Does Your International Shipment Need a Letter of Credit?
Why do you require a Letter of credit?
There are almost as many different types of letters of credit as there are letters in the alphabet. In this article, we’ll cut through any confusion surrounding these critical shipping documents. After reading this, you should have enough information to decide whether or not you need a letter of credit. Let’s get started with a definition of a letter of credit (LC).
What Is a Letter of Credit?
A letter of credit is a legally-binding document frequently used in international trade. Its key purpose is to give sellers/exporters of goods a guarantee that they’ll receive payment for those goods from the buyer.
An LC (which may also be referred to as a banker’s commercial credit or documentary credit) is issued by a bank. It denotes that the bank agrees to pay for the seller’s goods if the buyer cannot make the payment. It follows that banks only issue letters of credit to buyers they are confident can pay.
Letters of credit usually stipulate the payment terms agreed between the buyer and seller in great detail, to ensure the nature of the agreement is clearly laid out. Details that must be accurately specified in the LC include:
- The amount to be paid for the goods
- The currency in which the payment is to be made
- When the payment is due.
An LC 90 denotes that the money promised in the letter must be paid within 90 days. An LC 60 allows 60 days for payment, while an LC 30 offers an even smaller payment window.
The rules governing letters of credit are set out in guidelines known as the UCP600 (Uniform Customs and Practice), issued by the International Chamber of Commerce
Who Needs an LC?
LCs are primarily, but not exclusively, used in international trade transactions between sellers and buyers who do not know each other well. They represent an arrangement entered into between banks, focused on amicably settling the commercial transaction to protect the financial interests of both parties. The involvement of banks gives buyers and sellers more peace of mind that the transaction will happen.
A letter of credit is particularly useful when the buyer and seller:
- Are entering into a new trading relationship
- Live/work/trade in different countries
- Are subject to different international trade laws, rules, and regulations
- Are trading an exceptionally large consignment
Benefits of LCs to Sellers
Understandably, a seller dealing with a new buyer of their goods may have doubts about whether the buyer can or will pay for their products. There are several reasons why a buyer may not be able to pay a seller for their goods. These include:
- The buyer is declared bankrupt
- The buyer’s assets are seized or frozen
- Payment is delayed by problems in the buyer’s country (political unrest, for example)
The involvement of a bank in the transaction brings a degree of assurance that payment will be made. If a seller doesn’t receive payment from the buyer after shipping their goods, the bank that issued the LC is liable to pay the seller.
Payment depends on the seller meeting specific criteria laid out in the letter. The bank will examine the claim, and if it complies, payment will be made.
Of course, the seller is reliant on the bank being able to make the payment promised in the LC. As explained in more detail later in this article, the seller can get another bank to guarantee payment from the initial bank.
Benefits of LCs to Buyers
When dealing with a seller from a different country for the first time, a buyer could have reservations about paying for goods before receiving them. A letter of credit will give the buyer a degree of certainty that they will receive the goods without having to make an upfront payment. The buyer can instruct a bank to issue a letter of credit, which effectively means that the bank accepts the risk on the buyer’s behalf.
How Does a Letter of Credit Work?
The process begins with the buyer of the goods instructing a bank to issue an LC. The LC will promise to pay the seller/exporter a specified sum for the goods. Usually, the buyer’s bank is known as the consignee in the transaction.
The seller may wish to engage a bank to act for them. This bank, known as the advising bank or nominated bank, receives the letter of credit from the buyer’s bank. Some sellers use yet another bank—usually one from their own country—to check that the LC is valid and guarantee that the seller will receive the payment even if the issuing bank fails to pay. This bank is known as the confirming bank in the transaction.
Based on the information stipulated in the LC, the seller prepares the consignment and paperwork for shipment. When the goods arrive at their destination, the seller shares copies of all their documents to the issuing bank in line with the terms and conditions in the LC. The issuing bank checks the accuracy of all documentation. Assuming everything is in order, the issuing bank pays the seller.
