Companies use Letters of Credit to minimize risk
of non-payment and non-delivery during transactions. The Letter of Credit stipulates that if the seller presents the document
s set by the Letter of Credit in the time frame stipulated, then the seller
will get paid, regardless of any other conditions delineated by other contract
s. Their uses differ, but at minimum, a letter of credit involves an applicant
(usually the buyer
), an issuer
that the buyer asks for the L/C
), and a beneficiary
(usually the seller
). In international trade
, frequently another bank, trusted by the seller, may be used as a confirmer
to the unknown to the seller-issuing bank.
A Letter of Credit must contain more than just the phrase “Letter of Credit.” Specific laws exist governing L/C’s in Section 5 of the Uniform Commercial Code, and Uniform Customs and Practices for Documentary Credits (UCP) and the International Standby Practices (ISP) influence and help guide the language and usage of Letters of Credit.
A wide variety of types of Letters of Credit exist, including revocable, irrevocable, confirmed, unconfirmed, transferable, Back-to-Back, documentary, and standby. The two most commonly used today are the documentary and the standby.
What’s a Letter of Credit all about?
A letter of credit is a document issued by a bank at the request of a buyer (or applicant), wherein the bank promises to pay the seller (or beneficiary) upon presentation of documents specified in the letter of credit.
As defined in both US law and international standards, L/C’s are contract-like, unique commercial devices independent from any other agreements related to the transaction. This “Principle of Independence” mitigates risk for both parties, because both parties know that regardless of what else happens, if the seller presents the documents stipulated in L/C, then he or she will receive payment.
Section 5 of the Uniform Commercial Code describes the law as it pertains to Letters of Credit. On the international front, the Uniform Customs and Practices for Documentary Credits (UPC) contains rules governing the formation and performances of letters of credit. Most banks either incorporate the terms of the UCP or borrow language from the UCP to such an extent that it influences almost all domestic and foreign issued letters of credit.
The International Standby Practices (ISP) address addresses the issues particular to standby L/C's. Sponsored by leading international banks and approved by the International Chamber of Commerce Banking Commission, the ISP states its rules in detail, and even has a 300 page "commentary" to accompany and assist in using it.
The UCC and UPC both agree (although with much more legal and official terms) that every letter of credit must include who, what, why, where, when, and how much will be involved in the transaction. For the who, the L/C must identify the applicant, beneficiary, and any middlemen involved. For the what, the L/C must explain the type of transaction, whether it is dealing with goods, services, etc. The question of why and how the L/C will be honored must also be addressed. What are the needs of the seller? What documents does he need to present to satisfy the buyer? Naming the issuing bank, as well as any confirming or advising financial institutions will satisfy the requirement for where in an L/C. Finally, the amount of the L/C must be delineated so that everyone knows how much will be paid to the beneficiary as well.
Because of the literal way that banks (and courts of law) interpret letters of credit, companies using them must clearly understand and clearly define all aspects of the transaction, including the locations and conditions upon which the buyer assumes responsibility for the product. Various acronyms, including but not limited to FAS, FOB, CIF, CFR, DAF, DES, DEQ, DDU, and DDP , outline the terms that define when the buyer assumes responsibility for the goods. For example, when Free On Board (FOB) is specified, the seller pays to load the goods, and the buyer assumes responsibility after the goods are loaded on the ship. If Free Alongside Ship (FAS) is used, the buyer must then assume responsibility once the goods are delivered to the pier. The buyer must also pay to have the goods loaded as well. Clearly specifying these aspects of the L/C minimizes risk to both the seller and the buyer because they have both planned for and anticipated all expenses—no hidden costs exist in a well-executed L/C.
Letter of Credit Cycle (6)
- The buyer issues a Request for Proposal or Quote (RFP/RFQ, mails it to likely vendors, and receives a response from several potential sellers. After evaluating them, the buyer chooses…The Seller!
- The seller receives notice from the buyer that they have been selected to provide the goods spelled out in the RFP/RFQ. The seller then sends the buyer an invoice defining the terms of the transaction.
