a letter of credit is a promise to pay

Dian Katleen BerneseFM3A

A letter of credit is a promise to pay. Banks issue letters of credit as a way to ensure sellers that they will get paid as long as they do what they've agreed to do.Letters of credit are common in international trade because the bank acts as an uninterested party between buyer and seller. For example, importers and exporters might use letters of credit to protect themselves. In addition, communication can be difficult across thousands of miles and different time zones. A letter of credit spells out the details so that everybody's on the same page.A Letter of Credit, simply defined, is a written instrument issued by a bank at the request of its customer, the Importer (Buyer), whereby the bank promises to pay the Exporter (Beneficiary) for goods or services, provided that the Exporter presents all documents called for, exactly as stipulated in the Letter of Credit, and meet all other terms and conditions set out in the Letter of Credit. A Letter of Credit is also commonly referred to as a Documentary Credit.There are two types of Letters of Credit: revocable and irrevocable. A revocable Letter of Credit can be revoked without the consent of the Exporter, meaning that it may be cancelled or changed up to the time the documents are presented. A revocable Letter of Credit affords the Exporter little protection; therefore, it is rarely used. An irrevocable Letter of Credit cannot be cancelled or changed without the consent of all parties, including the Exporter. Unless otherwise stipulated, all Letters of Credit are irrevocable.

The Money behind a Letter of CreditA bank promises to pay on behalf of a customer, but where does the money come from?The bank will only issue a letter of credit if they know the buyer will pay. Some buyers have to deposit (or already have) enough money to cover the letter of credit, and some customers use a line of credit with the bank. Sellers must trust that the bank issuing the letter of credit is legitimate.

Executing a Letter of CreditA seller only gets paid after performing specific actions that the buyer and seller agree to.For example, the seller may have to deliver merchandise to a shipyard in order to satisfy requirements for the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that he made delivery. The letter of credit now must be paid even if something happens to the merchandise. If a crane falls on the merchandise or the ship sinks, it's not the seller's problem.To pay on a letter of credit, banks simply review documents proving that a seller performed his required actions. They do not worry about the quality of goods or other items that may be important to the buyer and seller.

Pitfalls of Letters of CreditLetters of credit make it possible to do business worldwide. They are important and helpful tools, but you should be careful when using letters of credit.As a seller, make sure you:

Carefully review all requirements for the letter of credit before moving forward with a deal Understand all the documents required Can get all the documents required for the letter of credit Understand the time limits associated with the letter of credit, and whether they are

reasonable Know how quickly your service providers (shippers, etc) will produce documents for you Can get the documents to the bank on time Make all documents required by the letter of credit match the letter of credit application

exactly


Advantages and Disadvantages of Using a Letter of Credit

Advantages to the Importer • Importer is assured that the Exporter will be paid only if all terms and conditions of the Letter of Credit have been met. • Importer is able to negotiate more favorable trade terms with the Exporter when payment by Letter of Credit is offered.

Disadvantages to the Importer • A Letter of Credit does not offer protection to the Importer against the Exporter shipping inferior quality goods and/or a lesser quantity of goods. Consequently, it is important that the Importer performs the appropriate due diligence to assess the reputation of the Exporter. If the Exporter acts fraudulently, the only recourse available to the Importer is through legal proceedings. • It is necessary for the Importer to have a line of credit with a bank before the bank is able to issue a Letter of Credit. The amount outstanding under each Letter of Credit issued is applied against this line of credit from the date of issuance until final payment.

Advantages to the Exporter • The risk of payment relies upon the creditworthiness of the Issuing Bank and the political risk of the Issuing Bank’s domicile, and not the creditworthiness of the Importer. • Exporter agrees in advance to all requirements for payment under the Letter of Credit. If the Letter of Credit is not issued as agreed, the Exporter is not obligated to ship against it. • Exporter can further reduce foreign political and bank credit risk by requesting confirmation of the Letter of Credit by a Canadian bank.

Disadvantages to the Exporter • Documents must be prepared and presented in strict compliance with the requirements stipulated in the Letter of Credit. • Some Importers may not be able to open Letters of Credit due to the lack of credit facilities with their bank which consequently inhibits export growth.

Letter of Credits are unique financial instruments that connects the movement of physical goods that are being bought and sold with the funding of these goods as they move through the channels of trade. Over the years, certain terms and modality has been established which are reflected through specific Incoterms through which the Buyer, Seller and the transporting company know when the responsibility for the goods move from one party to another and when title to the underlying goods transfers from one party to another.

Generally a Letter of Credit will be irrevocable and at sight. This means that the Letter of Credit issuing bank is irrevocably committing to pay the Seller once the seller meets the terms of the Letter of Credit. ‘At Sight” means that when the Letter of Credit issuing bank receives the documents from the Seller and ‘sees’ them the issuing bank is obligated to pay if all the Letter of Credit documents are in order.

