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Letter of Credit - Beware of potential traps in L/C payment

Date: November 25, 2010 Author: Dr. Amit K Chatterjee

Letter of credit (L/c) is a widely accepted and commonly used payment method in international trade. They are usually issued by larger banks and contain a promise to pay a seller (beneficiary) upon receipt of goods by a buyer if certain conditions outlined in the letter have been met.

There are three general principles governing the use of letters of credit:
  1. The banks' responsibility to deal in documents only;

  2. the rule of strict construction, which dictates that the terms and conditions of the letter of credit are to strictly adhered to; and

  3. the rule of independence, which mandates that the letter of credit is to be considered independent from the sales contract or any other agreement between the parties.

Put simply, the Issuing bank has two main roles:
  1. To give a binding undertaking to the seller that if compliant documents are presented, the bank will pay the seller the amount due. This offers security to the seller

  2. To examine the documents, and only pay if these comply with the terms and conditions set out in the letter of credit. This protects the buyer's interests

Note that the letter of credit refers to documents representing the goods - not the goods themselves! Banks are not in the business of examining goods on behalf of their customers. Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill, an insurance document; but there are many others.

How secure is the L/c payment method ? Although an L/c is considered one of the most secure means of payment, exporters should understand that they can never totally control the payment process. Documents which are required to be presented under an L/c are frequently prepared by other people, and may not meet the strict compliance standards required by the banking community for payment. Sometimes banks which have not properly ensured their own reimbursement by customer (the buyer), apply very narrowly L/c principles to deny payment. Such denials have regularly been upheld by courts on grounds that the seller has not strictly complied with the terms of the L/c.

How to Secure your Payment ?

Like most other things in life -prudence, knowledge and certain precautions can greatly reduce your risk. Following are certain steps that an exporter can take to maximize his control of the L/c process

Knowledge is Power

The rules governing L/c are codified in a publication sponsored by the International Chamber of Commerce ("ICC"), known as the Uniform Customs and Practice for Documentary Credits. Professionals advising exporters should have a good understanding of the UCP 500. The rules in the UCP 500 are drafted by and for the banking community. One of the major purposes is to protect the banks from liability in L/c transactions. The banks are providing a service - the financing of the transaction - and they expect to be protected from getting involved in disputes between the parties as to the terms of the contract of sale. For this reason "the independence principle" is a very important concept in LC transactions. This means that the LC, and the documents required under the LC for payment, are completely independent from the underlying transaction between buyer and seller.

The bank is not concerned if the contract between buyer and seller is being performed according to its terms. The bank's only concern is whether the documents presented by the seller conform to the documents required under the LC, and whether the documents are presented within the required time periods. The bank employees who examine documents presented under the L/c are essentially clerks. Their job is not to make judgment calls, but simply to see if the documents presented by the seller/ beneficiary comply strictly with the documents required by the LC. It is therefore very important to understand the rules as a lack of knowledge may invite disaster.

Your choice of Issuing Bank

One way of securing some control on payment process is to choose a bank you know or familiar with. This implies that during negotiating seller should try to get the buyer to use a bank of the seller's choice to issue the L/c. The seller should find out from his/her own bank, preferably a bank with a substantial international presence, what corresponding bank it uses in the country of the buyer. If the buyer can have the L/c issued by that correspondent bank, the process can proceed more expeditiously. At the very least, the seller should insist that the buyer use a bank that is well-known and highly regarded by the banking community. The seller's own bank can provide information on the financial status and reputation of the foreign bank. Since a major purpose served by an L/c is that the issuing bank assumes the risk of the buyer's insolvency, if the bank itself is financially weak, the L/c may not serve its purpose.

When in doubt - Get Confirmation

If the seller is not comfortable with the bank of the buyer's choice, the L/c should be confirmed by a prime world bank. When a prime bank confirms an L/c issued by a foreign bank, it takes upon itself the payment obligation. There is a charge for confirmation, which varies directly on perceived risk the prime bank believes it is taking in confirming the L/c. The question of who pays the prime bank's confirmation charges is negotiable, but if not negotiated in advance the bank may charge the beneficiary.

Simple Documentation

The seller should ensure during negotiation that as few documents as possible are submitted to bank, that documents should have simple description and all documents called for by the L/c can in fact be produced. Seller should avoid dependence on unknown or unreliable parties (e..g. if bank documents include a certificate from the government of buyer's country or a signature from someone under buyer's control - complications may arise).

Accuracy of Wording

Accuracy of wording in respect of all documents to be submitted in bank is vital. For example, almost all L/c's require production of a commercial invoice and a transport bill of lading. The invoice must state the description of goods in the same way as in L/c. If the goods are not described in exactly the same way, the seller may not be paid even though Bill of Lading may have correct wording.

