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HOW TO USE LETTERS OF CREDIT
Source CREDIT RESEARCH FOUNDATION
Letters of credit accomplish their purpose by substituting the credit
of the bank for that of the customer, for the purpose of facilitating
trade. There are basically two types: commercial and standby. The
commercial letter of credit is the primary payment mechanism for
a transaction, whereas the standby letter of credit is a secondary
payment mechanism.
What is a Letter of Credit?
A letter of credit is a document issued mostly by a financial institution
which usually provides an irrevocable payment undertaking (it can
also be revocable, confirmed, unconfirmed, transferable or others
e.g. back to back: revolving but is most commonly irrevocable/confirmed)
to a beneficiary against complying documents as stated in the Letter
of Credit. Letter of Credit is abbreviated as an LC or L/C, and
often is referred to as a documentary credit, abbreviated as DC
or D/C, documentary letter of credit, or simply as credit (as in
the UCP 500 and UCP 600). Once the beneficiary or a presenting bank
acting on its behalf, makes a presentation to the issuing bank or
confirming bank, if any, within the expiry date of the LC, comprising
documents complying with the terms and conditions of the LC, the
applicable UCP and international standard banking practice, the
issuing bank or confirming bank, if any, is obliged to honour irrespective
of any instructions from the applicant to the contrary. In other
words, the obligation to honour (usually payment) is shifted from
the applicant to the issuing bank or confirming bank, if any. Non-banks
can also issue letters of credit however parties must balance potential
risks.
The LC can also be the source of payment for a transaction,
meaning that an exporter will get paid by redeeming the letter of
credit. Letters of credit are used nowadays primarily in international
trade transactions of significant value, for deals between a supplier
in one country and a wholesale customer in another. They are also
used in the land development process to ensure that approved public
facilities (streets, sidewalks, stormwater ponds, etc.) will be
built. The parties to a letter of credit are usually a beneficiary
who is to receive the money, the issuing bank of whom the applicant
is a client, and the advising bank of whom the beneficiary is a
client. Almost all letters of credit are irrevocable, i.e., cannot
be amended or canceled without prior agreement of the beneficiary,
the issuing bank and the confirming bank, if any. In executing a
transaction, letters of credit incorporate functions common to giros
and Traveler's cheques. Typically, the documents a beneficiary has
to present in order to avail himself of the credit, are commercial
invoice, bill of lading, insurance documents. However, the list
and form of documents is open to imagination and negotiation and
might contain requirements to present documents issued by a neutral
third party evidencing the quality of the goods shipped.
How Letters of Credit work
Imagine that a business called the WAPRO from time to time imports
steel from a business called MIL, which banks with the India Business
Bank. WAPRO holds an account at the Commonwealth Financials. WAPRO
wants to buy $500,000 worth of merchandise from MIL, who agrees
to sell the goods and give WAPRO 60 days to pay for them, on the
condition that they are provided with a 90-day LC for the full amount.
The steps to get the letter of credit would be as follows:
* WAPRO goes to The Commonwealth Financials and
requests a $500,000 letter of credit, with MIL as the beneficiary.
* The Commonwealth Financials can issue an LC either on approval
of a standard loan underwriting process or by WAPRO funding it directly
with a deposit of $500,000 plus fees between 1% and 8%.
* The Commonwealth Financials sends a copy of the LC to the India
Business Bank, which notifies the MIL that payment is ready and
they can ship the merchandise WAPRO has ordered with the full assurance
of payment to them.
* On presentation of the stipulated documents in the letter of credit
and compliance with the terms and conditions of the letter of credit,
the Commonwealth Financials transfers the $500,000 to the India
Business Bank, which then credits the account to the MIL by that
amount.
* Note that banks deal only with documents under the letter of credit
and not the underlying transaction.
* Many exporters have misunderstood that the payment is guaranteed
after receiving the LC. The issuing bank is obligated to pay under
the letter of credit only when the stipulated documents are presented
and the terms and conditions of the letter of credit have been met
accordingly.