- The buyer then takes the invoice to the bank and asks for a Letter of Credit.
- After verifying the conditions and evaluating the buyer’s creditworthiness, the buyer’s bank drafts the Letter of Credit and sends it to the seller’s bank.
- The seller’s bank verifies the Letter of Credit, and mails it to the seller.
- The seller compares the L/C with the original invoice to ensure that the seller can send the goods before the Letter’s expiration, and most importantly, that all terms and conditions listed in the invoice were included correctly in the L/C.
- The seller and their Freight Forwarder produce an invoice and packing list, exactly as specified in the Letter of Credit, as well as any other required customs documents etc.
- The freight forwarder receives and ships the goods to the destination (the buyer). It is at this point that, depending on the agreements in the L/C; the buyer may assume responsibility (FOB, FAS).
- After shipping the goods, the freight forwarder presents the L/C and the required documentation to the seller’s bank.
- The seller’s bank examines the documents, and after ensuring they meet the requirements of the letter of credit the bank then sends the documents to the buyer’s bank.
- The buyer’s bank reviews the documentation and, if the documents conform exactly to the L/C’s specifications, transfers funds to the seller’s and deducts money from the buyers account.
- The seller can then withdraw the funds from their bank.
- Finally, the buyer’s bank gives the document package to the buyer, enabling the buyer to pick up the goods.
Letter of Credit Types
An irrevocable letter of credit cannot be changed or withdrawn without everyone’s concurrence, including the seller (applicant), buyer (beneficiary) and the issuer (bank.) Almost all L/C’s are irrevocable, because the ability of any party to stop the deal would make an L/C useless to mitigate risk. Because of this, if an L/C does not specify whether or not it is Irrevocable or Revocable, it is considered Irrevocable.
A revocable Letter of credit can be changed or withdrawn without consulting the buyer’s.
Confirmed letters of credit help businesses to accept letters of credit from unknown financial institutions by using trusted banks to confirm/guarantee the L/C. These are useful when doing business with developing countries, or when just starting a relationship with another company as a way of mitigating risk.
Transferable and Back to Back
In a standard L/C, only the buyer named in the letter can present the documents and redeem it. In a transferable L/C, anyone designated by the beneficiary can receive the goods. In a back-to-back L/C, an L/C is issued to an agent of the beneficiary (a financial institution), who then turns around and issues another L/C to the beneficiary. These are useful when acting as a middleman, to keep the producer and buyer away from one another, or as financing before the sale takes place. Also, banks that may not grant a buyer a letter of credit on the buyers’ own merits may grant a back-to-back L/C—the first L/C acts as assurance that the issuing bank will receive payment.
Standby Letter of Credit
Businesses use Standby letters not for the movement of goods but as a guarantee that certain terms in a contract will be met. If the terms outlined in the Standby L/C are violated, then the beneficiary can produce the called upon documentation, and receive the funds specified in the L/C.
Although a standby L/C is the most direct example, all Letters of Credit mitigate risk in some way. They allow companies to buy and sell products without worrying about payment—when using a letter of credit, producing the documents specified in the L/C guarantees payment. However, this dependability comes at a price for the unwary. Laws regarding L/C’s are extremely literal—if a certain person must sign a document called for in an L/C, and if that person is not available to sign it, the issuer will not authorize funds. In the case of Samuel Rappaport Family Partnership v. Meridian Bank
, a dead man’s signature was needed for payment. Unable to produce the deceased Mr. Orleans’ signature, the bank refused to honor the letter of credit. Even after pursuing the matter in court, the beneficiary was unable to gain payment because of the literal nature of L/C law. As the appellate court
’s opinion states, “the purpose of letters of credit is to assure prompt payment upon the presentation of documents. Moreover, the issuer's payment obligation comes into play only upon the presentation of conforming documents.”(2) If the documents do not conform, then payment is not made. Banks can rely only upon the documents, and may not interpret anything further. Letters of credit’s firm basis on documents allow the continued assurance of payment, and continue to make them the financing vehicle of choice for international trade.