The Purpose of Letters of Credit
When selling goods, a seller must take into account and manage the risk of not being paid. In the case of exported goods, these risks include not just the risk that a buyer will not have enough cash to pay, or will dispute their liability to pay, but also the risk that something will happen in the buyer’s country that prevents payment. Letters of credit were developed as a means of payment that, when properly structured and drawn upon, sidesteps these risks.
How Letters of Credit Work
A letter of credit is a bank’s own engagement to pay a specified amount of money to the named beneficiary upon presentation to the bank of specified documents. In a transaction involving a sale of goods, the contract of sale will specify that payment is to be made by means of a letter of credit. The buyer will then ask their bank to issue an LofC naming the seller as beneficiary for the amount of the order. The bank undertakes in the LofC to pay the seller, not specifically upon shipment of the goods the buyer has ordered, but upon presentation of the documents specified in the credit. A bank would be hard-pressed to verify that goods have actually been shipped in accordance with a contract of sale, but has little trouble checking documents for compliance with stated content requirements. The buyer tells the bank what documents to call for and agrees to reimburse the bank for the payment when made to the seller. The bank does not really care what documents the buyer wants them to pay against as they are just going to pass the documents along. To the buyer, however, since the purpose of the LofC is to pay for goods when shipped, it is important that the documents provide evidence that the goods have been shipped as agreed.
When the seller receives the LofC, they should read it carefully to determine whether the LofC requirements can be complied with. Besides the list of documents, these include such information as how soon the transport document must be issued (evidence of when the goods were shipped), how soon the documents must be presented, and where the documents must be presented. Among other things, the seller should make sure that:
· the credit amount is sufficient to cover the shipment (particularly if the terms are cost, insurance and freight (CIF) or cost and insurance paid to (CIP));
· the documents required will be available and can be presented before the expiry date of the credit;
If the requirements are not acceptable, the seller should request the buyer to get the credit amended. To avoid the time and expense of amendments, it is highly recommended that the seller provide the buyer with letter of credit instructions up front so that the buyer knows what documents and other requirements are acceptable to the seller.
Roles of the Advising and Nominated Banks
In international transactions, it is almost unheard of for the seller to deal directly with the issuing bank. The issuing bank will arrange for a bank in the country of the seller to deliver the LofC to the seller, and the LofC will provide for the seller to present documents to a bank in the seller’s country (see Figure 1). The bank that delivers the LofC is called the “advising bank” and the bank to which the seller is to present documents is called the “nominated bank.” The advising bank is responsible for the accuracy of the information it delivers. The rules governing letters of credit require that the advising bank take steps to verify the authenticity of the credit as well, but an advising bank is not responsible for payment.
Oftentimes, the advising bank is also the nominated bank, but it is also fairly common for letters of credit to state that they are “available with any bank.” This allows the seller to present documents to a bank of their own choosing. The nominated bank examines the documents and collects payment from the issuing bank. By insisting that LofCs be freely available, sellers gain the freedom to present documents to their own bank regardless of who played the role of advising bank. The seller’s own bank may be willing to provide discount pricing and special services to the seller, like expedited processing, assistance with correcting discrepancies in the documents, or loans against documents in the process of collection.
Confirmed Letters of Credit
Confirmed letters of credit work a bit differently. A confirmed letter of credit is one where the advising bank has added its own engagement to pay to that of the issuing bank. The advising bank becomes a party to the credit, and it must be invited by the issuing bank to add its confirmation. As a party to the LofC, it has the right to reject amendments. And, in order to take advantage of a bank’s confirmation of a letter of credit, the seller must present documents to that bank.
The purpose of getting a letter of credit confirmed is to shift the risk of nonpayment from the buyer’s bank to another bank. After all, the buyer’s bank is probably in the same country as the buyer, and if a country event takes place that affects the buyer’s ability to get funds out of the country, like a government-imposed payment moratorium or a new system of exchange controls, the buyer’s bank is likely to be caught in the same problem. Thus, it is important that the confirming bank not be just a foreign branch of the buyer’s bank, lest it, too, get caught in the same problem. Even foreign branches are subject to regulations imposed by their home countries.