Commercial Letter of Credit
Commercial letters of credit have been used for centuries to facilitate
payment in international trade. Their use will continue to increase
as the global economy evolves. Letters of credit used in international
transactions are governed by the International Chamber of Commerce
Uniform Customs and Practice for Documentary Credits. The general
provisions and definitions of the International Chamber of Commerce
are binding on all parties. Domestic collections in the United States
are governed by the Uniform Commercial Code. A commercial letter
of credit is a contractual agreement between a bank, known as the
issuing bank, on behalf of one of its customers, authorizing another
bank, known as the advising or confirming bank, to make payment
to the beneficiary. The issuing bank, on the request of its customer,
opens the letter of credit. The issuing bank makes a commitment
to honor drawings made under the credit. The beneficiary is normally
the provider of goods and/or services. Essentially, the issuing
bank replaces the bank's customer as the payee.
Elements of a Letter of Credit
* A payment undertaking given by a bank (issuing bank)
* On behalf of a buyer (applicant)
* To pay a seller (beneficiary) for a given amount of money
* On presentation of specified documents representing the supply
of goods
* Within specified time limits
* Documents must conform to terms and conditions set out in the
letter of credit
* Documents to be presented at a specified place
Beneficiary
The beneficiary is entitled to payment as long as he can provide
the documentary evidence required by the letter of credit. The letter
of credit is a distinct and separate transaction from the contract
on which it is based. All parties deal in documents and not in goods.
The issuing bank is not liable for performance of the underlying
contract between the customer and beneficiary. The issuing bank's
obligation to the buyer, is to examine all documents to insure that
they meet all the terms and conditions of the credit. Upon requesting
demand for payment the beneficiary warrants that all conditions
of the agreement have been complied with. If the beneficiary (seller)
conforms to the letter of credit, the seller must be paid by the
bank.
Issuing Bank
The issuing bank's liability to pay and to be reimbursed from its
customer becomes absolute upon the completion of the terms and conditions
of the letter of credit. Under the provisions of the Uniform Customs
and Practice for Documentary Credits, the bank is given a reasonable
amount of time after receipt of the documents to honor the draft.
The issuing banks' role is to provide a guarantee to the seller
that if compliant documents are presented, the bank will pay the
seller the amount due and to examine the documents, and only pay
if these documents comply with the terms and conditions set out
in the letter of credit. Typically the documents requested will
include a commercial invoice, a transport document such as a bill
of lading or airway bill and an insurance document; but there are
many others. Letters of credit deal in documents, not goods.
Advising Bank
An advising bank, usually a foreign correspondent bank of the issuing
bank will advise the beneficiary. Generally, the beneficiary would
want to use a local bank to insure that the letter of credit is
valid. In addition, the advising bank would be responsible for sending
the documents to the issuing bank. The advising bank has no other
obligation under the letter of credit. If the issuing bank does
not pay the beneficiary, the advising bank is not obligated to pay.
Confirming Bank
The correspondent bank may confirm the letter of credit for the
beneficiary. At the request of the issuing bank, the correspondent
obligates itself to insure payment under the letter of credit. The
confirming bank would not confirm the credit until it evaluated
the country and bank where the letter of credit originates. The
confirming bank is usually the advising bank.
Letter of Credit Characteristics
Negotiability
Letters of credit are usually negotiable. The issuing bank is obligated
to pay not only the beneficiary, but also any bank nominated by
the beneficiary. Negotiable instruments are passed freely from one
party to another almost in the same way as money. To be negotiable,
the letter of credit must include an unconditional promise to pay,
on demand or at a definite time. The nominated bank becomes a holder
in due course. As a holder in due course, the holder takes the letter
of credit for value, in good faith, without notice of any claims
against it. A holder in due course is treated favorably under the
UCC. The transaction is considered a straight negotiation if the
issuing bank's payment obligation extends only to the beneficiary
of the credit. If a letter of credit is a straight negotiation it
is referenced on its face by "we engage with you" or "available
with ourselves". Under these conditions the promise does not pass
to a purchaser of the draft as a holder in due course.
Revocability
Letters of credit may be either revocable or irrevocable. A revocable
letter of credit may be revoked or modified for any reason, at any
time by the issuing bank without notification. A revocable letter
of credit cannot be confirmed. If a correspondent bank is engaged
in a transaction that involves a revocable letter of credit, it
serves as the advising bank. Once the documents have been presented
and meet the terms and conditions in the letter of credit, and the
draft is honored, the letter of credit cannot be revoked. The revocable
letter of credit is not a commonly used instrument. It is generally
used to provide guidelines for shipment. If a letter of credit is
revocable it would be referenced on its face. The irrevocable letter
of credit may not be revoked or amended without the agreement of
the issuing bank, the confirming bank, and the beneficiary. An irrevocable
letter of credit from the issuing bank insures the beneficiary that
if the required documents are presented and the terms and conditions
are complied with, payment will be made. If a letter of credit is
irrevocable it is referenced on its face.
