A letter of credit is basically a document issued by a bank guaranteeing a client's ability to pay for goods or services. A bank or finance company issues a letter of credit on behalf of an importer or buyer,
authorizing the exporter or seller to obtain payment within a specified timeframe once the terms and conditions outlined in the letter of credit are met. The letter of credit acts like an insurance contract for both
the buyer and seller and practically eliminates the credit risk for both parties, while at the same time reducing payment delays. A letter of credit provides the exporter or seller with the greatest degree of safety
when extending credit. It is useful when the importer or buyer is not well known and when exchange restrictions exist or are possible.
Benefits of an L/C
How to obtain an L/C
Practical difficulties and how to address them
Types of Letters of Credit
letter of credit allows for amendments, modifications and cancellation of the terms outlined in the letter of credit at any time and without the consent of the exporter or beneficiary. Because this places the
exporter at risk, revocable letters of credit are not generally accepted.
An irrevocable letter of credit requires the consent of the issuing bank, the beneficiary and applicant before
any amendment, modification or cancellation to the original terms can be made. This type of letter of credit is commonly used and preferred by the exporter or beneficiary because payment is always assured, provided
the documents submitted comply with the terms of the letter of credit. Irrevocable letters of credit can be both confirmed and unconfirmed (See below).
An irrevocable letter of credit
may also be transferable. With a transferable letter of credit, the exporter can transfer all or part of his rights to another party. Transferable letters of credit are often used when the exporter is the importer's
agent or a middleman between supplier and importer, and not the actual supplier of merchandise. With a transferable letter of credit, the exporter uses the credit standing of the issuing bank and avoids having to
borrow or use his own funds to buy goods from a supplier. Hence, it is a viable pre-export financing vehicle. Before transfer can be made, the exporter must contact, in writing, the bank handling the disbursement of
funds - the transferring bank. Transferable letters of credit can only be transferred based on the terms and conditions specified in the original credit, with certain exceptions. Therefore, it may be difficult to
achieve flexibility and confidentiality with this finance method.
The transferring bank, whether it has confirmed the letter of credit or not, is only obligated to effect the transfer to the extent and in the
manner expressly specified in the letter of credit. Transferable letters of credit involve specific risks. When a bank opens a transferable letter of credit for a buyer, neither party can be certain of who will be
the ultimate supplier. Both parties must rely upon the importer's assessment of the exporter's reputation and ability to perform. To reduce overall risk and prevent the shipment of substandard goods, an independent
certificate of inspection can be required in the documentation.
For simplicity's sake, many banks prefer single transfer and discourage multiple transfers, but will do multiple transfers if conditions are
right. Partial transfers can also be made to one or several suppliers if the terms of the original letter of credit allow for partial shipments. The processing of this type of letter of credit can become complicated
and tricky, requiring logistics coordination and the highest level of precision. Incomplete and/or ambiguous information on the transferable letter of credit almost always leads to problems. Furthermore, the
beneficiary of the transferable letter of credit must be available throughout the entire negotiation process to assist the transferring bank.
Other forms of irrevocable letters of credits, though not widely used,
are unconfirmed, confirmed and back-to-back.
A confirmed letter of credit is when a second guarantee is added to the document by another bank. The advising bank, the branch or the
correspondent through which the issuing bank routes the letter of credit, adds its undertaking and commitment to pay to the letter of credit. This confirmation means that the seller/beneficiary may also look to the
credit worthiness of the confirming bank for payment assurance.
An unconfirmed letter of credit is when the document bears the guarantee of the issuing bank alone. The advising bank
merely informs the exporter of the terms and conditions of the letter of credit, without adding its obligation to pay. The exporter assumes the payment risk of the issuing bank, which is typically located in a
Back-to-Back Letters of Credit
Back-to-back letters of credit are two individual letters of credit that together offer an alternative to a transferable letter of credit. The
back-to-back letter of credit allows exporters (sellers or middlemen) who do not qualify for unsecured bank credit to use a letter of credit as security for a second letter of credit in favor of a supplier. In other
words, if a foreign buyer will issue a letter of credit to an exporter, certain banks and trade finance companies will issue independent letters of credit to the exporter's suppliers so that the required goods can
be purchased. Even if the initial letter of credit is not successfully completed, the second remains valid, and the issuing bank is obligated to pay under its terms.
Although back-to-back letters of credit
provide small and medium exporters virtually unlimited working capital to finance their sales and complete more export transactions, many banks are reluctant to take on this type of arrangement. Because back-to-back
letters of credit involve two separate transactions, it is likely that several participating banks will be involved and the risk of confusion and dispute is high. To protect itself, a bank generally will require
that the exporter present all relevant documents that are part of the first letter of credit before issuing the second letter of credit. The second document is worded to conform precisely to the original and dated
to expire at some date prior to the first, ensuring that the seller has sufficient time to present documents within the time limits of the first.
Standby Letter of Credit
Unlike a commercial letter
of credit, which is basically a payment mechanism, a standby letter of credit is a form of a bank guarantee. It may be used as necessary to cover nonpayment of a financial obligation. A standby letter of credit
normally is intended to be drawn on only in the event of nonpayment. The standby letter of credit is issued by the bank and held by the seller, who in turn provides the customer open account terms. If payment is
made according to the seller's terms, the letter of credit is never drawn on. However, if the customer is unable to pay, the seller presents a draft, and all other documents as required, to the bank for payment. The
standby letter of credit typically expires within 12 months.
Cash Advance Against Letter of Credit
A cash advance against a letter of credit works like back-to-back letters of credit, with the
exception that the bank or financing company will issue cash to the suppliers instead of another letter of credit.