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Introduction and Transaction Flows
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. In this first article in a two part series on letters of credit, I will give some background information and introduce the transaction flows involved in letters of credit.
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 was 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.
The typical contracts that arise from a L/C transaction are shown at Figure 1. 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)
<img src=http://www.bearing.com.cn/direc/myimg/201201125.gif>
Figure 1
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.
So, the first piece of advice to the exporting firm is: follow the Enterprise Risk Management (ERM) 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 2000 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.
Figure 2: Typical Letter of Credit transaction flows (Adapted from Bergami, R. 2009, International Trade: a practical approach, Eruditions Publishing, Melbourne, Australia, p. 438)
<img src=http://www.bearing.com.cn/direc/myimg/201201126.gif>
Figure 2
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
Flows:
L/C Application (2)
L/C Issue and Transfer (3, 4)
Documents (6, 7, 8)
Funds (9, 10, 11)
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. In my next article we will have a look at each.
| Product Model | Inside Diameter | Outside Diameter | Thickness |
| 292/530E NACHI | 530 | 710 | 109 |
| 294/500E NACHI | 500 | 870 | 224 |