Business transactions usually experience their fair share of challenges particularly in the realm of financial matters. One of these is a mutual lack of trust between the concerned parties especially in international transactions. Buyers on the one hand might be afraid of paying for goods upfront due to the risk of getting ripped-off and sellers on the other hand may be uncomfortable supplying goods for fear they may not get paid.
A letter of credit (LC) is one of the most popular solutions to this problem. It refers to a legally binding agreement made between a buyer and seller as a guarantee that payment will be made for goods delivered. The issuer of the credit letter, mostly a bank or other financial institution, is necessitated by the document to pay the seller in case the buyer defaults.
Payment is therefore guaranteed to the seller for as long all of the requirements stipulated on this binding document are met and the required paperwork is submitted within a set span of time.
There are a number of parties involved in the issuance of a letter of credit:
- Applicant – this is the buyer or importer who makes the payment
- Beneficiary – this refers to the exporter or seller who expects payment
- Issuer – this is the financial institution that issues out the credit letter and acts as the backbone of the transaction enabling its smooth completion
- Advising bank – this is the beneficiary’s bank that may receive payment on his behalf
There are as many different types of LCs as there are varied transaction types. Here is an in-depth look at some of the situations that necessitate the use of a letter of credit as well as the precise type that would be applicable in each case:
Import and Export letters of credit, as the name would suggest, are used specifically for international business transactions and are the most popular. This is because the probability of fraud is much higher in these types of transactions than in most others, an effect that is largely the result of distance, time-zone differences and variations in legal requirements.
The use of this document for international transactions receives oversight from the International Chamber of Commerce. It in turn exercises governance under the rules provided by the Uniform Customs and Practice (UCP) for Documentary Credits’ authority.
It balances the risk for both parties because the payment process is automated, taking effect as soon as all conditions are met. This keeps the buyer’s money safe until goods are delivered and assures the seller of a backup payment plan even if the buyer fails to honor his commitment to pay.
In certain cases, before payment is made, the seller might have to deliver the goods to a courier company of choice as specified by the buyer or to a shipyard. Upon delivery, he gets documentation to prove that the courier received the goods and forwards these documents to the bank for payment to be processed. In other cases, the requirement might be that the buyer must first receive the goods and examine them and then instruct his bank to release the funds.
The bank is in all cases a disinterested third-party that only acts on the instructions received provided it is furnished with proof that the set requirements have been met.
To Ascertain Legitimacy
There are a couple of risks that face the beneficiary of an LC, one of which is referred to as country risk. The buyer’s country may be considered a risk if at the time it is experiencing political unrest or an economic upheaval. This may cause a seller to lose their trust and require some sort of proof of the buyer’s creditworthiness.
It could also be that the issuing bank chosen by the applicant has an unimpressive credit reputation and the beneficiary therefore fears the risk of payment failure.
In both instances, a second bank will issue a confirmed letter of credit to assure the beneficiary that payment will be received for the transaction. The confirming bank therefore not only assures the seller of the reliable credit reputation of the applicant, it also undertakes to make this payment whether or not the original issuing bank avails the funds.
This implies that any other LC for which a secondary guarantee is not sought is therefore an unconfirmed LC.
For Performance Transactions
A standby letter of credit is usually issued in cases where the nature of business carried out might take an extended period of time and will require thorough inspection upon completion. This is referred to as a performance transaction, whereby, if a task is not carried out to satisfaction or completed within a stipulated deadline, the applicant will be forced to cancel the document.
Unlike the commercial LC, the standby letter of credit is not used as a payment service but rather, is held as security just in case the client to whom services are rendered defaults on payment upon satisfactory completion of the contract.
If on the other hand the beneficiary fails to deliver on the contract requirements, a cancellation of the LC is done by proving to the issuing bank that the beneficiary failed to meet his obligations and requests for a refund. The bank then pays back the applicant to allow them to get another person to perform the required task.
Payment of Last Resort
The standby letter of credits also at times issued as a sign of good faith to assure a beneficiary of his client’s creditworthiness and grant him confidence to carry out his end of the bargain without any cause for doubt.
It could in this case serve as a last resort payment for the beneficiary in case the client does not carry out his payment commitment. In such instances, the beneficiary would only need to prove to the bank that he played his part and payment would subsequently be released.
Payment for Transactions Carried out by an Intermediary
In certain situations, the actual supplier of goods and the beneficiary listed on a letter of credit are two separate entities. A transferable letter of credit makes it possible for this primary beneficiary to carry out all other requirements for the transaction but when it gets to the payment, the bank is at liberty to pay the actual supplier, referred to as the secondary beneficiary.
