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Home > Operations Management Best Practice > Exporting Against Letters of Credit

Operations Management Best Practice

Exporting Against Letters of Credit

by Buddy Baker

Executive Summary

  • A letter of credit is a great way for exporters to protect themselves against nonpayment risk, as long as they are prepared and able to present the documents called for. If they don’t, the issuing bank might not pay.

  • The exporter should provide the importer with explicit guidelines for what the letter of credit is to include.

  • The exporter should refuse a confirmation added to a letter of credit by a branch or subsidiary of the issuing bank.

  • Exporters can centralize their letter of credit business by insisting on freely available letters of credit and using “silent confirmation” when in need of protection against country risks.

  • Discrepancies should and can be avoided by reading every credit in advance, getting amendments when necessary, and preparing the documents exactly as specified.

  • Payment can be obtained almost immediately and at lower cost, even when documents are discrepant, by working with one’s relationship bank and using shippers’ indemnities.

  • Letters of credit also serve as a vehicle for very inexpensive financing.

Introduction

Letters of credit (LofCs) are a time-honored means of payment for international shipment of goods. Although the vast majority of letters of credit get paid when drawn upon, it is a mistake to think of them as guarantees. Rather, LofCs have specific rules governing how payment works. If sellers do not comply with these rules, they risk not being paid when shipping goods—which is precisely the risk that letters of credit are supposed to guard against.

In addition to providing risk protection, LofCs serve as a vehicle of payment. A knowledgeable seller can obtain LofCs that provide immediate funds.

The Purpose of Letters of Credit

When selling goods, a seller must take into account and manage the risk of not being paid. In the case of exported goods, these risks include not just the risk that a buyer will not have enough cash to pay, or will dispute their liability to pay, but also the risk that something will happen in the buyer’s country that prevents payment. Letters of credit were developed as a means of payment that, when properly structured and drawn upon, sidesteps these risks.

How Letters of Credit Work

A letter of credit is a bank’s own engagement to pay a specified amount of money to the named beneficiary upon presentation to the bank of specified documents. In a transaction involving a sale of goods, the contract of sale will specify that payment is to be made by means of a letter of credit. The buyer will then ask their bank to issue an LofC naming the seller as beneficiary for the amount of the order. The bank undertakes in the LofC to pay the seller, not specifically upon shipment of the goods the buyer has ordered, but upon presentation of the documents specified in the credit. A bank would be hard-pressed to verify that goods have actually been shipped in accordance with a contract of sale, but has little trouble checking documents for compliance with stated content requirements. The buyer tells the bank what documents to call for and agrees to reimburse the bank for the payment when made to the seller. The bank does not really care what documents the buyer wants them to pay against as they are just going to pass the documents along. To the buyer, however, since the purpose of the LofC is to pay for goods when shipped, it is important that the documents provide evidence that the goods have been shipped as agreed.

When the seller receives the LofC, they should read it carefully to determine whether the LofC requirements can be complied with. Besides the list of documents, these include such information as how soon the transport document must be issued (evidence of when the goods were shipped), how soon the documents must be presented, and where the documents must be presented. Among other things, the seller should make sure that:

  • the credit amount is sufficient to cover the shipment (particularly if the terms are cost, insurance and freight (CIF) or cost and insurance paid to (CIP));

  • the documents required will be available and can be presented before the expiry date of the credit;

  • the latest shipment date (if there is one) specified in the letter of credit can be met.

If the requirements are not acceptable, the seller should request the buyer to get the credit amended. To avoid the time and expense of amendments, it is highly recommended that the seller provide the buyer with letter of credit instructions up front so that the buyer knows what documents and other requirements are acceptable to the seller.

Roles of the Advising and Nominated Banks

In international transactions, it is almost unheard of for the seller to deal directly with the issuing bank. The issuing bank will arrange for a bank in the country of the seller to deliver the LofC to the seller, and the LofC will provide for the seller to present documents to a bank in the seller’s country (see Figure 1). The bank that delivers the LofC is called the “advising bank” and the bank to which the seller is to present documents is called the “nominated bank.” The advising bank is responsible for the accuracy of the information it delivers. The rules governing letters of credit require that the advising bank take steps to verify the authenticity of the credit as well, but an advising bank is not responsible for payment.

Oftentimes, the advising bank is also the nominated bank, but it is also fairly common for letters of credit to state that they are “available with any bank.” This allows the seller to present documents to a bank of their own choosing. The nominated bank examines the documents and collects payment from the issuing bank. By insisting that LofCs be freely available, sellers gain the freedom to present documents to their own bank regardless of who played the role of advising bank. The seller’s own bank may be willing to provide discount pricing and special services to the seller, like expedited processing, assistance with correcting discrepancies in the documents, or loans against documents in the process of collection.

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Further reading

Book:

  • Baker, Walter (Buddy), and John F. Dolan. Users’ Handbook for Documentary Credits under UCP600. (Publication number 694.) Paris: International Chamber of Commerce, 2008. Available as eBook online at: www.iccbooksusa.com

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