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Letters of credit

Letters of credit

The cash with order arrangement might not suit the buyer as they'll have to pay before receiving the goods. You might not be happy selling using an open account method because you'll have to send the goods before being paid. You may also have concerns about the buyer not paying and want to have some guarantee that you'll be paid once you've sent the goods (see Financing for more information).

A method that offers a compromise is paying by letter of credit.

What is a letter of credit?

A letter of credit (also called a documentary credit) is a contract by a bank to pay the seller (you) when the bank is presented with the documents specified in the letter of credit. Usually, if you're selling goods to a buyer located abroad, the buyer would get a letter of credit issued by their bank promising to pay you the price of the goods. The letter of credit is usually sent by the buyer's bank ('issuing bank') to a bank in your country ('advising bank'). The advising bank is often a correspondent bank of the buyer's bank. The advising bank advises you that the letter of credit has been set up. The advising bank may also help the buyer's bank by receiving the documents from you, checking them and then sending them to the buyer's bank.

The buyer's bank must pay you the sum stated in the letter of credit once they've received the specified documents. If they don't pay you, you can claim against them directly for the sum in the letter of credit.

The interpretation and use of letters of credit are governed by international rules and standards.

Advantages of a letter of credit

The main advantage of a letter of credit is that you have an assurance from the buyer's bank that you'll be paid. Also, if you agree to be paid in exchange for the documents, you could receive the price before the goods themselves reach the buyer.

An option is that you could agree to use the letter of credit with a bill of exchange. This means that the buyer's bank would agree to accept a bill of exchange payable to you for the price of the goods when it receives the documents specified in the letter of credit. You'd then be able to sell the bill of exchange if you wanted to.

Documents you need to present

The documents you need to present to the buyer's bank before they pay you are specified in the letter of credit. These, in turn, depend on what you've agreed in the sale agreement.

A sale-of-goods contract and corresponding letter of credit will usually specify some or all of the following documents:

  • Packing list
  • Insurance policy
  • Certificate of origin
  • Commercial invoice
  • Certificate or cover note of insurance
  • Clean bill of lading (showing that you've delivered the goods to the shipping company) or waybill (see Shipping documents).

Revocable and irrevocable letters of credit

Unless it's clearly stated to be revocable, a letter of credit will be assumed to be irrevocable.

An irrevocable credit means that once the credit has been given to you or your bank, the buyer can't ask for it back. If the buyer's bank fails to honour the terms of the credit, you'll have a direct claim against it. If there's a problem, you'd have to take action against the buyer's bank in a foreign country. To overcome this, you might wish the letter of credit to be irrevocable and confirmed (see below).

A revocable credit means the buyer may ask for it back at any time. Revocable credits are rare in practice.

Confirmed and unconfirmed letters of credit

A confirmed letter of credit is one that is guaranteed ('confirmed') by a bank in your country as well as by the buyer's bank.

If the letter of credit isn't paid, you can sue the confirming bank directly rather than claiming against the buyer's bank in another country.

Confirmed letters of credit are more expensive than unconfirmed letters of credit, as the confirming bank will add its own bank charges. The buyer might not be willing to pay the cost of a confirmed letter of credit. Whether you manage to get them to agree to do so will depend on your bargaining power.

Steps for using a letter of credit

1. First agree with the buyer that they'll get a letter of credit, and agree the type of credit.

2. Agree arrangements for the letter of credit, e.g. whether you'll be paid cash once the bank has received the specified documents, or whether the letter of credit will be coupled with a term bill of exchange to give the buyer a credit period. (In this case, the letter of credit would say that when the specified documents are presented, the bank would accept a bill of exchange payable in a certain number of days. Once you've presented the documents and the bank has accepted the bill of exchange, you'd be able to either keep the bill of exchange and get payment on the due date, or sell the bill at a discount.)

3. Once you've agreed the sale contract and letter of credit arrangements, the buyer will apply to their bank for the credit. Their bank will issue it and tell a bank in your country (the advising bank). The advising bank will tell you that the letter of credit has been set up.

4. You'd then deliver the goods to the shipping company in exchange for a document called a bill of lading. This is issued by the shipping company to prove that you've delivered the goods to them. You'll need to get a 'clean' bill of lading, which means that the goods have been delivered according to the contract. The bill of lading is also evidence of who owns the goods. You'll need to give it to the buyer, as without it they can't collect the goods from the shipping company (see Shipping documents).

5. You'd take all the documents specified in the letter of credit to the advising bank. This bank would check the documents on behalf of the issuing bank and then send them on to the issuing bank. Depending on the terms of the letter of credit, the advising bank could accept a bill of exchange or pay you cash on behalf of the buyer's bank.

6. The buyer's bank would collect the money from the buyer and reimburse the advising bank. The buyer's bank would give the buyer the documents, including the bill of lading.

7. The buyer would then use the bill of lading to collect the goods.

Independence of documentary letter of credit and bill of exchange from sales agreement

It's important to know that the letter of credit and the underlying sales agreement are 2 completely separate transactions. If the buyer gets an irrevocable letter of credit, they can't ask for it back even if there's a problem with the underlying sale contract, e.g. if the goods are faulty. The bank is obliged to pay out on the letter of credit anyway.

Similarly, the bill of exchange, like a cheque, is independent of the sale contract. If the bill of exchange isn't honoured, you can claim on the bill of exchange itself.

This, however, doesn't apply in fraud cases. If the buyer can prove that you've deliberately presented fraudulent documents, their bank can refuse to pay you.

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