It is most popular for transactions that involve middlemen and the transfer details are clearly laid out in the documentation including the fact that the credit is transferable. It is an especially useful document for this type of businessmen who rarely have the financial input required as capital for big transactions
For Payment Security Purposes
Revocable LCs used to be a highly risky type of agreement for business ventures. It used to be possible to cancel this type of letter of credit at any given time and for any reason whatsoever by the issuing bank. If this happened, all that a beneficiary would have in hand is a useless piece of paper. But the current credit rules eliminated the use of this risky type of agreement as explained in UCP600.
The irrevocable letter of credit therefore currently defines all LCs because none can be amended or canceled without all the parties to the agreement coming to that consensus. Any cancellation has to be approved particularly by the beneficiary to avoid the risk of fraud and financial rip-off.
To Determine the Date of Payment
A letter of credit has the authority to determine when the beneficiary should receive payment for goods delivered or services rendered. There are two different types of LCs used for this purpose the first of which is referred to as a sight LC. When issued with this one, a beneficiary is paid as soon as the correct letter of credit documents are availed to the issuing bank.
The usance LC is the second type, also commonly referred to as a deferred payment LC or time LC. The term usance is used to signify the period of time that elapses between a date of bill and actual payment. This time period varies from country to country and the local custom will dictate how long the beneficiary has to wait. The issuing bank will in this case receive the relevant documents, assess them for accuracy and schedule the payment for the specified future date.
The convenience offered by this type of LC is that it might allow sufficient time for a buyer to receive goods and sell them to raise the cash needed to honor the payment pledge. This means that even if they may not have adequate cash reserves, they can still trade comfortably without having to apply for a line of credit from the bank.
It is mostly used by traders who have a cordial relationship as they need to agree on an undisputable payment date within the confines of the local regulations. It is however still as secure an arrangement as the sight LC because the issuing bank still assures the beneficiary’s advising bank that the applicant is credit-worthy and payment resources are available.
To Receive Advance Payment
There is another special set of LCs that allows for a loan advance to be availed to the seller by the buyer. The Red Clause LC makes it possible for a beneficiary to get access to funds before the letter of credit documents have been provided. The issuing bank makes the payment and later when the actual payment date arrives, the credit amount is deducted from the face amount and the difference is paid out to the seller.
This unsecured loan is a very convenient provision particularly in international business transactions whereby the beneficiary in the trade deal acts as an agent purchasing on behalf of a buyer in a different country.
The concept dates back to the early days of the Australian wool trade whereby the clause making this provision possible was indicated in red so as to direct attention to the nominated back in the trade deal.
The green clause LC also serves to provide advance payment but avails this provision even before the presentation of relevant documents by the beneficiary. Additionally, this clause allows for the beneficiary to get access to storage facilities at the shipment port, a feature that provides evidence that the goods awaiting shipment are in the warehouse.
Application Process and Documentation
The letter of credit procedure for application is normally carried out by the buyer through his bank and is relatively simple and straightforward. The buyer will approach his bank with the purchase order or export contract and supply all other relevant details.
The bank will then require the buyer to pay up the money up-front or if there is cash available in his account, it will block up a specified amount, referred to as a margin amount. This marginal amount is not fixed and can be negotiated depending on the buyer’s credit history, cash flow patterns and other pertinent factors. It could be as little as 1% of the total worth of the transaction or even 100% especially of the buyer is a new client of the issuing bank and is therefore considered risky.
Once the LC is produced, there are still many important factors that need to be considered. There are a number of crucial letter of credit documents that need to be carefully filed as they will be required at every step of the way. They include the following:
- A certificate of origin
- An airway bill or bill of lading
- A sales invoice
- Insurance documents
- An inspection certificate
All of the above documents need to be safeguarded diligently as they will serve as proof of the transactions that have taken place and will be required for payment and in case a dispute arises.
Why Waystocap is Your Best Bet
The international business terrain is filled with figurative land mines and both newcomers and more experienced players alike require the assistance of expert professionals to avoid financial disaster. Waystocap is the first African platform of its kind to offer online marketplace resources for companies wishing to trade securely in a convenient environment.
On this platform, you will have the opportunity to network with fellow importers and exporters and partner with them to realize your objectives. The experience offered by Waystocap in this high-risk field is not only limited to offering an effective trading platform. It also encompasses the tedious logistical processes involved.
They are in a position to help business persons familiarize themselves with the ever-changing policies and regulations pertinent to this business. They acquaint newbies with the entry requirements that apply to their area of interest and the licenses required for operation. They also guide the more experienced traders and bring them up to speed when changes occur in this ever-evolving field.
By signing up with waystocap.com you are getting unlimited access to all the necessary resources to help you along this new business path and a limitless pool of expertise to help you grow your import-export business to the level of world-class enterprises.