Introduction to Letters of Credit
Most trade in the world is done internationally. In order to facilitate this, a business needs to have trade agreements with their partners and counterparts.
Trust is incredibly important when agreeing payment terms. Putting this on a scale, at the riskier end, trade can be done on open account terms – where the seller bears the risk of not being paid. A Letter of Credit, or LC is less risky.
A Letter of Credit is relevant where there is an exporter and an importer; and there needs to be prepayment or a confirmation of payment in order for goods to be shipped. A letter of credit is an instrument from a bank, which guarantees a buyer’s payment to a seller if certain criteria are met. If the buyer can’t pay up, due to the agreed contract through the Letter of Credit, the bank will cover the remaining price.
Letters of Credit are fundamental components of international trade. They’re governed universally by a set of guidelines called the UCP 600, which are issued by the International Chamber of Commerce.
So what is a Letter of Credit?
An LC is a promise written on a legal document that comes from a bank with a promise to pay the holder if the holder fulfills certain obligations. Obligations include payment when the goods are shipped if certain criteria are met. A Letter of Credit is usually used when the buyer and seller do not know each other well and this is why it is used so frequently in international trade. Letters of Credit are incredibly specific and close attention to detail is required. If there is a misspelling in the contract, for example, the name of the goods is incorrectly spelled, there may be non-payment until a new, corrected LC is issued and accepted.
Advantages of Letters of Credit
For the buyer, they are certain to receive the goods as stipulated in the letter of credit, and they do not need to pay for the goods upfront. For the seller, they’re somewhat protected against non-payment from the buyer. There are many different types of LCs, and I’ll cover most of them today. Often people get confused between commercial letters of credit, which acts as the primary payment mechanism for a transaction, and a standby letter of credit, the secondary payment mechanism, a fail safe guarantee. Depending on the perspective of the buyer or the seller, there are also import Letters of Credit, set up by the importer or buyer of goods or services, and export Letters of Credit, which are set up by the exporter or seller.
How does a Letter of Credit work?
On behalf of a buyer, the issuing bank promises payment to a seller or beneficiary. An advising bank may act on behalf of the seller. The advising bank will receive payment, normally when they’ve been presented with specified documents representing the supply of goods.
How is payment collected on Letters of Credit?
To receive payment, the beneficiary must present documentation of completion of their part in the transaction to the issuing bank and must present documents, such as but not limited to the following:
- Bills of Exchange
- Shipping documents including Bills of Lading
- Chamber of Commerce documents
- Inspection Report
- Certificate of Origin
- Certification of Conformity
- Certification of Authenticity.
- Government documents and Approvals
- Other stipulated documents covering the terms and conditions of the LC and transaction.