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LETTERS OF CREDIT IN BUSINESS TRANSACTIONS
INTRODUCTION:
In most of the world
and, indeed, in much of the United States the parties to a transaction
often do not know each other and are concerned that the transaction will
not proceed without problems. The manufacturer or supplier is concerned
that it will not be paid for goods or services rendered. The buyer is
worried that defective goods will be supplied or will arrive late or
incomplete. The seller wants cash up front and the buyer does not want to
pay until the goods are in hand, inspected, and approved.
The situation is exacerbated when transactions occur
across international borders. First, practically speaking, it is
difficult to enforce contractual commitments far from home and most often
far more expensive than litigation in a local arena. Secondly, many
jurisdictions are corrupt, or slow, or hostile to foreign litigants. Some
huge markets, as China, with flourishing economies, do not have any
effective court system at all, to their own dismay. While arbitration of
disputes in a neutral locale and effective
Terms and Conditions on invoices can
resolve many of the problems, most international businesses and quite a
few domestic businesses utilize a more direct method of assuring both
payment and performance - THE LETTER OF CREDIT.
In its most simple
form, a Letter of Credit is simply a guaranty that one financial
institution will pay monies to another financial institution upon certain
events occurring. The money is deposited into one of the banks
(“Assigning Bank”) which guaranties payment to the other bank
and the money can not be removed by the depositor (is “irrevocable
Letter of Credit’) absent consent of the other party or collapse of
the entire transaction (usually, passage of time without delivery of
goods, etc.). On the other end of the transaction, the money will not be
released by the receiving bank until conditions are met, such as timely
delivery of a stated number of goods or inspection of the quality of the
goods by a expert. (Note the banks do not normally provide the inspection
services. They merely release the money if and only if the expert you
arrange presents a certificate of successful completion of the
conditions.)
The purpose of this
article is to give the reader the basic workings of the typical types of
letters of credit, defining terms that the reader may encounter.
DEFINITION of LETTER OF CREDIT (SIMPLE):
·
A Letter of Credit (LC) is a
document issued by a bank that essentially acts as an irrevocable
guarantee of payment to a beneficiary. This means that if one of the
parties fails to pay despite performance by the other party, the bank
pays.
·
The letter
of credit can also be the source of repayment of the transaction meaning that
the exporter will get paid with the redemption of the letter of credit.
EXAMPLE AND DEFINITION OF TERMS:
·
For
simplicity sake let’s imagine that your company imports radios from
a Korean manufacturer called Seoul Manufacturing, which banks at First Seoul
Bank. Your company currently banks at First American Bank.
For the purpose of this example these will be the roles that the
parties will play:
1.
Your
company : applicant
2.
Seoul Manufacturing : beneficiary
3.
First
American Bank : Issuing Bank
4.
First
Seoul Bank : Advising Bank
The example: You
want to buy $50,000 worth of radios from Seoul Manufacturing, 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 LC would be as follows:
1) You
go to First American Bank and request a $50,000 letter of credit with
Seoul Manufacturing as a beneficiary.
2) The bank goes through
its underwriting process. Although the bank is not advancing money, they
are extending credit on your
behalf and are taking on a contingent liability. If your company
qualifies from a credit standpoint the LC is issued.
3) Even if your company does not qualify for
credit, you can still get an LC if you are willing to put cash collateral
CD, secured letters of credit are very common for small business.
4) The bank sends a copy of the letter of
credit to First Seoul Bank, which lets the vendor know and the merchandise
is shipped.
Take into consideration that the letter of credit itself might be
the source of repayment of the transaction. It could be that Seoul
Manufacturing is interested in getting paid as soon as the merchandise is
shipped. Therefore, the letter of
credit will indicate that payment shall be made as soon as Seoul
Manufacturing can present proof of shipping.
If the letter of credit that your vendor requires is not tied to a
particular transaction, but they are asking for a guarantee that makes
sure that you will not default, they are probably asking for a Stand-By letter of credit or a Revolving letter of credit. These
types of LCs are usually for a longer term, often a year, and are the
vendor’s guarantee that they will get paid.
The example above describes the simplest of letter of credit
transactions. Although there are
other factors involved such as the role of correspondent banks and confirmations, the thing that you should be concerned as a
customer is expediency and the fees involved, which can run anywhere from
1.5% to 8% of the value of the LC
TYPES OF LETTERS OF CREDIT
1.
Revocable:
Just like the name says the LC can
be revoked by the Issuing Bank without
the agreement of the
beneficiary.
2.
Irrevocable
Can not be cancelled or amended without all the parties’
agreement.
3.
Standby Guarantee of Payment.
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.
4.
Revolving LC
It is established when there are regular shipments of the same
commodity between supplier and customer. Eliminates the need to issue an
LC for each
Individual
CONCLUSION:
The reason LCs exist,
of course, is to remove the risk of credit in international transactions.
Certain nations, such as many in Asia or the Middle East, have legal
systems of dubious value or, as in the United States, great expense.
While the LCs may cost extra to obtain, many companies have determined
that the cost is far less than attempts to collect the sums in the
various legal systems. It is likely that LCs will remain major factors
for international trade until and unless the internet economy develops
equally effective means to assure dependable payment.
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