Do Letters of Credit Work?

At a recent exporter’s breakfast hosted by a well known UK bank which promoted the use of letters of credit, a disgruntled manufacturer raised his hand during the question and answer session and made some very sweeping statements including:

“Letters of credit just don’t work, they are a waste of time, you just don’t get paid!”

Having tracked the individual down, soon after his outburst, and asked for some more details about the underlying transaction and terms of the letter/s of credit in question, the picture became clearer.

The manufacturer was representing a small – medium sized business, without significant experience in exporting, but in a particular case had been successful in winning a (for them) large contract to supply a piece of machinery to a buyer in China. The exporter negotiated payment terms with some funds paid with order, and the balance to be paid against the support of a letter of credit issued by the buyer’s bank in China. In essence a reasonable set of payment terms, albeit the letter of credit was unconfirmed by the advising bank in the UK, but this is common practice for Chinese banks to be reluctant to ask UK correspondent banks to add confirmation.

However, the real issue for the UK manufacturer was that the terms and conditions of the letter of credit were not agreed upon or considered from a workability perspective. It is not uncommon to encounter this, as so many exporters fail to proactively ask their buyer to ask the issuing bank to initiate a letter of credit in a particular way and even worse, fail to understand the implications of a poorly (and in some cases unworkable) constructed letter of credit.

A simple template can be downloaded here which will provide a robust guide for exporters to use when they ask for letters of credit during negotiations with their overseas buyers.

In this particular instance, the letter of credit received by the UK manufacturer required (amongst a number of other documents) the presentation of a certificate issued by the applicant (buyer), confirming that the machine had been received, installed and was in working order. There was a further stipulation that this certificate had to be signed by a specifically named member of staff in the applicant’s company.

International Standard Banking Practice, International Chamber of Commerce publication No. 745, is an essential guide, primarily intended for documentary credit practitioners, providing sensible and informed opinion on the interpretation of the rules governing documentary letters of credit – UCP 600.

There is a paragraph in the preliminary considerations section at the beginning of this guide, which is very relevant to this particular issue . It states –

“A credit or any amendment thereto should not require presentation of a document that is to be issued, signed or countersigned by the applicant. If, nevertheless, a credit or amendment is issued including such a requirement, the beneficiary should consider the appropriateness of such a requirement and determine its ability to comply with it, or seek a suitable amendment”.

It is important that all parties to a letter of credit are comfortable with the terms and conditions, as the terms must reflect those in the commercial contract/agreement which underpins the trade transaction.

Whilst, it is unfortunately not uncommon to see conditions similar to the one mentioned above, in letters of credit received by exporting companies, it is best practice to seek an amendment, better still to view a draft copy of the letter of credit and suggest deleting these types of clauses before issuance has occurred.

In simple terms, the beneficiary of a letter of credit, should be in a position to present a set of complying documents to the negotiating bank, without any documentary input from the applicant. Clearly, if such a requirement is agreed between the applicant and the beneficiary, it provides the perfect opportunity for an unscrupulous buyer to refuse to provide the necessary document/s to the beneficiary, which will result in an incomplete and therefore discrepant documentary presentation, and in a worst case scenario, a bad debt.

Check out our LETTER OF CREDIT TRAINING COURSES

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2017-03-19T09:07:58+00:00 March 3rd, 2016|