Letters of Credit
For new trading entities, a letter of credit is often an excellent means to arrange payment. It compromises the exposures on both sides of the trade.
A letter of credit is used to reduce the risk in international trade. It is a contract in letter form, written by a bank (issuing bank) on behalf of the buyer (applicant). The issuing bank then forwards the letter of credit, which is transmitted through a bank. If you are the exporter, you must have your foreign buyer specify your bank to be the advising bank. Similarly, if you want to have the letter of credit confirmed, you should have your buyer include the request for confirmation on the application for the letter of credit.
Because the advising bank has no contact with the buyer but takes the instructions from the issuing bank, it is, therefore, important that the seller (beneficiary) examine the letter of credit carefully to ensure that it is consistent with the agreed upon terms of sale and that the seller can comply with its terms and conditions. If changes are needed, the seller should contact the buyer immediately to request an amendment to the letter of credit. A credit cannot be amended without the agreement of both parties.
The documents required under letters of credit may vary, but most often call for the presentation of a draft, commercial invoices, packing lists, and bills of lading. It is the responsibility of the bank making payments to examine those documents with care to be certain that they appear on their face to comply with the terms and conditions of the credit. It must be understood that in documentary credit operations all parties concerned deal in documents and not in goods. Because credits advised by the bank are subject to the Uniform Customs and Practice for Documentary Credit, its provisions will be applied to documents presented under such credits in determining whether payment will be made.
It is important to remember that all terms and conditions should be consistent with the sales contracts, since an irrevocable letter of credit cannot be modified or canceled without the consent of all parties concerned. If a situation arises where a letter of credit has to be amended, the buyer submits a written request, whereupon the credit may be amended. Once the amendment is accepted by the seller, the amendment will become an integral part of the credit.
A letter of credit may be payable at sight against presentation of documents in accordance with the credit or at a future date.
Letters of credit may be issued in U.S. dollars or foreign currency. The credit may also be transmitted by full text teletransmission, short cable/telex, and airmail or courier.
TERMS OF SALE (INCO)
Sending goods from one country to another as part of a commercial transaction can be a risky business. If they are lost or damaged, or if the delivery does not take place for some other reason, the climate of confidence between parties may degenerate to the point where a lawsuit is initiated.
However, if when drawing up the contract, buyer and seller specifically refer to one of the following common international trade terms, they can be sure of defining their respective responsibilities, simply and safely. In doing so, they eliminate any possibility of a misunderstanding and subsequent dispute.
Ex Works (named place). Under this term, the price quoted applies only at the point of origin, and the seller agrees to place the goods at the disposal of the buyer at the agreed place on the date or within the period fixed.
Free Alongside Ship (FAS) or FAS Vessel (named port of shipment). Under this term, the seller quotes a price including delivery of the goods alongside the overseas vessel and within reach of its loading tackle.
Free on Board (FOB) or FOB Vessel (named port of shipment). Under this term, the seller quotes a price covering all expenses up to and including delivery of the goods upon the overseas vessel provided by or for the buyer at the named port of shipment.
Cost and Freight (CFR) or CFR (named port of destination). Under this term, the seller quotes a price including the cost of transportation to the named point of destination.
Cost, Insurance, Freight (CIF) or CIF (named port of destination). Under this term, the seller quotes a price including the cost of the goods, the insurance, and all transportation charges to the named point of destination.
Delivered, Duty, Paid (DDP). Under this term, the seller assumes responsibility for all aspects of the transaction, cost of goods, insurance transportation charges, clearance costs, and duties to the final destination.
TYPES OF LETTERS OF CREDIT
Documentary Credits
Irrevocable Letter of Credit. One in which the issuing bank irrevocably undertakes to pay or accept drafts presented with documents in compliance with the credit terms. Can only be modified/canceled with the agreement of all parties concerned. Virtually all import credits are issued irrevocably by the bank.
Irrevocable Unconfirmed Letter of Credit. The same as an irrevocable letter of credit, except it is being advised through another bank that does not add any obligation of its own. Most import credits are advised by foreign banks on an unconfirmed basis.
Irrevocable Confirmed Letter of Credit. A credit that adds the obligation of the second (confirming) bank to the irrevocable undertaking of the first (issuing) bank. The beneficiary has protection from two banks; however, protection is only as good as the banks giving it.
Revocable Letter of Credit. Contains the undertaking of no one and can be revoked anytime prior to payment being effected. Rarely issued.
Red Clause Credit. A special notation that the beneficiary may draw advances up to a stipulated amount to purchase and pay for the merchandise before shipping against presentation of “Undertaking to Ship” or of a similar document. When issuing a red clause credit, the issuing bank, on behalf of applicant, undertakes to repay the foreign bank for advances made even if shipment did not take place.
Revolving Credit. Allows the beneficiary to make multiple shipments and draw a specific amount of money on a specified periodic basis. The amount drawn becomes available to the beneficiary as the shipments and drawings are made and continues up to the expiration of the letter of credit.