Be sure what you are doing

If seller realizes there is a mistake or a problem with the documents to be submitted in bank, the goods should not be shipped until the L/c is amended. The UCP 500 makes clear that no amendment can take place unless the issuing bank, the confirming bank, if any, and the seller, agree to it. Unless the seller has written confirmation from the bank that the amendment to the L/c has been issued, and the confirming bank has accepted the amendment, he bears the risk of not being paid.

A stitch in time...

A prudent seller should not let buyer take possession of goods until he has been paid under the L/c. The reason is obvious - if there are discrepancies in the documents preventing payment of the L/c, a buyer in possession of the goods has much less incentive to waive discrepancies so the seller can be paid. If the seller is not paid by the bank, the buyer still has a contractual obligation to pay for goods, but the difficulty of collection can make the price drop substantially, even assuming the buyer is solvent and can pay something. Particularly when the goods have been shipped to a foreign country, the payment collection can be quite costly. The buyer, knowing this, may attempt to negotiate a lower price (that is if he pays at all).

To keep goods out of the buyer's possession till payment is settled, the seller should have the bill of lading consigned to order of the bank. Since the bill of lading is a title document, a consignment to order of the bank gives the bank title to the goods until they have been paid for by the buyer. Assuming proper payment, the bank transfers title to the buyer, who can then take the bill of lading and collect the goods. If buyer does not pay, the bank has an obligation to hold the documents for the seller, or return them to the seller if instructed to do so by the seller. The buyer should not be able to get the goods without the title document.

Look Before you Leap...

The buyer may ask seller to have the bill of lading made out to order and blank endorsed, and to send one or more sets to the buyer within a few days of shipping the goods. This is like writing a blank check. It enables the buyer to pick up the goods, and thereby provides him with a disincentive to waive any discrepancies in documents the seller presents to the bank. Given the high failure rate of initial presentations of documents under an L/c, a seller needs to know he will have the buyer's cooperation in correcting discrepancies or in waiving them. The buyer's cooperation will be more forthcoming if he cannot get possession of the goods until any problems with discrepancies have been resolved.

Know Your Deadline, for your sake...

Every L/c has three vital dates: the date by which goods must be shipped, the date by which documents must be presented, and the expiry date for the L/c. A seller should make sure that each of these dates can be met, and should allow a large margin for error. After the L/c has been issued, if the seller learns that the date for shipping goods cannot be met, he should not ship any goods until he obtains an amendment to the L/c permitting later shipment.

If an L/c which calls for transport documents does not contain a date by which documents must be presented, does this mean the seller can wait until the expiry date to present his documents? Not if he wants to be paid. Article 43 of the UCP 500 provides that if no time period after shipment is given in the Credit for presentation of documents, banks will not accept documents presented to them later than 21 days after shipment. An exporter unfamiliar with the 21 day rule of the UCP 500 could easily miss this deadline.

The exporter should make sure that the expiry date of the L/c permits sufficient time to permit correction, if possible, of any mistakes in the documents. Under the UCP 500, once the documents are presented, the bank has a maximum of seven days to let the beneficiary know if there are any discrepancies. If discrepancies can be corrected, they must be corrected and the documents resubmitted before the expiry date of the L/c. Thus the exporter should make sure that the expiry date allows enough time for errors to be rectified.

Finally - A Quick Checklist
Always make following checks with your L/c:

  • Did you receive the letter of credit directly from a bank? If your answer is "No" - do not proceed any further as the letter of credit has not been authenticated and may be fraudulent.
  • Is the letter of credit irrevocable? If your answer is "No", do not proceed any further as a revocable letter of credit can be "revoked" by the buyer without your consent.
  • Has the latest shipment date passed? If your answer is yes, the letter of credit must be amended to extend the latest shipment date.
  • Is the letter of credit : Confirmed by a U.S. or prime world bank ? Please see above for correct procedure
  • Is the amount on the credit correct?
  • Is the beneficiary's name and address correct?
  • Is the buyer's name and address correct?
  • Is the merchandise description correct and consistent with other documents? .
  • Do any of the documents in the credit need to be legalized?
  • Which documents are required in the Letter of Credit:
    • Commercial Invoice
    • Packing List
    • Insurance Certificate
    • Ocean Bill of Lading
    • Air Waybill
    • Other

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Blog Categories : Misc. Business / Financial Services
Financial Services / Banking / Insurance

Blog Sector : Foreign Trade

vincent gomez says :             on : 11-01-12
You have a vast informative site, but one cannot access to clearify any difficulty one is facing, hence this site is like a TV screen wherein one can see only and cannot do anything to resolve once difficulty on the screen, hence a feedback should be provided in the page, which can be accessed by any member of this site.

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