LETTERS OF CREDIT – the basics

LETTERS OF CREDIT – the basics

In this article, we take look at what a letter of credit (also known as “documentary credit”) is, what its main function is and what you, as an exporter or importer, should primarily focus on.

MWA THEMES #2 LETTERS OF CREDIT – the basics

MWA Themes are short articles on various topics with a focus on what is most important for you as an exporter or importer. This doesn’t mean that other factors are not important. There are several “product-technical” features to deal with, just as there will specific considerations in relation to the commercial contract.

In this article, we take look at what a letter of credit (also known as “documentary credit”) is, what its main function is and what you, as an exporter or importer, should primarily focus on.

Letters of credit are widely used in international trade with the primary purpose of providing the seller security for payment, and, at the same time, giving the buyer assurance that payment will not be released until the agreed documents have been received (e.g. bill of lading and other shipping documents, or other documents as per the underlying commercial contract).

Hence, a letter of credit primarily serve as a guarantee for payment to the seller against presentation of prescribed documents within a given time limit.

In addition, the letter of credit is used to settle the actual payment, and it can also be the basis for financing as agreed between the banks involved.

Letters of credit are issued by banks, and it is the buyer’s bank who issues the letter of credit at the request of the buyer and in accordance with the buyer’s instructions. Before the buyer request the bank to issue a letter of credit, it is therefore important that buyer and seller are in agreement on what the letter of credit should look like – both in terms of content (document requirements and deadlines, etc.) and the “letter of credit technical” details. Otherwise you risk having to waste time and effort on getting the letter of credit amended after it has been issued – an exercise that often proves to be quite challenging as by nature the buyer and the seller will have certain conflicting preferences…

When a letter of credit is issued, it is advised to the seller via a bank nominated by the seller (“advising bank”). Advising bank can potentially confirm the letter of credit – i.e. assume an obligation to pay the seller in case the issuing bank does not pay when the seller presents correct documents within the deadline.

Letters of credit are subject to a relatively well-functioning international set of rules, “Uniform Customs & Practice for Documentary Credits”, which is established by the International Chamber of Commerce (ICC). Within this framework, however, a letter of credit can be drafted and issued in many different ways, each of which has an impact on the buyer’s and seller’s risk position.

As a seller, it is important to ensure i.a.

  • that the credit risk of the issuing bank is acceptable, or
  • that the letter of credit has been confirmed by an acceptable bank (e.g. your house bank)
  • that that you have full control over being able to present prescribed documents within the deadline
  • that the bank you have nominated has the mandate to examine and approve documents
  • that in the event of presentation of correct documents within the deadline, there are no other reservations of any kind from the issuing and / or confirming bank

As a buyer, it is important to ensure i.a.

  • that the document requirements are adequate in relation to what has been agreed and what the documents are subsequently to be used for (e.g. inspection and release of goods, issuing of bonds, etc.)
  • that the issuing bank has the mandate to examine and approve (or reject) documents

As can be seen, there are conflicting recommendations – for example it is not possible for two different banks to have the mandate to examine and approve documents in relation to the seller (but in case the mandate is held by the bank nominated by the seller, then it will of course be liable to the issuing bank if it has approved non-compliant documents and / or documents that were not presented within the deadline).

The same challenge – i.e. that a letter of credit cannot fully accommodate all the buyers and the sellers preferences at the same time – applies to a number of the “letter of credit technical” conditions, and also – and not least – in relation to what has been agreed in the underlying contract with regard to which documents the seller must present in order to obtain payment.

In addition to the mentioned important points, there is a number of other factors having an impact on your position as buyer and seller respectively, and which you should therefore also focus on – be it “letter of credit technical” matters, or matters related to the underlying contract.

And finally we have the costs. Normally – but not necessarily – issuing commission is paid by the buyer, while advising- and document commission is paid by the seller. Other costs such as confirmation fee, acceptance fee and reimbursement fee, are shared as agreed. And it does matter how cost is distributed – the confirmation fee in particular can add up to an amount which is not insignificant…

Letters of credit are well suited for settling international trade – especially in emerging markets and/or where there is some uncertainty in the relationship between the buyer and the seller.

But as ca be seen above, there are plenty of issues to deal with when it comes to reaching agreement between buyer and seller (and the banks) on how a letter of credit should be drafted and issued – and who should pay for what. There is a good basis for some arm-wrestling, and like in other situations it is of course a matter of trying to get the “upper hand”….

This article points out some of the important general considerations one should make. But as you know, the devil is in the details, so it might be a good idea to have professionals involved – preferably with insight from both the banking and corporate side. At MWA Trade Finance we “coincidentally” have experience from both sides of the table – so don’t hesitate to contact us for a closer look at specific contracts and transactions, etc. 🙂

Feel free to ask questions or comment on the article – see the box further down the page.

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