Transfer and Assignment
The beneficiary has the right to transfer or assign the right to
draw, under a credit only when the credit states that it is transferable
or assignable. Credits governed by the Uniform Commercial Code (Domestic)
maybe transferred an unlimited number of times. Under the Uniform
Customs Practice for Documentary Credits (International) the credit
may be transferred only once. However, even if the credit specifies
that it is nontransferable or nonassignable, the beneficiary may
transfer their rights prior to performance of conditions of the
credit.
Sight and Time Drafts
All letters of credit require the beneficiary to present a draft
and specified documents in order to receive payment. A draft is
a written order by which the party creating it, orders another party
to pay money to a third party. A draft is also called a bill of
exchange. There are two types of drafts: sight and time. A sight
draft is payable as soon as it is presented for payment. The bank
is allowed a reasonable time to review the documents before making
payment. A time draft is not payable until the lapse of a particular
time period stated on the draft. The bank is required to accept
the draft as soon as the documents comply with credit terms. The
issuing bank has a reasonable time to examine those documents. The
issuing bank is obligated to accept drafts and pay them at maturity.
Standby Letter of Credit (SLOC)
A guarantee of payment issued by a bank on behalf of a client that
is used as "payment of last resort" should the client fail to fulfill
a contractual commitment with a third party. Standby letters of
credit are created as a sign of good faith in business transactions,
and are proof of a buyer's credit quality and repayment abilities.
The bank issuing the SLOC will perform brief underwriting duties
to ensure the credit quality of the party seeking the letter of
credit, then send notification to the bank of the party requesting
the letter of credit (typically a seller or creditor).
Also known as a "non-performing letter of credit".
A standby letter of credit will typically be in
force for about one year, allowing for enough time for payment to
be made through standard contractual guidelines.
Standby letters of credit are often used in international
trade transactions, such as the purchase of goods from another country.
The seller will ask for a standby letter of credit, which can be
cashed on demand if the buyer fails to make payment by the date
specified in the contract. The cost to obtain a standby letter of
credit is typically 1-8% of the face amount annually, but the letter
can be canceled as soon as the terms of the contract have been met
by the purchaser or borrower.
The standby letter of credit serves a different
function than the commercial letter of credit. The commercial letter
of credit is the primary payment mechanism for a transaction. The
standby letter of credit serves as a secondary payment mechanism.
A bank will issue a standby letter of credit on behalf of a customer
to provide assurances of his ability to perform under the terms
of a contract between the beneficiary. The parties involved with
the transaction do not expect that the letter of credit will ever
be drawn upon. The standby letter of credit assures the beneficiary
of the performance of the customer's obligation. The beneficiary
is able to draw under the credit by presenting a draft, copies of
invoices, with evidence that the customer has not performed its
obligation. The bank is obligated to make payment if the documents
presented comply with the terms of the letter of credit. Standby
letters of credit are issued by banks to stand behind monetary obligations,
to insure the refund of advance payment, to support performance
and bid obligations, and to insure the completion of a sales contract.
The credit has an expiration date. The standby letter of credit
is often used to guarantee performance or to strengthen the credit
worthiness of a customer. In the above example, the letter of credit
is issued by the bank and held by the supplier. The customer is
provided open account terms. If payments are made in accordance
with the suppliers' terms, the letter of credit would not be drawn
on. The seller pursues the customer for payment directly. If the
customer is unable to pay, the seller presents a draft and copies
of invoices to the bank for payment. The domestic standby letter
of credit is governed by the Uniform Commercial Code. Under these
provisions, the bank is given until the close of the third banking
day after receipt of the documents to honor the draft.
Procedures for Using the Tool
The following procedures include a flow of events that follow the
decision to use a Commercial Letter of Credit. Procedures required
to execute a Standby Letter of Credit are less rigorous. The standby
credit is a domestic transaction. It does not require a correspondent
bank (advising or confirming). The documentation requirements are
also less tedious.
