An international letter of credit (L/C) is a method of payment that is particularly suited to high value/high risk transactions. It is one of the four traditional methods of payment and is quite complex.
The decision to trade under L/C terms is usually the result of either a foreign government regulation or a lack of trust between the trading parties. This lack of trust is usually associated with the value of the transaction—the financial risk.
As an example, Exporter A and Importer B may be quite happy to trade in consignments worth $30,000 at a time on an open account basis, but if a transaction worth $1 million is contemplated, then the payment terms would, rightly so, be subject to review.
There is no magic number at which reviews are triggered or payment methods chosen, but the higher the transaction amount involved, the greater the need for a financial safety net to ensure payment is forthcoming as due or to avoid payment being made when the terms of the contract have not been met.
At the onset it must be remembered that trading across international borders means trading across different jurisdictions and legal systems, different rules and regulations, and the application, or lack thereof, of international conventions. It is cold comfort to a seller, or a buyer, to be advised that there is a solution to the problem: just sue the other party! International court cases take many years to be resolved and cost a lot of money.
In a L/C, the buyer's credit risk is substituted with that of their bank, because it is the bank issuing the L/C that conditionally guarantees payment. The condition is that the exporter (seller/beneficiary) must meet the documentary conditions of the L/C for the payment to be triggered.
L/C transactions are subject to a special set of rules, referred to as the UCP 600, administered by the International Chamber of Commerce. The UCP 600 is not a convention, nor a body of law, but a set of rules adhered to by banks worldwide. These rules outline the obligations of the parties involved in L/C transactions, with particular emphasis on banking processes and procedures.
Some terminology is useful. The seller is also referred to as the exporter, and as far as the L/C is concerned, the seller is the beneficiary. The buyer is also referred to as the importer, and as far as the L/C is concerned, the buyer is the applicant. The buyer's bank is the issuing bank and the seller's bank is the advising bank.
International Sales Contracts
The typical contracts that arise from a L/C transaction are shown at Figure 1 below. The most important contract is number 3 (shown in blue), which represents the undertaking to pay from the issuing bank to the exporter.
Contract number 1 is the underlying contract, that is, the contract from which the L/C is derived. It is extremely important to understand that the L/C is separate from the contract of sale as far as banking operations (and payment) are concerned. Banks must honour their undertaking to pay, but only if there is 100% documentary compliance with the terms of the L/C. It's all about the documents, not the goods!
Contract number 2 is the L/C application. It follows logically that the seller and the buyer agree on contract terms, and the L/C should reflect the essence of the contractual agreement. Therefore, it is important that essential issues are considered as part of the negotiations leading up to the contract signing and the issue of the L/C.
Figure 1: The 'contracts' arising from a Letter of Credit transaction (Adapted from Bergami, R. 2009, International Trade: A Practical Approach, Eruditions Publishing, Melbourne, Australia, p. 411)
The setting of the method of payment is typically done by the export sales staff. This is the first point at which it is appropriate to provide some advice to the exporting firm.
Sales staff are the heroes of the firm, because after all, they bring the dollars in, right? Well, not entirely. The other heroes of the firm are actually the operations people—the packing, shipping and documentation staff that actually convert the contract on paper (or through an electronic message) into a physical consignment of goods that will be dispatched from origin to destination.
Enterprise Risk Management (ERM) Principles
So, the first piece of advice to the exporting firm is: follow the Enterprise Risk Management principles when dealing with letters of credit. ERM principles necessitate that all key stakeholders in the transaction be involved in the decision making process of choosing the L/C as the method of payment. This requires an inclusive approach to the process to make sure that all risk factors are considered in arriving at the final decision on a particular item, issue or process.
This is the opposite of the compartmentalized approach to decision making, or as some have described it, a silo mentality. It can be very easy for this to happen in a larger firm with specialist departments and well delineated lines of responsibility, and probably less likely to happen in smaller firms where people are engaged in a multitude of activities, and their jobs cut across a number of areas.
In this context, the ERM approach should be followed and deciding the choice of terms within the L/C should not be limited to sales/marketing or finance and possibly production, but, importantly, it ought to include the operations people.
Advice on issues such as delivery points, frequency of sailings, availability of space on vessels or aircrafts, importing requirements of overseas countries (both in terms of documentation and also regulatory needs, e.g. fumigation certificates) and costs of moving the product are the contributions the operations people can make to the transaction.
