods, and the reputation of the buyer and seller.
Documents
In specifying required documents, it is very important to include
those required for customs and those reflecting the agreement reached
between the buyer and the seller. Required documents usually include the
bill of lading, a commercial and/or consular invoice, the bill of
exchange, the certificate of origin, and the insurance document. Other
documents required may be an inspection certificate, copies of a cable
sent to the buyer with shipping information, a confirmation from the
shipping company of the state of its ship, and a confirmation from the
forwarder that the goods are accompanied by a certificate of origin.
Prices should be stated in the currency of the letter of credit and
documents should in the same language as the letter of credit.
The Letter of Credit Application
The following information should be addressed when establishing a
letter of credit.
- Beneficiary
The seller should provide to the buyer its full corporate name and
correct address. A simple mistake here may translate to inconsistent or
improper documentation at the other end.
- Amount
The seller should state the actual amount of the letter of credit. One
can request a maximum amount when there is doubt as to the actual count
or quantity of the goods. Another option is to use words like
"approximate", "circa", or "about" to indicate an acceptable 10 % plus
or minus from the stated amount. For consistency, if you use this
wording you will need to use it also in connection with the quantity.
- Validity
The seller will need time to ship and to prepare all the necessary
documents. Therefore, the seller should ensure that the validity and
period for document presentation after the shipment of the goods is long
enough.
- Seller's Bank
The seller should list its advising bank as well as a reimbursing bank
if applicable. The reimbursing bank is the local bank appointed by the
issuing bank as the disbursing bank.
- Type of Payment Availability
The buyer and seller may agree to use sight drafts, time drafts, or some
sort of deferred payment mechanism.
- Desired Documents
The buyer specifies the necessary documents. Buyers can list, for
example, a bill of lading, a commercial invoice, a certificate of
origin, certificates of analysis, etc. The seller must agree to all
documentary requirements or suggest an amendment to the letter of
credit.
- Notify Address
This is the address to notify upon the imminent arrival of goods at the
port or airport of destination. A notification listing damaged goods is
also sent to this address, if applicable.
- Description of Goods
The seller should provide a short and precise description of the goods
as well as the quantity involved. Note the comments in step #2 above
concerning approximate amounts.
- Confirmation Order
With international arrangements, the seller may wish to confirm the
letter of credit with a bank in its country.
Amendment of a Letter of Credit
For the seller to change the terms noted on an irrevocable letter of
credit, it must request an amendment from the buyer. The amendment process
is as follows:
- The seller requests a modification or
amendment of questionable terms in the letter of credit;
- If the buyer and issuing bank agree to
the changes, the issuing bank will change the letter of credit;
- The buyer's issuing bank notifies the
seller's advising bank of the amendment; and
- The seller's advising bank notifies the
seller of the amendment. Tips for Buyers and Sellers
Seller
- Before signing a sales contract, the
seller should make inquiries about the buyer's creditworthiness and
business practices. The seller's bank will generally assist in this
investigation.
- In many cases, the issuing bank will
specify the advising and/or confirming bank. These designations are
usually based on the issuing bank's established correspondent
relationships. The seller should ensure that the advising/confirming
bank is a financially sound institution.
- The seller should confirm the good
standing of the buyer's issuing bank if the letter of credit is
unconfirmed.
- For confirmed letters of credit, the
seller's advising bank should be willing to confirm the letter of credit
issued by the buyer's bank. If the advising bank refuses to do so, the
seller should request another issuing bank as the current bank may be or
is in the process of becoming insolvent.
- The seller should carefully review the
letter of credit to ensure its conditions can be met. All documents must
conform to the terms of the letter of credit. The seller must comply
with every detail of the letter of credit specifications; otherwise the
security given by the credit is lost.
- The seller should ensure that the letter
of credit is irrevocable.
- If amendments are necessary, the seller
should contact the buyer immediately so that the buyer can instruct the
issuing bank to make the necessary changes quickly. The seller should
keep the letter of credit's expiration date in mind throughout the
amendment process.
- The seller should confirm with the
insurance company that it can provide the coverage specified in the
letter of credit and that insurance charges listed in the letter of
credit are correct. Typical insurance coverage is for CIF (cost,
insurance and freight) often the value of the goods plus about 10
percent.
- The seller must ensure that the goods
match the description in the letter of credit and the invoice
description.
- The seller should be familiar with
foreign exchange limitations in the buyer's country that could hinder
payment procedures.
Buyer
- When choosing the type of letter of
credit, the buyer should consider the standard payment methods in the
seller's country.
- The buyer should keep the details of the
purchase short and concise.
- The buyer should be prepared to amend or
re-negotiate terms of the letter of credit with the seller. This is a
common procedure in international trade. With irrevocable letters of
credit, the most common type, all parties must agree to amend the
document.
- The buyer can reduce the foreign
exchange risk by buying forward currency contracts.
- The buyer should use a bank experienced
in foreign trade as its issuing bank.
- The validation time stated on the letter
of credit should give the seller ample time to produce the goods or to
pull them out of stock.
- A letter of credit is not fail-safe.
Banks are only responsible for the documents exchanged and not the goods
shipped. Documents in conformity with the letter of credit
specifications cannot be rejected on grounds that the goods were not
delivered as specified in the contract. The goods shipped may not in
fact be the goods ordered and paid for.
- Purchase contracts and other agreements
pertaining to the sale between the buyer and seller are not the concern
of the issuing bank. Only the letter of credit terms are binding on the
bank.
- Documents specified in the letter of
credit should include those the buyer requires for customs clearance.
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