Step-by-step process:
1)* Buyer and seller agree to conduct business. The seller wants
a letter of credit to guarantee payment.
2)* Buyer applies to his bank for a letter of credit in favor of
the seller.
3)* Buyer's bank approves the credit risk of the buyer, issues and
forwards the credit to its correspondent bank (advising or confirming).
The correspondent bank is usually located in the same geographical
location as the seller (beneficiary).
4)* Advising bank will authenticate the credit and forward the original
credit to the seller (beneficiary).
5)* Seller (beneficiary) ships the goods, then verifies and develops
the documentary requirements to support the letter of credit. Documentary
requirements may vary greatly depending on the perceived risk involved
in dealing with a particular company.
6)* Seller presents the required documents to the advising or confirming
bank to be processed for payment.
7)* Advising or confirming bank examines the documents for compliance
with the terms and conditions of the letter of credit.
8)* If the documents are correct, the advising or confirming bank
will claim the funds by:
a. Debiting the account of the issuing bank.
b. Waiting until the issuing bank remits, after receiving the documents.
c. Reimburse on another bank as required in the credit.
9)* Advising or confirming bank will forward the
documents to the issuing bank.
10)* Issuing bank will examine the documents for compliance. If
they are in order, the issuing bank will debit the buyer's account.
11)* Issuing bank then forwards the documents to the buyer.
Standard Forms of Documentation
When making payment for product on behalf of its customer, the issuing
bank must verify that all documents and drafts conform precisely
to the terms and conditions of the letter of credit. Although the
credit can require an array of documents, the most common documents
that must accompany the draft include:
Commercial Invoice
The billing for the goods and services. It includes a description
of merchandise, price, FOB origin, and name and address of buyer
and seller. The buyer and seller information must correspond exactly
to the description in the letter of credit. Unless the letter of
credit specifically states otherwise, a generic description of the
merchandise is usually acceptable in the other accompanying documents.
Bill of Lading
A document evidencing the receipt of goods for shipment and issued
by a freight carrier engaged in the business of forwarding or transporting
goods. The documents evidence control of goods. They also serve
as a receipt for the merchandise shipped and as evidence of the
carrier's obligation to transport the goods to their proper destination.
Warranty of Title
A warranty given by a seller to a buyer of goods that states that
the title being conveyed is good and that the transfer is rightful.
This is a method of certifying clear title to product transfer.
It is generally issued to the purchaser and issuing bank expressing
an agreement to indemnify and hold both parties harmless.
Letter of Indemnity
Specifically indemnifies the purchaser against a certain stated
circumstance. Indemnification is generally used to guaranty that
shipping documents will be provided in good order when available.
Common Defects in Documentation
About half of all drawings presented contain discrepancies. A discrepancy
is an irregularity in the documents that causes them to be in non-compliance
to the letter of credit. Requirements set forth in the letter of
credit cannot be waived or altered by the issuing bank without the
express consent of the customer. The beneficiary should prepare
and examine all documents carefully before presentation to the paying
bank to avoid any delay in receipt of payment. Commonly found discrepancies
between the letter of credit and supporting documents include:
* Letter of Credit has expired prior to presentation
of draft.
* Bill of Lading evidences delivery prior to or after the date range
stated in the credit.
* Stale dated documents.
* Changes included in the invoice not authorized in the credit.
* Inconsistent description of goods.
* Insurance document errors.
* Invoice amount not equal to draft amount.
* Ports of loading and destination not as specified in the credit.
* Description of merchandise is not as stated in credit.
* A document required by the credit is not presented.
* Documents are inconsistent as to general information such as volume,
quality, etc.
* Names of documents not exact as described in the credit. Beneficiary
information must be exact.
* Invoice or statement is not signed as stipulated in the letter
of credit.
When a discrepancy is detected by the negotiating
bank, a correction to the document may be allowed if it can be done
quickly while remaining in the control of the bank. If time is not
a factor, the exporter should request that the negotiating bank
return the documents for corrections. If there is not enough time
to make corrections, the exporter should request that the negotiating
bank send the documents to the issuing bank on an approval basis
or notify the issuing bank by wire, outline the discrepancies, and
request authority to pay. Payment cannot be made until all parties
have agreed to jointly waive the discrepancy.