The decision of which Incoterms 2010 delivery option should be chosen is extremely important in a L/C transaction, as it will directly impact the exporting firm’s obligations in shipment and documentation requirements. As ultimately some of these issues will translate into specific documentary requirements of the L/C, it is important that everyone make a contribution from their area of expertise.
A good tip to minimize problems with L/C documentary demands is to develop a template for your buyer. The template is used to signal to your buyer what you, as the exporter (seller/beneficiary), expect to see in terms of documentary demands.
Figure 2 shows the typical flows for a L/C transaction; the crucial steps are 5 and 6, and these are shown in blue.
Legend to Figure 2
1. Contract of sale between the parties
2. Importer lodges L/C application with issuing bank
3.Importer’s bank issues L/C to exporter’s bank
4. L/C advised to exporter
5. Goods despatched
6. Required documents lodged by exporter to the bank
7. Documents sent to issuing bank for acceptance
8. Documents released to importer
9. Funds transferred from importer as due
10. Funds transferred from issuing bank
11. Funds transferred to exporter
Once the exporter receives the L/C, they should check it for compliance against the template and make sure that all the terms and conditions of this method of payment are acceptable. If there is anything in the L/C that is either unacceptable or ambiguous, the shipment should not proceed until matters are cleared up.
If there is a discrepancy between the contract and the terms of the L/C, this needs to be corrected by a L/C amendment before the goods are dispatched. Likewise, if there is an unclear documentary requirement, it must also be cleared up. A good way to get unclear requirements cleared up is for the exporter to seek a written explanation from their bank about the requirement in question.
It is important that any perceived issues are cleared up before shipment, because if documents that contain errors are presented to the bank, the payment security chain is broken. In the context of this article, the weakest link is the documentation the exporter lodges with the bank. The reported 70% documentary discrepancy rate on first presentation against L/C business highlights the weakness of documentation.
Amendments are not free, so if as an exporter you are seeking a change that cannot be reasonably attributable to the doing of the buyer, be prepared to pay for it. Better pay a few dollars and be sure to get paid than save a few dollars and perhaps not get paid at all. To quote an old cliché, that would be a case of being "penny wise and pound foolish."
With all due respect to exporters, the problem clearly rests with you; you have to meet the banker's requirements. So check the L/C carefully, and if you are satisfied with what it asks, then and only then go ahead and send the goods.
This brings us to step 5 in Figure 2. There are two categories of documents that are produced and issued under a L/C: externally produced documents and internally produced documents.
Export Transport Documents
The transport document is externally produced by the carrier. This document is often the bane of the exporter. Most mistakes appearing on transport documents are fixable, except for shipment dates. Alteration of shipment dates is fraud, and no self-respecting carrier would do that. In any case, this sort of behaviour would cause them to lose insurance coverage, something they would not be keen to see happening.
There are a myriad of reasons for shipments being delayed. It could be due to the exporting firm's inability to fill the order in time and that, in turn, may be due to a supplier's late delivery of raw materials/components. Or it may be due to the ship arriving late because of weather or some other contributing factor. How can late shipment against the L/C be avoided?
Best Practice Tip
Plan early, of course. If you know that you are running very close to the latest shipment date, and there is a chance that you may miss it, seek an amendment asking for an extension of time to ship.
Now that the goods are with the carrier, how do you make sure that no errors on the transport documents occur? The carrier will be furnished with instructions—it is the responsibility of the exporter to properly instruct the carrier on how to handle the goods and how to issue the documents.
Best Practice Tip
Automate processes, if possible, and send the instructions electronically to avoid transcription and other human errors.
Where the exporter uses an intermediary, such as a freight forwarder, the onus does not shift. It is not a good option to simply give the forwarder a copy of the L/C and, in doing so, naively believe that the documentary risk has magically transferred to the forwarder. In the end, the exporter is the one who may experience payment delays, or no payment at all, if unrectifiable errors appear on documents.
Banks do not care who produces the documents, they just want to see them with the required data contents to satisfy the L/C demands. If errors occur these may be rectified, but usually at a cost, because there is no such thing as a free lunch!
Best Practice Tip
Get the carrier (or whomever else you may use) to send you a copy of the final transport document before it is issued so you can check for compliance against the L/C.
Other Externally Produced Export Documents
Other externally produced documents could be anything, such as government permits (e.g. quarantine), private contractors meeting import entry requirements (e.g. fumigation certificates), or chambers of commerce or consular certification of documents (e.g. certificates of origin).
