LETTERS OF CREDIT EXPLAINED.

Dear Subscriber,

The World has become smaller especially with the advent of the internet and it is now simpler for people that are not in the same geographical location to do business without necessarily seeing or meeting each themselves. With this simplicity however comes the huge risk of transacting parties either misunderstanding themselves or a dubious party to the transaction deliberately swindling the innocent party on the other side.

As international trade evolved, the need arose for a suitable model that allow parties that are geographically separated to still transact with adequate comfort and one of the models developed is known as Letters of Credit (otherwise referred to as LC). This can offer a guarantee to the seller that they will be paid, and the buyer can be sure that no payment will be made until they receive the goods. Our article this week explains the meaning, types and benefits of using a Letter of Credit in International Transactions.

Meaning

In simple terms a Letter of Credit simply means a  letter from a bank guaranteeing that a buyer’s payment to a seller will be received  within an agreed time frame and in the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase..

Types

• Revocable letter of credit- Just like the name says the Letter of Credit can be revoked by the Issuing Bank without the agreement of the Beneficiary.
• Irrevocable letter of credit-This cannot not be cancelled or amended without all the parties being in agreement.
• Standby letter of credit- This basically means if the beneficiary does not get paid from its customer it can then demand payment from the Bank by forwarding the copy of the invoice that was not paid and supporting documentation.
• Revolving letter of credit- This is usually used where there are regular shipments of the same commodity between supplier and customer. It eliminates the need to issue an LC for each individual transaction

Benefits

For the Seller-

• The seller has the obligation of buyer’s Bank’s to pay for the shipped goods in accordance with the invoice.
• It reduces loss in production if the buyer cancels or changes his order
• It gives the opportunity to get financing in the period between the shipment of the goods and receipt of payment.
• The seller is able to calculate the payment date for the goods.
• The buyer will not be able to refuse to pay due to a complaint about the goods

For the Buyer-

• The bank will pay the seller for the goods until he presents to the bank the agreed documents (quality certificate, bill of lading);
• The buyer can control the time period for shipping of the goods;
• By a letter of credit, the buyer demonstrates his solvency;
• In the case of issuing a letter of credit providing for delayed payment, the seller grants a credit to the buyer.
• Providing a letter of credit allows the buyer to avoid or reduce pre-payment.

Process

Let us imagine that your company is importing automobile spare parts from China and your Company banks with XYZ Bank. Your Company wants to buy $100,000 worth of spare parts from a Manufacturer in China which agrees to sell the merchandise and gives you 60 days to pay it with the condition that you provide them with a 90 days letter of credit for the full amount. The steps to get the Letter of Credit would be as follows:

1. You go to XYZ Bank and request a $100,000 letter of credit with the Sellers as a beneficiary.
2. The bank goes through its processes and gives you conditions for issuing the Letter of Credit.
3. After meeting the conditions, XYZ bank sends a copy of the letter of credit to the Sellers Bank, which lets the Seller know and the merchandise is shipped.
4. Payment is made by XYZ Bank as indicated on the Letter of Credit

As you can see, Seller and Buyers Banks take the pressure and risk off the transacting parties which enables them to deal more comfortably.

Take Away

The use of letters of credit as a tool to reduce risk has grown substantially over the years. Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. It is essential to consult with professionals before embarking on international trade.

The content of this document is solely for information purposes only and should not in any way be construed as a legal opinion.  If you require specific legal advice on any of the matters covered in this article please contact a professional.

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