It is important to note that Letter of Credits deal with documents not with goods. In other words the Letter Credit requires that to be paid the seller has to provide certain documents such as an Invoice, Packing List and Bill of Lading showing the goods have been taken over by the shipping company. If these documents are correct, then issuing bank will pay. The issuing bank will not physical verify that the goods have actually been shipped but do reasonable due diligence to make sure that the documents are authentic. For this reason, it is


important to have the goods inspected by reliable third parties and the shipping company, the freight forwarders are reputable established credit worthy companies so that if something goes wrong the buyer will have redress to financially strong companies.

Other than 'at sight’ Letter of Credits, there are Letter of Credits where the payment is made after a certain period of time. The staring point should be from the date on the Bill of Lading, or the date the draft was accepted by the issuing bank, etc. Letter of Credits use “Incoterms” which are abbreviations of International Commercial Terms that are key elements of international contracts of sale. In a trade transaction there are generally three parties involved: the Seller, the Buyer and the Transporting Company moving the goods from the seller to the buyer. The Incoterms explain the distribution of function, costs, risks and title to the goods relating to the transfer of goods from seller to buyer Some common Incoterms:

FOB (Free on Board)a) Transportation or carriage is to be arranged by the Buyer. b) Risk transfer from the Seller to the Buyer when the goods pass the ship’s rails.c) Cost transfer from the Seller to the Buyer when the goods pass the ship’s rails. Here Buyer’s costs are the cost of the goods, freight and insurance.

CIF (Cost, Insurance and Freight)a) Freight and insurance to be arranged by the Seller.b) Risks transfer from the Seller to the Buyer when the goods pass the ship’s rails.c) Costs transfer at port of destination, Buyer pays the costs of the goods but not the freight and insurance. In essence the Buyer pays for all the costs when the goods arrive at port of destination and takes delivery.

CFR (Cost and Freight)Same as CIF except the insurance is the responsibility of the Buyer.

FAS (Free Alongside Ship)a) Transportation to be arranged by the Buyer.b) Risks transfers from the Seller to the Buyer when the goods have been placed alongside the ship.c) Costs transfers from the Seller to the Buyer when the goods have been placed alongside the ship.

EXW (Ex Works)a) Transportation to be arranged by the Buyer who is responsible to pick up the goods from the Seller’s warehouse.b) Risks transfers from the Seller to the Buyer when the goods are delivered at the warehouse and are at the disposal of the Buyer.c) Costs transfers from the Seller to the Buyer when the goods are at the disposal of the Buyer at the warehouse.

DDP (Delivered Duty Paid)a) Transportation to be arranged by the Seller.b) Risks transfers form the Seller to the Buyer when the goods have been put at the disposal of or delivered to the Seller.c) Costs transfers from the Seller to the Buyer when the goods have been put at the disposal of or


delivered to the Seller. The Seller pays for the transportation of the goods, any duties, and insurance.

Kinds of Letters of Credit

1.) Confirmed letter of credit: the correspondent bank gives the seller the absolute assurance that it will pay the seller for the issuing bank (and becomes the paying bank.) 2.) Irrevocable letter of credit: can't be revoked by the issuing bank unless the buyer and seller agree. It is a definite obligation for the issuing bank to pay when the papers are presented. An irrevocable letter of credit doesn't mean it's confirmed. The correspondent bank might not confirm it.3.) Revolving letter or credit: provides for renewed credit to become available as soon as the opening bank has advised the negotiating or paying bank that the drafts already drawn by the beneficiary were reimbursed to the opening bank by the buyer.4.) Back-to-back letter of credit: credit with identical documentary requirements and covering the same merchandise as another letter of credit, except for a difference in the price of the merchandise (shown by the invoice and draft.) The second letter of credit can be negotiated only after the first one is negotiated.5.) Standby letter of credit: security arrangement for the performance of certain obligations. It can be drawn against only if another business transaction isn't performed and may be issued in place of a performance bond. The beneficiary must prove that the obligor failed to perform the secured obligation, unlike an ordinary letter of credit where the beneficiary can recover if he can show that he performed his obligation (delivered the purchased goods.)

There are three contracts involved in a letter of credit:

1.) The contract between the buyer and seller2.) The contract between the buyer and the issuing bank3.) The letter of credit proper where the bank pays the seller according to the stated terms and conditions

The parties to a letter of credit are:

1.) The buyer2.) The seller -located abroad3.) The issuing bank -the bank that pays the seller when the letter of credit is delivered. The document of title is issued in its name.4.) The notifying bank -the bank that notifies the seller that the letter of credit was issued.5.) The confirming bank -a large and well-known bank (usually) that guarantees the transaction by jointly cooperating with the opening bank under the letter of credit's terms and conditions (and consequently lending its credibility to the transaction.)6.) The paying bank -the issuing bank pays the seller through this bank, which is located in the seller's place (can be the notifying bank) or in another place (negotiating bank.) The negotiating bank pays by buying or discounting the draft.