Tips for Exporters
* Communicate with your customers in detail before they apply for
letters of credit.
* Consider whether a confirmed letter of credit is needed.
* Ask for a copy of the application to be fax to you, so you can
check for terms or conditions that may cause you problems in compliance.
* Upon first advice of the letter of credit, check that all its
terms and conditions can be complied with within the prescribed
time limits.
* Many presentations of documents run into problems with time-limits.
You must be aware of at least three time constraints - the expiration
date of the credit, the latest shipping date and the maximum time
allowed between dispatch and presentation.
* If the letter of credit calls for documents supplied by third
parties, make reasonable allowance for the time this may take to
complete.
* After dispatch of the goods, check all the documents both against
the terms of the credit and against each other for internal consistency.
The use of the letters of credit as a tool to reduce
risk has grown substantially over the past decade. Letters of credit
accomplish their purpose by substituting the credit of the bank
for that of the customer, for the purpose of facilitating trade.
The credit professional should be familiar with two types of letters
of credit: commercial and standby. Commercial letters of credit
are used primarily to facilitate foreign trade. The commercial letter
of credit is the primary payment mechanism for a transaction. The
standby letter of credit serves a different function. The standby
letter of credit serves as a secondary payment mechanism. The bank
will issue the credit on behalf of a customer to provide assurances
of his ability to perform under the terms of a contract. Upon receipt
of the letter of credit, the credit professional should review all
items carefully to insure that what is expected of the seller is
fully understood and that he can comply with all the terms and conditions.
When compliance is in question, the buyer should be requested to
amend the credit.
Types of Letters of Credit
There are two basic forms of letters of credit: Standby and Documentary.
Documentary letters of credit can be either Revocable or Irrevocable,
although the first is extremely rare. Irrevocable letters of credit
can be Confirmed or Not Confirmed. Each type of credit has advantages
and disadvantages for the buyer and for the seller, which this information
will review below. Charges for each type will also vary. However,
the more the banks assume risk by guaranteeing payment, the more
they will charge for providing the service.
Documentary Revocable Letter
of Credit
Revocable credits may be modified or even canceled by the buyer
without notice to the seller. Therefore, they are generally unacceptable
to the seller.
Documentary Irrevocable Letter
of Credit
This is the most common form of credit used in international trade.
Irrevocable credits may not be modified or canceled by the buyer.
The buyer's issuing bank must follow through with payment to the
seller so long as the seller complies with the conditions listed
in the letter of credit. Changes in the credit must be approved
by both the buyer and the seller. If the documentary letter of credit
does not mention whether it is revocable or irrevocable, it automatically
defaults to irrevocable. See Credit Administration, Sample Procedure
for Administration of a Documentary Irrevocable Letters of Credit
for a systematic procedure for establishing an irrevocable letter
of credit.
There are two forms of irrevocable
credits:
Unconfirmed credit
(the irrevocable credit not confirmed by the advising bank) In an
unconfirmed credit, the buyer's bank issuing the credit is the only
party responsible for payment to the seller. The seller's advising
bank pays only after receiving payment from the issuing bank. The
seller's advising bank merely acts on behalf of the issuing bank
and, therefore, incurs no risk.
Confirmed credit (the irrevocable
confirmed credit)
In a confirmed credit, the advising bank adds its guarantee to pay
the seller to that of the buyer's issuing bank. Once the advising
bank reviews and confirms that all documentary requirements are
met, it will pay the seller. The advising bank will then look to
the issuing bank for payment. Confirmed Irrevocable letters of credit
are used when trading in a high-risk area where war or social, political,
or financial instability are real threats. Also common when the
seller is unfamiliar with the bank issuing the letter of credit
or when the seller needs to use the confirmed letter of credit to
obtain financing its bank to fill the order. A confirmed credit
is more expensive because the bank has added liability.
Standby Letter of Credit
This credit is a payment or performance guarantee used primarily
in the United States. They are often called non-performing letters
of credit because they are only used as a backup should the buyer
fail to pay as agreed. Thus, a stand-by letter of credit allows
the customer to establish a rapport with the seller by showing that
it can fulfill its payment commitments. Standby letters of credit
are used, for example, to guarantee repayment of loans, to ensure
fulfillment of a contract, and to secure payment for goods delivered
by third parties. The beneficiary to a standby letter of credit
can cash it on demand. Stand-by letters of credit are generally
less complicated and involve far less documentation requirements
than irrevocable letters of credit. See Credit Administration, Sample
Procedure for Administration of a Standby Letter of Credit for a
systematic procedure for establishing a standby letter of credit.
