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
Just like the name says the LC can be revoked by the Issuing Bank without the agreement of the
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.
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.