The issuing bank will not ask the advising bank to add its confirmation unless requested to do so by its customer, the buyer. The buyer will not request that the LofC be confirmed unless the seller tells them to. Thus, it is the seller who states, probably in the contract of sale, that payment is to be by means of a confirmed letter of credit. Unfortunately, the seller cannot dictate to the issuing bank which advising or confirming bank it must use. The issuing bank considers it their own prerogative to choose advising and confirming banks. First, the advising bank must be an established correspondent of the issuing bank in order that they may verify the authenticity of the letter of credit as part of the advising process. If the LofC is to be confirmed, the advising bank must also have acredit line established for the issuing bank. It is very embarrassing to a bank to request that another bank confirm one of their letters of credit and then be declined. So the issuing bank may well use its own choice of advising and confirming banks even when the seller has specified another bank. Indeed, some issuing banks are known to choose their own branches and subsidiaries, which, as previously described, does not provide the protection expected to come with confirmation.
Presenting Documents
Whether or not the LofC is confirmed, the seller is entitled to payment only if they comply with the requirements of the credit. Many LofCs authorize the nominated bank to charge the issuing bank’s account upon presentation to it of compliant documents. Theissuing bank is entitled to ask for the money back if, when it receives the documents, it determines that the documents are not compliant. The nominated bank must therefore examine the documents and will pay the seller only upon the presentation of documents which it feels certain will not be refused by the issuing bank. Because any discrepancy is grounds for refusal, the nominated bank will insist that the documents comply strictly with the terms of the letter of credit. In fact, over 75% of letter of creditdocuments are found to contain discrepancies.
Avoiding Discrepancies
While the documents required under letters of credit may vary, most LofCs commonly call for the presentation of a draft, commercial invoices, and transport documents. The nominated bank is expected to examine these and any other specified documents with care, to be certain they appear on their face to comply with the terms and conditions of the credit. The Uniform Customs and Practice for Documentary Credits provides a set of guidelines banks use for examining documents. (See the article “Understanding the UCP600” for further information.)
These are some of the most common discrepancies found in LofC documents:
· Documents contain inconsistent data.
· Documents were presented more than 21 days after date of shipment (or other presentation period specified in the LofC).
· Full set of transport documents was not presented or other required documents are missing.
· Draft is drawn incorrectly or for the wrong amount.
· Draft is not signed or not endorsed.
· Invoice does not describe merchandise in exact accordance with the letter of credit. Note: If the letter of credit describes merchandise in a foreign language, then the seller must describe the merchandise in that language on the invoice; translations are not acceptable.
· Invoice does not show the same shipping terms as specified in the LofC.
· Invoice includes charges inconsistent with the shipping terms in the LofC.
· Invoice is not made out in the name of the applicant shown in the LofC.
· Insurance certificate or policy is not endorsed.
· Insurance certificate is dated later than the shipment date (acceptable if coverage is stated to be warehouse-to-warehouse).
· Transport document is not clean (defective condition of goods or packaging is indicated).
· Transport document does not clearly indicate the name and capacity of the signer and who the carrier is (must be signed “ABC Co. as carrier” or “XYZ Co. as agent for ABC Co., the carrier”).
· Transport document is not consigned correctly or is not endorsed (if endorsement is required).
· Multimodal transport document was presented when LofC calls for a bill of lading (acceptable if an “on board” notation has been added that includes the name of the vessel and the port of loading).
· Multimodal transport document was presented when shipping terms are FOB (i.e., port to port) and does not indicate inland freight has been prepaid or otherwise fails to meet requirements for port-to-port shipment.
· Transport document is not marked “freight prepaid” or “freight collect” as required under the credit or in agreement with the invoice and shipping terms.
· Not all documents show license numbers, letter of credit numbers, or other identification required in the credit.
· Documents are not signed in accordance with LofC terms (any document called a “certificate” must be signed).
Financing the Transaction
On once the nominated bank is satisfied that the documents comply with the LofC requirements (or has a satisfactory indemnity from the seller), it will trigger the payment mechanism outlined in the credit. Payment may be expected in a few days, for a letter of creditpayable at sight, or a few months, for a credit available against time drafts or by deferred payment. If the seller is a relationship customer, the nominated bank may be willing to advance funds to him prior to receipt of payment from the issuing bank. It is even likely the seller can sell the receivable to the nominated bank without recourse (similar to the silent confirmation structure described before, but without the commitment in advance) and take the receivable off their books. This practice is referred to as “discounting,” since the bank deducts its interest charges from the amount paid. The interest rate for discounting such bank obligations is usually much less than the company’s normal borrowing rate (often even lower than the US Federal Funds and international LIBOR rates at which banks lend money to each other), making it very attractive to accept such financing.