Examples of Special Letters
of Credit:
Back-to-Back Letter of Credit
This is a new letter of credit opened based on an already existing,
nontransferable credit used as collateral. Traders often use back-to-back
arrangements to pay the ultimate supplier. A trader receives a letter
of credit from the buyer and then opens another letter of credit
in favor of the supplier. The first letter of credit serves as collateral
for the second credit.
Deferred Payment (Usance)
Letter of Credit In Deferred Payment Letters of Credit, the buyer
accepts the documents related to the letter of credit and agrees
to pay the issuing bank after a fixed period. This credit gives
the buyer a grace period for payment.
Red Clause Letter of Credit
Red Clause Letters of Credit provide the seller with cash prior
to shipment to finance production of the goods. The buyer's issuing
bank may advance some or all of the funds. The buyer, in essence,
extends financing to the seller and incurs the risk for all advanced
credits.
Revolving Letter of Credit
With a Revolving Letter of Credit, the issuing bank restores the
credit to its original amount once it has been used or drawn down.
Usually, these arrangements limit the number of times the buyer
may draw down its line over a predetermined period.
Transferable Letter of Credit
This type of credit allows the seller to transfer all or part of
the proceeds of the original letter of credit to a second beneficiary,
usually the ultimate supplier of the goods. The letter of credit
must clearly state that it is transferable for its to be considered
as such. This is a common financing tactic for middlemen and is
common in East Asia.
Assignment of Proceeds
The beneficiary of a letter of credit may assign all or part of
the proceeds under a credit to a third party (the assignee). However,
unlike a transferred credit, the beneficiary maintains sole rights
to the credit and is solely responsible for complying with its terms
and conditions. For the assignee, an assignment only means that
the paying bank, once it receives notice of the assignment, undertakes
to follow the assignment instructions, if and when payment is made.
The assignee is dependent upon the beneficiary for compliance, and
thus this arrangement is riskier than a transferred credit. Before
agreeing to an assignment of proceeds arrangement, the assignee
should carefully review the original letter of credit.
Common Problems with Letters
of Credit
Most problems result from the seller's inability to fulfill obligations
stated in the letter of credit. The seller may find these terms
difficult or impossible to fulfill and, either tries to fulfill
them and fails, or asks the buyer to amend to the letter of credit.
As most letters of credit are irrevocable, amendments may at times
be difficult since both the buyer and the seller must agree. Sellers
may have one or more of the following problems:
# The shipment schedule cannot be met;
# The stipulations concerning freight costs are unacceptable;
# The price becomes too low due to exchange rates fluctuations;
# The quantity of product ordered is not the expected amount;
# The description of product is either insufficient or too detailed;
and,
# The stipulated documents are difficult or impossible to obtain.
Even when sellers accept the terms of a letter of
credit, problems often arise late in the process. When this occurs,
the buyer's and seller's banks will try to negotiate any differences.
In some cases, the seller can correct the documents and present
them within the time specified in the letter of credit. If the documents
cannot be corrected, the advising bank will ask the issuing bank
to accept the documents despite the discrepancies found. It is important
to note that, if the documents are not in accord with the specifications
of the letter of credit, the buyer's issuing bank is no longer obligated
to pay.
Basic Procedures for Establishing
a Letter of Credit
The letter of credit process has been standardized by a set of rules
published by the International Chamber of Commerce (ICC). These
rules are called the Uniform Customs and Practice for Documentary
Credits (UCP) and are contained in ICC Publication No. 500. The
following is the basic set of steps used in a letter of credit transaction.
Specific letter of credit transactions follow somewhat different
procedures.
1. After the buyer and seller agree on the terms
of a sale, the buyer arranges for his bank to open a letter of credit
in favor of the seller. Note: The buyer will need to have a line
of credit established at the bank or provide cash collateral for
the amount of the letter of credit.
2. The buyer's issuing bank prepares the letter
of credit, including all of the buyer's instructions to the seller
concerning shipment and required documentation.