Transferable Letter of Credit. One that expressly authorizes transfers to be made to other parties by a bank as directed by the beneficiary. The transfer credit must contain the identical conditions as the original letter of credit except that the amount transferred may be less and the dates indicated may be earlier.
Back to Back Letter of Credit Arrangement. One in which a beneficiary under an original confirmed letter of credit utilizes this letter of credit issued in his or her favor as collateral to open another letter of credit in favor of a supplier. A back to back letter of credit must contain the same conditions, merchandise, and documents as the original letter of credit with the exception of the invoice, unit prices, amount of drawing and shipping, and validity dates that must be prior to the dates stipulated in the original letter of credit.
Time or Usance Credit. Allows payment at a future specified time.
Stand by Letter of Credit. Does not involve the direct purchase of merchandise or the presentation of title documents. Rather, it is similar to performance or bid bonds. The bank’s obligation to pay should arise only upon the presentation of a draft or other documents as specified in the letter of credit, and the bank must not be called upon to determine questions of fact or law at issue between the applicant and the beneficiary. The applicant for a standby letter of credit must trust the beneficiary. If the beneficiary presents documents in accordance with the terms of the standby credit, the bank must pay irrespective of any extenuating circumstances brought to its attention. The applicant is legally bound to reimburse the bank. Standby letters of credit are versatile instruments and can be used for the following:
Payments for merchandise shipped on open account
Bid and performance bonds
Advance payment guarantees
Other financial obligations
Assignments Under Letters of Credit. The beneficiary of a letter of credit may, at his or her discretion, assign the proceeds of a letter of credit to another party. An assignment of a credit should not be construed as a transfer of the instrument. By an assignment, the beneficiary does not transfer the credit, but only directs the bank involved in the payment or negotiation of documents to pay the assignee a certain portion of the beneficiary’s proceeds. An assignment of proceeds may be made against any letter of credit; it need not be designated as “transferable.” The assignment of proceeds has no monetary value until the proceeds come into existence. In other words, receipt of an assignment does not guarantee payment; it ensures payment only if the beneficiary presents the documents against the credit, and the credit terms are satisfied. For the assignee to receive payment directly from the bank, the assignment of proceeds must be made directly through the bank.
LETTER OF CREDIT CHECKLIST
On receipt of the letters of credit, the beneficiary should check the following:
1.Name and address of beneficiary and applicant. All documents presented under the credit must show names and addresses consistent with those in the credit.
2.The type of credit and its terms and conditions conform to the sales contract or purchase order; if not, request amendment.
3.All conditions are acceptable.
4.The documents can be obtained in the form stated.
5.The description of the merchandise or commodity and any unit price conforms with the sales contract.
6.The amount of the credit is sufficient to cover all costs permitted by the terms of the contract.
7.The shipping and expiration dates and the period of time allowed for presentation of the shipping documents following their date of issuance and making presentation of the documents to the bank for payment, acceptance, or negotiation.
8.The points of shipment and destination are as agreed.
9.The provision for insurance is in accordance with the terms of the sale.
10.Country in which credit is payable.
11.The credit is subject to Uniform Customs and Practice for Documentary Credits, International Chamber of Commerce, Paris, France, that are in effect on the issue date.
PARTIES TO COMMERCIAL CREDITS
1. Direct Parties
The Buyer—Bank Customer/Applicant/Importer
Applies for letter of credit from bank.
Creditworthiness must be satisfactory to bank.
The Beneficiary—Party to Be Paid/Seller/Exporter/Shipper
Party to whom letter of credit is issued/addressed.
Party who arranges compliance with terms and presentation of documents to the paying bank.
Issuing Bank
Buyer’s bank that issues the letter of credit to the beneficiary.
Examines documents to insure conformity to letter of credit.
Arranges for financing of transactions, if requested.
Releases documents to buyer and charges his or her account.
Advising Bank
Bank that advises the beneficiary of the opening of the credit. May be the issuing bank, negotiating bank, or a third bank.
Confirming Bank
The advising bank, which adds its obligation to that of the issuing bank.
Negotiating Bank
Bank, usually unnamed in credit, that agrees to purchase draft of beneficiary.
Pays beneficiary immediately, usually with recourse.
2. Indirect Parties
Steamship Company
Receives merchandise from exporter/shipper/forwarder and arranges for transport of merchandise.
Issues bills of lading that serve as the title document, receipt of goods, contract between shipper and steamship company.
Air Carrier
Receives merchandise from exporter/shipper/forwarder and arranges for transport of merchandise.
Issues airway bill that serves as the receipt of goods and the contract between shipper and carrier.
Acts as the agent for exporter.
Assists exporter to expedite shipments.
Prepares necessary documents and makes other arrangements for the movement of merchandise.
Customs Broker
Acts as the agent for the importer.
Receives shipping documentation from the bank or importer.
Clears merchandise upon arrival.
Arranges for delivery of merchandise to the importer. Insurance Company
Insures shipment for value requested.
Issues policy/certificate covering risks requested.
Settles claims, if any.