Letters of credit explained
Lesley Batchelor OBE and Kevin Shakespeare, Director General and Head of Education at the Institute of Export & International Trade, explain this method of payment in international trade, which you might consider for a large transaction.
What is a letter of credit
A bank guarantee of payment is usually issued by the overseas buyer’s bank, issued in favour of the beneficiary (you the exporter), guaranteeing that they will pay you the quoted sum of money, providing you meet the terms and conditions quoted in the letter of credit. These conditions require that you present the quoted documents in the letter of credit ‘on time and in order’.
The documents required are usually those that the overseas buyer requires in order to meet quality assurance, and documents required by the Customs authorities of the buyer’s country.
- be presented within specified time limits
- in strict accordance with the terms and conditions set out in the letter of credit – that’s exactly not just more or less right!
- be presented at a specified place.
Why might I use or need letters of credit?
Letters of credit are another way of managing risk. They 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.
It pays to think about the following:
- Laws and regulations – does the country you’re exporting to require a letter of credit?
- Costs – does the value of the order justify the cost of a letter of credit, and who will pay these costs?
- The customer’s creditworthiness – do they have a track record with you?
- Risks associated with the country you’re exporting to – is it politically stable or are there extra risks at the moment?
- Normal trading practices – is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity?
- Available guidance – banks may recommend using of a letter of credit in certain trading situations regardless of other factors, while credit insurers sometimes insist on it.
Give some thought to alternative arrangements, such as insurance, factoring or cash in advance terms.
What are the advantages of letters of credit?
For the seller (that’s you)
- Guaranteed payment upon presentation of correct documents. This guarantee is provided by the buyer’s bank. In some cases the buyer’s country may not allow payment due to currency restrictions. If you have concerns about this happening please contact your bank to ask them to add their ‘Confirmation to a Letter of Credit’. Confirmation is where your bank adds their guarantee for a fee.
- Ability to structure delivery schedule according to your own business’s needs and interest
- Opportunity to obtain finance for production (or purchase of goods) e.g. discount a Term Letter of Credit (banks buy bank promises especially if it’s their own)
For the buyer
- May be able to structure payment plan, introduce credit terms allow them better interest rates than their own country offers
- Can introduce documents which evidence quality control
- Payment is only made upon presentation of documents stipulated in the letter of credit
Your responsibilities under a letter of credit
Seller (that’s you)
- Be clear on bank charges: only pay UK bank charges or make sure you understand what you have covered in your price
- Try to get the letter of credit routed through your own bank – you can then work closely with your bank can act as the Advising and Negotiating bank for the Letter of Credit, which means they can assist you in checking and presenting documents
- Give a copy of the L/C to your freight forwarder to ensure documents are provided on time
- Ensure everyone in the company knows their responsibilities to make this work
- Ensure documents evidence quality /quantity e.g. inspection certificate exactly as stated on the L/C
- A good credit rating will improve the prospects of the buyer’s bank issuing a letter of credit, and terms applicable
- Agree all wording beforehand with seller (avoid amendments as they cost money)
What could go wrong?
Like any method of payment, letters of credit involve a degree of risk. Some examples of common discrepancies are:
- The company cannot supply the goods ordered
- The letter of credit expired prior to presentation of documents
- The buyer has not specified the correct import and customs documentation required (this can happen with less experienced buyers)
- The Bill of Lading evidences shipment prior to or after the date range stated in the letter of credit (for example, the shipping date is later than that allowed in the letter of credit)
- Charges are included on the invoice that are not authorised in the letter of credit
- The description of the goods is inconsistent or not as stated in the letter of credit
- Bills of Lading not stipulated as in the letter of credit – such as, freight prepaid is quoted when it was not stipulated
- A document required by the letter of credit is not included in the documents presented
- It takes too long to obtain certain documentation
- Invoice is not signed, or does not specify shipment terms as quoted in the letter of credit
- Insurance coverage is insufficient or does not include the risks specified by the letter of credit
Letters of credit checklist
At negotiation stage
- Do you and your buyer understand how letters of credit operate?
- Are you able to deliver the order – the right quality, quantity and on time?
- What payment terms have you discussed?
- Will any specific requirements be allowed, for example, transhipment, partial shipment?
- Advise your UK bank or preferred bank routings
- Do you/your staff know the customer you/they are dealing with?
- Have credit checks been undertaken?
- Is the buyer experienced in dealing with letters of credit, and experienced in the documentary requirements in their country? This is very important.
- Can the goods be shipped on the required dates?
What about the costs?
There are costs associated with letters of credit. Has it been agreed between you and the buyer who will pay these costs? Open to Export also has a handy guide to letters of credit charges.
Remember, while the letter of credit is a bank guarantee of payment it will happen ONLY if:
- All documents are presented on time and in order
- The Guarantee comes from the Issuing Bank (the buyer’s bank) and only comes from your bank if you ask for Confirmation to be added.
How do I proceed?
First of all, ensure you have completed the following steps:
- Make sure that you can do all the steps that the customer and their bank has asked of you in terms of packing, documentation and shipping – this should be done by reviewing a draft of the letter of credit before it is issued’.
- Next brief your shipping agents about the letter of credit giving them a copy.
- Make sure your staff are aware of the detail that must be used in operating with this banking product and ensure they have the training to do this.
Then, ideally, the letter of credit should be instructed through online banking which:
- allows information to be stored on templates to avoid re-keying
- ensures the credit is received much quicker at the Bank, instead of having to be posted
- allows the Bank to automatically ‘pass the credit’ through to issuance stage, without having to retype/transfer any information
- allows mandatory fields to be captured (avoiding delays in the bank having to get the credit re-completed)
- greatly reduces propensity for error.
What if I need to amend my letter of credit?
If there are any errors or if it turns out that you as the seller are unable to meet the agreed terms, then an amendment will be necessary. Always attend to these as soon as possible.
As an exporter you need to communicate the changes needed both your buyer to see if they will agree (this must be done straight away) and then to the advising bank (your UK bank). If your buyer agrees:
- The advising bank will contact the issuing bank (the buyer’s bank) and seek authority to amend the credit
- The buyer will hopefully have advised the issuing bank to amend the credit already
- If agreement is reached an amendment to the letter of credit will be received by you, the seller.
Some final thoughts
Letters of credit are great but be warned – very few are right the first time because the supplier (that’s you) often misread them or don’t produce the correct documents to support the letter of credit.
If the documents are not compliant it is unlikely that you will get paid under the letter of credit.
You can also find out more about letters of credit at the HMRC web site.