3. The buyer's bank sends the letter of credit to
the seller's advising bank.
4. The seller's advising bank forwards the letter
of credit to the seller.
5. The seller carefully reviews all conditions stipulated
in the letter of credit. If the seller cannot comply with any of
the provisions, it will ask the buyer to amend the letter of credit.
6. After final terms are agreed upon, the seller
ships the goods to the appropriate port or location.
7. After shipping the goods, the seller obtains
the required documents. Please note that the seller may have to
obtain some documents prior to shipment.
8. The seller presents the documents to its advising
bank along with a draft for payment.
9. The seller's advising bank reviews the documents.
If they are in order, it will forward them to the buyer's issuing
bank. If a confirmed letter of credit, the advising bank will pay
the seller (cash or a bankers' acceptance).
10. Once the buyer's issuing bank receives and reviews
the documents, it either (1) pays if there are no discrepancies;
or (2) forwards the documents to the buyer if there are discrepancies
for its review and approval.
Amendment of a Letter of Credit
For the seller to change the terms noted on an irrevocable letter
of credit, it must request an amendment from the buyer. The amendment
process is as follows:
1. The seller requests a modification or amendment
of questionable terms in the letter of credit;
2. If the buyer and issuing bank agree to the changes, the issuing
bank will change the letter of credit;
3. The buyer's issuing bank notifies the seller's advising bank
of the amendment; and
4. The seller's advising bank notifies the seller of the amendment.
Tips for Buyers and Sellers
Seller
1. Before signing a sales contract, the seller should make inquiries
about the buyer's creditworthiness and business practices. The seller's
bank will generally assist in this investigation.
2. In many cases, the issuing bank will specify the advising and/or
confirming bank. These designations are usually based on the issuing
bank's established correspondent relationships. The seller should
ensure that the advising/confirming bank is a financially sound
institution.
3. The seller should confirm the good standing of the buyer's issuing
bank if the letter of credit is unconfirmed.
4. For confirmed letters of credit, the seller's advising bank should
be willing to confirm the letter of credit issued by the buyer's
bank. If the advising bank refuses to do so, the seller should request
another issuing bank as the current bank may be or is in the process
of becoming insolvent.
5. The seller should carefully review the letter of credit to ensure
its conditions can be met. All documents must conform to the terms
of the letter of credit. The seller must comply with every detail
of the letter of credit specifications; otherwise the security given
by the credit is lost.
6. The seller should ensure that the letter of credit is irrevocable.
7. If amendments are necessary, the seller should contact the buyer
immediately so that the buyer can instruct the issuing bank to make
the necessary changes quickly. The seller should keep the letter
of credit's expiration date in mind throughout the amendment process.
8. The seller should confirm with the insurance company that it
can provide the coverage specified in the letter of credit and that
insurance charges listed in the letter of credit are correct. Typical
insurance coverage is for CIF (cost, insurance and freight) often
the value of the goods plus about 10 percent.
9. The seller must ensure that the goods match the description in
the letter of credit and the invoice description.
10. The seller should be familiar with foreign exchange limitations
in the buyer's country that could hinder payment procedures.
Buyer
1. When choosing the type of letter of credit, the buyer should
consider the standard payment methods in the seller's country.
2. The buyer should keep the details of the purchase short and concise.
3. The buyer should be prepared to amend or re-negotiate terms of
the letter of credit with the seller. This is a common procedure
in international trade. With irrevocable letters of credit, the
most common type, all parties must agree to amend the document.
4. The buyer can reduce the foreign exchange risk by buying forward
currency contracts.
5. The buyer should use a bank experienced in foreign trade as its
issuing bank.
6. The validation time stated on the letter of credit should give
the seller ample time to produce the goods or to pull them out of
stock.
7. A letter of credit is not fail-safe. Banks are only responsible
for the documents exchanged and not the goods shipped. Documents
in conformity with the letter of credit specifications cannot be
rejected on grounds that the goods were not delivered as specified
in the contract. The goods shipped may not in fact be the goods
ordered and paid for.
8. Purchase contracts and other agreements pertaining to the sale
between the buyer and seller are not the concern of the issuing
bank. Only the letter of credit terms are binding on the bank. 9.
Documents specified in the letter of credit should include those
the buyer requires for customs clearance.
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