A Letter of Credit is a standard tool for international transactions. A letter of credit (LOC) is issued by a foreign bank (representing the buyer) and confirmed by a corresponding bank usually in the country of the seller. The LOC is the buyer's bank's commitment to pay for goods sold.
A Letter of Credit is literally a 'letter' that describes a sales transaction between a buyer and seller. The 'letter' is offered by the buyer to the seller. This mechanism allows the buyer to establish his ability to pay for goods purchased and the seller to have assurance that his bill for goods will be paid. Letters of credit are handled through banking institutions.
Revocable vs. Irrevocable Letters of Credit
A Letter of Credit may be revocable or irrevocable. In a revocable Letter of Credit, the buyer's bank has the right to cancel or alter its obligation at any time before payment even if goods were shipped in reliance on the LOC. This circumstance can occur if there is a change in the buyer's stability which could impact the buyer's ability to pay on the terms of the letter of credit. An irrevocable Letter of Credit cannot be altered or cancelled without the consent of the seller. Any change to an irrevocable Letter of Credit requires the consent of all parties.
Confirmed vs. Unconfirmed
Only an irrevocable Letter of Credit can be confirmed or unconfirmed. A confirmed Letter of Credit requires that the buyer's bank independently agrees to pay the seller the agreed-upon amount of money, as long as all the requirements of the Letter of Credit are fulfilled.
Letter of Credit Contents
The usual conditions included in a Letter of Credit include:
- delivery dates
- product specifications
- receipt by the bank of specific documents (such as bills of lading, inspection certificates, commercial invoices and packing lists).
- time period for production of documents
You should agree on all Letter of Credit terms and conditions and all required documents in advance of opening a Letter of Credit. Letter of Credit issuance instructions should then conform to the terms of such an agreement.
If the shipping and documentation requirements listed in the sale contract and those in a Letter of Credit do not agree, the bank may not pay the seller; banks interpret conditions very strictly. Approximately 60% of document presentations on Letters of Credit are presented with discrepancies, on a worldwide basis. Banks charge for each discrepancy. Therefore, it is extremely important to ensure document presentations are accurate and complete to avoid additional costs and delays in payment processing.
Payment on a Letter of Credit
When the seller presents the buyer's bank with the documents required by the LOC, which typically include invoice, bill of exchange (or draft), any necessary certificates such as certificate of origin and so on, the bank provides payment in accordance with the terms of the letter of credit.
The Bill of Exchange or draft is the demand for payment. Drafts are classified as either sight or time. A sight draft requires the buyer's bank to pay the amount shown in full upon proper presentation of documentation. A time draft stipulates payment by a date later than the date of presentation of documents (which may be identified as 30 days after sight or could be a specific date).
How to obtain a Letter of Credit
As a buyer, you may obtain a letter of credit through a bank in your country, by funding an account with the bank or by applying for a loan against assets or future sale of goods.
The International Chamber of Commerce (ICC) had developed a standard Documentary Credit Application Form. The ICC has also published a guide to Documentary Credit Operations. Banks throughout the world adhere to the rules developed by the ICC.
You can find more information about international payment through a letter of credit at the ICC site: www.iccwbo.org
The LOC mechanism protects the seller by creating bank channels and assurances that payment will be made. However, given the very specific nature of LOC terms, the seller must be very certain that the terms of the LOC are met precisely or that an amendment to the LOC has been made, or the bank will refuse to honor the LOC and will not make payment. Careful sellers will find the LOC a very effective way of doing business.
Buyers are less inclined to LOC transactions because banks charge a one to eight percent of costs fee for administering the LOC, and LOC payments can take up to 4 weeks to complete, thus delaying receipt of an order. As a result, the LOC is an expensive way to guarantee payment. As sellers become more confident in a buyer, it is in the buyer's best interest to negotiate away from transacations by LOC to less expensive payment mechanisms such as documentary drafts.