Letters of Credit demystified

Published: 03rd March 2010
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Although the idea of a letter of credit is simple, the paperwork is challenging. The idea is that the seller will receive payment when he presents certain documents at his bank even before the merchandise has reached the buyer. These "certain documents" typically include commercial invoice, packing slip, bill of lading and insurance documents. That simple idea is called "letter of credit".

How does a letter of credit come into force ? The buyer (aka "Applicant") goes to his bank ("Issuing Bank") and instructs it to pay the seller ("Beneficiary") once the seller presents the documents. The Issuing Bank normally asks a secondary bank in the country of the beneficiary to aid in the transaction by e.g. advising the beneficiary that the LC has been opened, by accepting the documents, and or by paying the beneficiary.

The payment of the bank however is independent of the underlying sales transaction . In other words, the seller will be paid, even though the goods shipped are not of the quality and quantity agreed upon. So, even if the goods shipped constitute a breach of contract, the bank will pay . This means that the documents to be presented need to be negotiated with great care. The bank's view is that it does not know anything about business (an attitude that the taxpayers of all countries have verified through a multi billion dollar bailout). Since it does not know anything about the business of the buyer and seller, the bank will pedantically examine the documents presented by the seller (aka the beneficiary) against the requirement of the letter of credit and will refuse payment when it finds the most minute deviation.

Why is the paperwork challenging ? Because your bank will refuse to pay you if the documents presented, deviate from their description in the letter of credit. Even the lack or the addition of a comma can lead the bank to refuse payment.

Letter of credit transactions are mass market transactions, however, they are not easy. Here are some pointers, how to start:

Ask your local bank. Medium-sized U.S. banks in recent years have tried to get into the LC business. They can be more responsive, particularly for an existing customer.

Also check out Wells Fargo or CapitalOne who have been trading in LCs for quite some time. Smaller banks located at international trading cernters ( New York, Los Angeles) also might be able to advise you.

Use a courier to get your documents to your bank. (That is self understood. If your documents are lost, you will have difficulties getting paid for your shipment. )

There are a couple of companies selling letter of credit software. I have seen some of them and advise against their use. Once you are proficient with the paperwork they will help you, but the software is not going to make your first entry into the LC arena easier.

There are companies who will for a small fee (around 400 USD) prepare your paperwork. These people are doing all day nothing else but preparing documents. They are better than you will ever be (OK, you will be as proficient as they are after a couple of years).

One of the websites I have found helpful is mentioned below, since you can ask your questions there and experts from many banks, importers and exporters will discuss your questions and help you out.

Letter of creditforum

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