The issuing bank then informs the buyer that the shipment is complete and all relevant documents have been received. The buyer then pays the issuing bank. When the issuing bank receives the funds, it endorses the Bill of Lading, enabling the cargo to be released to the buyer.
Transactions may not follow this pattern precisely, so LCs allow for plenty of flexibility to be agreed between buyer and seller. For example, the LC may stipulate that the seller deliver the goods to a specific location before any documents are forwarded to the issuing bank. In other cases, payment is made much earlier in the process—sometimes after the consignment is loaded onto the vessel that’s transporting it to its destination.
The Importance of Clarity
Whatever terms and conditions are contained in an LC, they must be explained clearly, as any errors can cause issues. It’s always a good idea for both the buyer and seller to:
- Review the content of the LC before agreeing to any deal.
- Ensure the letter of credit is fully understood, especially any time limits associated with the payment for and/or delivery of goods.
Types of Letters of Credit
Much of the complication and confusion surrounding LCs stems from the many different types of letter in use. Let’s take a look at some of the most common variants.
IRREVOCABLE LETTER OF CREDIT
UCP600 guidelines state that all letters of credit are irrevocable unless otherwise stated, making this the most common type of LC. It permits the buyer to cancel or change the terms stated in the letter if their bank and/or the seller’s bank agrees.
REVOCABLE LETTER OF CREDIT
Used far less frequently in international shipping, this letter of credit can be altered or even canceled by the issuing bank at any time, without the seller’s permission.
CONFIRMED LETTER OF CREDIT
This type of LC provides extra security for the seller. It’s issued by a bank that confirms that the original LC is valid, and that the issuing bank can honor its financial commitment. If the issuing bank defaults, the confirming bank agrees to pay the seller. A confirmed LC is invaluable if the seller is not familiar with the issuing bank and would like a payment guarantee from an institution they know and trust.
LETTER OF CREDIT AT SIGHT
This LC-variant accelerates the shipping process. It makes the fee stated in the LC payable upon presentation and verification of specific documents, or when the buyer has inspected and accepted the goods.
DEFERRED OR USANCE LETTER OF CREDIT
This permits the buyer to delay payment for the goods for a specified time. This is especially useful if the buyer needs time to sell the goods to a third party.
RED CLAUSE LETTER OF CREDIT
This LC allows the seller to receive a percentage payment from the issuing bank before their products are shipped. It carries a clause under which the buyer pays a deposit for the goods. The name derives from the color of the ink traditionally used to write such a clause.
GREEN CLAUSE LETTER OF CREDIT
No prizes for guessing the color of ink traditionally used for this clause. It gives the beneficiary access to credit before the consignment ships or any documentation is presented.
BACK-TO-BACK LETTERS OF CREDIT
This involves two letters of credit being issued, the second of which only comes into effect if the original seller is unable to supply the goods as agreed. A second LC outlines a new agreement between the original buyer and a new seller who can provide the goods.
STANDBY LETTER OF CREDIT
As the name suggests, this is an LC that’s held in reserve should there be a default on the terms of the initial LC. It provides security for both seller and buyer if the obligations of the initial contract cannot be met.
Is a Letter of Credit a Loan?
Most banks require buyers to make an advance payment before they will issue an LC. However, using a line of credit with a bank allows buyers to effectively get a loan from that bank via a letter of credit.
How Can I Get a Letter of Credit? You should approach a bank when you require an LC, although it’s important to note that not all banks offer letters of credit. Smaller banks are likely to point you in the direction of a larger institution with an international trade department or commercial division.
The Letter of Credit: Peace of Mind for Buyer and Seller Many buyers and sellers who are familiar with each other and enjoy a trusting business relationship won’t need a letter of credit. LCs are an invaluable tool, though, for any company entering into a new trading relationship. They provide peace of mind for the seller and the buyer by clearly stating the terms of payment. With banks acting as guarantors, an LC offers the assurance that both parties will honor the agreement.