Letters of Credit Demystified

Letters of Credit are an involved subject. Bankers spend lots of time studying the various types and rules and regulations. “But hold on” I hear you say. I thought this article was entitled ‘Demystified.’ Well, for the typical importer or exporter dealing in individual transactions, they can be quite straightforward.

Why Letters of Credit?

Imagine you’re an exporter with an order from a company overseas. Your customer wants credit, but you can’t get the ok for a credit line on them, either by reason of their lack of creditworthiness or maybe economic or political issues in their country. Perhaps it is just a much larger order than has previously been the case in the relationship.

Consider the importer’s reasons. It may be just that they are unsure whether goods will be shipped if they pay the exporter in advance.

In these examples the exporter’s and/or the importer’s minds can be put at rest by utilising the banking system and employing a Letter of Credit (L/C). The L/C provides the comfort of a guarantee, and the banking system checks that the required documents are compliant and prove shipment prior to release of payment.

As ever in business life, there is a cost. Aside from the bank fees and commissions, perhaps the most important thing that should be kept in mind is that the moment the opening bank signs off on the L/C a contingent liability is created. The L/C is a conditional guarantee, so the importer’s opening bank must assume that the conditions will be met by the exporting beneficiary. The bank’s liabilities increase by the value of the credit the moment it is opened. Therefore, the opener may have their banking facilities reduced by the value of the credit, or they’ll need to put an equivalent sum on deposit. Perhaps they may need to offer some other security such as property. Exporters would do well, therefore, to consider the strain imposed on the importer’s banking facilities, and importers need to factor potential delays into their cash flow projections. Importers can often solve this problem by engaging a trade finance broker to arrange finance. A trade finance house can open the credit for a small share of the transaction. An exporter just needs to comply with the conditions and the guarantee will work!

L/Cs often have a bad press. They can be viewed as a complication, awkward, even cumbersome. Documentary presentations are so often discrepant, especially from UK exporters.

Just a few simple rules for you to observe. You are most likely to be dealing with the most straightforward documentary credits. The main rules for you to be aware of are those covered by Uniform Customs and Practice 600 (UCP600). I would suggest that exporters work as though they have their own set of rules. You could call them your guidelines, though ‘rules’ will have your staff taking more notice.

Suggested ‘rules’ for Beneficiaries

Discuss early in the process by ensuring there is a dialogue between opener and beneficiary. Obtain an L/C application form from your own bank and then send your suggested conditions to the opener in the same format, which will be similar to that they might expect from their own opening bank. This can help avoid receiving a credit with challenging conditions that are difficult to comply with.

If it doesn’t look feasible get it changed. If the opener has suggested difficult or impossible conditions, get them changed. You don’t have to do just what the importer suggests. Keep in mind that the conditions are negotiable based upon the commercial transaction itself, the import regulations for the opener’s own country and what works for you, the exporter and beneficiary.

Better to change early than afford costly amendments. You can get conditions changed if they don’t fit within the transaction specifications or timescales but the process of applying for amendments takes time and will cost a bank amendment fee. Getting things right initially is always the best option.

An Irrevocable L/C should be requested. Note: Under UCP600 if the L/C doesn’t state whether it is irrevocable or revocable it must be assumed to be irrevocable. Confirmation is key, especially for very large sums. An L/C opened by the importer’s bank is a conditional guarantee of payment from an overseas jurisdiction. The exporter’s own or a choice of many other banks at home will be pleased to add their confirmation of payment, for a fee, provided all conditions are met. This adds so much more certainty to the situation because the guarantee of payment has now moved to the exporter’s own jurisdiction. It also means that payment can often be made earlier than would otherwise have been the case. 

Get document changes agreed prior to presentation of documents. e.g. Claused Bill of Lading (B/L). Liaise with the opener and use the relationship you have built up to ensure that the claused B/L is acceptable. It may be something as simple as damage to a case or pallet. The B/L, which is the carrier’s receipt for cargo, will quite rightly make reference to a damaged item received. If the document is presented with that clause the bank will regard it as a discrepancy and reject the whole set of documents. Obtain the opener’s agreement to the clause and request an amendment to that effect prior to presentation.

Many, though not all L/Cs will request a Draft. Familiarise yourself with the definition of a Bill of Exchange as per the Bills of Exchange Act of 1882 and note that bankers always refer to these as a ‘Draft.’

In summary, do what the L/C says but have some input into the conditions. Bear in mind that amendments, and even waivers can be requested, if necessary. Keep a relationship with a trade finance adviser to ask challenging questions and/or review documents prior to presentation if that will give you some comfort.  

Want to know more about Letters of Credit?

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Graham Card MIEx (Grad) has worked with Letters of Credit for over 45 years.

W www.corporateliquidity.com

E g.card@corporateliquidity.com