The same comments made under transport documents equally apply here. Make sure these documents can be obtained in time for presentation within the allowable period by the L/C.
Best Practice Tip
It is known that delays can occur with the issue of external documents, especially with consular certification. Act early, plan ahead. Find out what the time requirements are for certification and make sure you have adequately considered these. Lodge the documents as soon as possible.
Internally Produced Documents
Invoice, packing slips/lists, laboratory reports, material safety data sheets, certification of compliance with standards, certificates of insurance, beneficiary's certificates, and bills of exchange (drafts) are all examples of documents that an exporter may produce in-house. How do you make sure errors are reduced or eliminated?
Best Practice Tip
Wherever possible, automate the production of documentation, preferably by using a specific export software package that may be able to be integrated with your main IT architecture. Automation should eliminate calculation errors, reduce data entry input time by removing duplicate fields across documents, and eliminate transposition errors.
On average, more than 50% of data content is replicated across documents—think about it. Regardless of whether it is an invoice or a packing list, the buyer details will not change any more than the consignee details, or the description of the product. Make sure that another staff member (different from the data entry member) checks the documents before these are lodged with the bank.
Internally issued documents are easily fixed and can be resubmitted, but there are two issues to consider: one is the time available to correct and represent, as per the L/C allowable presentation period, and the other is the cost of rectifying errors—again there is no such thing as a free lunch!
Best Practice Tip
Automate your documentation production processes. Changes to documents produced through an automated system flow to all documents concurrently, thereby reducing error correction times and transposition errors. (See how easy export software can be to use. Watch the free Shipping Solutions export documentation software video.)
Lodgement of Documents with the Bank
One thing needs to be clear for the exporter: the documents are yours until they are accepted by the bank, so you can take them back as many times as you like to correct them/have them corrected, unless these are unsolvable discrepancies, as discussed earlier.
There will typically be a presentation period for the lodgement of documents—10 to 15 days seems to be average, but it could be shorter or longer but not exceeding 21 days. The presentation period is usually pegged to the date of shipment—usually the date of the transport document.
Best Practice Tip
The exporter should lodge the documents as quickly as possible after shipment to have the maximum period of time to make any changes, if necessary. Also, where the payment terms are at sight, payable on presentation of the documents at the counter of the exporter's bank, there may be cash flows to be gained by getting it right.
The earlier the lodgement, the earlier the payment. Think of this as a reward or a bonus for the exporting firm because of the job well done by the relevant staff.
Summary: What Are We Trying to Avoid?
In a nutshell, we are trying to avoid errors on documents, which is not easy to do. No one is employed to do one L/C transaction at a time with the luxury of working in a vacuum and isolated from all other activity within the firm.
There are many competing factors, work pressures, timelines, and things that go wrong during the ordinary course of a day's work. However, none of these matter to the bank when checking documents for compliance and eventual payment in a L/C transaction.
L/C's are a double-edged sword; get the documentation right, and you can be assured of payment without interference from the buyer. But get the documents wrong, and it really is in the hands of the buyer as the bank cannot buy the documents from you. They would be in breach of the L/C application, so they will seek a waiver from the buyer and ask them to accept the discrepancies in writing.
What will the buyer do?
Available estimates tell us that the bad debt rate is quite low on L/C transactions, estimated to be less than half of one percent, but this is cold comfort for the exporter that faces a bad debt. Other studies inform us of the alternative to the bad debt, which is a discount approach.
This is where the buyer, sitting in judgement of the documents because they have discrepancies, exerts their power in the situation and demands from the exporter (and usually gets) a discount from the agreed price in exchange for accepting the documents. Thus, the exporter gets paid but at a reduced rate.
The whole purpose of dealing with a L/C, from the exporter's point of view, is to get paid. What is the point of having the L/C if the exporter cannot get the documentation correct? In failing to meet the L/C requirements, they lose the very thing they sought in the first place.
In conclusion, exporting firms are encouraged to adopt a multidisciplinary approach to the negotiation, management and processing of L/C transactions. Wherever possible, automated documentation should be used. Finally, documentation should be promptly produced and checked before lodgement with the bank.
In the end it is very simple: you are trying to avoid screwing up the process, so you don't get screwed yourself!
This post was originally published in two parts in January and February 2010. It has been updated to include current information, links and formatting.